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DAILY JOURNAL CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations

June 24, 2014

Results of Operations

The Company continues to operate as two different businesses: (1) The "Traditional Business", being the business of newspaper and magazine publishing and related services that the Company had before 1999 when it purchased Sustain, and (2) the Sustain, New Dawn and ISD software businesses ("The Technology Companies") which supply case management software systems and related products to courts and other justice agencies.

Acquisitions in Fiscal 2013



On December 4, 2012, the Company purchased all of the outstanding stock of New Dawn for $14,000,000 in cash. New Dawn provides products and services similar to those of Sustain to more than 350 justice agencies in 39 states, three U.S. territories and two other countries. On September 13, 2013, the Company acquired substantially all of the operating assets and liabilities of ISD Corporation for about $16,000,000 in cash. Now operating under the name of ISD Technologies, Inc., ISD provides case management systems to California courts and other governmental agencies, similar to those of Sustain and New Dawn, and a service that provides the general public a secure website to pay traffic citations online. Both acquisitions were accounted for using the purchase method of accounting, and these acquisitions expand the Company's position in the case management software marketplace.

The results of operations of New Dawn from December 5, 2012 through September 30, 2013 have been included in the Company's Consolidated Financial Statements: revenues were $10,403,000, expenses were $10,625,000 (including intangible amortization expenses of $1,587,000), and its pretax loss was $222,000. The Company allocated the purchase price to tangible assets ($4,805,000 including cash of $2,122,000, prepaid and other assets of $1,881,000, accounts receivable of $660,000, and fixed assets of $142,000), identifiable intangible assets (purchased software and customer relationships of $9,500,000) and liabilities ($12,090,000 including accounts payable and accrued expenses of $2,334,000, deferred maintenance agreements of $2,200,000 and deferred installation contracts of $7,472,000) based on their fair values with the remaining balance in excess of the net assets allocated to goodwill ($11,700,000). Included in accrued expenses was $1,100,000 related to prior claims by customers for amounts previously collected on software installation projects. Goodwill, which is not amortized for financial statement purposes, is amortized over a 15-year period for tax purposes. Goodwill represents the expected synergies in expanding the Company's software business. Identifiable intangible assets are being amortized on a straight-line basis over five years due to the short life cycle of technology that customer relationships depend on.

The Company made certain year-end adjustments to the allocated fair values for goodwill, intangibles, prepaid and other assets and accrued expenses as a result of (i) adjusting the fair value of certain pre-acquisition contingencies based on additional information and (ii) determining the fair value of work-in-progress on software installation projects. The cumulative effect of these changes was to establish work-in-progress costs of approximately $1,760,000 included in prepaid and other assets, decrease accrued liabilities by $540,000 and reduce goodwill by $2,300,000.

The results of operations of ISD for the month of September 2013 have been included in the Company's Consolidated Financial Statements: revenues were $784,000, expenses were $694,000 (including intangible amortization expenses of $278,000), and its pretax income was $90,000. The Company allocated the purchase price to tangible assets ($4,410,000 including cash of $2,546,000, accounts receivable of $1,636,000, fixed assets of $141,000; and prepaid assets of $87,000), identifiable intangible assets (purchased software and customer relationships of $16,702,000) and liabilities ($5,112,000 including accounts payable and accrued expenses of $2,270,000 and deferred maintenance agreements of $2,842,000) based on their fair values. The Company's allocation to identifiable intangibles is preliminary, pending the results of a third party valuation, and these assets are being amortized over five years due to the short life cycle of technology that customer relationships depend on.

Deferred revenues on installation contracts primarily represent the fair value of advances from customers of The Technology Companies for software licenses and installation services in various stages of completion. After a customer's acceptance of the completed project, the advances are generally no longer at risk of refund and are therefore considered earned. Deferred revenues on maintenance contracts represent prepayments of annual maintenance fees. Goodwill is not amortized for financial statement purposes but evaluated for impairment annually, or whenever events or changes in circumstances indicate that the value may not be recoverable. Considered factors for potential goodwill impairment evaluation include the current year's business profitability before intangible amortization, fluctuations of revenues, changes in the market place, the status of deferred installation contracts and new business, among other things.

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Overall Results



During fiscal 2013, consolidated pretax income decreased by $3,332,000 (42%) to $4,569,000 from $7,901,000 in the prior year. The Company's Traditional business segment pretax income decreased by $1,382,000 (14%) to $8,707,000 from $10,089,000, primarily resulting from a reduction in trustee sale notice and related service fee revenues of $4,454,000, partially offset by an increase in dividends and interest income of $574,000.

The Technology Companies' business segment had a pretax loss of $4,138,000 compared to $2,188,000 in the prior year primarily resulting from The Technology Companies' intangible amortization costs of $1,865,000. Most of the intangible amortization costs related to New Dawn, which was acquired in fiscal 2013 and therefore not part of our fiscal 2012 results.

There were pretax other-than-temporary impairment losses on investments of $1,719,000 versus $2,855,000 in the prior year. These losses impact the results of the Traditional business, but it is important to note that these write-downs are the result of an accounting requirement and they do not indicate that a loss has actually been realized due to a sale of the security or that the decline in value is necessarily permanent. For example, the market price of the security written down in fiscal 2012 had already recovered to more than its original cost as of September 30, 2013.

Net income per share decreased to $2.74 from $4.01.

Comprehensive income includes net income and unrealized net gains on investments, net of taxes, as summarized below:

Comprehensive Income Fiscal 2013 2012 Net income $ 3,779,000$ 5,541,000



Net change in unrealized appreciation of investments (net of taxes)

21,292,000 15,085,000 Reclassification adjustment of other-than-temporary impairment losses recognized in net income (net of taxes) 1,051,000 1,720,000 Comprehensive income $ 26,122,000$ 22,346,000 * * * * * * * * * * * * 15



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The Company's Traditional Business is one reportable segment, and The Technology Companies are another. In fiscal 2012, given that Sustain was the only one of The Technology Companies then owned by the Company, it is generally referred to as the Sustain segment prior to fiscal 2013. Additional detail about each of the reportable segments is set forth below:

Reportable Segments Traditional The Technology Business Companies* Total Fiscal 2013 Revenues $ 23,830,000$ 13,846,000$ 37,676,000 Income (loss) from operations 7,974,000 (4,131,000 ) 3,843,000 Other-than-temporary impairment losses on investments 1,719,000 - 1,719,000 Pretax income (loss) 8,707,000 (4,138,000 ) 4,569,000 Income tax (expense) benefit (3,053,000 ) 2,263,000 (790,000 ) Net income (loss) 5,654,000 (1,875,000 ) 3,779,000 Amortization of intangible assets - 1,865,000 1,865,000 Traditional Business Sustain Total Fiscal 2012 Revenues $ 28,956,000$ 2,918,000$ 31,874,000 Income (loss) from operations 10,877,000 (2,195,000 ) 8,682,000 Other-than-temporary impairment losses on investments 2,855,000 - 2,855,000 Pretax income (loss) 10,089,000 (2,188,000 ) 7,901,000 Income tax (expense) benefit (3,340,000 ) 980,000 (2,360,000 ) Net income (loss) 6,749,000 (1,208,000 ) 5,541,000



* Includes (i) New Dawn's financial results from December 5, 2012 through September 30, 2013 with revenues of $10,403,000 and expenses of $10,625,000 (including intangible amortization expenses of $1,587,000), and (ii) ISD's September 2013 financial results with revenues of $784,000 and expenses of $694,000 (including intangible amortization expenses of $278,000).

Consolidated revenues were $37,676,000 and $31,874,000 for fiscal 2013 and 2012, respectively. This increase of $5,802,000 (18%) was primarily from the additional New Dawn and ISD revenues of $11,187,000, partially offset by the reduction in trustee sale notice and related service fee revenues of $4,454,000. The Company's revenues derived from The Technology Companies' operations constituted about 37% and 9% (for Sustain only) of the Company's total revenues for fiscal 2013 and 2012, respectively.

Consolidated operating costs and expenses increased by $10,641,000 (46%) to $33,833,000 from $23,192,000, primarily for The Technology Companies. Total personnel costs increased by $5,644,000 (42%) to $19,236,000 from $13,592,000 primarily due to The Technology Companies' additional personnel costs of $8,331,000, partially offset by a decrease of $1,610,000 in the expenses related to the Company's Management Incentive Plan ("Incentive Plan"). The decrease in Incentive Plan expense consisted of a reduction of $2,580,000 in the long-term Incentive Plan accrual during fiscal 2013 due to reduced estimated current and future consolidated pretax profits before this accrual versus a reduction of $970,000 in the prior comparable year. This reduction occured because the Incentive Plan is based primarily on the pretax profits of the Company before workers' compensation, supplemental compensation and adjustment for certain items. Depreciation and amortization costs increased by $1,938,000 (385%) to $2,441,000 mainly resulting from the amortization of The Technology Companies' intangible costs of $1,865,000. Other general and administrative expenses also increased by $2,990,000 (87%) primarily resulting from additional rent, sales and marketing expenses for The Technology Companies and increased professional fees, including those associated with the two acquisitions.

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The Traditional business segment advertising revenues, which declined by $4,749,000 from $19,221,000 to $14,472,000, are very much dependent on the number of California and Arizona foreclosures for which public notice advertising is required by law. The number of foreclosure notices published by the Company decreased by 51% during fiscal 2013 as compared to fiscal 2012. Although public notice advertising revenues were down compared to the prior year, the Company still continued to benefit from a relatively large number of foreclosures in California and Arizona compared to historical foreclosure rates. Along with slowing due to general improvements in the economy, effective January 1, 2013, the California Homeowner's Bill of Rights imposed new requirements that have contributed to the slowdown in foreclosures. Because this slowing is expected to continue, we anticipate there will be fewer foreclosure notice advertisements and declining revenues in fiscal 2014, and the Company's print-based earnings will also decline significantly because it will be impractical for the Company to offset all revenue loss by expense reduction. The Company's smaller newspapers, those other than the Los Angeles and San Francisco Daily Journals ("The Daily Journals"), accounted for about 95% of the total public notice advertising revenues in the twelve-month period. Public notice advertising revenues and related advertising and other service fees constituted about 35% of the Company's total revenues during this period. Because of this concentration, the Company's revenues would be significantly affected if California (and to a lesser extent Arizona) eliminated the legal requirement to publish public notices in adjudicated newspapers of general circulation, as has been proposed from time to time. Also, if the adjudication of one or more of the Company's newspapers was challenged and revoked, those newspapers would no longer be eligible to publish public notice advertising, and it could have a material adverse effect on the Company's revenues.

We do not expect to experience an offsetting increase in commercial advertising because of the continuing challenges in the commercial advertising business, which declined $358,000 from $4,629,000 to $4,271,000. The Daily Journals accounted for about 85% of the Company's total circulation revenues, which declined by $184,000 from $6,530,000 to $6,346,000. The court rule and judicial profile services generated about 12% 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.

In fiscal 2013, The Technology Companies recognized $9,956,000 in revenues from fees for the licensing and maintenance of their software products, compared to Sustain's licensing and maintenance revenues of $2,205,000 in fiscal 2012. Sustain's portion of the 2013 licensing and maintenance revenues was $2,338,000, and the balance was attributable to New Dawn and ISD. The Technology Companies recognized consulting revenues of $3,367,000 in fiscal 2013 compared to $713,000 in fiscal 2012 (for Sustain only).

The Technology Companies' consulting, licensing and maintenance revenues are subject to uncertainty because they depend on (i) the timing of the acceptance of the completed installations, (ii) the unpredictable needs of their existing customers, and (iii) their ability to secure new customers. In most cases, revenues from their new installation projects will only be recognized, if at all, upon completion and acceptance of their services by the various customers. The Company is continuing to update and upgrade its software products. These costs are expensed as incurred and will materially impact earnings at least through the foreseeable future.

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Taxes



On a pretax profit of $4,569,000 and $7,901,000 for the fiscal years ended September 30, 2013 and 2012, respectively, the Company recorded a tax provision of $790,000 and $2,360,000 respectively, which was lower in each case than the amount computed using the statutory rate because of the available dividends received deduction, the domestic production activity deduction and a change this year in California franchise taxes regarding revenue allocation among states resulting in a lower California tax rate which reduced the current year's tax rate and prior years' deferred taxes on the unrealized appreciation of the Company's investments by about $500,000. In addition, in fiscal 2012, there was a reversal of an uncertain tax liability as the Company reached an agreement with the Internal Revenue Service in March 2012 to settle the Company's previously claimed research and development credits in its tax returns for the years 2002 to 2007. Consequently, the Company's effective tax rate was 17% and 30% for fiscal 2013 and 2012, respectively. The acquisition of New Dawn was structured as a stock acquisition with an Internal Revenue Code Section 338 (h)(10) election, which results in the acquisition being treated as an acquisition of assets for income tax purposes. The ISD acquisition was structured as an asset purchase. As such, the amounts allocated to purchased software and customer relationships as well as goodwill are amortized over a 15-year period on a straight-line basis for tax purposes. Differences in the amortization period and methods between book and tax useful lives will result in deferred tax assets or liabilities. The Company files federal income tax returns in the United States and with various state jurisdictions and is no longer subject to examinations for years before 2010 with regard to federal income taxes.

Liquidity and Capital Resources

During fiscal 2013, the Company's cash and cash equivalents, and marketable security positions increased by $44,391,000. Cash and cash equivalents were used primarily for the purchase of capital assets of $280,000 (mostly computer software and office equipment). During the first quarter of fiscal 2013, the Company borrowed $14 million from its investment margin account to purchase all of the outstanding stock of New Dawn, and during the fourth quarter of fiscal 2013, it borrowed another $15.5 million to acquire substantially all assets and liabilities of ISD Corporation, in each case pledging its marketable securities to obtain favorable financing. During the first quarter of fiscal 2012, the Company bought shares of common stock of a Fortune 200 company, and during the third quarter of fiscal 2012, it bought additional shares of common stock of one of the foreign manufacturing companies in which it had previously invested. There were no additional purchases in fiscal 2013. The investments in marketable securities, which cost approximately $47,976,000 and had a market value of about $136,994,000 at September 30, 2013, generated approximately $2,541,000 in dividends and interest income, which lowers the Company's effective income tax rate because of the dividends received deduction. As of September 30, 2013, there were unrealized investment pretax gains of $89,018,000 as compared to $52,464,000 as of September 30, 2012. Most of the unrealized gains were in the common stocks of three U.S. financial institutions.

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The cash provided by operating activities of $5,672,000 included net decreases in deferred installation contracts and maintenance agreements of $307,000 and deferred subscriptions of $115,000. Cash flows from operating activities decreased by $1,287,000 during the twelve months ended September 30, 2013 as compared to the prior comparable period primarily resulting from the decreases in net income of $1,762,000 and accounts payable and accrued liabilities of $1,521,000, including a deferred ISD acquisition cost balance of about $507,000 that was paid in December 2013, partially offset by the decreases in accounts receivable of $805,000.

As of September 30, 2013, the Company had working capital of $98,854,000, including the liabilities for deferred subscriptions and deferred installation contracts and maintenance agreements of $17,277,000, which are scheduled to be earned within one year, and the deferred tax liability of $34,610,000 for the unrealized gains described above.

The Company believes that it will be able to fund its operations for the foreseeable future through its cash flows from operating activities and its current working capital and expects that any such cash flows will be invested in its businesses. The Company continues to have the ability to borrow against its marketable securities on favorable terms as it did for the New Dawn and ISD acquisitions. The Company also may entertain additional business acquisition opportunities. Any excess cash flows could be used to reduce the investment margin account liability or invested as management and the Board of Directors deem appropriate at the time.

Such investments may include additional securities of the companies in which the Company has already invested, securities of other companies, government securities (including U.S. Treasury Notes and Bills) or other instruments. The decision as to particular investments will be driven by the Company's belief about the risk/reward profile of the various investment choices at the time, and it may utilize government securities as a default if attractive opportunities for a better return are not available. The Company's Chairman of the Board, Charles Munger, is also the vice chairman of Berkshire Hathaway Inc., which maintains a substantial investment portfolio. The Company's Board of Directors has utilized his judgment and suggestions, as well as those of J.P. Guerin, the Company's vice chairman, when selecting investments, and both of them will continue to play an important role in monitoring existing investments and selecting any future investments.

As noted above, however, the investments are concentrated in just six companies. Accordingly, a significant decline in the market value of one or more of the Company's investments may not be offset by the hypothetically better performance of other investments, and that could result in a large decrease in the Company's shareholders' equity and, under certain circumstances, in the recognition of impairment losses in the Company's income statement (such as the other-than-temporary impairment losses of $1,719,000 recognized during the fourth quarter of 2013 and the $2,855,000 recognized in the third quarter of 2012).

Critical Accounting Policies and Estimates

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

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 and are net of commissions. An allowance for doubtful accounts for receivable is recorded.

The Technology Companies recognize revenues in accordance with the provisions of Accounting Standards Codification ("ASC") 605, Revenue Recognition and ASC 985-605, Software-Revenue Recognition. Revenues from leases of software products are recognized over the life of the lease while revenues from software product sales are generally recognized upon delivery, installation or acceptance pursuant to a signed agreement. Revenues from annual maintenance contracts generally call for the Company to provide software updates and upgrades to customers and are recognized ratably over the maintenance period. Consulting and other services are recognized upon acceptance by the customers under the completed contract method. The Company elects to use the completed contract method because customer's acceptance is unpredictable and reliable estimates of the progress towards completion cannot be made. Only after a customer's acceptance of a completed project are customer advances generally no longer at risk of refund and are therefore considered earned.

Approximately 37% of the Company's revenues in fiscal 2013 were derived from sales and leases of software licenses, annual maintenance contract and support services and consulting services that typically include implementation and training.

With regard to arrangements accounted for under ASC 605-35, Multiple Elements Arrangements which include consulting and other services, licenses and annual maintenance, the Company has established Vendor Specific Objective Evidence (VSOE) of the values of these services, such that consulting and one-time license fees are generally recognized upon delivery, installation or acceptance pursuant to a signed agreement and the annual maintenance is recognized ratably over the specific maintenance contract term, usually one year. VSOE of fair value of the annual maintenance exists because a substantial majority of The Technology Companies' actual maintenance renewals is within a narrow range of pricing as a percentage of the underlying license fees and are deemed substantive.

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Accounting Standards Codification ("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 expects that most of The Technology Companies' development costs will continue to be expensed for the foreseeable future given the continuous upgrading of their software products and the fact that once technological feasibility is achieved, the product is made available.

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 2012 and 2013. 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 Management Incentive Plan's future commitment is calculated using Level 3 inputs, as defined in the fair value hierarchy, based on an average of the current year and the current expectation of fiscal 2014 pretax earnings before certain items, discounted to the present value since each granted Unit will expire over its remaining life term of up to 10 years.

ASC 805, Business Combinations, requires the use of the purchase method of accounting in connection with the acquisition of businesses. This requires all of the acquired assets and liabilities to be recorded at their fair values and for the purchase price to be allocated accordingly. Furthermore, intangible assets must be categorized and separated into two groups: those with an identifiable remaining useful life and those with an indefinite useful life. The latter is classified as goodwill. In fiscal 2013, the acquisition of New Dawn resulted in the Company allocating $11,700,000 to goodwill. The identifiable intangible assets acquired for New Dawn were based on Level 3 fair value measurements using an income approach discounted to the present value.

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The Company analyzes goodwill for possible impairment under ASC 350, Intangibles - Goodwill and Other, annually or whenever events or changes in circumstances indicate that the value may not be recoverable. Considered factors for potential goodwill impairment evaluation with respect to The Technology Companies include current year's business profitability before intangible amortization, fluctuations of revenues, changes in the market place, the status of deferred installation contracts and new business, among other things. In addition, Accounting Standards Codification 2011-08, Testing Goodwill for Impairment, allows for the option of performing a qualitative assessment before calculating the fair value of a reporting unit. If it is determined based on qualitative factors that there is no impairment to goodwill, then the fair value of a reporting unit is not needed. If a quantitative analysis is required and the unit's carrying amount exceeds its fair value, then the second step is performed to measure the amount of potential impairment. The Company's annual goodwill impairment analysis in 2013 did not result in an impairment charge based on the qualitative assessment.

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 statements 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 net unrealized gains on investments. See Note 3 of Notes to Consolidated Financial Statements for further discussion.

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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