DAILY JOURNAL CORP (DJCO) FY 2023 MD&A

Item 7. 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 e-filing and a website to pay traffic citations and fees online. These products are licensed or subscribed in approximately 30 states and internationally.

Impact of the COVID-19 Pandemic

On March 13, 2020, the United States declared the outbreak of COVID-19 to be a national emergency, and several states and municipalities also declared public health emergencies. Unprecedented actions were taken by public health and other governmental authorities to contain and combat the spread of COVID-19, including “stay-at-home” orders and similar mandates that restricted the daily activities of individuals and limited the operation of businesses that were deemed “non-essential”. In addition, most of Journal Technologies’ customers, which are primarily courts and governmental agencies in the United States, Canada and Australia, were either closed or significantly scaled back their activities. Similarly, many law firms and companies from which the Traditional Business derives advertising and subscription revenues also curtailed their in-person operations and spending.

Although the World Health Organization has declared an end to the COVID-19 emergency, enduring changes in society resulting from efforts to contain the COVID-19 pandemic are likely to have continuing effects on the Company’s business. For example, for Journal Technologies, there have been several delays or cancellations in government procurement processes. Also, although we were able to complete many existing projects remotely, we were delayed in finishing certain implementations and trainings because of our inability to work with clients in-person. Given that we are typically paid for implementation services upon “go-live” of a system, recognition of those revenues has been delayed. This can also create a risk of contract cancellations of in-progress projects, which has not been a common issue to date (although there were two in the past year), and Journal Technologies is working to minimize additional cancellations.

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Reportable Segments

The Company’s Traditional Business is one reportable segment and the other is Journal Technologies which includes Journal Technologies, Inc. and Journal Technologies (Canada) Inc. All inter-segment transactions were eliminated. Additional detail about each of the reportable segments and the Company's corporate income and expenses is set forth below:

During fiscal 2023 and 2022, the Traditional Business had total operating revenues of $16,253,000 and $15,922,000 of which $11,850,000 and $11,528,000, respectively, were recognized after services were provided while $4,403,000 and $4,394,000, respectively, were recognized ratably over the subscription terms. Total operating revenues for the Company’s software business were $51,456,000 and $38,087,000, of which $28,209,000 and $19,459,000, respectively, were recognized upon completion of services while $23,247,000 and $18,628,000, respectively, were recognized ratably over the subscription periods.

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Fiscal 2023 compared with fiscal 2022

Consolidated Financial Comparison

Consolidated revenues were $67,709,000 and $54,009,000 for fiscal 2023 and 2022, respectively. This increase of $13,700,000 (25%) was primarily from increases in (i) Journal Technologies’ consulting fees of $7,911,000, license and maintenance fees of $4,311,000 and other public service fees of $1,147,000, and (ii) the Traditional Business’ advertising revenues of $364,000, partially offset by a decrease in the Traditional Business’ advertising service fees and other of $42,000.

Approximately 76% of the Company’s revenues during fiscal 2023 were derived from Journal Technologies, as compared with 71% in the prior fiscal year. In addition, the Company’s revenues have been primarily from the United States, with approximately $3,293,000 (5%) from foreign countries. Almost all of Journal Technologies’ revenues are from governmental agencies.

Consolidated operating expenses increased by $9,037,000 (17%) to $61,057,000 from $52,020,000. Total salaries and employee benefits increased by $6,970,000 (19%) to $43,450,000 from $36,480,000 primarily due to the annual salary adjustments and the hiring of additional staff members to strengthen operational efficiencies, product development, and bolster the teams working on the company’s installation projects. Outside services increased by $2,312,000 (52%) to $6,768,000 from $4,456,000 mainly because of additional contractor services and increased third-party hosting fees which were billed to clients. Equipment maintenance and software increased by $286,000 (28%) to $1,315,000 from $1,029,000 mainly resulting from increased maintenance costs and additional miscellaneous office and enterprise software license purchases. Other general and administrative expenses increased by $518,000 (15%) to $3,876,000 from $3,358,000 mainly because there were increased business travel expenses as compared to the prior fiscal year period.

The Company’s non-operating income, net of expenses, increased by $125,988,000 to $21,450,000 from a loss of $104,538,000 in the prior fiscal year primarily because of (i) the recording of net unrealized gains on marketable securities of $17,024,000 as compared with net unrealized losses of $123,401,000 in the prior fiscal year, and (ii) increases in dividends and interest income of $2,885,000 (53%) to $8,356,000 from $5,451,000. These increases were partially offset by (i) the recording of realized net gains on sales of marketable securities of $422,000 during fiscal 2023 as compared with $14,249,000 in the prior fiscal year, (ii) increases in interest expenses of $3,229,000 (315%) to $4,255,000 from $1,026,000 primarily due to the federal interest rate increases, and (iii) gains of $272,000 on a partial land sale associated with the City of Logan’s street widening project during fiscal 2022.

During fiscal 2023, the Company’s consolidated pretax income was $28,102,000, as compared to pretax loss of $102,549,000 in the prior fiscal year. There was consolidated net income of $21,452,000 ($15.58 per share) for fiscal 2023, as compared with consolidated net loss of $75,624,000 (-$54.81 per share) in the prior fiscal year.

At September 30, 2023, the aggregate fair market value of the Company’s marketable securities was $303,128,000. These securities had approximately $137,716,000 of net unrealized gains before taxes of $36,260,000. They generated approximately $8,336,000 in dividends and interest income during fiscal 2023, as compared with $5,451,000 in the prior fiscal year. Most of the unrealized gains were in the common stocks of three U.S. financial institutions and one foreign manufacturer.

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Taxes

During fiscal 2023, the Company recorded an income tax provision of $6,650,000 on pretax income of $28,102,000.   The income tax provisions consisted of tax provisions of $110,000 on the realized gains on marketable securities, $4,140,000 on the unrealized gain on marketable securities, and $2,803,000 on operating income, partially offset by a tax benefit of $403,000 for the dividends received deduction and other permanent differences.  Consequently, the overall effective tax rate for fiscal 2023 was 23.7%, after including the taxes on the realized and unrealized gains on marketable securities.

During fiscal 2022, the Company recorded an income tax benefit of $26,925,000 on the pretax loss of $102,549,000.   The income tax benefit consisted of a tax benefit of $32,840,000 on the unrealized losses on marketable securities and a benefit of $340,000 for the dividends received deduction and other permanent book and tax differences, offset by tax provisions of $3,790,000 on the realized gains on marketable securities, $1,735,000 on income from operations, and $730,000 for the effect of a change in state apportionment on the beginning of the year’s deferred tax liability.  Consequently, the overall effective tax rate for fiscal 2022 was 26.3%, after including the taxes on the realized gains and unrealized losses on marketable securities.

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 2019 with regard to federal income taxes and fiscal 2018 for state income taxes.

The Traditional Business

The Traditional Business’ pretax income increased by $1,682,000 (240%) to $2,384,000 from $702,000 in the prior fiscal year, primarily due to a reduced long-term supplemental compensation accrual of $1,600,000 (142%) to a reduction of $470,000 from an addition of $1,130,000 in the prior fiscal year, partially offset by increased personnel costs of $798,000 to $10,416,000 from $9,618,000.

During fiscal 2023, the Traditional Business had total operating revenues of $16,253,000, as compared with $15,922,000 in the prior fiscal year. Advertising revenues increased by $364,000 (4%) to $8,955,000 from $8,591,000, primarily resulting from increased trustee sale notice advertising revenues of $207,000 (mainly because of the lifting of COVID-related foreclosure moratoriums on lenders), legal notice advertising revenues of $53,000, government notice advertising revenues of $44,000 and commercial advertising revenues of $60,000.

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 increased by 22% during fiscal 2023 as compared to the prior fiscal year. The Company’s smaller newspapers, those other than the Los Angeles and San Francisco Daily Journals (“The Daily Journals”), accounted for about 88% of the total public notice advertising revenues during fiscal 2023. Public notice advertising revenues and related advertising and other service fees, including trustee sales legal advertising revenues, constituted about 14% of the Company's total operating revenues for fiscal 2023 and 17% for fiscal 2022.

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The Daily Journals accounted for about 93% of the Traditional Business’ total circulation revenues, which increased by $9,000 to $4,403,000 from $4,394,000. The court rule and judicial profile services generated about 5% 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, excluding the adjustments to the long-term supplemental compensation accrual, increased by $249,000 (2%) to $14,339,000 from $14,090,000, primarily resulting from the annual salary adjustments.

Journal Technologies

During fiscal 2023, Journal Technologies’ business segment pretax income increased by $2,981,000 (232%) to $4,268,000 from $1,287,000 in the prior fiscal year primarily resulting from increased revenues of $13,369,000, partially offset by increased operating expenses of $10,388,000.

Revenues increased by $13,369,000 (35%) to $51,456,000 from $38,087,000 in the prior fiscal year. Licensing and maintenance fees increased by $4,311,000 (22%) to $23,503,000 from $19,192,000. Consulting fees increased by $7,911,000 (67%) to $19,776,000 from $11,865,000 mainly resulting from more project go-lives (i.e. signoffs by the clients). Other public service fees increased by $1,147,000 (16%) to $8,177,000 from $7,030,000 primarily because of increased e-filing fee revenues.

Deferred consulting fees primarily represent 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 periods.

Operating expenses increased by $10,388,000 (28%) to $47,188,000 from $36,800,000 primarily because of (i) increased personnel costs because of salary adjustments due to recent inflation in the compensation market for talent, (ii) additional contractor services and the hiring of additional staff members to strengthen operational efficiencies, product development, and bolster the teams working on the company’s installation projects, (iii) increased third-party hosting fees which were billed to clients and (iv) increased business travel expenses.

Journal Technologies continues to update and upgrade its software products. These costs are expensed as incurred and will impact earnings at least through the foreseeable future.

Liquidity and Capital Resources

During fiscal 2023, the Company’s cash and cash equivalents, restricted cash, and marketable security positions increased by $35,269,000, after the sales of marketable securities of approximately $2,826,000, and the recording of net pretax unrealized gains on marketable securities of $17,024,000. Cash, cash equivalents, and the proceeds from the sales of marketable securities were primarily used to purchase additional marketable securities of $10,001,000.

The investments in marketable securities, which had an adjusted cost basis of approximately $165,412,000 and a market value of about $303,128,000 at September 30, 2023, generated approximately $8,336,000 in dividends and interest income during fiscal 2023. These securities had approximately $137,716,000 of net unrealized gains before estimated taxes of $36,260,000 which will become due only when we sell securities in which there is unrealized appreciation. The balance on the Company's margin loan secured by the securities portfolio was $75,000,000 at both September 30, 2023 and September 30, 2022.

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Cash flows from operating activities increased by $20,345,000 during fiscal 2023, as compared to the prior fiscal year, primarily due to (i) decreases in the Company’s accounts receivable of $5,651,000 mainly resulting from more collections, its income tax receivable of $2,038,000 and its deferred tax benefit of $36,144,000 and (ii) increases in net accounts payable and accrued liabilities of $230,000 (because of the timing difference in remitting e-filing fees to the courts), deferred revenues of $1,434,000 and income tax payable of $7,313,000. This was partially offset by decreases in net income of $32,228,000, excluding the increases in unrealized gains on marketable securities of $140,425,000; decreases in realized net gains on sales of marketable securities of $13,827,000; additional stock dividends of $2,978,000; and prior year’s gains of $272,00 on land sale associated with Logan City’s street widening project.

As of September 30, 2023, the Company had working capital of $303,207,000, including the liabilities for deferred subscriptions, deferred consulting fees and deferred maintenance agreements and others of $25,539,000.

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. 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. The amount available for borrowing is based on the market value of the Company’s investment portfolio and fluctuates depending on the value of the underlying securities.  In addition, the Company could be subject to margin calls should the balance of the investment decrease significantly.

The Company is not a smaller version of Berkshire Hathaway Inc.  Indeed, given the passing of Mr. Munger, the Company does not expect its holdings of marketable securities to generate gains in the future consistent with the past. The Company’s goal is simply to continue to develop a successful and profitable software business, while continuing to enjoy the benefit of its Traditional Business for as long as possible.

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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 the long-term Incentive Plan liabilities) and income taxes are critical accounting policies and estimates.

The Company recognizes revenues in accordance with the provisions of ASU No. 2014-09, Revenue from Contracts with Customers (ASC Topic 606).

For the Traditional Business, proceeds from the sale of subscriptions for newspapers, court rule books and other publications and other services are recorded as deferred revenue and are included in earned revenue only when the services are provided, generally over the subscription term. Advertising revenues are recognized when advertisements are published.

Journal Technologies' contracts may include several products and services, which are generally distinct and include separate transaction pricing and performance obligations. Most are one-transaction contracts. These current subscription-type contract revenues include (i) implementation consulting fees to configure the system to go-live, (ii) subscription software license, maintenance (including updates and upgrades) and support fees, and (iii) third-party hosting fees when used. Revenues for consulting are generally recognized at point of delivery (go-live) upon completion of services. These contracts include assurance warranty provisions for limited periods and do not include financing terms. For some contracts, the Company acts as a principal with respect to certain services, such as data conversion, interfaces and hosting that are provided by third-parties, and recognizes such revenues on a gross basis. For legacy contracts with perpetual license arrangements, licenses and consulting services are recognized at point of delivery (go-live), and maintenance revenues are recognized ratably after the go-live. Other public service fees are earned and recognized as revenues when the Company processes credit card payments on behalf of the courts via its websites through which the public can e-file cases and pay traffic citations and other fees.

ASC 985-20, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed, provides that costs related to the research and development of a new software product are to be expensed as incurred until the technological feasibility of the product is established. Accordingly, costs related to the development of new software products are expensed as incurred until technological feasibility has been established, at which time such costs are capitalized, subject to expected recoverability. In general, “technological feasibility” is achieved when the developer has established the necessary skills, hardware and technology to produce a product and a detailed program design has been (i) completed, (ii) traced to the product specifications and (iii) reviewed for high-risk development issues. The Company believes its process for developing software is essentially completed concurrent with the establishment of technological feasibility, and accordingly, no software development costs have been capitalized to date.

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ASC 820, Fair Value Measurement and Disclosures, requires the Company to (i) disclose the amounts of transfers in and out of Level 1 and Level 2 fair value measurements and the reasons for the transfers and (ii) present separately information about purchases, sales, issuances and settlements in the reconciliation of Level 3 measurements. This guidance also provides clarification of existing disclosures requiring the Company to determine each class of its investments based on risk and to disclose the valuation techniques and inputs used to measure fair value for both Level 2 and Level 3 measurements. The Company made no transfers in and out of Level 1 and Level 2 measurements in fiscal years 2023 and 2022. During that time all of the Company’s investments have been quoted on public markets and, therefore, all fair value calculations have been based on Level 1 measurements. The estimated Incentive Plan’s future commitment is calculated using Level 3 inputs, based on an average of the prior fiscal year (fiscal 2022) and the current year’s pretax earnings before certain items, discounted to the present value at 6% since each granted Incentive Plan Unit will expire over its remaining life term of up to 10 years.

ASC 740, Income Taxes, establishes financial accounting and reporting standards for the effect of income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and the deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the financial statements or tax returns. This accounting guidance also prescribes recognition thresholds and measurement attributes for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Judgment is required in assessing the future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences could materially impact the Company’s financial position or its results of operations and its deferred tax liabilities related to the unrealized net gains on investments. See Note 3 of Notes to Consolidated Financial Statements for further discussion.

ASC 280-10, Segment Reporting, defines an operating segment as a component of a public entity that has discrete financial information that is evaluated regularly by the Company’s Chief Executive Officer to decide how to allocate resources and to assess performance. In accordance with ASC 280-10, the Company has two reportable business segments which are: (i) the Traditional Business and (ii) Journal Technologies and Journal Technologies (Canada).

The above discussion and analysis should be read in conjunction with the consolidated financial statements and the notes thereto included in this report.

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