ALJ REGIONAL HOLDINGS INC - Quarter Report: 2016 December (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

(Mark One)

For the Quarterly Period Ended December 31, 2016

For the transition period from           to           

Commission File Number: 001-37689

ALJ REGIONAL HOLDINGS, INC.  

(Exact name of registrant as specified in its charter)

244 Madison Avenue, PMB #358

New York, NY 10016

(Address of principal executive offices, Zip code)

(212) 883-0083

(Registrant’s telephone number, including area code)

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 and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted 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 and post such files).    Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or smaller reporting company.  See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 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  ☒ 

The number of shares of common stock, $0.01 par value per share, outstanding as of January 31, 2017 was 34,574,641.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q includes statements regarding our assumptions, projections, expectations, targets, intentions or beliefs about future events or other statements that are not historical facts.  Words or phrases such as “anticipates,” “may,” “will,” “should,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “projects,” “targets,” “will likely result,” “will continue” or similar expressions are intended to identify forward-looking statements.  These forward-looking statements are based on current assumptions and predictions and are subject to numerous risks and uncertainties.  Actual results or events could differ materially from those set forth or implied by such forward-looking statements and related assumptions due to certain factors, including, without limitation, the risks set forth under the caption “Risk Factors” below.

Any forward-looking statements included in this Form 10-Q are made as of the date hereof, based on information available to us as of the date hereof, and, we assume no obligation to update any forward-looking statements.

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ALJ REGIONAL HOLDINGS, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE MONTHS ENDED DECEMBER 31, 2016

INDEX

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PART I.  FINANCIAL INFORMATION

Item 1 - Financial Statements

ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

See accompanying notes

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

(in thousands, except per share amounts)

See accompanying notes

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(in thousands)

See accompanying notes

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Organization and Basis of Presentation

Organization

ALJ Regional Holdings, Inc. (including subsidiaries, referred to collectively in this Report as “ALJ,” the “Company” or “we”) is a holding company.  ALJ’s primary assets as of December 31, 2016, were all of the outstanding capital stock of the following companies:

ALJ has organized its business and corporate structure along the following business segments: Faneuil, Carpets, and Phoenix. ALJ is reported as corporate overhead.

Basis of Presentation

The interim unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States, or U.S. GAAP, for interim financial information and with the instructions to the Securities and Exchange Commission, or SEC, Form 10-Q and Article 10 of SEC Regulation S-X. They do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. Therefore, these financial statements should be read in conjunction with ALJ’s audited financial statements and notes thereto for the years ended September 30, 2016 and 2015, filed with the Securities and Exchange Commission on December 23, 2016.  

The Company has made estimates and judgments affecting the amounts reported in its condensed consolidated financial statements and the accompanying notes.  Significant estimates and assumptions by management are used for, but are not limited to, determining the fair value of assets and liabilities, including intangible assets acquired and allocation of acquisition purchase prices, estimated useful lives, recoverability of long-lived and intangible assets, the recoverability of goodwill, the realizability of deferred tax assets, stock-based compensation, the likelihood of material loss as a result of loss contingencies, customer lives, the allowance for doubtful accounts and inventory reserves, and calculation of insurance reserves.  Actual results may differ materially from estimates. The interim financial information is unaudited but reflects all normal recurring accruals and adjustments that, in the opinion of management, are necessary to present fairly ALJ’s results of operations and financial position for the interim period.  The results of operations for the three months ended December 31, 2016, are not necessarily indicative of the results expected for future quarters or the full year.  ALJ reclassified certain prior period amounts on the balance sheet to conform to current period presentation.  See Note 2 – Accounting Standard Adopted for further discussion.

For a complete summary of ALJ’s significant accounting policies, please refer to Note 2, “Summary of Significant Accounting Policies,” included with ALJ’s audited financial statements and notes thereto for the years ended September 30, 2016 and 2015, filed with the Securities and Exchange Commission on December 23, 2016.  There were no material changes to significant accounting policies during the three months ended December 31, 2016.  

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

2. Recent Accounting Standards

Accounting Standards Adopted

In February 2015, the FASB issued ASU 2015-02, "Amendments to the Consolidation Analysis.”  ASU 2015-02 changes the analysis that a reporting entity must perform to determine whether it should consolidate certain types of legal entities.  ALJ adopted ASU 2015-02 during the three months ended December 31, 2016.  The standard did not have a significant impact on our condensed consolidated financial statements.  

In April 2015, the FASB issued ASU 2015-03 “Interest – Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs,” which requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts.  ALJ adopted ASU 2015-03 during the three months ended December 31, 2016.  As a result of the adoption, ALJ made the following adjustments to the condensed consolidated balance sheet as of September 30, 2016: a $3.4 million decrease to total assets, a $1.0 million decrease to total current liabilities, and a $2.4 million decrease to non-current liabilities.  

In September 2015, the FASB issued ASU 2015-16, “Business Combinations.”  ASU 2015-16 simplifies the accounting for measurement-period adjustments by eliminating the requirement to restate prior period financial statements for measurement period adjustments. The new guidance requires the cumulative impact of measurement period adjustments, including the impact on prior periods, to be recognized in the reporting period in which the adjustment is identified. ALJ adopted ASU 2015-16 during the three months ended December 31, 2016.  The standard did not have a significant impact on our condensed consolidated financial statements.  

Accounting Standards Not Yet Adopted

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers,” to supersede nearly all existing revenue recognition guidance under U.S. GAAP.  The core principle of ASU 2014-09 is to recognize revenue when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for those goods or services.  ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process than required under existing U.S. GAAP including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation.  Subsequently, the FASB has issued the following standards to provide additional clarification and implementation guidance for ASU 2014-09: (i) ASU 2016-08, “Principal versus Agent Considerations (Reporting Revenue Gross versus Net),” (ii) ASU 2016-10, “Identifying Performance Obligations and Licensing,” and (iii) ASU 2016-12, “Narrow-Scope Improvements and Practical Expedients.”  Management is currently evaluating the effect that ASU 2014-09, including all subsequently-issued standards, will have on the Company’s consolidated financial statements and related disclosures.  Included in management’s assessment is the determination of an effective adoption date and transition method for adoption.  We expect to complete our initial assessment process, including the selection of an effective adoption date and transition method for adoption, by September 30, 2017.  

In July 2015, the FASB issued ASU 2015-11, “Simplifying the Measurement of Inventory (Topic 330): Simplifying the Measurement of Inventory.”  The amendments in ASU 2015-11 require an entity to measure inventory at the lower of cost or market. Market could be replacement cost, net realizable value, or net realizable value less an approximately normal profit margin. The amendments do not apply to inventory that is measured using last-in, first out (LIFO) or the retail inventory method.  The amendments apply to all other inventory, which includes inventory that is measured using first-in, first-out (FIFO) or average cost.  The amendments should be applied prospectively with earlier application permitted as of the beginning of an interim or annual reporting period.  Management is currently evaluating the effect that ASU 2015-11 will have on the Company’s consolidated financial statements and related disclosures.  Included in management’s assessment is the determination of an effective adoption date and transition method for adoption.  We expect to complete our initial assessment process, including the selection of an effective adoption date and transition method for adoption, by September 30, 2017.  

In November 2015, the FASB issued ASU 2015-17, “Income Taxes,” to simplify the presentation of deferred taxes. This amendment requires that all deferred tax assets and liabilities, along with any related valuation allowances, be classified as noncurrent on the balance sheet.  Management is currently evaluating the effect that ASU 2015-17 will have on the Company’s consolidated financial statements and related disclosures.  Included in management’s assessment is the determination of an effective adoption date and transition method for adoption.  We expect to complete our initial assessment process, including the selection of an effective adoption date and transition method for adoption, by September 30, 2017.    

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

In February 2016, the FASB issued ASU 2016-02, “Leases.”  ASU 2016-02 requires companies to generally recognize on the balance sheet operating and financing lease liabilities and corresponding right-of-use assets. Management is currently evaluating the effect that ASU 2016-02 will have on the Company’s consolidated financial statements and related disclosures.  Included in management’s assessment is the determination of an effective adoption date and transition method for adoption.  We expect to complete our initial assessment process, including the selection of an effective adoption date and transition method for adoption, by September 30, 2017.    

In March 2016, the FASB issued ASU 2016-09, “Compensation – Stock Compensation.”  ASU 2016-09 simplifies the accounting for share-based payment transactions. Included in the update are modifications to the accounting for income taxes upon vesting or settlement of awards, employer tax withholding on shared-based compensation, forfeitures, and financial statement presentation of excess tax benefits. Management is currently evaluating the effect that ASU 2016-09 will have on the Company’s consolidated financial statements and related disclosures.  Included in management’s assessment is the determination of an effective adoption date and transition method for adoption.  We expect to complete our initial assessment process, including the selection of an effective adoption date and transition method for adoption, by September 30, 2017.    

In June 2016, the FASB issued ASU 2016-13, “Financial Instruments - Measurement of Credit Losses on Financial Instruments.”  ASU 2016-13 provides new guidance that changes the accounting for recognizing impairments of financial assets. Under the new guidance, credit losses for certain types of financial instruments will be estimated based on expected losses. The new guidance also modifies the impairment models for available-for-sale debt securities and for purchased financial assets with credit deterioration since their origination. Management is currently evaluating the effect that ASU 2016-09 will have on the Company’s consolidated financial statements and related disclosures.  Included in management’s assessment is the determination of an effective adoption date and transition method for adoption.  We expect to complete our initial assessment process, including the selection of an effective adoption date and transition method for adoption, by September 30, 2017.    

In August 2016, the FASB issued ASU 2016-15, “Classification of Certain Cash Receipts and Cash Payments.”  ASU 2016-15 provides new guidance related to the classification of certain cash receipts and cash payments on the statement of cash flows.  Management is currently evaluating the effect that ASU 2016-15 will have on the Company’s consolidated financial statements and related disclosures.  Included in management’s assessment is the determination of an effective adoption date and transition method for adoption.  We expect to complete our initial assessment process, including the selection of an effective adoption date and transition method for adoption, by September 30, 2017.   

In October 2016, the FASB issued ASU 2016-16, “Intra-Entity Transfers of Assets Other Than Inventory.”  ASU 2016-16 provides new guidance that changes the accounting for income tax effects of intra-entity transfers of assets other than inventory. Under the new guidance, the selling (transferring) entity is required to recognize a current tax expense or benefit upon transfer of the asset. Similarly, the purchasing (receiving) entity is required to recognize a deferred tax asset or deferred tax liability, as well as the related deferred tax benefit or expense, upon receipt of the asset.  Management is currently evaluating the effect that ASU 2016-16 will have on the Company’s consolidated financial statements and related disclosures.  Included in management’s assessment is the determination of an effective adoption date and transition method for adoption.  We expect to complete our initial assessment process, including the selection of an effective adoption date and transition method for adoption, by September 30, 2017.    

3. Concentration Risks

Cash

The Company maintains its cash balances in accounts, which, at times, may exceed federally insured limits. The Company has not experienced any loss in such accounts and believes there is little exposure to any significant credit risk.

Major Customers and Accounts Receivable

ALJ did not have any customer with net revenue in excess of 10% of consolidated net revenue during the three months ended December 31, 2016.  ALJ had one customer with net revenue of 19.1% of consolidated net revenue for the three months ended December 31, 2015.  However, each of ALJ’s segments had customers that represent more than 10% of their respective net revenue as described below.  

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Faneuil.  The percentage of Faneuil net revenue derived from its significant customers was as follows:

**Less than 10% of Faneuil net revenue.

Trade receivables from these customers totaled $10.9 million on December 31, 2016.  As of December 31, 2016, all Faneuil accounts receivable were unsecured.  The risk with respect to accounts receivable is mitigated by credit evaluations performed on customers and the short duration of payment terms extended to customers.

Carpets.  The percentage of Carpets net revenue derived from its significant customers was as follows:

**Less than 10% of Carpets net revenue.

Trade receivables from these customers totaled $4.1 million on December 31, 2016.  As of December 31, 2016, all Carpets accounts receivable were unsecured.  The risk with respect to accounts receivable is mitigated by credit evaluations performed on customers and the short duration of payment terms extended to customers.

Phoenix.  The percentage of Phoenix net revenue derived from its significant customers was as follows:

Trade receivables from these customers totaled $4.8 million on December 31, 2016.  As of December 31, 2016, all Phoenix accounts receivable were unsecured.  The risk with respect to accounts receivable is mitigated by credit evaluations performed on customers and the short duration of payment terms extended to customers.

Supplier Risk

ALJ did not have any suppliers that represented more than 10% of consolidated inventory purchases.   However, two of ALJ’s segments had suppliers that represented more than 10% of their respective inventory purchases, as described below.

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Carpets.  The percentage of Carpets inventory purchases from its significant suppliers was as follows:

If these suppliers were unable to provide materials on a timely basis, Carpets management believes alternative suppliers could provide the required materials with minimal disruption to the business.

Phoenix.  The percentage of Phoenix inventory purchases from its significant suppliers was as follows:

If these suppliers were unable to provide materials on a timely basis, Phoenix management believes alternative suppliers could provide the required supplies with minimal disruption to the business.

4. Composition of Certain Financial Statement Captions

Accounts Receivable, Net

The following table summarizes accounts receivable at the end of each reporting period (in thousands):

Inventories, Net

The following table summarizes inventories at the end of each reporting period (in thousands):

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Property and Equipment

The following table summarizes property and equipment at the end of each reporting period (in thousands):

Property and equipment depreciation and amortization expense, including amounts related to capitalized leased assets, was $2,953,000 and $2,158,000 for the three months ended December 31, 2016 and 2015, respectively.

Goodwill

The following table summarizes goodwill by reportable segment at the end of each reporting period (in thousands):

Intangible Assets

The following table summarizes identified intangible assets at the end of each reporting period (in thousands):

Intangible asset amortization expense was $1,008,000 and $972,000 for the three months ended December 31, 2016 and 2015, respectively.

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The following table presents expected future amortization expense for the remainder of 2017 and yearly thereafter (in thousands):

Term Loan

The following table summarizes ALJ’s current and noncurrent term loan payables at the end of each reporting period (in thousands):

Accrued Expenses

The following table summarizes accrued expenses at the end of each reporting period (in thousands):

Workers’ Compensation Reserve

Faneuil.  Faneuil is self-insured for workers’ compensation claims up to $350,000 per incident, and maintains insurance coverage for costs above the specified limit. Faneuil is self-insured for health insurance claims up to $150,000 per incident, and maintains insurance coverage for costs above the specified limit. Reserves have been provided for workers’ compensation and health claims based upon insurance coverages, third-party actuarial analysis, and management’s judgment.  

Carpets.  Carpets maintains outside insurance to cover workers’ compensation claims.

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Phoenix. Before the acquisition of Phoenix by ALJ, Phoenix was self-insured for workers’ compensation under their parent company for claims up to $500,000 per incident, and maintains coverage for costs above the specified limit.  After the acquisition, Phoenix changed to a fully insured plan.  

5. Earnings Per Share

ALJ computed basic and diluted earnings per common share for each period as follows (in thousands, except per share amounts):

ALJ computed basic earnings per share of common stock using net income attributable to ALJ divided by the weighted average number of shares of common stock outstanding during the period.  ALJ computed diluted earnings per share of common stock using net income attributable to ALJ divided by the weighted average number of shares of common stock outstanding plus potentially dilutive shares of common stock outstanding during the period. Potentially dilutive shares issuable upon exercise of options to purchase common stock were determined by applying the treasury stock method to the assumed exercise of outstanding stock options.  

6. Debt

Term Loan and Line of Credit

In August 2015, ALJ entered into a financing agreement (“Financing Agreement”) with Cerberus Business Finance, LLC (“Cerberus”), to borrow $105.0 million in a term loan (“Cerberus Term Loan”) and have available up to $30.0 million in a revolver (“Cerberus/PNC Revolver”), collectively (“Cerberus Debt”).  The proceeds were used to fund the acquisition of Phoenix, to refinance the outstanding debt of ALJ, Faneuil and Carpets, and to provide working capital facilities to all three of ALJ’s subsidiaries and ALJ.   In July 2016, ALJ entered into the First Amendment to the Financing Agreement, which increased borrowings under the Cerberus Term Loan by $10.0 million and modified certain covenants.

During the three months ended December 31, 2016, interest accrued at an annual rate of 9.5% on the $10.0 million incremental borrowings, and 7.5% on the remaining Cerberus Term Loan borrowings.  When certain loan covenants are met, the annual interest rate on the incremental borrowings will decrease from 9.5% to 7.5%.   Interest payments are due in arrears on the first day of each month.  Quarterly principal payments of approximately $2.2 million are due on the last day of each fiscal quarter and annual principal payments equal to 75% of ALJ’s excess cash flow, as defined in the Financing Agreement, are due upon delivery of the audited financial statements.  A final balloon payment is due at maturity, August 14, 2020.  There is a prepayment penalty equal to 2% if the Cerberus Term Loan is repaid prior to August 2017, and 1% if it is paid between August 2017 and August 2018.  ALJ may make payments against the loan with no penalty up to $7.0 million.  As of December 31, 2016, ALJ’s balance on the outstanding term loan to Cerberus was approximately $97.5 million.

ALJ has the option to prepay (and re-borrow) the outstanding balance of the Cerberus/PNC Revolver, without penalty.  Each subsidiary has the ability to borrow under the revolver (up to $30.0 million in the aggregate for all subsidiaries combined) but limited to 85% of eligible receivables. The Cerberus/PNC Revolver carries an unused fee of 0.5%. Additionally, the Cerberus/PNC Revolver provides for a sublimit for letters of credit up to $15.0 million. Faneuil had a $2.7 million letter of credit under the Financing Agreement as of December 31, 2016.  The Cerberus/PNC Revolver has a final maturity date of August 14, 2020.  As of December 31, 2016, ALJ had a zero balance on its outstanding line of credit.  

The Cerberus Debt is secured by substantially all the Company’s assets and imposes certain limitations on the Company, including its ability to incur debt, grant liens, initiate certain investments, declare dividends and dispose of assets.  The Cerberus Debt also requires ALJ to comply with certain debt covenants.  As of December 31, 2016, ALJ was in compliance with all debt covenants and had unused borrowing capacity of $20.2 million.

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Estimated future minimum payments are as follows (in thousands): 

Capital Lease Obligations

Faneuil and Phoenix lease equipment under non-cancelable capital leases. As of December 31, 2016, future minimum payments under non-cancelable capital leases with initial or remaining terms of one year or more are as follows (in thousands):

7. Commitments and Contingencies

Operating Leases

The Company leases real estate, equipment, and vehicles under noncancellable operating leases. As of December 31, 2016, future minimum rental commitments under noncancellable leases were as follows (in thousands):

Employment Agreements

ALJ maintains employment agreements with certain key executive officers that provide for a base salary and annual bonus to be determined by the Board of Directors.  The agreements also provide for termination payments, which includes base salary and

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

performance bonus, stock options, non-competition provisions, and other terms and conditions of employment.  As of December 31, 2016, termination payments related to base salary totaled $888,000.

Surety Bonds

As part of Faneuil’s normal course of operations, certain customers require surety bonds guaranteeing the performance of a contract.  As of December 31, 2016, the face value of such surety bonds, which represents the maximum cash payments that Faneuil would have to make under certain circumstances of non-performance, was $25,330,000.  To date, Faneuil has not made any non-performance payments.

Litigation, Claims, and Assessments

Faneuil, Inc. v. 3M Company

Faneuil filed a complaint against 3M Company on September 22, 2016 in the Circuit Court for the City of Richmond, Virginia.  The dispute arises out of a subcontract entered into between 3M and Faneuil in relation to a toll road project in Portsmouth, Virginia. Under the terms of the subcontract, Faneuil provides certain services to 3M as part of 3M’s agreement to provide services to Elizabeth River Crossing (“ERC”).  After multiple attempts to resolve a dispute over unpaid invoices failed, Faneuil determined to file suit against 3M to collect on its outstanding receivables through the date of the filing.  In its complaint, Faneuil seeks recovery of $5.1 million based on three causes of action:  breach of contract, breach of the implied covenant of good faith and fair dealing and unjust enrichment. 

Subsequent to filing suit against 3M, Faneuil entered into an agreement with ERC whereby ERC would become responsible for paying Faneuil directly for all services rendered from April 1, 2016 through December 31, 2016.  That agreement resulted in a payment from ERC to Faneuil on December 8, 2016, which resolved a portion of the $5.1 million claim against 3M.  

On October 14, 2016, 3M filed its answer and counterclaim against Faneuil.  In its counterclaim, 3M seeks recovery in excess of $10.0 million based on three claims:  breach of contract/indemnification, breach of the implied covenant of good faith and fair dealing and unjust enrichment.  3M’s counterclaim alleges it incurred approximately $3.2 million in damages payable to ERC as a result of Faneuil’s conduct and seeks indemnification of an additional $10.0 million in damages incurred as a result of continued performance under its contract with ERC.  

In response, Faneuil filed a demurrer to several claims contained within 3M’s counterclaim.  Prior to a hearing on Faneuil’s demurrer, the parties negotiated a stipulated order, pursuant to which 3M withdrew its request for an award of attorney’s fees, limited the scope of its good faith and fair dealing claim and narrowed the scope of its damages claims by acknowledging that it is not seeking indemnification damages at this time. The joint order has been presented to the court but has not yet been approved or executed.  

The litigation is in the pleading stage and early discovery is underway. Faneuil believes that the facts support its claims that the disputed services should be paid and that 3M’s counterclaims are without merit.  Faneuil intends to vigorously prosecute its claims against 3M and to defend against 3M’s counterclaims.  Although litigation is inherently unpredictable, Faneuil is confident in its ability to continue to collect for the disputed services and believes it will collect all or substantially all of its outstanding receivables.  ALJ intends to reassess the litigation periodically, and will update its disclosure accordingly.

McNeil, et al. v. Faneuil, Inc.

Tammy McNeil, a former Faneuil call center employee, filed a Fair Labor Standards Act collective action case against Faneuil in federal court in Newport News, Virginia in 2015.  The class asserts various timekeeping and overtime violations that Faneuil denies.  The trial court conditionally granted a nationwide class for a three-year period from 2012-2015 and going forward.  The parties are engaging in substantive discovery at this time and Faneuil is working with outside counsel and expert witnesses to assess the potential scope of damages.  Depositions of key witnesses are scheduled to begin on February 13, 2017.  Faneuil is actively defending the matter; however, the company is unable to assess the potential risk of exposure at this time in full until further discovery is completed. 

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Just Like Sugar vs. Carpets et al.

On August 10, 2016, Just Like Sugar, Inc. ("JLS") filed a complaint in the Nevada District Court for Clark County against Carpets, among others.  The complaint includes claims for "statutory violations" stemming from the alleged emission of silica dust from Carpet's fabrication facility. On September 16, 2016, Carpets filed its answer to the complaint and counterclaims. On October 25, 2016, an early case conference was held, in which JLS requested a 30-day extension to begin discovery. ALJ and Carpets believe this action is without merit and intend to defend it vigorously while pursuing our counterclaims.

Thornton vs. ALJ Regional Holdings, Inc., et al.

On September 21, 2016, Plaintiffs Clifford Thornton and Tracey Thornton filed a complaint in the Nevada District Court for Clark County against ALJ, Carpets, Steve Chesin, and Jess Ravich.  The complaint includes claims for (1) fraud, (2) bad faith, (3) civil conspiracy, (4) unjust enrichment, (5) wrongful termination, (6) intentional infliction of emotional distress, (7) negligent infliction of emotional distress, and (8) loss of marital consortium. On November 1, 2016, the defendants filed an answer to the complaint generally denying all claims. ALJ and Carpets believe this action is without merit and intend to defend it vigorously.

In connection with its pending litigation matters (including the matters described above), management has estimated the range of possible loss, including fees and expenses, to be between $0.9 million and $1.1 million; however, as management has determined that no one estimate within the range is better than another, it has accrued $0.9 million as of December 31, 2016.

Other Litigation

We and our subsidiaries have been named in, and from time to time may become named in, various other lawsuits or threatened actions that are incidental to our ordinary business. Litigation is inherently unpredictable. Any claims against us, whether meritorious or not, could be time-consuming, cause us to incur costs and expenses, require significant amounts of management time and result in the diversion of significant operational resources. The results of these lawsuits and actions cannot be predicted with certainty. We concluded as of December 31, 2016 that the ultimate resolution of these matters will not have a material adverse effect on our business, consolidated financial position, results of operations or cash flows.

8. Equity

Common Stock

ALJ did not have any common stock activity during the three months ended December 31, 2016.

ALJ repurchased 16,520 shares of ALJ common stock at an average price of $3.90 per share during the three months ended December 31, 2015.

Equity Incentive Plans

ALJ’s equity incentive plans are broad-based, long-term programs intended to attract and retain talented employees and align stockholder and employee interests.

Stock-Based Compensation.  

The following table sets forth the total stock-based compensation expense included in ALJ’s Statements of Income (in thousands):

At December 31, 2016, ALJ had approximately $592,000 of total unrecognized compensation cost related to unvested stock options. This cost is expected to be recognized over a weighted-average period of approximately 1.7 years.

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Stock Option Awards.  ALJ had no stock option awards during the three months ended December 31, 2016.  

The “intrinsic value” of options is the excess of the value of ALJ stock over the exercise price of such options.  The total intrinsic value of options outstanding (of which all are vested or expected to vest) was approximately $5.1 million at December 31, 2016.

Restricted Stock Awards.  In December 2015, ALJ’s Board of Directors approved a director compensation package that included an annual restricted stock award (“RSA”) with a value of $40,000 for each outside director.  Additionally the Board of Directors approved an annual RSA for ALJ’s Executive Chairman with a value of $100,000.  During the three months ended December 31, 2016, ALJ expensed $85,000, associated with the RSAs.  

9. Related-Party Transactions

Harland Clarke Holdings Corp. (“Harland Clarke”), a stockholder who owns in excess of five percent of ALJ outstanding common stock, is a counterparty to Faneuil in two contracts.  Under one contract, Faneuil provides call center services to support Harland Clarke’s banking-related products.  This contract renews annually every April. Under the other contract, Faneuil provides managed print services.  The term of this contract concludes on September 30, 2018. Faneuil recognized revenue from Harland Clarke totaling $327,000 and $437,000 for the three months ended December 31, 2016 and 2015, respectively. The associated cost of revenue was $308,000 and $429,000 for the three months ended December 31, 2016 and 2015, respectively. All revenue from Harland Clarke contained similar terms and conditions as for other transactions of this nature entered into by Faneuil.  Total accounts receivable from Harland Clarke was $217,000 and $176,000 at December 31, 2016 and September 30, 2016, respectively.  

10. Reportable Segments and Geographic Information

Reportable Segments

As discussed in Note 1, ALJ has organized its business along three reportable segments (Faneuil, Carpets, and Phoenix), together with a corporate group for certain support services.  ALJ’s operations are aligned on the basis of products, services and industry.  The Chief Operating Decision Maker (“CODM”) is ALJ’s Executive Chairman. The CODM allocates resources to and assesses the performance of each operating segment using information about its net revenue and operating income. The CODM does not evaluate operating segments using discrete asset information.  The accounting policies for segment reporting are the same as for ALJ as a whole.

Net revenue and operating income by reportable segment for the three months ended December 31, 2016 and 2015 were as follows (in thousands):

Geographic Information

Substantially all of the Company’s assets were located in the United States.  Substantially all of the Company’s revenue was earned in the United States.

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Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations

Our Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is provided in addition to the accompanying consolidated financial statements and notes to assist readers in understanding our results of operations, financial condition and cash flows. MD&A is organized as follows:

The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes included in “Part I, Item 1 – Financial Statements.”  The following discussion contains a number of forward-looking statements that involve risks and uncertainties. Words such as "anticipates," "expects," "intends," "goals," "plans," "believes," "seeks," "estimates," "continues," "may," "will," "should," and variations of such words and similar expressions are intended to identify such forward-looking statements. Such statements are based on our current expectations and could be affected by the risk and uncertainties described in “Item 1A - “Risk Factors.”  Our actual results may differ materially.    

Overview

ALJ Regional Holdings, Inc. (“ALJ” or “we”) is a holding company that operates Faneuil, Inc., or Faneuil, Floors-N-More, LLC, dba Carpets N’ More, or Carpets, and Phoenix Color Corp., or Phoenix. With several members of senior management and our Board of Directors coming from long careers in the professional service industry, ALJ is focused on acquiring and operating exceptional customer service-based businesses.

We continue to see our business evolve as we execute our strategy of buying attractively valued companies, such as our July 18, 2016 acquisition of Color Optics, a leading printing and packaging solutions enterprise servicing the beauty, fragrance, cosmetic and consumer-packaged goods markets.  In analyzing the financial impact of any potential acquisition, we focus on earnings, operating margin, cash flow and return on invested capital targets. We hire successful and experienced management teams to run each of our operating companies and incentivize them to drive higher profits. We are focused on increasing our revenue at each of our operating subsidiaries by investing in sales and marketing and expanding into new products and markets, evaluating and executing on tuck-in acquisitions, while continually examining our cost structures to drive higher profits.

On May 11, 2016, our stock began trading on the NASDAQ market under the ticker symbol “ALJJ.” We believe our investment, which included approximately $1.0 million in expenses, of which $0.7 million is non-recurring, to uplist our stock will provide greater liquidity for our investors and allow us to better leverage our stock for future acquisitions.

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Results of Operations  

The following table sets forth certain consolidated condensed statements of income data as a percentage of net revenue for each period as follows (in thousands, except per share amounts): 

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Net Revenue

Faneuil Net Revenue

Faneuil net revenue for the three months ended December 31, 2016, was $38.1 million, an increase of $4.2 million, or 12.6%, compared to net revenue of $33.8 million for the three months ended December 31, 2015. The increase in net revenue was attributable to a $7.3 million increase in new customer revenue and a $2.1 million increase in operational revenue from existing customers primarily in the healthcare industry, offset by a reduction in revenue of $5.2 million from customer contracts that concluded prior to the start of the three months ended December 31, 2016.  

The following table reflects the amount of Faneuil’s backlog, which represents multi-year contract deliverables, by the fiscal year Faneuil expects to recognize such revenue (in millions):

The majority of the decrease as of December 31, 2016 compared to December 31, 2015 was a result of revenue recognized during the last twelve months from contracts included in Faneuil’s backlog at December 31, 2015.

Carpets Net Revenue

Carpets net revenue for the three months ended December 31, 2016 was $15.5 million, an increase of $3.8 million, or 32.7%, compared to net revenue of $11.7 million for the three months ended December 31, 2015.  The increase was primarily attributable to two builders adding cabinets and more homes to their existing contracts.

The following table reflects the amount of Carpets’ backlog, which represents multi-year contracts with contractors to build-out communities with typical terms of two to three years, by the fiscal year Carpets expects to recognize such revenue (in millions):

The majority of the increase as of December 31, 2016 compared to December 31, 2015 was a result of new contracts executed during the past twelve months.  

Phoenix Net Revenue

Phoenix net revenue for the three months ended December 31, 2016 was $24.0 million, an increase of $4.7 million or 24.6%, compared to net revenue of $19.3 million for the three months ended December 31, 2015.  Of the $4.7 million increase, $3.7 million was attributable to increased packaging revenue as a result of the acquisition of Color Optics.  The remaining increase was attributable to increased book sales offset by decreased component sales during the normal course of business.  

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Phoenix has recently executed several contract renewals and extensions with its largest customers.  These extensions provide for combined expected net revenue during the additional terms, which range from two to four years, of over $100 million. In connection with these extensions, Phoenix agreed to lower pricing in exchange for higher sales volume guarantees over the life of the contracts.

The following table reflects the amount of Phoenix’s backlog, which represents executed contracts that contain minimum volume commitments over multiple years for future product deliveries, by the fiscal year Phoenix expects to recognize such revenue (in millions):

The majority of the increase as of December 31, 2016 compared to December 31, 2015 was a result of new contracts with volume commitments executed during the last twelve months.    

See “Part II, Item 1A. Risk Factors - Risks Related to our Business Generally and our Common Stock - We may not receive the full amounts estimated under the contracts in our backlog, which could reduce our revenue in future periods below the levels anticipated. This makes backlog an uncertain indicator of future operating results.”

Cost of Revenue