ALJ REGIONAL HOLDINGS INC - Quarter Report: 2017 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, 2017

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, smaller reporting company, or an emerging growth company.  See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) 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, 2018 was 37,921,116.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

The statements included in this Form 10-Q regarding future financial performance, results and conditions and other statements that are not historical facts, including, among others, the statements regarding competition, the Company’s intention to retain earnings for use in the Company’s business operations, the Company’s ability to continue to fund its operations and service its indebtedness, the adequacy of the Company’s accrual for tax liabilities, management’s projection of continued taxable income, and the Company’s ability to offset future income against net operating loss carryovers, constitute forward-looking statements. The words “can,” “could,” “may,” “will,” “would,” “plan,” “future,” “believes,” “intends,” “expects,” “anticipates,” “projects,” “estimates,” and similar expressions are also intended to identify forward-looking statements. These forward-looking statements are based on current expectations and are subject to 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 important factors, including, without limitation, the risks set forth under the caption “Risk Factors” below, which are incorporated herein by reference. Some, but not all, of the forward-looking statements contained in this Form 10-Q include, among other things, statements about the following:

The Company is also subject to general business risks, including results of tax audits, adverse state, federal or foreign legislation and regulation, changes in general economic factors, the Company’s ability to retain and attract key employees, acts of war or global terrorism and unexpected natural disasters. Any forward-looking statements included in this Form 10-Q are made as of the date hereof, based on information available to the Company as of the date hereof, and the Company assumes 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, 2017

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 data)

See accompanying notes

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (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, 2017, 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, 2017 and 2016, filed with the Securities and Exchange Commission on December 19, 2017.  

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, 2017, are not necessarily indicative of the results expected for future quarters or the full year.  

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, 2017 and 2016, filed with the Securities and Exchange Commission on December 19, 2017.  There were no material changes to significant accounting policies during the three months ended December 31, 2017.  

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

2. RECENT ACCOUNTING STANDARDS

Accounting Standards Adopted  

In July 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“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 net realizable value.  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.  ASU 2015-11 should be applied prospectively.   ALJ adopted ASU 2015-11 on October 1, 2017.  The standard did not have a significant impact on ALJ’s 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 including: (i) ASU 2016-08, “Principal versus Agent Considerations (Reporting Revenue Gross versus Net),” (ii) ASU 2016-10, “Identifying Performance Obligations and Licensing,” (iii) ASU 2016-12, “Narrow-Scope Improvements and Practical Expedients,” and (iv) ASU 2017-10, Service Concession Arrangements (Topic 853): Determining the Customer of the Operation Services.

ASU 2014-09 will be effective for ALJ on October 1, 2019 as ALJ has determined that it will not adopt ASU 2014-09 early. ASU 2014-09 allows for two methods of adoption: (a) “full retrospective” adoption, meaning the standard is applied to all periods presented, or (b) “modified retrospective” adoption, meaning the cumulative effect of applying ASU 2014-09 is recognized as an adjustment to the opening retained earnings balance in the year of adoption.  ALJ has not yet determined which method it will adopt.  

As the new standard will supersede substantially all existing revenue guidance, it could impact the timing of ALJ’s revenue and cost of revenue recognition across all business segments. ALJ has formed a project team and has engaged an outside revenue recognition consultant who has completed a revenue recognition adoption roadmap that includes three phases.  Phase I is the identification, documentation, and preliminary analysis of how ALJ currently accounts for revenue transactions compared to the revenue accounting required under the new standard.  Phase I is expected to be completed in early 2018.  Phase II includes a more detailed analysis, including the development of revenue recognition models, data analysis, analyzing implementation options, and finalizing a transition method.  Phase II is expected to be completed in mid-2018.  Phase III includes identification of system requirements, changes to internal controls and business processes, and final implementation.  Phase III is expected to be completed in mid-2019.  Because of the nature of the work that remains, at this time we are unable to reasonably estimate the impact of adoption on our consolidated financial statements.  ALJ’s evaluation of the financial impact and related disclosure of the new standard will likely extend over several future reporting periods.

In February 2016, the FASB issued ASU 2016-02, “Leases.”  ASU 2016-02 requires lessees to recognize a right-of-use asset and corresponding lease liability for all leases with terms of more than 12 months. Recognition, measurement, and presentation of expenses will depend on classification as either a finance or operating lease. ASU 2016-02 also requires certain quantitative and qualitative disclosures. The provisions of ASU 2016-02 should be applied on a modified retrospective basis.   ASU 2016-02 will be effective for ALJ on October 1, 2020 as ALJ has determined that it will not adopt ASU 2016-02 early.  The adoption of ASU 2016-02 will result in a material increase to the Company’s consolidated balance sheets for lease liabilities and right-of-use assets. The Company is currently evaluating the other effects the adoption of ASU 2016-02 will have on its consolidated financial statements and related disclosures.

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

3. ACQUISITIONS  

Printing Components Business

On October 2, 2017 (the “Purchase Date”), Phoenix acquired certain assets and assumed certain liabilities from LSC Communications, Inc. (“LSC”) and Moore-Langen Printing Company, Inc. related to its printing and manufacturing services division in Terre Haute, Indiana. Such assets and liabilities are referred to hereinafter as the “Printing Components Business.”  Total purchase price was $10.0 million in cash, subject to customary net working capital adjustments.  Phoenix withheld $1.0 million from the consideration paid at closing, which will be paid on October 2, 2018.  

The Printing Components Business leverages Phoenix’s existing capabilities and core competencies, strengthens its position in the education markets, and expands revenue into new markets.

As part of the Printing Components Business acquisition, Phoenix and LSC entered into a supply agreement (the “Supply Agreement”).  Pursuant to the Supply Agreement, LSC agreed to purchase from Phoenix its print requirements to continue servicing certain of its customers, buy minimum amounts of certain components from Phoenix, and provide Phoenix with a right of last refusal to supply certain non-component work.

Phoenix and ALJ financed the acquisition by borrowing $7.5 million under a term loan with Cerberus, selling an aggregate of $1.5 million of ALJ common stock in a private offering to two investors who are unaffiliated with ALJ, and using $1.0 million cash from the exercise of stock options by Jess Ravich, Executive Chairman of ALJ.  ALJ amended its financing agreement with Cerberus to facilitate the term loan (Note 7).  

The following schedule reflects the estimated fair value of assets acquired and liabilities assumed on the Purchase Date and the purchase price details (in thousands):

The Company accounted for the Printing Components Business acquisition using the purchase method of accounting. Accordingly, the assets and liabilities were recorded at their fair values at the date of acquisition. The excess of the purchase price over the fair value of the tangible and intangible assets acquired and the liabilities assumed was recorded as goodwill. During the measurement period, if new information is obtained about facts and circumstances that existed as of the acquisition date, cumulative changes in the estimated fair values of the net assets recorded may change the amount of the purchase price allocable to goodwill. During the measurement period, which expires one year from the acquisition date, changes to any purchase price allocations that are material to the Company's consolidated financial results will be adjusted in the reporting period in which the adjustment amount is determined.

During the three months ended December 31, 2017, the Printing Components Business recorded $4.5 million of net revenue.  Because the Printing Components Business was closely aligned with Phoenix’s existing business, including the overlap of customers, its operations were immediately integrated into Phoenix’s operations, and financial metrics other than net revenue were not separately tracked.    

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

During the three months ended December 31, 2017, the Company incurred approximately $123,000 of acquisition-related costs in connection with the Printing Components Business acquisition, which were expensed to selling, general and administrative expense.

Customer Management Outsourcing Business

On May 26, 2017 (the “CMO Business Purchase Date”), Faneuil acquired certain assets and assumed certain liabilities associated with the customer management outsourcing business (“CMO Business”) of Vertex Business Services LLC.  

The CMO Business, which was purchased to expand Faneuil’s presence into the utilities market, provides direct customer care call center operations, back-office processes, including billing, collections and business analytics, and installation and cloud-based customer care support exclusively for the utilities industry.

The following schedule reflects the final fair value of assets acquired and liabilities assumed on the CMO Business Purchase Date and the purchase price details (in thousands):

The following is a summary of CMO Business revenue and earnings included in the Company’s consolidated statement of operations for the three months ended December 31, 2017 (in thousands):  

4. 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.  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:

Trade receivables from these customers totaled $8.2 million on December 31, 2017.  As of December 31, 2017, 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:

Trade receivables from these customers totaled $3.1 million on December 31, 2017.  As of December 31, 2017, 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 $6.1 million on December 31, 2017.  As of December 31, 2017, 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.

5. 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 $3,452,000 and $2,953,000 for the three months ended December 31, 2017 and 2016, 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 $1,381,000 and $1,008,000 for the three months ended December 31, 2017 and 2016, 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 fiscal 2018 and yearly thereafter (in thousands):

Debt

The following table summarizes ALJ’s line of credit, and 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):

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Workers’ Compensation Reserve

Faneuil.  Faneuil is self-insured for workers’ compensation claims up to $500,000 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.

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.  

6. (LOSS) EARNINGS PER SHARE

ALJ computed basic and diluted (loss) 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 (loss) income 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 (loss) income 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.

Stock options to purchase 1,914,000 shares of common stock were not considered in calculating ALJ’s diluted earnings per common share for the three months ended December 31, 2017 as their effect would be anti-dilutive.

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

7. 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 revolving loan (“Cerberus/PNC Revolver,” and together with the Cerberus Term Loan, the “Cerberus Debt”).  ALJ has subsequently entered into three amendments to the Financing Agreement.  The Financing Agreement and three amendments are summarized below (in thousands):

Interest payments are due in arrears on the first day of each month.  Quarterly principal payments are due on the last day of each fiscal quarter.  Annual principal payments equal to 75% of ALJ’s excess cash flow (“ECF”), as defined in the Financing Agreement, are due upon delivery of the audited financial statements.  During the three months ended December 31, 2017, ALJ made an ECF payment of $4.1 million.  A final balloon payment is due at maturity, August 14, 2020.  There is a prepayment penalty equal to 1% if the Cerberus Term Loan is repaid prior to August 2018.  ALJ may make payments of up to $7.0 million against the loan with no penalty.

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, 2017, ALJ was in compliance with all debt covenants and had unused borrowing capacity of $10.8 million.

Deferred Loan Costs

During the three months ended December 31, 2017, in connection with the Third Amendment, ALJ paid legal and other fees totaling $0.3 million, which were deferred and are being amortized to interest expense over the life of the debt.

Contingent Loan Costs

As part of the Second Amendment, ALJ paid Cerberus an amendment fee. Additionally, as part of the Second Amendment, ALJ is required to pay a fee in each of three consecutive annual periods commencing May 27, 2018 and ending on the termination date, if at any time during each annual period there are any amounts outstanding on the Cerberus/PNC Revolver (“Contingent Payments”).   Such Contingent Payments become due and payable on the first day within each annual period there is an outstanding balance on the Cerberus/PNC Revolver.  

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Cerberus Debt Estimated Future Minimum Payments

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, 2017, future minimum payments under non-cancelable capital leases with initial or remaining terms of one year or more are as follows (in thousands):

8. COMMITMENTS AND CONTINGENCIES

Operating Leases

The Company leases real estate, equipment, and vehicles under noncancellable operating leases. As of December 31, 2017, future minimum rental commitments under noncancellable leases were as follows (in thousands):

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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 performance bonus, stock options, non-competition provisions, and other terms and conditions of employment.  As of December 31, 2017, termination payments related to base salary totaled $1.3 million.

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, 2017, the face value of such surety bonds, which represents the maximum cash payments that Faneuil’s surety would be obligated to pay under certain circumstances of non-performance, was $29.1 million.  To date, Faneuil’s surety 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.  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. 

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. A five-day bench trial is set for April 2018. A pretrial scheduling order has been entered and the parties are engaged in substantive discovery at this time.  

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.  

During June 2017, ERC transitioned the services that were provided by Faneuil to an internal customer service operation.  As a result of this transition, Faneuil no longer provides services to 3M or ERC.  ERC continues to reimburse Faneuil for immaterial transition costs incurred by Faneuil.  

Faneuil believes 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 remains confident in its ability to collect all of its outstanding receivables from 3M. 

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 action asserted various timekeeping and overtime violations, which Faneuil denied.  On June 6, 2017, the case was settled by the parties as part of a court-ordered mediation, for $0.3 million in damages, plus plaintiff’s attorney fees.  Because the parties could not agree on the dollar amount of plaintiff’s attorney fees, both parties agreed to allow the court to determine the amount.  On November 8, 2017, Faneuil received the court’s recommendation, which awarded a total of $0.7 million for plaintiff’s attorney fees and court fees.  Faneuil has objected to a portion of the recommendation and has requested that the district court judge further reduce the award.

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Marshall v. Faneuil, Inc.

On July 31, 2017, plaintiff Donna Marshall (“Marshall”), filed a proposed class action lawsuit in the Superior Court of the State of California for the County of Sacramento against Faneuil and ALJ. Marshall, a previously terminated Faneuil employee, alleges various California state law employment-related claims against Faneuil.  Faneuil has answered the complaint and removed the matter to the United States District Court for the Eastern District of California; however, Marshall has recently filed a motion to remand the case back to state court. The case is in an early stage and the parties have not begun substantive discovery at this time. Faneuil believes this action is without merit and intends to defend it vigorously.

Thornton v. 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. The parties are engaged in substantive discovery at this time, with the close of discovery scheduled for May 25, 2018 and all substantive dispositive motions due June 25, 2018. 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 $1.6 million and $2.4 million; however, as management has determined that no one estimate within the range is better than another, it has accrued $1.6 million as of December 31, 2017.

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, 2017 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.

9. EQUITY

Common Stock Activity during the Three Months Ended December 31, 2017

ALJ’s common stock activity for the three months ended December 31, 2017 consisted of the following:

Common Stock Activity during the Three Months Ended December 31, 2016

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

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.

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Stock-Based Compensation.  

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

At December 31, 2017, ALJ had approximately $1.0 million of total unrecognized compensation cost related to unvested stock options. This cost is expected to be recognized over a weighted-average period of approximately 2.1 years.

Stock Option Awards.   ALJ granted an option to purchase 10,000 shares of ALJ common stock with a total estimated fair value of approximately $15,000 during the three months ended December 31, 2017.  ALJ estimated the fair value of the option on the grant date using the Black-Scholes valuation model under the following assumptions:  weighted average expected option life of 6.0 years, weighted average expected volatility of 48.4%, expected dividend yield of 0%, and weighted average risk free interest rate of 2.1%.  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 $1.0 million at December 31, 2017.

Common Stock Awards.  

Members of ALJ’s Board of Directors receive a director compensation package that includes an annual common stock award.  In connection with such awards, ALJ recorded stock-based compensation expense of $102,000 and $85,000 during the three months ended December 31, 2017 and 2016, respectively.

10. INCOME TAX

United States Tax Reform

On December 22, 2017, the President of the United States signed and enacted into law H.R. 1 (the “Tax Reform Law”). The Tax Reform Law, effective for tax years beginning on or after January 1, 2018, except for certain provisions, resulted in significant changes to existing United States tax law, including various provisions that will impact ALJ.  Below is a summary of the provisions of the Tax Reform Law that management believes will be most impactful to ALJ.

Federal Corporate Tax Rate Reduction.  The Tax Reform Law reduces the federal corporate tax rate from 35% to 21% effective January 1, 2018. Pursuant to Section 15 of the Internal Revenue Code (“IRC”), ALJ will apply a blended corporate tax rate of 28.1%, which is based on the applicable tax rates before and after the Tax Reform Law and the number of days in ALJ’s initial tax year under the Tax Reform Law, which ends June 30, 2018. Subsequent to June 30, 2018, the federal tax rate will be 21%.

Interest Expense Limitation.  The Tax Reform Law disallows the deduction for interest expense in excess of 30% of “adjusted taxable income” as defined by the IRC.  

Bonus Depreciation.  The Tax Reform Law allows for the immediate deduction of 100% of eligible property placed in-service after September 27, 2017, and before January 1, 2023. For certain property with longer production periods, the 100% bonus depreciation is extended through December 31, 2023.      

Pursuant to Accounting Standards Codification (“ASC”) Topic 740-10, “Income Taxes,” ALJ recognized the effect of the Tax Reform Law on deferred tax assets and liabilities during the three months ended December 31, 2017.  As a result of the enacted reduction in the federal corporate income tax rate, ALJ recorded a one-time, non-cash increase to deferred income tax expense of $4.1 million to revalue ALJ’s net deferred tax asset.  The resulting $4.1 million decrease to ALJ’s net deferred tax asset was reasonably estimated, and based on the tax rates at which they are expected to reverse in the future.  ALJ will continue to analyze the provisions of the Tax Reform Law to assess the impact to ALJ’s consolidated financial statements.  

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

11. RELATED-PARTY TRANSACTIONS

Harland Clarke Holdings Corp. (“Harland Clarke”), a stockholder who owns ALJ shares in excess of five percent, is a counterparty to Faneuil in two contracts.  One contract provides call center services to support Harland Clarke’s banking-related products and renews annual every April. The other contract provides dispatch services for managed print operations and concluded September 30, 2017. Faneuil recognized revenue from Harland Clarke totaling $94,000 and $327,000 for the three months ended December 31, 2017 and 2016, respectively. The associated cost of revenue was $94,000 and $308,000 for the three months ended December 31, 2017 and 2016, respectively. All revenue from Harland Clarke contained similar terms and conditions as those found in other transactions of this nature entered into by ALJ and its subsidiaries.  Total accounts receivable from Harland Clarke was $94,000 and $106,000 at December 31, 2017 and September 30, 2017, respectively.

12. 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 operating segments are aligned on the basis of products, services, and industry.  The Chief Operating Decision Maker (“CODM”) is ALJ’s Executive Chairman. The CODM manages the business, allocates resources to, and assesses the performance of each operating segment using information about its net revenue and segment adjusted EBITDA.  ALJ defines segment adjusted EBITDA as segment net income (loss) before interest expense, provision for income taxes, depreciation and amortization expense, stock-based compensation expense, restructuring expense, acquisition-related expense, loss (gain) on sales of assets, and other non-recurring items.  Such amounts are detailed in our segment reconciliation below. The accounting policies for segment reporting are the same as for ALJ as a whole.

The following tables present ALJ’s segment information for the three months ended December 31, 2017 and 2016 (in thousands):

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ALJ REGIONAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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.

13. SUBSEQUENT EVENT

ALJ issued 300,000 shares of common stock upon exercise of employee stock options at a weighted-average exercise price of $0.93 per share.

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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 “Part II, 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, d/b/a Carpets N’ More, or Carpets, and Phoenix Color Corp., or Phoenix. With several members of our senior management and 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 assets, such as the acquisition of the Printing Components Business by Phoenix on October 2, 2017, the acquisition of the customer management outsourcing business (“CMO Business”) by Faneuil on May 26, 2017, and the acquisition of Color Optics by Phoenix on July 18, 2016.  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 net revenue at each of our operating subsidiaries by investing in sales and marketing, expanding into new products and markets, and evaluating and executing on tuck-in acquisitions, while continually examining our cost structures to drive higher profits.

Results of Operations  

Our results of operations are impacted by the timing of acquisitions, including the CMO Business by Faneuil on May 26, 2017, and   the Printing Components Business by Phoenix on October 2, 2017.  

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