Heritage Global Inc. - Quarter Report: 2018 June (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended June 30, 2018

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 every Interactive Data File required to be submitted 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 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 August 1, 2018, there were 29,253,278 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, 2017, filed with the SEC on March 13, 2018.

The results of operations for the six month period ended June 30, 2018 are not necessarily indicative of those operating results to be expected for any subsequent interim period or for the entire year ending December 31, 2018. The accompanying condensed consolidated balance sheet at December 31, 2017 has been derived from the audited consolidated balance sheet at December 31, 2017, 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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Revenue Recognition

On January 1, 2018, the Company adopted the new accounting standard FASB ASC Topic 606, Revenue from Contracts with Customers (“ASC 606”) to all contracts using the modified retrospective method. Based on the Company’s analysis of contracts with customers in prior periods, there was no cumulative effect adjustment to the opening balance of the Company’s accumulated deficit as a result of the adoption of this new standard. We expect the impact of the adoption of the new standard to be immaterial to the consolidated financial statements on an ongoing basis.

Services revenue generally consists of commissions and fees from providing auction services, appraisals, brokering of sales transactions and providing merger and acquisition advisory services. Asset sales revenue generally consists of proceeds obtained through sales of purchased assets. Revenue is recognized for both services revenue and asset sales revenue based on the ASC 606 standard recognition model, which consists of the following: (1) an agreement exists between two or more parties that creates enforceable rights and obligations, (2) the performance obligations are clearly identified, (3) the transaction price has been determined, (4) the transaction price has been properly allocated to each performance obligation, and (5) the entity satisfies a performance obligation by transferring a promised good or service to a customer for each of the entities.

All services and asset sales revenue from contracts with customers is considered to be one reporting segment – the asset liquidation business. Although the Company provides various services within the asset liquidation business, it does not disaggregate revenue streams further than that in its statement of operations, services revenue and asset sales. Generally, revenue is recognized in the asset liquidation business at the point in time in which the performance obligation has been satisfied and full consideration is received. The exception to recognition at a point in time occurs when certain contracts provide for advance payments recognized over a period of time. Services revenue recognized over a period of time is not material in comparison to total revenues (5% of total revenues for the period ended June 30, 2018), and therefore not reported on a disaggregated basis. Further, as certain contracts stipulate that the customer make advance payments, amounts not recognized within the reporting period are considered deferred revenue and the Company’s “contract liability”. For the period ended June 30, 2018, the deferred revenue balance was approximately $19,000. The Company records receivables related to asset liquidation in certain situations based on timing of payments for asset liquidation transactions held at the end of the reporting period; however, revenue is generally recognized in the period that the Company satisfies the performance obligation and cash is collected. The Company does not record a “contract asset” for partially satisfied performance obligations.

We evaluate revenue from asset liquidation transactions in accordance with the accounting guidance to determine whether to report such revenue on a gross or net basis. We have determined that we act as an agent for our fee based asset liquidation transactions and therefore we report the revenue from transactions in which we act as an agent on a net basis.  

The Company also earns asset liquidation income through asset liquidation transactions that involve the Company acting jointly with one or more additional purchasers, pursuant to a partnership, joint venture or limited liability company (“LLC”) agreement (collectively, “Joint Ventures”). For these transactions, the Company does not record asset liquidation revenue or expense. Instead, the Company’s proportionate share of the net income (loss) is reported as earnings of equity method investments. In general, the Joint Ventures apply the same revenue recognition and other accounting policies as the Company.

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, 2017. There have been no changes to these policies in the six months ended June 30, 2018, except for the adoption of ASC 606 as described above.

Recent Accounting Pronouncements

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 above stated updates became effective January 1, 2018 and did not have a material impact on the Company’s consolidated financial statements, except for more comprehensive disclosure requirements (see Note 2 – Revenue Recognition for further detail).

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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 became effective January 1, 2018 and did not have a material impact on the Company’s 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 became effective January 1, 2018 and did not have a material impact on the Company’s 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.  

In 2018, the FASB issued ASU 2018-07, Compensation – Stock Compensation (“ASU 2018-07”), which expands the scope of Topic 718 to include share based payment transactions for acquiring goods and services from nonemployees. The amendments in this update are effective for public business entities for fiscal years beginning after December 15, 2018, including interim periods within that fiscal year. The Company is still evaluating the impact of ASU 2018-07 on the consolidated financial statements.  

Note 3 – Stock-based Compensation

Options

At June 30, 2018 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, 2017, contained in the Company’s most recently filed Annual Report on Form 10-K.

During the six months ended June 30, 2018, the Company issued options to purchase 441,500 shares of common stock to the Company’s employees and options to purchase 85,000 shares of common stock to the Company’s non-employee directors as part of their annual compensation.  During the same period, the Company cancelled options to purchase 931,550 shares of common stock as a result of employee resignations and natural expiration.

On June 1, 2018, the Company issued options to purchase 300,000 shares of common stock to the employees of NLEX, in connection with the Addendum to the Employment Agreements of David Ludwig and Tom Ludwig. These stock options have an expiration date of July 31, 2018 and through June 30, 2018, 173,130 shares of common stock were issued pursuant to the exercise of these common stock options.

The following summarizes the changes in common stock options for the six months ended June 30, 2018:

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The Company recognized stock-based compensation expense related to stock options of $0.1 million for both the three and six months ended June 30, 2018.  As of June 30, 2018, there is approximately $0.6 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 2.6 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.

On June 1, 2018, the Company granted 600,000 shares of Company restricted common stock in connection with certain addenda to the Employment Agreements of David Ludwig and Tom Ludwig. The shares are subject to certain restrictions on transfer and a right of repurchase over five years, ending May 31, 2023, and require a continued term of service to the Company. Stock-based compensation expense related to the restricted stock awards was not material for the three and six months ended June 30, 2018 and 2017.

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.

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For the six months ended June 30, 2018 and 2017 there were potential common shares totaling approximately 4.2 million and 2.0 million, respectively, that were excluded from the computation of diluted EPS as the inclusion of such shares would have been anti-dilutive. For the three months ended June 30, 2018 and 2017 there were potential common shares totaling approximately 1.0 million and 5.1 million, respectively, that were excluded.

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 remaining estimated useful lives of one to eight 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 the six months ended June 30, 2018 and 2017 was $0.1 million.

The estimated amortization expense as of June 30, 2018 during the next five fiscal years and thereafter is shown below (in thousands):

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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 six months ended June 30, 2018 and 2017.

Note 6 – Debt

Outstanding debt at June 30, 2018 and December 31, 2017 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%.  As of June 30, 2018 and December 31, 2017, the interest rate on the loan was 5.75% and 5.50%, 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. During the six months ended June 30, 2018, the Company had not drawn on the Line of Credit. Refer to Note 10 Subsequent Events for further discussion of the Company’s Line of Credit.

On January 30, 2018, Heritage Global LLC (“HGLLC”), a wholly owned subsidiary of HGI, settled a long-standing litigation matter that was commenced against the predecessor in interest of HGLLC. The settlement, which also involved several other co-defendant parties, included a complete release of HGLLC’s predecessor in interest and its successors and affiliates by the plaintiffs from all claims arising from or relating to the facts and circumstances underlying the litigation. The portion of the settlement attributable to HGLLC’s predecessor in interest was paid on behalf of HGLLC by 54 Finance, LLC (“54 Finance”) (an affiliate of a co-defendant in the litigation) in consideration of a Promissory Note dated January 30, 2018 (the “Note”) from HGLLC in the amount of $1,260,000. Pursuant to a Guaranty dated January 30, 2018, HGI has guaranteed the obligations of HGLLC under the Note, which are required to be paid in 36 equal installments of $35,000, with any remaining outstanding balance due and payable in full on January 30, 2021. As of December 31, 2017, the Company accrued the present value of the Note based on the payment terms noted above and at an interest rate of 6.5%. The Note was recorded as this was determined to be a recognized subsequent event pursuant to ASC 855, Subsequent Events. Upon the occurrence of any Event of Default (as defined below), in the sole discretion of 54 Finance, the

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outstanding principal balance of the Note will bear interest at a rate per annum (computed on the basis of a 360-day year, actual days elapsed) equal to 12%. An “Event of Default” means: (a) any failure of HGLLC to pay when due any amount thereunder, when and as due, (b) any failure on the part of HGLLC to pay upon 54 Finance’s demand any fees, costs, expenses or other charges hereunder or otherwise due to HGLLC under the Note or the Guaranty, (c) any breach, failure or default under the Guaranty, (d) HGLLC or HGI repudiates or revokes, or purports to repudiate or revoke, any obligation under the Note or the Guaranty, or the obligation of HGI under the Guaranty is limited or terminated by operation of law or by HGI, or (e) HGLLC or HGI are insolvent or admit in writing its inability to pay debts as they mature, or make a general assignment for the benefit of its creditors, or institute any bankruptcy, insolvency or similar proceeding under the laws of any jurisdiction, or take any action to authorize such proceeding. During the six months ended June 30, 2018, the Company made the first five payments on the Note totaling $175,000.  

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 June 30, 2018 and December 31, 2017, the Company had no Level 1 or Level 2 assets or liabilities measured at fair value.  As of both June 30, 2018 and December 31, 2017, 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 June 30, 2018 and December 31, 2017 (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 six months ended June 30, 2018 (in thousands):

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Note 8 – Income Taxes

At June 30, 2018 the Company has aggregate tax net operating loss carry forwards of approximately $76.3 million ($61.1 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 2036. 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.

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 June 30, 2018 and December 31, 2017.

Note 9 – Related Party Transactions

Debt with Street Capital

As of June 30, 2018, 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 June 30, 2018 and December 31, 2017, the Company reported amounts owed to Street Capital of $0.1 million and $0.4 million respectively, as related party debt (see Note 6). Total interest of $0.6 million has been accrued on the debt and remains unpaid through June 30, 2018.

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 was approximately $50,000 for both the six months ended June 30, 2018 and 2017, and is included in selling, general and administrative expenses in the consolidated financial statements.  All of the payments in both 2018 and 2017 were made to David Ludwig. On June 1, 2018, the Company amended its lease agreement with David Ludwig, whereby the term of the agreement extends to May 31, 2023 and the rent amounts were agreed upon for the new term. 

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, share equally in all payments made by the Company to satisfy obligations under the loan agreement. During the six months ended June 30, 2018, the Company made payment of approximately $34,000 to the respective parties based on the profit share provision for principal and guarantee transactions that occurred in 2017. Additionally, the Company has accrued as interest expense approximately $120,000 profit share for principal and guarantee transactions that occurred in the six months ended June 30, 2018. See Note 10 Subsequent Events.

Note 10 – Subsequent Events

The Company has evaluated events subsequent to June 30, 2018 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 six month periods ended June 30, 2018 and 2017, 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, 2017, 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” as defined by the Private Securities Litigation Reform Act of 1995 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 one of our wholly owned divisions.

The organization chart below outlines our basic domestic corporate structure as of June 30, 2018.

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Asset liquidation

We are a value-driven, innovative leader in corporate and financial asset liquidation transactions, valuations and advisory services. We specialize 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.

Our 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 our operations. Equity Partners is a boutique M&A advisory firm and provider of financial solutions for businesses and properties in transition.  

In 2012, we increased our 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 our wholly-owned subsidiary Heritage Global Partners UK Limited, we opened three European-based offices, one each in the United Kingdom, Germany and Spain.

In 2014, we again expanded our 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 our 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 our expanded global platform will allow us to achieve our long term industry leadership goals.

Industry and Competition

Our 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 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.

Our 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 us access to more opportunities, helping to mitigate some of the competition from the market’s larger participants and contribute to our 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.

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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.

We have no off-balance sheet arrangements.

We have not paid any dividends, and do 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, 2017. There have been no changes to these policies in the six months ended June 30, 2018, except for the changes to revenue recognition accounting standards (see Note 2-Revenue Recognition for further detail).

Management’s Discussion of Financial Condition

Liquidity and Capital Resources

Liquidity

At June 30, 2018 we had a working capital deficit of $2.5 million, as compared to a working capital deficit of $5.6 million at December 31, 2017, a decrease of approximately $3.1 million primarily as a result of our net income of $3.0 million during the first half of 2018.

Our current assets at June 30, 2018 increased to $6.2 million compared to $3.0 million at December 31, 2017. The most significant change was an approximate $2.6 million increase in cash and cash equivalents primarily as a result of our net income of $3.0 million during the first half of 2018. Our current liabilities remained consistent at June 30, 2018 as compared December 31, 2017, in the amount of $8.7 million.

During the six months ended June 30, 2018, our primary source of cash was the cash on hand plus the cash provided by operations of our asset liquidation business.  Cash disbursements other than those related to debt repayment (including the contingent consideration payment) of $1.4 million were primarily related to operating expenses.

We expect that our asset liquidation business will continue to be the primary source of cash required for ongoing operations for the foreseeable future.

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Ownership Structure and Capital Resources

Cash Position and Cash Flows

Cash and cash equivalents at June 30, 2018 were $4.8 million as compared to $2.1 million at December 31, 2017, an increase of approximately $2.7 million.

Cash provided by operating activities.  Cash provided by operating activities was $4.0 million during the six months ended June 30, 2018 as compared to $0.9 million cash provided during the same period in 2017. The approximate $3.1 million increase was primarily attributable to a favorable change in the net income adjusted for noncash items, which was $2.5 million better during the six months ended June 30, 2018 compared to the same period in 2017.  

The significant changes in operating assets and liabilities during the six months ended June 30, 2018 as compared to 2017 are primarily due to the nature of our operations. We earn 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.  Cash used in investing activities during the six months ended June 30, 2018 was $0.1 million, as compared to no cash used during the six months ended June 30, 2017.    

Cash used in financing activities.  Cash used in financing activities was $1.3 million during the six months ended June 30, 2018, as compared to $0.8 million used during the same period in 2017. The 2018 activity consisted of repayments to Street Capital ($0.2 million), repayments to an unrelated third party ($0.1 million), and an advance contingent consideration payment of $1.0 million to the former owner of NLEX. The 2017 activity consisted of repayments to Street Capital ($0.4 million) and an advance contingent consideration payment of $0.4 million to the former owner of NLEX.

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Contractual Obligations

Our only significant contractual obligation, other than our related party and third party loan(s), is our earn-out obligation owed to the former owner (and current president) of NLEX (“David Ludwig”).  We are obligated to 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 will continue until July of 2018. In 2015 we paid David Ludwig $0.5 million to satisfy the first earn out payment.  In 2016 we paid David Ludwig $0.8 million to satisfy the second earn out payment.  In 2017 we paid David Ludwig $0.9 million to satisfy the third earn out payment. During the six months ended June 30, 2018 we have paid David Ludwig $1.0 million related to the fourth earn out payment. We have paid approximately $1.6 million in July of 2018 for the remaining amount owed under the earn-out provision.  

On April 18, 2018, we entered into an Addendum to the Employment Agreements of David Ludwig and Tom Ludwig (the “Addendum”), effective June 1, 2018 (the “Effective Date”). The Addendum extends the term of the Employment Agreements by five years, from May 31, 2018 to May 31, 2023. The Addendum eliminates the prior provisions for bonus compensation or option grants contained in the Employment Agreements. Pursuant to the Addendum, for each calendar year, NLEX will allocate thirty percent of its Net Operating Income (as defined in the Addendum) in the aggregate to a “Sales and Marketing Pool” and an “Operations Pool”, in the proportions specified in the Addendum and varying each year, for cash incentive awards. Each year in advance, David Ludwig will recommend to our Board of Directors (the “Board”) the NLEX employees (including David Ludwig) entitled to receive a portion of the Sales and Marketing Pool as well as the portion to be received, and Tom Ludwig will recommend to the Board the NLEX employees (including Tom Ludwig) entitled to receive a portion of the Operations Pool, and the portion to be received. Also pursuant to the Addendum, for each calendar year, NLEX will allocate twenty percent of its Principal Net Operating Income (as defined in the Addendum) in the aggregate to a “Principal Sales and Marketing Pool” and a “Principal Operations Pool”, in the proportions specified in the Addendum and varying each year, for cash incentive awards. Each year in advance, David Ludwig will recommend to the Board the NLEX employees (including David Ludwig) entitled to receive a portion of the Sales and Marketing Pool as well as the portion to be received, and Tom Ludwig will recommend to the Board the NLEX employees (including Tom Ludwig) entitled to receive a portion of the Operations Pool, and the portion to be received. On June 1, 2018, the Company granted 600,000 shares of Company restricted common stock in connection with certain addenda to the Employment Agreements of David Ludwig and Tom Ludwig. The shares are subject to certain restrictions on transfer and a right of repurchase over five years, ending May 31, 2023, and require a continued term of service to the Company. In connection with the Addendum and promptly after the Effective Date, the Company issued options to purchase 300,000 shares of Common Stock under the Heritage Global 2010 Non-Qualified Stock Option Plan (the “2010 Plan”) or the Heritage Global 2016 Stock Option Plan (the “2016 Plan”), to certain employees of NLEX (excluding Executives), and in such amounts, as recommended by the Executives. Subject to the approval of such recommendation by the Board, NLEX also paid a one-time bonus to each recipient of such options in an amount equal to the aggregate exercise price of such recipient’s option. The options were fully vested upon issuance and expire on July 31, 2018. In addition, not later than sixty days prior to each of the first three anniversaries of the Effective Date, the Executives will recommend to the Board the NLEX employees (including the Executives) who are entitled to receive options to acquire an aggregate 200,000 shares of Common Stock per year (for a total of 600,000 shares of Common Stock over three years). The options will be issued under the 2010 Plan or the 2016 Plan, and in the case of options issued to Executives, outside either the 2010 or 2016 Plans, as determined by the Board.

Management’s Discussion of Results of Operations

The following table sets out the Company’s condensed consolidated results of operations for the three and six months ended June 30, 2018 and 2017 (dollars in thousands).

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Our 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 June 30, 2018 Compared to Three-Month Period Ended June 30, 2017

Revenues and cost of revenues – Revenues were $6.8 million during the three months ended June 30, 2018 compared to $4.8 million during the same period in 2017. Costs of services revenue and asset sales were $1.0 million during the three months ended June 30, 2018 compared to $1.7 million during the same period in 2017.  The gross profit of these items was therefore $5.8 million during the three months ended June 30, 2018 compared to $3.1 million during the same period in 2017, an increase of approximately $2.7 million, or approximately 87%. Services revenue increased during the three months ended June 30, 2018 as compared to the same period in 2017, and cost of services revenue decreased during the three months ended June 30, 2018 as compared to the same period in 2017, based on a higher volume of deals for the NLEX division, which has lower direct costs as compared to other divisions. 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 $4.1 million during the three months ended June 30, 2018 compared to $3.0 million during the same period in 2017.    

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 salaries and commissions, due to improved performance, for the HGP and NLEX divisions as compared to the prior year.

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Depreciation and amortization expense – Depreciation and amortization expense was $0.1 million during the three months ended June 30, 2018 and the same period in 2017, and consisted almost entirely of amortization expense related to intangible assets.  Depreciation of property and equipment was not material.

Six-Month Period Ended June 30, 2018 Compared to Six-Month Period Ended June 30, 2017

Revenues and cost of revenues – Revenues were $12.6 million during the six months ended June 30, 2018 compared to $9.8 million during the same period in 2017. Costs of services revenue and asset sales were $1.9 million during the six months ended June 30, 2018 compared to $3.0 million during the same period in 2017.  The gross profit of these items was therefore $10.8 million during the six months ended June 30, 2018 compared to $6.8 million during the same period in 2017, an increase of approximately $4.0 million, or approximately 59%.  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 $7.6 million during the six months ended June 30, 2018 compared to $6.2 million during the same period in 2017.

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 salaries and commissions, due to improved performance, for the HGP and NLEX divisions as compared to the prior year and slightly offset by the decrease in consulting fees.

Depreciation and amortization expense – Depreciation and amortization expense was $0.2 million during both the six months ended June 30, 2018 and the same period in 2017, and consisted almost entirely of amortization expense related to intangible assets.  In both years the depreciation of property and equipment was not material.

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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).

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

As a Smaller Reporting Company, we are not required to provide the information required by this item.  

Item 4. Controls and Procedures.

As of the end of the period covered by this Report, our Chief Executive Officer and Chief Financial Officer (the “Certifying Officers”) conducted evaluations of our disclosure controls and procedures. As defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), the term “disclosure controls and procedures” means controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer’s management, including the Certifying Officers, to allow timely decisions regarding required disclosure. Based on this evaluation, the Certifying Officers have concluded that our disclosure controls and procedures were effective.

Further, there were no changes in our internal control over financial reporting during the six months ended June 30, 2018 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II – OTHER INFORMATION

Item 1.  Legal Proceedings

There have been no material changes to the legal proceedings discussed in our Annual Report on Form 10-K for the year ended December 31, 2017, as filed with the SEC on March 13, 2018.

Item 1A.  Risk Factors

As a Smaller Reporting Company, we are not required to provide the information required by this item.  

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds.

On June 1, 2018, we issued 600,000 shares of Company restricted common stock in connection with certain addenda to the Employment Agreements of David Ludwig and Tom Ludwig. The shares are subject to certain restrictions on transfer and a right of repurchase over five years, ending May 31, 2023, and require a continued term of service. This issuance was exempt from registration pursuant to Section 4(2) of the Securities Act and/or Regulation D promulgated thereunder.  

Item 3.  Defaults Upon Senior Securities.

None.

Item 4.  Mine Safety Disclosures.

Not applicable.

Item 5.  Other Information.

None.

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Item 6.  Exhibits.

(a) Exhibits