Heritage Global Inc. (HGBL) Earnings Call Transcript & Summary

Good afternoon, ladies and gentlemen, and welcome to the Heritage Global Inc. Third Quarter 2020 Earnings Conference Call. [Operator Instructions] As a reminder, this call may be recorded. I would now like to turn the conference over to Michael Kim, Investor Relations. Please go ahead, Michael?

Thank you, and good afternoon, everyone. Before we begin, I'd like to remind everyone that this conference call contains forward-looking statements based on our current expectations and projections about future events and are subject to change based on various important factors. In light of these risks, uncertainties and assumptions, you should not place undue reliance on these forward-looking statements, which speak only as of the last -- as of the date of this release. For more details on factors that could affect these expectations, please see our filings with the Securities and Exchange Commission. Now I'd like to turn the call over to Heritage Global's Chief Executive Officer, Mr. Ross Dove. Ross?

Thanks, Michael, and good afternoon, everyone. Welcome to Heritage Global's First earnings conference call. As you may know, we recently uplisted our shares to the Nasdaq stock market and successfully completed a public offering of our common stock, which I'll discuss in more detail a bit later. So as part of our effort to enhance Investor Relations, we wanted to provide the investment community with a forum to discuss quarterly results as well as review why we believe the company is positioned to increasingly leverage our differentiated, diversified business model. Heritage Global is an asset liquidation services company, specializing in financial and industrial asset transactions. We provide auctions, brokered asset sales, principal market making, secured lending and asset advisory services to a diversified clientele base across sectors and geographies. Turning to our performance for the third quarter, we reported strong results, highlighted by net income of $1.3 million, consistent with the third quarter of 2019 and adjusted EBITDA of $1.8 million, equating to a 28% growth over the third quarter of 2019. Focusing on industrial assets, Heritage Global advises enterprise and financial customers on the sale via auctions of industrial assets, mostly from surplus and sometimes distressed circumstances while acting in a range of roles, including as an agent, a guarantor or principal. During the quarter, we continued to capitalize on rising demand for the e-commerce of used surplus equipment as companies increasingly look to source more affordable machinery. As a result, we benefited from strong growth in online auction volumes and related revenue. In addition, auctions represent a key source of market intelligence for our valuation business, which provides industrial and wholesale inventory and equipment valuations to assist financial decisions in making lending decisions. Turning to financial assets. We have 2 powerful reasons for our optimism. First, we believe Heritage National Loan Exchange, or as we call it NLEX, is poised to benefit from accelerating volumes as nonperforming loans increasingly come to market. Remember, NLEX provides liquidity to issuers of consumer debt that are looking to monetize charged-off loans, which creditors have written off as uncollectible. Second, Heritage Global Capital continues to ramp up its business of providing specialty financing solutions for businesses small and medium-sized investors in charged-off and nonperforming asset portfolios. We're currently excited about deploying a portion of the capital we raised from our recent equity offering to fund secured loans to financial debt buyers. That capital is expected to generate attractive returns with upfront fees, interest income, ongoing fees and back-end participation. Looking ahead, we remain focused on driving sustainable growth by increasing, capitalizing on several powerful drivers. First, a more challenging economic backdrop typically drives increased supply of surplus and distressed assets and rising demand for liquidation services via brokered asset sales, which bodes well for auction volumes. Related to that ongoing social distancing as a result of COVID-19 pandemic, enhances the relative attractiveness of Heritage Global's online auction model. Second, we believe rising charged-off consumer loan sales, as indicated by banks significantly increasing their loan loss reserves will drive expanding volumes and commissions for NLEX, particularly given the continued growth of digital and other nonbank lending platforms. Third, with conventional lenders continuing to tighten underwriting standards to manage credit losses through the cycle, we believe Heritage Global Capital remains well positioned to capitalize on rising demand for capital by debt buyers. Fourth, the additional working capital from our recent stock offering enables us to accelerate a mix shift toward higher contribution principal deals in our industrial asset business as well as to support increased lending volumes in our financial assets business. Finally, we believe we remain poised to take advantage of consolidation opportunities across the highly fragmented markets with deep domain expertise though potential transactions must meet our rigorous strategic and financial criteria. With that, I'll now pass it over to our Chief Financial Officer, Scott West, for a deeper dive into our financials. Thank you.

Thanks, Ross. For the third quarter of 2020, total revenue increased 14% year-over-year to $7.6 million, reflecting strong growth in services revenue, which were up 16% as well as higher asset sales. Importantly, we maintained multiple revenue streams across businesses, including brokered asset sales, principal auctions, sales commissions and advisory and secured lending fees on top of recurring forward flow contracts with industry-leading customers, reinforcing the sustainability of our top line growth. Gross profit, or total revenue less cost of services revenue and asset sales, totaled $5 million for the third quarter of 2020 compared to $5.3 million in the prior year quarter. With a modest decline, mostly a function of timing and activity of asset liquidation transactions as well as a mix shift between financial assets and industrial assets. Operating income grew 27% to $1.6 million compared to $1.3 million for the third quarter of 2019. The lower selling, general and administrative expenses, mostly due to the discontinuation of the equity partners at the end of last year was partially offset by slightly lower gross profit and higher compensation expense related to improved financial performance by the industrial assets division and additional headcount to underpin growth primarily at Heritage Global Capital. From a margin perspective, we believe that tailwinds going forward will include a favorable mix shift toward higher contribution businesses and fee structures as well as rising operating leverage, as economies of scale increasingly build within businesses and across platforms. We remain focused on managing expenses, both at the corporate level and across business units. And increasingly, leveraging synergies across processes and systems to drive further operational efficiencies. And as mentioned earlier, net income totaled $1.3 million or $0.04 per share for the third quarter of 2020, and adjusted EBITDA was up 28% year-over-year to $1.8 million from $1.4 million in the prior year quarter, reinforcing the building earnings power of our model. Net income and EPS were essentially flat year-over-year, reflecting lower tax expense for the year ago quarter with pretax income up 28%. At September 30, 2020, the company had aggregate tax net operating loss carryforwards of approximately $82 million, including $62 million of unrestricted net operating tax losses and approximately $21 million of restricted net operating tax losses. Substantially all of the net operating loss carryforwards expire between 2024 and 2037. Stepping back, increased principal versus agency revenue, more predictable event in transaction flow and rising contribution from our specialty lending division all bode well for a smoother forward trajectory for revenue and earnings, thereby driving improving EPS visibility and growth over time. Finally, turning to our financial position. The company maintains a strong and growing balance sheet with stockholders' equity of $16 million as of September 30, 2020, up 35% from the end of 2019. And net cash of $5.7 million. Importantly, our $5 million credit facility remains untapped and we raised $8.7 million of net proceeds from the company's common stock offering that closed on October 6, 2020. With that, we'll open up the call for questions. Operator?

[Operator Instructions] The first question comes from Mark Argento from Lake Street Capital Markets.

Ross, Scott, congrats on a solid quarter. Just wanted to dig in a little bit kind of in the environment we have right now. It's kind of a unique environment. You've got parts of the economy doing really well, starting to see maybe a little distress on the consumer credit side. Can you maybe just talk us through some of the things that you guys are focused on in terms of identifying opportunities and then in particular, on the financial asset side, is there a backlog there building in terms of assets that some of these institutions need to get out of their books?

So I'll take it from here, and Scott can add on. This is Ross. And great to hear from you, Mark. So really, what you're looking at right now is what I would call a pent-up demand by the buyers of nonperforming loans. They've all raised a lot of capital, and they all look to borrow a lot of capital in this marketplace where it's available from people like us. But at the same time, there has not been enough product released yet. So they're looking at the loan loss reserves from the nation's lenders. They're looking at increased fintech assets that they think are going to become available very soon. There is obviously the new category, the buy now pay later assets that are about to come on market, too. So there's a general enthusiasm that there's going to be a lot of product. But I would say, honestly, that, that product, we're probably looking at not hitting until next year. We think with the election just finishing and everybody is still kind of being careful that you're really looking at a next year and the year after increase.

Yes. I agree with that, Ross. It's kind of like the floods, the rains are pouring. The water is building up behind the dam. We know the volume is increasing, but we just haven't seen as much as we expect to see in the coming quarters and years.

So on the flip side, Mark, in our industrial assets group, we've seen record attendance at our auctions and record pricing. Right now, the supply chain on new equipment has slowed down. The ingress and egress globally hasn't been what it was before at COVID. And even at this current point in time, used assets are bringing a premium in most of the sectors we're in and demand is very high because you're able to get those assets and purchase them real time. So we expect that to continue over the next year, and that we'll continue getting record crowds in very high prices on used equipment.

And that pharma has been -- yes. No, that's super helpful. And then I know pharma is an area that you guys have built kind of an expertise from continued M&A activity in that space. You guys seeing continued activity there. Is that going to be a focus for you guys going forward?

Yes. I mean, if you look right now, we have 3 assets currently on the book for Pfizer. Everybody who read world-class great announcement today that we're moving towards a vaccine, we think that not only bodes well for the world but we think is going to free up a lot of redundant assets as pharma companies across the world retool and as the governments put leverage on all of them to cooperate in rolling out these vaccines. You're going to see a strong purchase of new equipment, and you're going to see a lot of secondary equipment get to the marketplace, which is much needed by the smaller companies now. So we think it bodes well not just for the country, but we think it bodes well for the people that can take advantage of used equipment, increasing in volume.

That's great. And then just, Scott, just turning into the P&L here. It looks like you guys have some pretty nice leverage in the model here as incremental revenues kind of build. Maybe talk to you a little bit about how you think about how this model scales and in particular, kind of thinking about it in terms of incremental margin?

Sure. Yes, happy to, Mark. So as a services based business, our primary operating costs are our people costs. And -- and so in terms of the fixed costs, in addition to the people cost, we have some rents and things like that. But our overall fixed operating costs are about $10 million a year. And so that's about $2.5 million per quarter. And as you know, we were broken out into two divisions of industrial assets and financial assets. On the financial assets side, for every $1 of incremental revenue once we've covered our fixed operating costs, then that drops about $0.75 to the, to the bottom line. And then on the industrial assets side, the -- for every incremental dollar of revenue, it drops about $0.40 to $0.45 to the bottom line. So the model is very scalable.

Yes. I was going to say hopefully put that NOL to use and yield some good earnings here. It looks like you got some nice margin or nice incremental margins there. And then just one -- last one for me, maybe for Ross. In terms of M&A opportunities, what's the high level criteria that you guys are really focused on there?

So when we look hard at M&A right now in what I would call a very transitionary marketplace where there's really 2 different segments. In both segments, M&A would be what I would call probably more of a niche play of a bolt-on of a specialty entity. On the industrial asset side, it could be somebody with expertise in global arbitrage of medical equipment, it could be somebody that has a special understanding of hospitality equipment as the world changes. So they would be bolt on. And on the financial assets side, we think that there's just a ton of room for de novo organic growth and that the current plan is to go greenfield. So the capital we raised primarily wasn't raised as M&A capital, the capital we raised really primarily organic growth capital. We always have our eyes open, Mark, but it's not on our current plan. It's not at the forefront.

The next question comes from Michael Diana from Maxim Group.

I think the call is a really good idea for you to tell your story in your own voice. In Scott's remarks, he mentioned a favorable mix shift. And I think when you -- when he was just talking about the scalability of the financial side versus the industrial side, maybe he partly answered that question. But could one or both of you talk about the favorable mix shift, possible favorable mix shift?

The thing that really we're most excited about is that we built this business so that we didn't need both businesses to do great at the same time. There were different times in different financial marketplaces where there's a lot of nonperforming loans, but there's a tightness in the amount of surplus industrial asset available and vice versa. So the good news is right now, we see tailwinds for very logical reasons in both businesses at once. And when both businesses at once synergistically are growing, it puts us in the best spot we could be in. Why is that happening? It's happening because there's a pent-up demand of nonperforming loans, and it's very unlikely that nonperforming loans magically become performing loans. So generally speaking, once they're not performing, whether they're getting sold now or getting sold in the future, the supply is growing. And simultaneous to that, there's a growth in the supply of industrial assets coming on the market that has nothing really to do with COVID. COVID created a huge buyer demand but the seller demand is because there's now going to be lots of technological advances as we move forward that are creating excess surplus assets. So there is -- the favorable mix shift is really the fact that -- what Scott is looking at is we believe we can get a higher contribution with the capital we raised, meaning we can act more as a principal. Or generally speaking, when we're a principal and a guarantor on the industrial asset side, there's greater margin than just fee-based. And we have more free capital there and simultaneously with us growing our capital and growing our credit lines on the financial asset side going to be able to put our capital to work, not just as an adviser, but as a principal lender. And taking that mix to where we can actually have a lot more capital out producing a lot more revenue, simultaneous to the growth in our fee basis. It bodes well, we believe, for the next 18 to 36 months. Scott?

Yes. Thank you, Ross. And Mike, yes, with the generation of good profits, good cash flows, good EBITDA. What that does is it creates more opportunities for us. As you know, we have on the industrial auction side, the various options of a fee-based auction, commission-based auction or a guarantee or a principal transaction. And on the principal transaction and on the guarantees, our margins tend to be a lot higher. And having all this excess cash does give us a lot more opportunities to take advantage of these guarantee and principal auction options.

Fair enough, Michael? And when Scott says it's excess cash, it's my job as the CEO to make sure it doesn't stay excess and make sure we deploy it.

All right. I like the 36-month part you mentioned. The longer the better.

Especially for a young guy like me.

The next question comes from John Fichthorn from Dialectic Capital.