Heritage Global Inc. - Quarter Report: 2017 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2017

OR

For the transition period from       to

Commission file number: 0-17973

Heritage Global Inc.

(Exact name of registrant as specified in its charter)

12625 High Bluff Drive, Suite 305, San Diego, CA 92130

(Address of Principal Executive Offices)

(858) 847-0656
(Registrant’s Telephone Number)

N/A

(Registrant’s Former Name)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.     ☐    

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

As of November 6, 2017, there were 28,480,148 shares of common stock, $0.01 par value, outstanding.

TABLE OF CONTENTS

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PART I – FINANCIAL INFORMATION

Item 1 – Financial Statements.

HERITAGE GLOBAL INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands of US dollars, except share and per share amounts)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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HERITAGE GLOBAL INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

AND COMPREHENSIVE INCOME

(In thousands of US dollars, except share and per share amounts)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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HERITAGE GLOBAL INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

(In thousands of US dollars, except share amounts)
(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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HERITAGE GLOBAL INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands of US dollars)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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HERITAGE GLOBAL INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Note 1 –Basis of Presentation

These unaudited condensed consolidated interim financial statements include the accounts of Heritage Global Inc. (“HGI”) together with its subsidiaries, including Heritage Global Partners, Inc. (“HGP”), Heritage Global LLC (“HG LLC”), Equity Partners HG LLC (“Equity Partners”) and National Loan Exchange, Inc. (“NLEX”). These entities, collectively, are referred to as the “Company” in these financial statements. The Company’s unaudited condensed consolidated interim financial statements were prepared in conformity with generally accepted accounting principles in the United States of America (“GAAP”), as outlined in the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”), and include the assets, liabilities, revenues, and expenses of all subsidiaries over which HGI exercises control. All significant intercompany accounts and transactions have been eliminated upon consolidation. The Company’s sole operating segment is its asset liquidation business.  The Company provides an array of value-added capital and financial asset solutions:  auction and appraisal services, traditional asset disposition sales, and financial solutions for businesses and properties in transition.  

The Company has prepared the condensed consolidated interim financial statements included herein pursuant to the rules and regulations of the United States Securities and Exchange Commission (the “SEC”). In the opinion of management, these financial statements reflect all adjustments that are necessary to present fairly the results for the interim periods included herein. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations; however, the Company believes that the disclosures are appropriate. These unaudited condensed consolidated interim financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2016, filed with the SEC on March 7, 2017.

The results of operations for the three and nine month periods ended September 30, 2017 are not necessarily indicative of those operating results to be expected for any subsequent interim period or for the entire year ending December 31, 2017. The accompanying condensed consolidated balance sheet at December 31, 2016 has been derived from the audited consolidated balance sheet at December 31, 2016, contained in the above referenced Form 10-K.  

Note 2 – Summary of Significant Accounting Policies

Use of Estimates

The preparation of the Company’s consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Management bases its estimates and judgments on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results could differ from those estimates.

Significant estimates include the assessment of collectability of revenue recognized, and the valuation of accounts receivable, inventory, other assets, goodwill and intangible assets, liabilities, contingent consideration, deferred income tax assets and liabilities, and stock-based compensation. These estimates have the potential to significantly impact the Company’s consolidated financial statements, either because of the significance of the financial statement item to which they relate, or because they require judgment and estimation due to the uncertainty involved in measuring, at a specific point in time, events that are continuous in nature.

Foreign Currency

The functional currency of foreign operations is deemed to be the local country’s currency.  Assets and liabilities of operations outside of the United States are generally translated into U.S. dollars, and the effects of foreign currency translation adjustments are included as a component of accumulated other comprehensive income.

Reclassifications

Certain prior year balances within the condensed consolidated financial statements have been reclassified to conform to the current year presentation.

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The critical accounting policies used in the preparation of the Company’s audited consolidated financial statements are discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016. There have been no changes to these policies in the nine months ended September 30, 2017.

Recent Accounting Pronouncements

In 2016, the FASB issued Accounting Standards update (“ASU”) 2016-07, Investments – Equity Method and Joint Ventures (“ASU 2016-07”), which simplifies the transition to the equity method of accounting by, among other things, eliminating retroactive adjustments to the investments as a result of an increase in the level of ownership interest or degree of influence.  ASU 2016-07 became effective January 1, 2017 and did not have a material impact on the Company’s consolidated financial statements.  

In 2016, the FASB issued ASU 2016-09, Compensation – Stock Compensation (“ASU 2016-09”), which provides improvements to employee share-based payment accounting.  ASU 2016-09 simplifies the accounting and presentation of various elements of share-based compensation including, but not limited to, income taxes, excess tax benefits, statutory tax withholding requirements, payment of employee taxes, and award assumptions.  ASU 2016-09 became effective January 1, 2017 and did not have a material impact on the Company’s consolidated financial statements.

In 2016, the FASB issued ASU 2016-02, Leases, (“ASU 2016-02”).  ASU 2016-02 changes the accounting for leases previously classified as operating leases under GAAP by, among other things, requiring a Company to recognize the lease on the balance sheet with a right-of-use asset and a lease liability.  ASU 2016-02 will be effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018.  The Company has not yet adopted ASU 2016-02 nor assessed its potential impact on its consolidated financial statements.

In 2014, the Financial Accounting Standards Board, or FASB, issued new guidance related to revenue recognition (ASU 2014-09 Revenue from Contracts with Customers (Topic 606)). Subsequently the FASB has issued additional guidance (ASUs 2015-14; 2016-08; 2016-10; 2016-12; 2016-13; 2016-20). The guidance establishes principles for reporting information about the nature, amount, timing, and uncertainty of revenue and cash flows arising from an entity’s contracts with customers. The guidance is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. Although the Company is still evaluating the impact of the new standard, the Company anticipates that the impact will not be material to its consolidated financial statements.

In 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (“ASU 2016-15”), which clarifies the classification of certain cash receipts and payments.  The specific cash flow issues addressed by ASU 2016-15, with the objective of reducing the existing diversity in practice, are as follows: (1) Debt prepayment or debt extinguishment costs; (2) Settlement of zero-coupon debt instruments or other debt instruments with insignificant coupon interest rates; (3) Contingent consideration payments made after a business combination; (4) Proceeds from the settlement of insurance claims; (5) Proceeds from the settlement of corporate-owned life insurance policies; (6) Distributions received from equity method investees; (7) Beneficial interest in securitization transactions; and (8) Separately identifiable cash flows and application of the predominance in principle.  ASU 2016-15 will be effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017.  The Company is still assessing the impact of ASU 2016-15 on its consolidated financial statements.

In 2017, the FASB issued ASU 2017-01, Business Combinations (“ASU 2017-01”), which clarifies the definition of a business under ASC 805. The main provisions of ASU 2017-01 provide a screen to determine when an integrated set of assets and activities is not a business.  The screen requires that when substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or group of similar identifiable assets, the set is not a business. ASU 2017-01 will be effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017.  The Company is still assessing the impact of ASU 2017-01 on its consolidated financial statements.    

In 2017, the FASB issued ASU 2017-04, Intangibles – Goodwill and Other (“ASU 2017-04”), which simplifies the test for goodwill impairment. The main provisions of ASU 2017-04 eliminate the second step of the goodwill impairment test which previously was performed to determine the goodwill impairment loss for an entity by calculating the difference between the implied fair value of the entity’s goodwill and its carrying value.  Under ASU 2017-04, if a reporting unit’s carrying value exceeds its fair value, an entity will record an impairment charge based on that difference. The impairment charge will be limited to the amount of goodwill which is allocated to that reporting unit.  ASU 2017-04 will be effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019.  Early adoption is permitted for annual and interim goodwill impairment testing dates after January 1, 2017. The Company is still assessing the impact of ASU 2017-04 on its consolidated financial statements.  

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Note 3 – Stock-based Compensation

Options

At September 30, 2017 the Company had four stock-based compensation plans, which are described more fully in Note 15 to the audited consolidated financial statements for the year ended December 31, 2016, contained in the Company’s most recently filed Annual Report on Form 10-K.

During the nine months ended September 30, 2017, the Company issued options to purchase a total of 50,000 shares of common stock to the Company’s independent directors as part of their annual compensation.  During the same period, the Company cancelled options to purchase 149,850 shares of common stock as a result of employee resignations.  Pursuant to the exercise of common stock options 10,000 shares of common stock were issued during the nine months ended September 30, 2017.    

The following summarizes the changes in common stock options for the nine months ended September 30, 2017:

The Company recognized stock-based compensation expense related to stock options of $0.1 million and $0.2 million, respectively, for the three and nine months ended September 30, 2017.  As of September 30, 2017, there is approximately $0.7 million of unrecognized stock-based compensation expense related to unvested option awards outstanding, which is expected to be recognized over a weighted average period of 3.2 years.

Restricted Stock

Restricted stock awards represent a right to receive shares of common stock at a future date determined in accordance with the participant’s award agreement.  There is no exercise price and no monetary payment required for receipt of restricted stock awards or the shares issued in settlement of the award.  Instead, consideration is furnished in the form of the participant’s services to the Company.  Compensation cost for these awards is based on the fair value on the date of grant and recognized as compensation expense on a straight-line basis over the requisite service period.

The following summarizes the changes in restricted stock awards for the nine months ended September 30, 2017:

Stock-based compensation expense related to restricted stock awards was not material for the three and nine months ended September 30, 2017 and 2016.

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Note 4 – Earnings Per Share

The Company is required in periods in which it has net income to calculate basic earnings per share (“basic EPS”) using the two-class method. The two-class method is required because the Company’s Class N preferred shares, each of which is convertible to 40 common shares, have the right to receive dividends or dividend equivalents should the Company declare dividends on its common stock. Under the two-class method, earnings for the period are allocated on a pro-rata basis to the common and preferred stockholders. The weighted-average number of common and preferred shares outstanding during the period is then used to calculate basic EPS for each class of shares.

In periods in which the Company has a net loss, basic loss per share is calculated by dividing the loss attributable to common stockholders by the weighted-average number of common shares outstanding during the period. The two-class method is not used in periods in which the Company has a net loss because the preferred stock does not participate in losses.

Stock options and other potential common shares are included in the calculation of diluted earnings per share (“diluted EPS”), since they are assumed to be exercised or converted, except when their effect would be anti-dilutive. The table below shows the calculation of the shares used in computing diluted EPS.

Potential common shares that were not included in the computation of diluted EPS because they would have been anti-dilutive for both the three and nine months ended September 30, 2017 were 5.0 million.  Potential common shares not included for both the three and nine months ended September 30, 2016 were 1.9 million.

Note 5 – Intangible Assets and Goodwill

Identifiable intangible assets

The Company’s identifiable intangible assets are associated with its acquisitions of HGP in 2012 and NLEX in 2014, as shown in the table below (in thousands), and are amortized using the straight-line method over their estimated useful lives of two to twelve years.  The Company’s tradename acquired as part of the acquisition of NLEX in 2014 has an indefinite life and therefore is not amortized.

Amortization expense during each of the nine months ended September 30, 2017 and 2016 was $0.2 million.

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The estimated amortization expense as of September 30, 2017 during the next five fiscal years and thereafter is shown below (in thousands):

Goodwill

The Company’s goodwill is related to its asset liquidation business, and is comprised of goodwill from three acquisitions, as shown in the table below (in thousands). There were no impairment losses to the carrying amount of goodwill during the three or nine months ended September 30, 2017 and 2016.

Note 6 – Debt

Outstanding debt at September 30, 2017 and December 31, 2016 is summarized as follows (in thousands):

In 2016, following an amendment, the Company’s related party debt with Street Capital (the “Street Capital Loan”) began accruing interest at a rate per annum equal to the Wall Street Journal prime rate + 1.0%.  The Company also agreed to a monthly payment schedule which began in the first quarter of 2017.  As of September 30, 2017 and December 31, 2016, the interest rate on the loan was 5.25% and 4.75%, respectively.  Please see Note 9 for further discussion of transactions with Street Capital.  

In 2016, the Company entered into a related party secured promissory note with an entity owned by certain executive officers of the Company (the “Entity”) for a revolving line of credit (the “Line of Credit”).  Under the terms of the Line of Credit, the Company received a revolving line of credit with an aggregate borrowing capacity of $1.5 million.  Interest under the Line of Credit is charged at a variable rate.  Aggregate loans under the Line of Credit up to $1.0 million incur interest at a variable rate per annum based on the rate charged to the Entity by its bank, plus 2.0%.  Amounts outstanding at any time in excess of $1.0 million incur interest at a rate of 8.0% per annum.  The Company is required to pay the Entity an annual commitment fee of $15,000, payable on a monthly basis, and due regardless of amounts drawn against the line.  Further, the Entity is eligible to participate in the net profits and net losses of certain industrial auction principal and guarantee transactions entered into by the Company on or after January 1, 2017, and consummated on or prior to the maturity date.  Principal transactions are those in which the Company purchases assets for resale.  Guarantee transactions are those in which the Company guarantees its client a minimum amount of proceeds from the auction.  The Line of Credit matures at the earlier of (i) three years from the date of the Agreement, (ii) the termination of the Entity’s line of credit with its bank, or (iii) forty-five (45) days following the date the Company closes a new credit facility with a financial institution.

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As of September 30, 2017 and December 31, 2016, the Company had not drawn on the Line of Credit.  

Note 7 – Fair Value Measurements

In accordance with the authoritative guidance for financial assets and liabilities measured at fair value on a recurring basis, the Company prioritizes the inputs used to measure fair value from market-based assumptions to entity specific assumptions:

As of September 30, 2017 and December 31, 2016, the Company had no Level 1 or Level 2 assets or liabilities measured at fair value.  As of both September 30, 2017 and December 31, 2016, the Company’s contingent consideration from the 2014 acquisition of NLEX was the only liability measured at fair value on a recurring basis.  The fair value of the Company’s contingent consideration was determined using a discounted cash flow analysis, which is based on significant inputs that are not observable in the market.

The following tables present the Company’s hierarchy for its assets and liabilities measured at fair value on a recurring basis as of September 30, 2017 and December 31, 2016 (in thousands):

When valuing its Level 3 liabilities, the Company gives consideration to operating results, financial condition, economic and/or market events, and other pertinent information that would impact its estimate of the expected contingent consideration payments.  The valuation of the liability is primarily based on management’s estimate of the Net Profits of NLEX (as defined in the NLEX stock purchase agreement).  Given the short term nature of the contingent consideration periods, changes in the discount rate are not expected to have a material impact on the fair value of the liability.

The following table summarizes the changes in the fair value of the liability during the nine months ended September 30, 2017 (in thousands):

The Company had no assets or liabilities measured at fair value on a non-recurring basis as of September 30, 2017.

Note 8 – Income Taxes

At September 30, 2017 the Company has aggregate tax net operating loss carry forwards of approximately $74.5 million ($59.3 million of unrestricted net operating tax losses and approximately $15.2 million of restricted net operating tax losses) and unused minimum tax credit carry forwards of $0.5 million. Substantially all of the net operating loss carry forwards and unused minimum tax credit carry forwards expire between 2024 and 2035. The Company’s utilization of restricted net operating tax loss carry forwards against future income for tax purposes is restricted pursuant to the “change in ownership” rules in Section 382 of the Internal Revenue Code.

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The reported tax expense varies from the amount that would be provided by applying the statutory U.S. Federal income tax rate to the income from operations before taxes primarily as a result of the change in the deferred tax asset valuation allowance.

The Company records net deferred tax assets to the extent that it believes such assets will more likely than not be realized. As a result of cumulative losses and uncertainty with respect to future taxable income, the Company has provided a full valuation allowance against its net deferred tax assets as of September 30, 2017 and December 31, 2016.

Note 9 – Related Party Transactions

Debt with Street Capital

As of September 30, 2017, the Company’s loan from Street Capital continues to be classified as related party debt because Allan Silber, an affiliate of Street Capital, is the Company’s chairman of the board and a significant shareholder of the Company.  At September 30, 2017 and December 31, 2016, the Company reported amounts owed to Street Capital of $0.5 million and $1.0 million respectively, as related party debt (see Note 6). Total interest of $0.5 million has been accrued on the debt and remains unpaid through September 30, 2017.

Transactions with Other Related Parties

As part of the operations of NLEX, the Company leases office space in Edwardsville, IL that is owned by the President of NLEX, David Ludwig.  The total amount paid to the related party is outlined in the table below.  All of the payments in both 2017 and 2016 were made to David Ludwig. 

The lease amounts paid by the Company to the related parties, which are included in selling, general and administrative expenses during the three and nine months ended September 30, 2017 and 2016, are detailed below (in thousands):

In 2016 the Company entered into a secured related party loan agreement with certain executive officers of the Company which is more fully described in Note 6.  Both Ross Dove and Kirk Dove, who were parties to the related party loan, shared equally in all payments made by the Company to satisfy obligations under the loan agreement. During the nine months ended September 30, 2017 there were no transactions under this agreement.

During the nine months ended September 30, 2017 the Company paid David Ludwig $0.9 million for his third earn-out provision payment.  

Note 10 – Subsequent Events

The Company has evaluated events subsequent to September 30, 2017 for potential recognition or disclosure in its condensed consolidated financial statements.  There have been no material subsequent events requiring recognition or disclosure in this Quarterly Report on Form 10-Q.

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion and analysis should be read in conjunction with the information contained in the unaudited condensed consolidated interim financial statements of Heritage Global Inc. (together with its consolidated subsidiaries, “we”, “us”, “our” or the “Company”) and the related notes thereto for the three and nine month periods ended September  30, 2017 and 2016, appearing elsewhere herein, and in conjunction with the Management’s Discussion and Analysis of Financial Condition and Results of Operations set forth in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016, filed with the Securities and Exchange Commission (“SEC”).

Forward Looking Information

This Quarterly Report on Form 10-Q (the “Report”) contains certain “forward-looking statements” that are based on management’s exercise of business judgment as well as assumptions made by, and information currently available to, management. When used in this document, the words “may,” "will,” “anticipate,” “believe,” “estimate,” “expect,” “intend,” and words of similar import, are intended to identify any forward-looking statements. You should not place undue reliance on these forward-looking statements. These statements reflect our current view of future events and are subject to certain risks and uncertainties, as noted in the Company’s Annual Report on Form 10-K, filed with the SEC, and as noted below. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, our actual results could differ materially from those anticipated in these forward-looking statements. We undertake no obligation, and do not intend, to update, revise or otherwise publicly release any revisions to these forward-looking statements to reflect events or circumstances after the date hereof, or to reflect the occurrence of any unanticipated events. Although we believe that our expectations are based on reasonable assumptions, we can give no assurance that our expectations will materialize.

Overview, History and Recent Developments

Heritage Global Inc. (“HGI”) was incorporated in the State of Florida in 1983 under the name “MedCross, Inc.” The Company’s name was changed to “I-Link Incorporated” in 1997, to “Acceris Communications Inc.” in 2003, to “C2 Global Technologies Inc.” in 2005, to “Counsel RB Capital Inc.” in 2011, and to Heritage Global Inc. effective in 2013. The most recent name change more closely identifies the Company with its core auction business, Heritage Global Partners, Inc. (“HGP”).

In 2014, HGI acquired all of the issued and outstanding capital stock in National Loan Exchange, Inc. (“NLEX”), a broker of charged-off receivables in the United States and Canada. As a result of this acquisition, NLEX now operates as a wholly owned division of the Company.

In 2016, the Company completed the sale of its real estate inventory to International Investments and Infrastructure, LLC (“III”) for $4.1 million.  The Company used the proceeds from the sale to repay $2.5 million of outstanding principal, plus accrued interest, on its loan with an unrelated party.  

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The organization chart below outlines the basic corporate structure of the Company as of September 30, 2017.

Asset liquidation

The Company is a value-driven, innovative leader in corporate and financial asset liquidation transactions, valuations and advisory services. The Company specializes both in acting as an adviser, as well as in acquiring or brokering turnkey manufacturing facilities, surplus industrial machinery and equipment, industrial inventories, real estate, accounts receivable portfolios, intellectual property, and entire business enterprises.

The Company’s asset liquidation business began operations in 2009 with the establishment of Heritage Global LLC (“HG LLC”). In addition to acquiring turnkey manufacturing facilities and used industrial machinery and equipment, HG LLC arranges traditional asset disposition sales, including liquidation and auction sales. In 2011, HG LLC acquired 100% of the business of EP USA, LLC (“Equity Partners”), thereby expanding the Company’s operations. Equity Partners is a boutique M&A advisory firm and provider of financial solutions for businesses and properties in transition.  

In 2012, the Company increased its in-house asset liquidation expertise with its acquisition of 100% of the outstanding equity of HGP, a global full-service auction, appraisal and asset advisory firm, and launched Heritage Global Partners Europe (“HGP Europe”). Through its wholly-owned subsidiary Heritage Global Partners UK Limited, the Company opened three European-based offices, one each in the United Kingdom, Germany and Spain.

In 2014, the Company again expanded its asset liquidation operations with the acquisition of 100% of the outstanding equity of NLEX. NLEX is the largest volume broker of charged-off receivables in the United States and Canada, and its offerings include national, state and regional portfolios on behalf of many of the world’s top financial institutions. The NLEX acquisition is consistent with the Company’s strategy to expand and diversify the services provided by its asset liquidation business.

As a result of the events and acquisitions outlined above, management believes that the Company’s expanded global platform will allow the Company to achieve its long term industry leadership goals.

Industry and Competition

Asset Liquidation

The Company’s asset liquidation business consists primarily of the auction, appraisal and asset advisory services provided by HGP, mergers and acquisitions advisory services provided by Equity Partners, and the accounts receivable brokerage services

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provided by NLEX. It also includes the purchase and sale, including at auction, of industrial machinery and equipment, real estate, inventories, accounts receivable and distressed debt. The market for these services and assets is highly fragmented. To acquire auction or appraisal contracts, or assets for resale, the Company competes with other liquidators, auction companies, dealers and brokers. It also competes with them for potential purchasers, as well as with equipment manufacturers, distributors, dealers and equipment rental companies. Some competitors have significantly greater financial and marketing resources and name recognition.

The Company’s business strategy includes the option of partnering with one or more additional purchasers, pursuant to a partnership, joint venture or limited liability company agreement (collectively, “Joint Ventures”). These Joint Ventures give the Company access to more opportunities, helping to mitigate some of the competition from the market’s larger participants and contribute to the Company’s objective to be the leading resource for clients requiring capital and financial asset solutions.

Government Regulation

We are subject to federal, state and local consumer protection laws, including laws protecting the privacy of customer non-public information and regulations prohibiting unfair and deceptive trade practices. Many jurisdictions also regulate “auctions” and “auctioneers” and may regulate online auction services. These consumer protection laws and regulations could result in substantial compliance costs and could interfere with the conduct of our business.

Legislation in the United States, including the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act of 2010, has increased public companies’ regulatory and compliance costs as well as the scope and cost of work provided by independent registered public accountants and legal advisors. The mandatory adoption of XBRL reporting in 2011 has also increased the Company’s costs paid to third party service providers. As regulatory and compliance guidelines continue to evolve, we expect to continue to incur costs, which may or may not be material, in order to comply with legislative requirements or rules, pronouncements and guidelines by regulatory bodies.

Critical Accounting Policies

Management’s Discussion and Analysis of Financial Condition and Results of Operations references our unaudited condensed consolidated interim financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”). This requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenue and expenses during the reporting period. Management bases its estimates and judgments on historical experience and various other factors that are considered to be reasonable under the circumstances. Actual results could differ from those estimates.

Significant estimates required in the preparation of the unaudited condensed consolidated interim financial statements included in this Report include the assessment of collectability of revenue recognized, and the valuation of accounts receivable, inventory, other assets, goodwill, intangible assets, liabilities, contingent consideration, deferred income tax assets and liabilities and stock-based compensation. These estimates are considered significant either because of the significance of the financial statement items to which they relate, or because they require judgment and estimation due to the uncertainty involved in measuring, at a specific point in time, events that are continuous in nature.

The Company has no off-balance sheet arrangements.

The Company has not paid any dividends, and does not expect to pay any dividends in the future.  

The critical accounting policies used in the preparation of our audited consolidated financial statements are discussed in our Annual Report on Form 10-K for the year ended December 31, 2016. There have been no changes to these policies in the nine months ended September 30, 2017.

Management’s Discussion of Financial Condition

Liquidity and Capital Resources

Liquidity

At September 30, 2017 the Company had a working capital deficit of $5.0 million, as compared to a working capital deficit of $4.1 million at December 31, 2016, a decrease of approximately $0.9 million.

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The Company’s current assets at September 30, 2017 decreased to $4.1 million compared to $4.4 million at December 31, 2016. The most significant change was an approximate $0.6 million decrease in accounts receivable due to the timing of payments for closed auctions. The Company’s current liabilities increased to $9.1 million compared to $8.6 million at December 31, 2016. The most significant change was an approximate $0.7 million increase in the current portion of contingent consideration primarily due to fair value adjustments of the liability during the nine months ended September 30, 2017.

During the nine months ended September 30, 2017, the Company’s primary source of cash was the cash provided by operations of its asset liquidation business.  Cash disbursements, other than those related to debt repayment of $0.5 million (all of which was paid to a related party) and the $0.9 million advance payment of the contingent consideration, were primarily related to operating expenses.

The Company expects that its asset liquidation business will continue to be the primary source of cash required for ongoing operations for the foreseeable future.

Ownership Structure and Capital Resources

Cash Position and Cash Flows

Cash and cash equivalents at September 30, 2017 were $3.0 million as compared to $2.5 million at December 31, 2016, an increase of approximately $0.5 million.

Cash provided by operating activities.  Cash provided by operating activities was $1.8 million during the nine months ended September 30, 2017 as compared to $4.0 million cash used during the same period in 2016. The approximate $2.2 million decrease was primarily attributable to a net unfavorable change of $3.5 million in the operating assets and liabilities in the nine months ended September 30, 2017 compared to the same period in 2016, the result of the Company completing the sale of its real estate inventory in the third quarter of 2016, offset by a favorable change in the net income adjusted for noncash items, which was $1.3 million better during the nine months ended September 30, 2017 compared to the same period in 2016.  

The significant changes in operating assets and liabilities during the nine months ended September 30, 2017 as compared to 2016 are primarily due to the completion of the sale of the Company’s real estate inventory in the third quarter of 2016, as well as the nature of the Company’s operations. The Company earns revenue from discrete asset liquidation deals that vary considerably with respect to their magnitude and timing, and that can consist of fees, commissions, asset sale proceeds, or a combination of these. The operating assets and liabilities associated with these deals are therefore subject to the same variability and can be quite different at the end of any given period.

Cash used in investing activities.  There was an insignificant amount of cash used in investing activities during the nine months ended September 30, 2017, as compared to $0.1 million used during the nine months ended September 30, 2016.    

Cash used in financing activities.  Cash used in financing activities was $1.4 million during the nine months ended September 30, 2017, as compared to $3.3 million used during the same period in 2016. During the nine months ended September 30, 2017 the Company repaid $0.5 million of its related party loan and made a contingent consideration payment of $0.9 million to the former owner of NLEX. The 2016 activity consisted of proceeds of $1.1 million from a related party loan, which $0.5 million was repaid during the same period. The Company also repaid $0.8 million of debt to Street Capital, and repaid the $2.5 million balance of its loan with an unrelated party (the “Third Party Loan”) in full. The Company also made contingent consideration payments in the amount of $0.6 million to the former owner of NLEX during the nine months ended September 30, 2016.  

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Contractual Obligations

The Company’s only significant contractual obligation, other than its related party loan(s), is its long-term earn-out obligation owed to the former owner (and current president) of NLEX (“David Ludwig”).  The Company will pay David Ludwig 50% of the Net Profits (as defined in the NLEX stock purchase agreement) of NLEX for each of the four years following the closing of the acquisition.  The payments are due on or about July 30 of each year, began in 2015, and are expected to continue until at least 2019.  In 2016 the Company agreed in principle with David Ludwig to extend the earn-out provision.  The extension of the earn-out is subject to ratification by the Board of Directors.  In 2015 the Company paid David Ludwig $0.5 million to satisfy the first earn out payment.  In 2016 the Company paid David Ludwig $0.8 million to satisfy the second earn out payment.  During the nine months ended September 30, 2017 the Company paid David Ludwig $0.9 million for his third earn-out provision payment. The Company expects to pay approximately $2.1 million over the remaining period of the earn-out provision.  

Management’s Discussion of Results of Operations

The following table sets out the Company’s condensed consolidated results of operations for the three and nine months ended September 30, 2017 and 2016 (dollars in thousands).

The Company’s asset liquidation business model has several components: (1) traditional fee based asset disposition services, such as commissions from on-line and webcast auctions, liquidations and negotiated sales, and commissions from the NLEX charged-off receivables business, (2) the acquisition and subsequent disposition of distressed and surplus assets, including industrial machinery and equipment and real estate, and (3) fees earned for appraisal and management advisory services.

Three-Month Period Ended September 30, 2017 Compared to Three-Month Period Ended September 30, 2016

Revenues and cost of revenues – Revenues were $4.7 million during the three months ended September 30, 2017 compared to $8.6 million during the same period in 2016. Costs of services revenue and asset sales were $0.8 million during the three months ended September 30, 2017 compared to $6.1 million during the same period in 2016.  The gross profit of these items was therefore $3.9 million during the three months ended September 30, 2017 compared to $2.5 million during the same period in 2016, an increase of approximately $1.4 million, or approximately 56%. The significant decrease in revenues and cost of revenues during the three months ended September 30, 2017 as compared to the same period in 2016 was primarily the result of the sale of the Company’s real estate inventory in 2016. In addition, cost of services revenue decreased during the three months ended September 30, 2017 as compared to the same period in 2016, and services revenue increased during the three months ended September 30, 2017 as compared

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to the same period in 2016, based on a higher volume of deals for the Equity Partners and NLEX divisions, which have lower direct costs as compared to deals for HGP. Because the Company conducts its asset liquidation operations both independently and through partnerships, and the ratio of the two is unlikely to remain constant in each period, the operations should be considered as a whole rather than on a line-by-line basis. The increased gross profit in the current year reflects the vagaries of the timing and magnitude of asset liquidation transactions.

Selling, general and administrative expense – Selling, general and administrative expense was $3.5 million during the three months ended September 30, 2017 compared to $2.8 million during the same period in 2016.    

Significant components of selling, general and administrative expense were as shown below (dollars in thousands):

The increase in total selling, general and administrative expenses was largely attributable to an increase in the annual performance bonus for the Equity Partners division based on improved financial performance, an increase in salaries and commissions for the NLEX division as compared to the prior year and an increase in the Company’s non-cash stock-based compensation expense, attributable to the Company-wide option grant in the fourth quarter of 2016.

Depreciation and amortization expense – Depreciation and amortization expense was $0.1 million during both the three months ended September 30, 2017 and the same period in 2016, and consisted almost entirely of amortization expense related to intangible assets.  In both years the depreciation of property and equipment was not material.

Nine-Month Period Ended September 30, 2017 Compared to Nine-Month Period Ended September 30, 2016

Revenues and cost of revenues – Revenues were $14.6 million during the nine months ended September 30, 2017 compared to $18.0 million during the same period in 2016. Costs of services revenue and asset sales were $3.8 million during the nine months ended September 30, 2017 compared to $9.2 million during the same period in 2016.  The gross profit of these items was therefore $10.7 million during the nine months ended September 30, 2017 compared to $8.7 million during the same period in 2016, an increase of approximately $2.0 million, or approximately 23%. The significant decrease in revenues and cost of revenues during the nine months ended September 30, 2017 as compared to the same period in 2016 was primarily the result of the sale of the Company’s real estate inventory in 2016. In addition, cost of services revenue decreased during the nine months ended September 30, 2017 as compared to the same period in 2016, and services revenue increased during the nine months ended September 30, 2017 as compared to the same period in 2016, based on a higher volume of deals for the Equity Partners and NLEX divisions, which have lower direct costs as compared to deals for HGP. Because the Company conducts its asset liquidation operations both independently and through partnerships, and the ratio of the two is unlikely to remain constant in each period, the operations should be considered as a whole rather than on a line-by-line basis. The increased gross profit in the current year reflects the vagaries of the timing and magnitude of asset liquidation transactions.

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Selling, general and administrative expense – Selling, general and administrative expense was $9.8 million during the nine months ended September 30, 2017 compared to $8.9 million during the same period in 2016.

Significant components of selling, general and administrative expense were as shown below (dollars in thousands):

The increase in total selling, general and administrative expenses was largely attributable to an increase in headcount in the HGP division, an increase in the annual performance bonus for the Equity Partners division based on improved financial performance, an increase in consulting related to external finders fees for the Equity Partners division, an increase in salaries and commissions for the NLEX division as compared to the prior year and an increase in the Company’s non-cash stock-based compensation expense, attributable to the Company-wide option grant in the fourth quarter of 2016.

Depreciation and amortization expense – Depreciation and amortization expense was $0.2 million during both the nine months ended September 30, 2017 and the same period in 2016, and consisted almost entirely of amortization expense related to intangible assets.  In both years the depreciation of property and equipment was not material.

Non-GAAP Financial Measure - Earnings before Interest, Taxes, Depreciation and Amortization (“EBITDA”) and Adjusted EBITDA

We prepared our unaudited condensed consolidated financial statements in accordance with GAAP. We use the non-GAAP financial measure “Adjusted EBITDA” in assessing the Company’s results. Adjusted EBITDA reflects the standard definition of EBITDA (net income plus depreciation and amortization, interest and other expense, and provision for income taxes), adjusted further to eliminate the effects of fair value adjustments of contingent consideration and stock-based compensation.  We believe that Adjusted EBITDA is relevant and useful supplemental information for our investors. Management believes that the presentation of this non-GAAP financial measure, when considered together with our GAAP financial measures and the reconciliation to the most directly comparable GAAP financial measure, provides a more complete understanding of the factors and trends affecting the Company than could be obtained absent these disclosures. Management uses Adjusted EBITDA to make operating and strategic decisions and to evaluate the Company’s performance. We have disclosed this non-GAAP financial measure so that our investors have the same financial data that management uses, with the intention of assisting investors to make comparisons to our historical operating results and analyze our underlying performance. Management believes that Adjusted EBITDA is a useful supplemental tool to evaluate the underlying operating performance of the Company on an ongoing basis. Our use of Adjusted EBITDA is not meant to be, and should not be, considered in isolation or as a substitute for, or superior to, any GAAP financial measure. You should carefully evaluate the financial information, below, which reconciles our GAAP reported net income to Adjusted EBITDA for the periods presented (in thousands).

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