2023-03-15 04:24:08 ET
Summary
- HGBL is an asset market-maker, participating in fixed assets, intangibles, inventories, receivables, and charged-off loans.
- The company's industries are interesting because they provide the opportunity to build a moat. However, the company has not done so, in my opinion, because employee compensation eats the profits.
- HGBL's FY22 earnings marked a record, aided by non-recurring asset sales and the reversal of tax allowances.
- Not only are future profits probably lower, but the company's current market cap already discounts a much larger and more profitable company.
- In my opinion, the stock does not leave room for error and already discounts all future opportunities.
Heritage Global ( HGBL ) is a broker, auctioneer, and adviser on distressed asset disposals.
The company operates in the fixed asset, intangibles, inventories, receivables, and charged-off loans markets, sometimes acting as an agent and sometimes as a principal. One of the company's subsidiaries owns the largest charged-off loan receivables exchange.
Recently, HGBL stock increased significantly in price, following one-time non-recurring earnings. A comparison with recent share price history shows that when one-time earnings revert, prices follow suit.
From a longer-term perspective, the business suffers from bad cost management, with difficulty controlling SG&A expenses. On the demand side, the company expects volume increases as more loans are charged-off and companies sell tangible assets. Although this could prove correct, I believe this expectation has market dynamics flaws.
Note: Unless otherwise stated, all information has been obtained from HGBL's filings with the SEC .
Business description
Distressed asset broker
HGBL has two divisions, industrial and financial.
The industrial division brokers and auctions inventories, receivables, fixed assets, and intangibles like IP or customer lists. Sometimes the company acts as an agent, making a commission on each sale. On other occasions, it acts as a principal or market-maker, purchasing from one side and then trying to find the other side and charging a markup.
The financial division mainly comprises the National Loan Exchange or NLEX, the largest volume broker of charged-off loans among financial institutions. This subsidiary acts only as an agent, providing an electronic marketplace for buyers and sellers to transact credit card, auto, and consumer loans.
Both businesses enjoy very interesting competitive dynamics.
Marketplaces enjoy network effects. The bigger they get, the stronger they become. This effect is stronger in the financial division, where customers are more recurrent (a failing manufacturer is unlikely to sell its assets twice, but a bank might recurrently sell charged-off loans).
HGBL needs experience buying and selling these assets because it has to act as a principal if the customer desperately needs liquidity. The company's appraisers have to be able to measure the risk of taking assets (real or financial) into inventory and the expected return of reselling them. If clients know that HGBL will act as a market-maker in difficult times, they will transact more with HGBL.
Finally, there are capital requirements for being a market-maker in these markets where transactions are in the order of the millions or sometimes hundreds of millions. As HGBL grows, it could build the balance sheet strength required to provide that capital.
Operational history
Unfortunately, HGBL has not realized its potential until now.
The company's financial division was created in 2014 when the company acquired NLEX. Since then, the company's service revenue (acting as an agent in both the industrial and financial divisions) has grown significantly, from $7 million in FY14 to $16 million in FY16 , $21 million in FY20 , and $23.5 million in FY22 .
Although the company does not disclose the percentage of revenue corresponding to each division, I suspect that most of the services revenue comes from the financial division. The reason is that the asset sale revenue (from the company acting as principal) has remained relatively stagnant across the cycle, with $6 million in FY14, $8 million in FY16, $4.5 million in FY20, and $5.8 million in FY21. The company's sales as an agent are more related to the industrial division.
The problem is that most of the new revenue has been used to pay for higher expenses, prohibiting an increase in profitability. The company has maintained its gross profit margins but has SG&A expenses that are too close to its gross profits.
The reason behind this lack of cost control might be twofold.
First, the company might require a scale that it has not achieved yet to sustain its structure. This seems implausible because it does not run an asset- or employee-intensive operation.
The second one is that the company has excessive compensation. With 63 employees, the company records $250 thousand in SG&A expenses per employee in FY21, 75% of which are compensation. This figure puts it above some of the most highly-compensated companies, like JPMorgan ( JPM ) or Salesforce ( CRM ). In FY22, the company increased compensation by 60%.
Valuation
Recent non-recurring revenues
HGBL's revenues for FY22 are twice those registered for FY21. Further, the company's income from equity investments, averaging less than $1 million for the past decade, jumped to $7 million in FY22.
Although SG&A and compensation grew 60% in the same period, the operating leverage generated by doubling revenues and 7x equity income quadrupled the operating income from $3 million to $11 million.
The windfall from equity investments comes from asset sales. In particular, the sale of two buildings held in JVs where the company had participations generated most of the equity income. These sales are one-time in nature. The JV that generated those sales (CPFH LLC) no longer has significant assets. There is another JV dedicated to purchasing and selling fixed assets (KNFH LLC), but its size is much smaller than CPFH ($2.5 million against $12 million of CPFH before the sales), meaning that it probably cannot generate the same level of revenue and profits in the future.
On the consolidated side, the company did not explain where the higher asset sales came from. The MD&A commentary has been that the variation comes from the 'reflects the vagaries of the timing and magnitude of asset liquidation transactions', with the phrase repeated quarter after quarter. This is not convincing, given that sales are four to five times above the previous decade's average.
In my opinion, the increased business level reflects inventory consolidations across the supply chain after the gluts generated in 2020 and 2021. These consolidations are unlikely to recur since companies have now accommodated to a lower demand level.
Lending on the financial division
Another growing sector is direct lending. The company is offering financing to the purchasers of charged-off loans.
As of 4Q22, the company accumulated $10 million in notes receivables against $4 million last year on its balance sheet directly. Most importantly, the unconsolidated JV HGC Funding I has $32 million in assets as of 3Q22, growing from $10 million in 3Q21. The company does not disclose its ownership percentage for HGC Funding. Still, given that it represents most of the JV's portfolio equity ($32 of $35 million) and that the portfolio is recorded as $9 million in the balance sheet, we can approximate ownership to 25% as of 3Q22.
This business is lending to clients purchasing loans and may take significant risks. The JV generated revenue of $1.6 million in the 9M22 period, with average assets of $22 million between December 2021 and September 2022. This approximates an annual rate of 9.5% on the loans. These rates are common among borrowers that cannot access more traditional financing.
The company's management gave an interesting explanation in their 3Q22 earnings call . Here they mention that these loans go to non-usual clients that do not have a low cost of funds and therefore require financing to purchase the charged-off loans. The counterparties usually would not receive funds from an FDIC-insured bank (their credit standing is risky). Finally, the loans are long-dated, up to five years.
The problem with these operations is not necessarily their risk but how income is treated. The company quickly recognizes interest income from these loans but does not record allowances. This enhances current profitability but hides the cost of some borrowers defaulting to a later period. Although the risk seems contained now (total exposition of about $15 million as of 3Q22), the practice is not conservative.
Growing thanks to the crisis
HGBL managers believe that the company's business volume will increase in the following years, given that financial companies will have to charge off more loans and manufacturing companies will reduce their operations.
I believe this reasoning is flawed because an increase in supply begets a decrease in demand.
On the industrial side, if some companies reduce their operations and sell assets and inventories, someone must buy them for brokered volumes to increase. That someone has to have a use for those assets. The uses for assets are generally lower during a recession. Therefore, buyers will also decrease. Say that a company is selling a piece of machinery because its markets are shrinking, why would a competitor expand production?
For the financial side, if the increase in interest rates multiplies the amounts of charge-offs, funding will probably be scarcer. Financial purchasers will have less desire for these now-deemed riskier investments. The general condition is for financial markets to dry during crises, not to increase the transacted volume.
Still, the crisis-fueled growth theory is compelling, so we can consider how much growth is needed to justify the company's current market cap.
Profitability, costs, and growth
HGBL has sustained an operating income of $3 million annually, on average, since 2018. The figure below is slightly lower but does not consider equity income from JVs. Therefore, the current $100 million market cap is elevated on a historical profitability basis.
If we move towards future expectations, we have two engines of profitability: services and asset sales.
The gross margins in the service segment have been close to 70/75%, while the margins in the asset sale segment are more in the 40% range.
Understanding SG&A expenses is difficult because they seem to rise with every increase in earnings. Particularly, compensation increased by 60% in Fy22.
Should we forecast SG&A costs of $21 million, in line with FY22 levels or $15 million, from FY21? Considering the previous operational history, if the company does well (the scenario analyzed below), employees will get compensated handsomely, so elevated SG&A costs are expected.
Finally, we have income from the lending operation at 10% of assets, currently at approximately $25 million, or $2.5 million yearly, without considering the (substantial) default risk costs unaccounted for in the company's statements.
Finally, the company is tax protected by $78 million in NOLs which should save a significant portion of profit taxation for a few years at least.
If we require $10 million in net income and add $21 million of SG&A expenses, we are considering $31 million in gross profit and income from equity investments.
If the asset sale business doubles its previous 10-year average and stays at $10 million in yearly revenue, it can generate $4 million in gross profits. If the lending business doubles and presents zero defaults, it could generate $5 million in net interest income.
This leaves $21 million in gross profits to be covered by the service business, which implies revenues of $30 million at a gross margin of 30% or revenue growth of 30%.
Therefore, current share prices already discount asset sales at twice the previous decade's average, a pristine credit business operating at twice its current size, and service revenue 30% higher than in FY22.
In my opinion, this leaves no room for opportunity. If everything goes well, the company is fairly priced. Otherwise, it is not.
No room for error
The company's shares have traded following EPS in the last few years, particularly after the company recovered operational profitability in 2018. The movement in prices and income has been wild, mostly generated by one-time events like asset sales in 2020 and 2022. In 4Q22, the company also recorded $7 million in tax valuation allowance reversals, further elevating income to unsustainable levels.
Even if the optimistic scenario in the previous section materialized, the company would still generate lower net income than in FY22 because it would not enjoy the one-time thrust of asset sales and tax allowance reversals. This could produce a decrease in share prices.
My recommended strategy
The company's probability of maintaining its current profitability is low. The possibility that it can materialize the optimistic scenario is slightly higher but not enormous. Still, the company's current share price already discounts these scenarios.
I prefer to wait for the share price to deflate on the news of lower earnings and use that time to judge if the company's future market will be much better than the one experienced in the past decade.
The investor may find a lower share price and more information in a few months. This would allow for a more informed decision with a higher degree of safety.
Conclusions
HGBL operates in a desirable market where a moat can be built. However, the company has not been able to do so. In my opinion, the reason is that the company has spent too much one employee compensation, which has precluded profitability, and the accumulation of capital needed to grow.
In FY22, HGBL recorded record profitability, partly because of recurring business growth (particularly on the financial side) but mostly because of nonrecurring asset sales and tax valuation reversals.
Not only a decrease in EPS is probable in FY23, but the company's current share price already discounts a much higher level of business.
The combination of an elevated share price, uncertain business perspectives, and unsustainable EPS indicates that HGBL stock is not an opportunity at these prices.
I prefer to wait until the company trades at more reasonable valuations and there is a higher understanding of its industry's perspectives.
For further details see:
Heritage Global's Earnings Are Unsustainable At Current Levels