Ladies and gentlemen, greetings, and welcome to the Heritage Global Inc. Third Quarter 2023 Earnings Conference Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, John Nesbett, with IMS Investor Relations.

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

Thank you, John, and thank everyone for attending and listening. Before Brian gives you an overview of what we feel was an extremely good quarter, I wanted to take a few moments upfront to walk everyone through our noncash $900,000 loan loss reserve, the reasons why we took it, and how we feel about it. So our largest borrower came to us and said that they would like to extend the term of their loan that they believe they'll definitely be able to pay off. However, the collection curves have slowed, and they've asked for an extension. The first thing I thought about them asking for an extension is, thank God, I'm only 71 years old. So I've got plenty of time to extend it. So we feel comfortable that it's going to work, but we took the $900,000 charge because the buyer is asking for an extension. So over time, we'll have to figure out whether or not that charge or that noncash reserve will stay on the books. For now, we believe it was prudent and the safest thing to do. So after I thought about it for a long time, I started thinking about a story from very early in my career that my grandfather, our founder, told me. He said to me, 'Kid, never worry too much about the money that people owe you. Worry far more about the people you owe money to.' So the good news there is our loan book has grown to $35 million plus while our bank debt is only $7 million. So with that perspective in mind, I feel very comfortable about our future here. So everybody is kind of looking at the market right now, and I'll talk about it later on after Brian speaks, says it looks like there are rocky roads coming ahead. After 50 years doing this, I can tell you over and over again that rocky roads have been ice cream to liquidators, and we think our time is going to get better and better over the next 2 or 3 years. The $13 million guidance we gave for this year, I'm still confirming after we took the loan loss reserve, and I'm positive that next year and the year after, you'll see growth. With that, I'll turn it over to Brian to walk you through the quarter. Once he does walk you through the quarter, I'll kind of walk you through why I see this growth over the next 2 years, 3 years, and beyond. Brian, go ahead. You're up.

Thank you, Ross. This was another very positive quarter for the company, where we delivered strong operating results on both sides of our business. Within our Industrial Assets division, we are seeing increased auction interest, specifically in the biotech and pharmaceutical sector as the industry continues to consolidate. Industrial posted a solid third quarter operating income of $2.1 million, with strong results from its core auction business. It is important to note that in the comparable quarter last year, we realized $1.5 million in earnings from equity method investments related to a real estate building closure, and we did not have any real estate transactions this quarter. Our financial asset division posted an excellent quarter as well, with operating income for the 3 and 9 months ended up 18% and 110% compared to the prior year periods, respectively. We are seeing sustained tailwinds with the current state of the economy, given consumer debt at record levels and high volumes of charged-off portfolios. The Brokerage segment is positioned to capitalize on continued growth in the volume of nonperforming loans and charged-off credit card accounts. In this environment, however, the offsetting impact is that consumers have less capacity to pay their debts, resulting in lower collections in the near term, which we are seeing across the industry. We recognize that there exists an elevated risk related to the underlying collateral and thus, our loan book due to the reduced collection rates. And as Ross mentioned, we are working diligently with our partners to complete amended agreements with our largest borrower to extend their maturity. In light of the situation with this particular borrower as well as the overall macro trends in the collections market, we felt it was prudent to increase our noncash credit loss reserves by approximately $900,000, resulting in a total balance of $1.4 million as of September 30, 2023. The increase to our credit loss reserve runs through the income statement against SG&A and as an offset of the earnings from equity method investments with a roughly even split between the 2 accounts. This situation is not having an impact on our other operating businesses, including NLEX, which continues to perform at record levels. Turning to the financial results, consolidated net operating income was $2.8 million in the third quarter. Excluding the total impact of our credit loss reserve adjustments, consolidated net operating income was approximately $3.6 million. Net income was $2 million or $0.05 per diluted share, and including our credit loss reserve adjustments, earnings per share was $0.07. For the quarter, we reported adjusted EBITDA of $3.1 million. Our balance sheet remains strong with stockholder's equity of $56 million as of September 30, 2023, up from $48 million at December 31, 2022, and a net working capital of $13.8 million. Additionally, our total balance related to investments in loans to buyers of charge-off and nonperforming receivable portfolios was $35.9 million as of September 30, 2023, of which $20.6 million is classified as notes receivable and $15.3 million is classified as equity method investments. The total increase in our loan book was $6 million during the quarter and $14 million year-to-date. So I'll wrap this up by reiterating that this was a great quarter for us, with strong macro tailwinds and both sides of our business performing well and benefiting from increased asset volume. With that, Ross, I'll pass it back to you.

Thank you, Brian. Over the next 30 days, we should gain much more clarity to report back on our ability to negotiate an extension that suits both our senior lender and us. We'll provide more detailed updates on our position and our optimism about avoiding a default, which we currently believe is achievable. During this time, we'll also be able to provide guidance on our Q4 numbers, which show promise for being a record quarter. We don't have all the figures yet, and we are still running auctions, but I want to explain why we are so optimistic. Each of our divisions seems positioned for record quarters, which could counterbalance any loan loss reserves as we expand our business significantly. On the NLEX front, we're adding new clients every month, and our existing clients are supplying us with increasing volumes of assets, as nonperforming loans are growing even faster now than last year. As defaults increase, so do charge-offs, leading to a growing influx of assets in our marketplace. NLEX achieved a record quarter in its brokerage business last quarter and is projecting another record quarter ahead. I've mentioned that Heritage Global Capital is facing challenges with the speed at which loans are being paid off. No other borrowers are currently seeking extensions, and we don't expect that to change. We're addressing the matters related to our main buyer carefully while being prudent with new loans. We anticipate that the financial asset business will remain profitable, and though the loan book is expected to grow, it will do so more cautiously over the next few years. We are optimistic about both sectors going forward. On the industrial side, we are hosting the highest number of auctions in a single quarter since Heritage Global Partners was founded. Our calendar shows nearly an auction every day, along with a strong pipeline leading into Q1 and beyond, indicating several years of growth ahead. There are still numerous struggling biotech companies that will require asset sales, keeping this segment solid. Simultaneously, our valuation is increasing as we navigate through uncertain times, where valuation businesses become more necessary. American Lab trading has significantly improved its inventory, and we foresee growth in the next 2 or 3 years as they continue these upgrades. More buyers are eager to acquire used equipment in a tougher economic climate, reinforcing our positive outlook. We're taking this charge very seriously, and we are confident about the future. We welcome any questions and appreciate your time. Thank you for being shareholders, and we'll continue striving to perform at our best while feeling optimistic about our current situation.

Our first question is from Mark Argento with Lake Street Capital Markets.

Brian. Just peeling a little bit of the onion on the loan loss reserve. Could you just maybe give color on is it a particular type of portfolio, like consumer credit versus student loan or what not? And have you guys done a pretty in-depth work in terms of understanding the exposure just given the environment we're in?

It's a mixed portfolio of all different types of consumer loans. There are some auto blended with some credit card, not a lot of student loans. So primarily that with fintech stuff at the same time, a combination of BNPL and peer-to-peer loans. So it's really across all the consumer sectors. And it's been performing, obviously, with collections every month. They were a little aggressive in how fast it's going through. If you saw that the big public companies, PRA and Encore, also announced that the collection curves have slowed, it's an industry-wide issue that collection curves have slowed, and that's why we're working with them, Mark.

Makes sense. When considering the allocation of additional capital at this stage, how do you evaluate the pricing of credit? Do interest rates increase, or do the terms change? What trends are you observing regarding pricing as you incur additional costs?

The first thing we need to do is ensure that when we allocate any funds, we consider two key factors. First, we need a larger down payment, and second, we recognize that it will take a longer time to be repaid. The main point in our underwriting is realizing that what we initially expected to be a three-year payback period may actually extend to five years. Therefore, we need to analyze whether it makes sense to issue a loan that will be repaid in five years. This is the significant change we’re observing. Currently, loans are expected to extend. As people pursue judgments, the courts are congested, leading to an increase in market products and buyers. We anticipate that loan timelines will extend not just this year or next, but possibly over the next few years as we navigate this substantial increase in volume.

Got it. And in terms of the loan loss reserve, is that something that you guys look at, obviously, quarterly, annually? And what's the probability of having to continue to tweak that materially here going forward?

So obviously, we're looking at it every quarter always. We think that it's sufficient and we don't anticipate doing it again, at least from everything we see today. We think that what we did was conservative and aggressive in taking the $900,000. So by making it conservative and aggressive, we think we've got ourselves covered for next year and beyond.

Our next question is from the line of George Sutton with Craig Hallum.

I apologize for not catching your earlier prepared comments, so if my questions seem unclear, there's a reason for that. However, it was quite evident from listening to PRIA's call that they discussed a significant increase in charge-offs. They mentioned opportunities in the market that would lead to brokered business, in which you are the main player. Is that an accurate assessment?

In the prepared remarks, I mentioned that NLEX achieved a record performance in Q3 and is on track for an exceptional Q4. Not only are we attracting new sellers, but our current sellers are increasing their product offerings as they have more inventory to sell. We anticipate that next year will be the biggest year in NLEX's history. Our marketplaces are very robust as we approach Q4, which I believe will also be the best quarter ever for NLEX. Currently, I agree with your assessment, and I think this growth is sustainable for the next few years. While the collection curves may be slowing, as noted by PRA and Encore, the volume is actually growing significantly each quarter.

Now relative to the capacity that your buyers have on the brokerage side, how much does the lender you’re specifically referencing and the related higher loan loss reserve impact your ability in the market to maintain that sort of normal operation?

So the absorption rate is still very, very strong. We're getting bids on everything we put out. The pricing has gone down to more normal levels. During the pandemic, there wasn't enough supply, and people were paying very high prices and thinking that the collection curves were quicker than they are now. But the absorption rate is 100%. We haven't had a portfolio that we've been unable to get bids on. And so a lot of these people really couldn't spend any money during the pandemic. And now all of a sudden, they're basically back in business. So I think there's a solid base of buyers right now.

Quick question on the biotech side. So we're somewhat stunned by the number of auctions that you've had. How much is that impacting the buyer side in terms of their willingness to pay up in these auctions? And understanding that if I don't buy today, there's a number of other auctions coming.

It's been really good because most of what we're doing is not for the Fortune 1000, big Pfizer's of the world, the Amgens of the world. Most of what we're doing is for companies that are struggling that basically have newer equipment. So because we're selling much newer equipment from venture-type companies to equipment 1, 2, 3, 4 years old, we're getting very aggressive bids. And what happens that people may not understand when times get tighter, there's an increase, not a decrease in the volume of people that will buy used equipment. So people that won't look at used equipment when they're getting $20 million funding from their VCs, and they can buy everything brand-new, shiny without any kind of worries are now not getting that kind of money. And so as they're trying to basically balance their supply chain, they're more and more looking at used equipment. We're selling used equipment now to guys that are buying used equipment for the first time.

Our next question is from Michael Diana with Maxim Group.

I'd like to ask about absorption rates, specifically the demand for charged-off loans. You mentioned that absorption rates remain high, even though pricing might be a bit softer. Could you explain how you earn revenue from these sales of charged-off loans and how this dynamic could affect your revenue?

We are never in a principal position and do not face any financial risk. We operate purely as a broker, which means we do not guarantee pricing. Our role is to provide guidance on valuations to ensure customer satisfaction with our performance. We earn a seller's commission, similar to how brokerage firms like CBRE or Cushman & Wakefield operate. We charge a brokerage fee that is paid upon closing. Our revenue is primarily driven by volume, so a decrease in pricing does not significantly affect us as long as we manage to sell more loan portfolios. For instance, if pricing drops from $0.10 to $0.08, the impact on our earnings is minimal compared to increasing the number of transactions from 200 to 300 in a year.

Right, right. So you get a fixed percentage of the amount sold. Right?

Yes.

So as you said, you can make it up and by right, even if the prices.

We can make up the volume. And the great news there is it's really easy to make it up in volume because in this business, you're not raising your OpEx. You don't need more people to sell more loans. We've got pretty much the staff in place that can handle the growth. Because in the end, it's different in the industrial auction business. You're not setting up the plants. You don't have shippers. You don't have rigors; you're not checking out the plants. Here, you're literally just selling paper. So there's tremendous leverage.

Thank you. As there are no further questions, I would now hand the conference over to the management for closing comments.

So thank everyone for listening in. We always appreciate having an audience of people that pay attention, that want to learn about our company that want to get more knowledge about our company. We're very successful if anybody wants to contact us after this call and have any one-on-one discussion. We'd love to have a one-on-one discussion with you. We think that next year is going to be the best year in the history of the company, and we have every reason to believe that and every indication to believe that, looking at the pipeline across the board. So this is about as excited as we can get. We've got a lot of work to do, and we're going to do that work. We realized that we're going to basically have to wait a little longer to get all of our money paid back. But as I said in the earnings call, I'm pretty glad that people owe me $35 million. So that's a good feeling. And if it takes a little longer to get paid back, we don't need the money tomorrow. We have excellent cash flow. We have excellent operating leverage, and we're in a fantastic position if we have to wait another 6 months or 1 year, 1.5 years to get paid back on some of this because we did everything right to be strong enough that we can wait. So everybody have a great day, and thank you all for listening.

Thank you. The conference of Heritage Global Inc. has now concluded. Thank you for your participation. You may now disconnect your lines.