DJCO Daily Journal Corp

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Results of Operations

The Company continues to operate as two different businesses: (1) The Traditional Business, being the business of newspaper publishing and related services that the Company had before 1999 when it purchased a software development company, and (2) Journal Technologies, Inc. (“Journal Technologies”), a wholly-owned subsidiary which supplies case management software systems and related products to courts, prosecutor and public defender offices, probation departments and other justice agencies, including administrative law organizations, city and county governments and bar associations. These organizations use the Journal Technologies family of products to help manage cases and information electronically, to interface with other critical justice partners and to extend electronic services to the public, including efiling and a website to pay traffic citations and fees online, and bar members. These products are licensed to more than 500 organizations in 42 states and internationally.

Impact of the Coronavirus (COVID-19) Pandemic

Management believes that the COVID-19 pandemic has had, and will continue to have, a significant impact on the Company’s business operations. That impact started in March, and management believes it will continue to be reflected in subsequent quarterly financial results and cash flows for the foreseeable future. This includes the substantial decrease in the value of the Company’s marketable securities portfolio, which could decrease further and is likely, at a minimum, to continue to be volatile. It also includes the unprecedented closure or scaling back of operations of courts and other governmental agencies that are the customers of Journal Technologies, and fundamental changes in the way the advertisers and subscribers of the Traditional Business conduct operations. Even if courts, governmental agencies and other businesses return to a more normal operations, there are likely to be changes in those operations and personal behaviors going forward, including limitations on travel, that will adversely affect the Company, its financial results and cash flows.

For the three months ended March 31, 2020, the Company experienced a material negative impact on its financial results primarily because of the recording of the unrealized losses on investments of $77,211,000 for its marketable securities as the stock market plunged. In addition, the Company’s portfolio is concentrated in the common stocks of three U.S. financial institutions, which have experienced a greater decline than the market as a whole. In the future, dividends income from the Company’s portfolio may be reduced. (Beginning in fiscal 2019, changes in unrealized gains (losses) on investments are now included in the Company’s net income (loss) and thus may have a significant impact depending on the fluctuations of the market prices of the securities in the portfolio.)

In recent years, the newspaper industry, including our Traditional Business, has declined, and we expect this to continue at an accelerated pace due to the impacts of COVID-19 and its aftermath, as advertising and subscription revenues decrease.

For Journal Technologies, there have been delays or cancellations in government procurement processes. Also, although we have been able to complete some existing projects remotely, we have been unable to finish certain implementations and trainings because we cannot work with clients in-person. Given that we are typically paid for implementation services upon “go-live” of a system, receipt of those revenues is being delayed. In addition, there has been a reduction in efiling revenues and delayed client payments as courts and other justice agencies are temporarily closed.

Due to the uncertainties associated with the duration and severity of the COVID-19 pandemic, the efforts to contain it, and the changes in business operations and personal behaviors that are likely to follow from it, management cannot at this point estimate the magnitude of its impact on the Company’s business operations. However, it is often said that past results are not indicative of future performance, and that is especially true of the Company’s operating results for the first half of fiscal 2020, which are not likely to be replicated in the second half of the year due to COVID-19 and its aftermath.

For risk factors associated with the Company’s businesses, please see “Item 1A – Risk Factors” of the Company’s annual report on Form 10-K for the fiscal year ended September 30, 2019, as well as the information contained in “Item 1A – Risk Factors” on page 23 of this Form 10-Q.

Comparable six-month periods ended March 31, 2020 and 2019

Consolidated revenues were $24,033,000 and $21,140,000 for the six months ended March 31, 2020 and 2019, respectively. This increase of $2,893,000 (14%) was primarily from (i) increased Journal Technologies’ license and maintenance fees of $1,285,000, consulting fees of $978,000 and public service fees of $770,000, and (ii) increased Traditional Business’ legal notice advertising and service fee net revenues of $215,000 and government notice advertising and service fee net revenues of $38,000, partially offset by a reduction in the Traditional Business’ display advertising net revenues of $252,000 (including conferences), classified advertising net revenues of $40,000, trustee sale notice advertising net revenues of $57,000 and circulation revenues of $13,000. The Company’s revenues derived from Journal Technologies’ operations constituted about 66% and 61% of the Company’s total revenues for the six months ended March 31, 2020 and 2019, respectively.

Consolidated operating expenses increased by $317,000 (1%) to $26,649,000 from $26,332,000. Total salaries and employee benefits increased by $1,119,000 (6%) to $18,565,000 from $17,446,000 primarily resulting from additional personnel costs for Journal Technologies. Outside services decreased by $388,000 (16%) to $2,014,000 from $2,402,000 mainly because of decreased contractor costs for Journal Technologies. Depreciation and amortization costs decreased by $47,000 to $256,000 from $303,000. Credit card merchant discount fees, which represent fees paid to credit card service providers to process payments for the public service fee revenues, increased by $125,000 (19%) to $770,000 from $645,000 mainly resulting from increased efilings. Rent expenses decreased by $173,000 (34%) to $342,000 from $515,000 because of the closure of both the San Francisco and Modesto offices in October 2019. Accounting and legal fees decreased by $341,000 (43%) to $458,000 from $799,000 primarily because of decreased legal fees to review and negotiate Journal Technologies’ contracts with customers, more of which was done in-house.

The Company’s non-operating income, net of expenses, decreased by $37,157,000 to a loss of $55,080,000 from a loss of $17,923,000 primarily because of the recording of net unrealized losses on investments of $57,680,000 during the six months ended March 31, 2020, as compared with $20,143,000 during the prior year period.

During the six months ended March 31, 2020, the consolidated pretax loss was $57,696,000, as compared with $23,115,000 in the prior year period. There was a consolidated net loss of $42,116,000 (-$30.50 per share) after tax benefits for the six months ended March 31, 2020, as compared with $16,515,000 (-$11.96 per share) in the prior year period.

At March 31, 2020, the aggregate fair market value of the Company’s marketable securities was $136,901,000. These securities had approximately $83,012,000 of net unrealized gains before taxes of $21,816,000, and generated approximately $2,977,000 in dividends income during the six months ended March 31, 2020, which lowers the Company’s effective income tax rate because of the dividends received deduction. Most of the unrealized gains were in the common stocks of three U.S. financial institutions and one foreign manufacturer.

Additional detail about each of the Company’s reportable segments, and its corporate income and expenses, is set forth below:

The Traditional Business

The Traditional Business had pretax income of $115,000, representing a $304,000 increase from a pretax loss of $189,000 in the prior year period.

Advertising revenues decreased by $182,000 to $4,118,000 from $4,300,000, primarily because of decreased display advertising net revenues of $252,000 (including conferences), classified advertising net revenues of $40,000 and trustee sale notice advertising net revenues of $57,000, partially offset by increased legal notice advertising net revenues of $152,000.

Trustee sale notices are very much dependent on the number of California and Arizona foreclosures for which public notice advertising is required by law. The number of foreclosure notices published by the Company decreased by 14% during the six months ended March 31, 2020 as compared to the prior year period. Unless the economic impact of the efforts to contain COVID-19 result in significant additional foreclosures in California and Arizona, management expects there will be fewer foreclosure notice and other public notice advertisements and declining revenues for all of fiscal 2020. The Company’s smaller newspapers, those other than the Los Angeles and San Francisco Daily Journals (“The Daily Journals”), accounted for about 87% of the total public notice advertising revenues in the six months ended March 31, 2020. Public notice advertising revenues and related advertising and other service fees constituted about 18% and 20% of the Company’s total revenues for the six months ended March 31, 2020 and 2019, respectively. Because of this concentration, the Company’s revenues would be significantly adversely affected if California and Arizona eliminated the legal requirement to publish public notices in adjudicated newspapers of general circulation, as was implemented in Arizona for one notice type that had represented approximately $500,000 in annual revenues for the Company. Also, if the adjudication of one or more of the Company’s newspapers was challenged and revoked, those newspapers would no longer be eligible to publish public notice advertising, and it could have a material adverse effect on the Company’s revenues.

The Daily Journals accounted for about 91% of the Traditional Business’ total circulation revenues, which declined by $13,000 to $2,598,000 from $2,611,000. The court rule and judicial profile services generated about 7% of the total circulation revenues, with the other newspapers and services accounting for the balance. Advertising service fees and other are Traditional Business segment revenues, which include primarily (i) agency commissions received from outside newspapers in which the advertising is placed, and (ii) fees generated when filing notices with government agencies.

The Traditional Business segment operating expenses decreased by $442,000 (5%) to $7,906,000 from $8,348,000, primarily due to decreased personnel costs and outside contract printing and distributing costs.

Journal Technologies

Journal Technologies’ business segment pretax loss decreased by $2,274,000 (45%) to $2,774,000 from $5,048,000 for the six months ended March 31, 2020 and 2019, respectively.

Revenues increased by $3,033,000 (23%) to $15,969,000 from $12,936,000 in the prior year period. Licensing and maintenance fees increased by $1,285,000 (14%) to $10,715,000 from $9,430,000. Consulting fees increased by $978,000 (104%) to $1,918,000 from $940,000 due to more go-lives.

Deferred revenues on installation contracts primarily represent the fair value of advances from customers of Journal Technologies for installation services and are recognized upon final project go-lives. Deferred revenues on license and maintenance contracts represent prepayments of annual license and maintenance fees and are recognized ratably over the maintenance period. Other public service fees increased by $770,000 (30%) to $3,336,000 from $2,566,000 primarily due to additional efiling fee revenues.

Operating expenses increased by $759,000 (4%) to $18,743,000 from $17,984,000, primarily because of increased salaries and employee benefit costs.

Taxes

For the six months ended March 31, 2020, the Company recorded an income tax benefit of $15,580,000 on a pretax loss of $57,696,000.   This was the net result of applying the effective tax rate anticipated for fiscal 2020 to the pretax loss, before the unrealized losses on investments, for the six months ended March 31, 2020.  The effective tax rate was more than the statutory rate primarily due to the dividends received deduction, which increased the taxable loss, and state tax benefits.   In addition, the Company recorded tax benefits of (i) $187,000 resulting from the Coronavirus Aid, Relief and Economic Security (“CARES”) Act (see below) and (ii) $15,425,000 for the unrealized losses on investments during the six months ended March 31, 2020.  The effective tax rate for the six months ended March 31, 2020 was 27%, after including the tax benefits from the CARES Act and the unrealized losses on investments.

The CARES Act, which was signed into law on March 27, 2020, contains two federal tax provisions beneficial to the Company.  One provision provides that net operating losses arising in tax years beginning in 2018, that were previously only available to be carried forward, can now be carried back to the five previous years.  In addition, any alternative minimum tax credits carried forward from prior years can be claimed as a refund in years beginning in 2018.  Consequently, the Company recorded a tax benefit resulting from carrying back a portion of the net operating loss generated in fiscal 2019 to fiscal 2014.  The Company anticipates receiving a refund for all taxes and alternative minimum taxes paid in fiscal 2014.  The resulting tax benefit from carrying back the net operating loss is primarily attributable to the difference in the federal tax rates of 34% in fiscal 2014 and 21% in fiscal 2019.

For the six months ended March 31, 2019, the Company recorded an income tax benefit of $6,600,000 on a pretax loss of $23,115,000.   This was the net result of applying the effective tax rate anticipated for fiscal 2019 to the pretax loss for the six months ended March 31, 2019. The effective tax rate was greater than the statutory rate primarily due to state tax benefits. 

The Company’s effective tax rate was 27% for the six months ended March 31, 2020 as compared with 29% in the prior year period. 

The Company files consolidated federal income tax returns in the United States and with various state jurisdictions and is no longer subject to examinations for fiscal years before fiscal 2016 with regard to federal income taxes and fiscal 2015 for state income taxes. 

Comparable three-month periods ended March 31, 2020 and 2019

Consolidated revenues were $12,356,000 and $10,712,000 for the three months ended March 31, 2020 and 2019, respectively. This increase of $1,644,000 (15%) was primarily from increased Journal Technologies’ license and maintenance fees of $865,000, consulting fees of $830,000 and public service fees of $22,000, partially offset by a reduction in the Traditional Business’ conference revenues of $80,000, classified advertising net revenues of $24,000 and trustee sale notice advertising net revenues of $20,000. The Company’s revenues derived from Journal Technologies’ operations constituted about 68% and 63% of the Company’s total revenues for the three months ended March 31, 2020 and 2019, respectively.

Consolidated operating expenses increased by $71,000 to $13,454,000 from $13,383,000. Total salaries and employee benefits increased by $887,000 (10%) to $9,678,000 from $8,791,000 primarily resulting from additional personnel costs for Journal Technologies. Outside services decreased by $90,000 (7%) to $1,154,000 from $1,244,000 mainly because of decreased contractor costs for Journal Technologies. Depreciation and amortization costs decreased by $22,000 to $128,000 from $150,000. Credit card merchant discount fees, which represent fees paid to credit card service providers to process payments for the public service fee revenues, increased by $13,000 (3%) to $388,000 from $375,000 mainly resulting from increased efilings. Rent expenses decreased by $87,000 (34%) to $170,000 from $257,000 because of the closure of both the San Francisco and Modesto offices in October 2019. Accounting and legal fees decreased by $194,000 (49%) to $202,000 from $396,000 primarily because of decreased legal fees to review and negotiate Journal Technologies’ contracts with customers, more of which was done in-house. Other general and administrative expenses decreased by $523,000 (38%) to $846,000 from $1,369,000 mainly resulting from reduced miscellaneous office equipment purchases.

The Company’s non-operating income, net of expenses, decreased by $85,494,000 to a loss of $76,088,000 from an income of $9,406,000 primarily because of the recording of net unrealized losses on investments of $77,211,000 during the three months ended March 31, 2020, as compared with net unrealized gains on investments of $8,497,000 during the prior year period.

During the three months ended March 31, 2020, consolidated pretax loss was $77,186,000, as compared with pretax income of $6,735,000 in the prior year period. There was consolidated net loss of $56,326,000 (-$40.79 per share) after tax benefits for the three months ended March 31, 2020, as compared with net income of $5,018,000 ($3.63 per share) in the prior year period.

Liquidity and Capital Resources

During the six months ended March 31, 2020, the Company’s cash and cash equivalents and marketable security positions decreased by $62,488,000, including unrealized losses on investments of $57,680,000. Cash and cash equivalents were used for the purchase of capital assets of $168,000 and operating activities of $4,578,000 which included net decreases of $3,735,000 in deferred subscriptions, deferred installation contracts and deferred maintenance agreements and others.

The investments in marketable securities, which had an adjusted cost basis of approximately $53,889,000 and a market value of about $136,901,000 at March 31, 2020, generated approximately $2,977,000 in dividends income during the six months ended March 31, 2020. These securities had approximately $83,012,000 of net unrealized gains before estimated taxes of $21,816,000 which will become due only when we sell securities in which there is unrealized appreciation. Beginning in fiscal 2019, changes in unrealized gains (losses) on investments are now included in the Company’s net income (loss) and thus may have a significant impact depending on the fluctuations of the market prices of the invested securities.

Cash flows from operating activities decreased by $1,203,000 during the six months ended March 31, 2020 as compared to the prior year period, primarily due to (i) decreases in accounts payable and accrued liabilities of $3,372,000 because of the timing difference in remitting efiling fees to the courts and (ii) decreases in net deferred subscriptions, deferred maintenance agreements and others and deferred installation contracts of $3,633,000, partially offset by decreases in accounts receivable of $3,228,000 resulting from more collections.

As of March 31, 2020, the Company had working capital of $124,574,000, including the liabilities for deferred subscriptions, deferred installation and maintenance agreements and others of $17,193,000.

The Company believes that it will be able to fund its operations for the foreseeable future through its cash flows from operations and its current working capital and expects that any such cash flows will be invested in its businesses. COVID-19 and the efforts to contain it, however, have significantly impacted the Company’s cash flows from operations and the value of its marketable securities portfolio. The Company may or may not have the ability to borrow additional amounts against its marketable securities and, among other possibilities, it may be required to consider selling some of those securities to generate cash if needed to fund ongoing operations.

As of March 31, 2020, the investments were concentrated in just six companies. Accordingly, a significant decline in the market value of one or more of the Company’s investments may not be offset by the hypothetically better performance of other investments, and that could result in a large decrease in the Company’s shareholders’ equity and net income, as it did in the three-month and six-month periods ending March 31, 2020.

Critical Accounting Policies and Estimates

The Company’s financial statements and accompanying notes are prepared in accordance with U.S. generally accepted accounting principles. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Management believes that revenue recognition, accounting for software costs, fair value measurement and disclosures (including for the long-term Incentive Plan liabilities) and income taxes are critical accounting policies and estimates.

The Company’s critical accounting policies are detailed in its Annual Report on Form 10-K for the year ended September 30, 2019. The above discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and notes thereto included in this report.

Disclosure Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Certain statements contained in this document, including but not limited to those in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” are “forward-looking” statements that involve risks and uncertainties that may cause actual future events or results to differ materially from those described in the forward-looking statements. Words such as “expects,” “intends,” “anticipates,” “should,” “believes,” “will,” “plans,” “estimates,” “may,” variations of such words and similar expressions are intended to identify such forward-looking statements. We disclaim any intention or obligation to revise any forward-looking statements whether as a result of new information, future developments, or otherwise. There are many factors that could cause actual results to differ materially from those contained in the forward-looking statements. These factors include, among others: risks associated with software development and implementation efforts; Journal Technologies’ reliance on professional services engagements with justice agencies; material changes in the costs of postage and paper; possible changes in the law, particularly changes limiting or eliminating the requirements for public notice advertising; possible loss of the adjudicated status of the Company’s newspapers and their legal authority to publish public notice advertising; the impacts of COVID-19 and the efforts to contain it on the Company’s customers, advertisers and subscribers, particularly the closure or scaling back of operations of courts, justice agencies and other businesses; a further decline in public notice advertising revenues because of fewer foreclosures; a further decline in subscriber and commercial advertising revenues; possible security breaches of the Company’s software or websites; the Company’s reliance on its president and chief executive officer, who has reduced his work schedule due to a health issue; changes in accounting guidance; material weaknesses in the Company’s internal control over financial reporting; and declines in the market prices of the securities owned by the Company. In addition, such statements could be affected by general industry and market conditions, general economic conditions (particularly in California) and other factors.  Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct. Important factors that could cause actual results to differ materially from those in the forward-looking statements are discussed in this Form 10-Q, including in conjunction with the forward-looking statements themselves. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained from time to time in documents filed by the Company with the Securities and Exchange Commission, including in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2019.