Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Note Regarding Forward-Looking Statements
This report, including this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”), contains “forward-looking statements” within the meaning of the federal securities laws. All such statements are qualified by this cautionary note, which is provided pursuant to the safe harbor provisions of Section 27A of the Securities Act of 1933, as amended (the “1933 Act”) and Section 21E of the 1934 Act, as amended. Forward-looking statements may also be included in our other public filings, press releases, our website, and oral and written presentations by management. Statements other than historical facts are forward-looking and may be identified by words such as “may,” “will,” “expects,” “believes,” “anticipates,” “plans,” “estimates,” “seeks,” “could,” “intends,” or “the negative thereof” or similar words of similar meaning. Examples include statements regarding (1) the impact the COVID-19 pandemic has had and the anticipated impact it will have on our business, strategies and initiatives, (2) the impact of restructuring activities and other adjustments to our cost structure and other actions designed to respond to market conditions and improve our performance, and the anticipated effectiveness and expenses associated with these actions, (3) our financial outlook for revenues, earnings per share, operating income, expense related to equity-based compensation, capital resources and other financial items, (4) expectations for our businesses and for the industries in which we operate, including the impact of economic conditions of the markets we serve and on the marketing expenditures and activities of our clients and prospects, (5) competitive factors, (6) acquisition, disposition, and development plans, (7) expectations regarding legal proceedings and other contingent liabilities, (8) the impact of recent tax reform legislation on our results of operations, and (9) other statements regarding future events, conditions, or outcomes.
These forward-looking statements are based on current information, expectations, and estimates and involve risks, uncertainties, assumptions, and other factors that are difficult to predict and that could cause actual results to vary materially from what is expressed in or indicated by the forward-looking statements. In that event, our business, financial condition, results of operations, or liquidity could be materially adversely affected and investors in our securities could lose part or all of their investments. Some of these risks, uncertainties, assumptions, and other factors can be found in our filings with the SEC, including the factors discussed under “Item 1A. Risk Factors” in the Annual Report on Form 10-K for the fiscal year ended December 31, 2019, Part II, Item 1a. “ Risk Factors” in this Quarterly Report on Form 10-Q for the quarter ended June 30, 2020 and in our other reports filed or furnished with the SEC. The forward-looking statements included in this report and those included in our other public filings, press releases, our website, and oral and written presentations by management are made only as of the respective dates thereof, and we undertake no obligation to update publicly any forward-looking statement in this report or in other documents, our website, or oral statements for any reason, even if new information becomes available or other events occur in the future, except as required by law.
Overview
The following MD&A is intended to help the reader understand the results of operations and financial condition of Harte Hanks. This section is provided as a supplement to, and should be read in conjunction with, our Condensed Consolidated Financial Statements and the accompanying notes included herein as well as our 2019 10-K. Our 2019 10-K contains a discussion of other matters not included herein, such as disclosures regarding critical accounting policies and estimates, and contractual obligations. See Note A, Overview and Significant Accounting Policies, in the Notes to Condensed Consolidated Financial Statements for further information.
Harte Hanks partners with clients to deliver relevant, connected, and quality customer interactions. Our approach starts with discovery and learning, which leads to customer journey mapping, creative and content development, analytics, and data management, and ends with execution and support in a variety of digital and traditional channels. We do something powerful: we produce engaging and memorable customer interactions to drive business results for our clients, which is why Harte Hanks is known for developing better customer relationships and experiences and defining interaction-led marketing.
Our services offer a wide variety of integrated, multi-channel, data-driven solutions for top brands around the globe. We help our clients gain insight into their customers’ behaviors from their data and use that insight to create innovative multi-channel marketing programs to deliver a return on marketing investment. We believe our clients’ success is determined not only by how good their tools are, but how well we help them use the tools to gain insight and analyze their consumers. This results in a strong and enduring relationship between our clients and their customers which is key to being leaders in customer interaction. We offer a full suite of capabilities and resources to provide a broad range of marketing services, utilizing a variety of media from direct mail to email, including:
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Database Marketing Solutions
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Mail and Product Fulfillment
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We are affected by the general, national, and international economic and business conditions in the markets where we and our customers operate. Marketing budgets are largely discretionary in nature, and as a consequence are easier for our clients to reduce in the short-term than other expenses. Our revenues are also affected by the economic fundamentals of each industry that we serve, various market factors, including the demand for services by our clients, and the financial condition of and budgets available to our clients, among other factors. We remain committed to making the investments necessary to execute our multichannel strategy while also continuing to adjust our cost structure to reduce costs.
We continued to face a challenging competitive environment in 2020. The sale of our Direct Mail Equipment to Summit in April 2020, together with our restructuring activities, have and will continue to result in a decrease of recurring expenses. These are all parts of our efforts to prioritize our investments and focus on our core business of optimizing the journey of our customers’ clients across an omni-channel delivery platform. We expect these actions will continue to enhance our liquidity and financial flexibility. For additional information, see “Liquidity and Capital Resources” section.
COVID-19
In the first quarter of 2020, we took a number of precautionary measures designed to help minimize the risk of the spread of the virus among our employees, including suspending all non-essential employee travel worldwide, temporarily closing the majority of our domestic and foreign offices, extensively and frequently disinfecting our offices that remain open, enforcing social distancing to the extent possible and requiring the majority of our employees to work remotely. These measures will remain in effect until we can safely re-open our offices.
In the second quarter of 2020, we continue to closely monitor the impact of the pandemic on all aspects of our business, including how the pandemic continues to impact our customers, employees, suppliers, vendors and our business partners, as well as how it has impacted our liquidity and compliance with our credit agreement.
In connection with the pandemic, some of our customers have reduced the amount of work we provide to them while other customers have requested accommodations including extensions of payment or restructuring of agreements. In addition, some of our customers have declared bankruptcy and we expect additional customers to file for bankruptcy in the coming months. We have also seen a number of wins for our contact centers solutions services as well as increased volume for existing customers as a result of the environment caused by the pandemic including an increased need for contact center services in the current economy. While the pandemic has not had a material effect on our business, liquidity or ability to comply with covenants to date, given the dynamic nature of the pandemic, we may experience material impacts in the future. We recommend that you review “Item 1A. Risk Factors” in this Quarterly Report on Form 10-Q for a further discussion on COVID-19.
Recent Developments
Restructuring Activities
In 2019, our management team, along with members of the Board, formed a project committee focused on our cost-saving initiatives and other restructuring efforts. This committee reviewed each of our business lines and other operational areas to identify both one-time and recurring cost-saving opportunities. In 2020, our management team continues to review and adjust our cost structure and operating footprint, optimize our operations, and invest in improved technology.
In the three and six months ended June 30, 2020, we recorded restructuring charges of $5.2 million and $6.6 million, respectively. These charges were mainly related to lease termination and impairment charges, fixed asset impairment and disposal charges and other facility related expenses as well as severance payments.
We expect that in connection with our cost-saving restructuring initiatives, we will incur total restructuring charges of approximately $20.9 million through the end of 2020. We recognized $6.6 million of restructuring expense in the six months ended June 30, 2020 and $11.8 million of restructuring expense in the year ended December 31, 2019. We expect to incur $2.5 million of restructuring charges through the end of 2020.
Sale of production equipment of Jacksonville facility and strategic partnership with Summit
On April 24, 2020, we sold the majority of the production equipment from our Jacksonville facility to Summit Direct Mail Inc.(“Summit”) for $1.5 million. In addition, the Company entered into a strategic partnership with Summit, pursuant to which the Company will manage client relationships and Summit will perform the direct mail campaigns. The Company is well positioned to provide the full suite of marketing solutions to Summit customers and will leverage the expanded print and direct mail capabilities provided by the partnership with Summit to grow our business.
As a result of this sale, we booked a $1.9 million impairment charge on our Jacksonville facility and recognized a $1.2 million capital loss from fixed asset disposal associated with the Summit deal. These expenses were included in our restructuring expense in the three months ended June 30, 2020.
Paycheck Protection Program Term Note
On April 14, 2020, the Company entered into a promissory note with Texas Capital Bank, for an unsecured loan with a principal amount of $10.0 million made to the Company pursuant to the Paycheck Protection Program (“PPP Term Note”) under the CARES Act. The PPP Term Note is guaranteed by the United States Small Business Administration.
The PPP Term Note bears interest at a fixed annual rate of 1.00%, with the first six months of interest deferred. Beginning in October 2020, the Company will make 18 equal monthly payments of principal and interest with the final payment due in April 2022. The PPP Term Note may be accelerated upon the occurrence of an event of default.
The proceeds may be used to maintain payroll or make certain covered interest payments, lease payments and utility payments. Under the terms of the CARES Act, the Company can be granted forgiveness for all or a portion of the loan granted under the PPP, with such forgiveness to be determined, subject to limitations, based on the use of the loan proceeds for payment of payroll costs and any payments of certain covered interest, lease and utility payments.
At this time, the Company anticipates forgiveness of the entire amount of the PPP Term Note; however, we are not in a position to estimate the timing of the completion of the forgiveness process. We have elected to classify the principal balance of the PPP Term Note within both Short-term and Long-term debt, net, on the condensed consolidated balance sheet as of June 30, 2020. Under the existing terms of the PPP Term Note, if no forgiveness were granted, approximately $5.0 million of the principal amount would be due within twelve months.
Texas Capital Credit Facility
On May 11, 2020, we entered into an amendment to the Texas Capital Credit Facility which further extended the maturity of the facility by one year to April 17, 2022 and decreased availability under the facility to $19 million.
Results of Operations
Operating results were as follows:
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Three Months Ended June 30,
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Six Months Ended June 30,
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In thousands, except percentages
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2020
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2019
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% Change
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2020
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2019
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% Change
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Revenues
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$
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41,601
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$
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54,686
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(23.9
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)%
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$
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82,123
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$
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113,836
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(27.9
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)%
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Operating expenses
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47,486
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61,299
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(22.5
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)%
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93,115
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131,390
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(29.1
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)%
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Operating Loss
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$
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(5,885
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)
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$
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(6,613
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)
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11.0
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%
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$
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(10,992
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)
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$
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(17,554
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)
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(37.4
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)%
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Operating margin
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(14.1
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)%
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(12.1
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)%
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(13.3
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)%
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(15.4
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)%
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Loss before taxes
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$
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(7,753
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)
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$
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(3,855
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)
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101.1
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%
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$
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(13,928
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)
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$
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(16,592
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)
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(16.1
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)%
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Diluted loss per common share from operations
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(0.99
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)
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(0.63
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57.1
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%
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(0.21
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(2.80
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)
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(92.5
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)%
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Revenues
Three months ended June 30, 2020 vs. Three months ended June 30, 2019
Revenues declined $13.1 million, or 23.9%, in the three months ended June 30, 2020, compared to the three months ended June 30, 2019. These results reflect the impact of declines in most of our industry verticals. Revenues declined in our retail, financial services, transportation, and healthcare verticals by $7.3 million, or 68.4%, $5.4 million, or 43.9%, $3.2 million, or 83.8%, and $1.1 million, or 21.7%, respectively. These declines were primarily due to lost clients and lower volumes of sales from existing clients. These declines were partially offset by the increase in B2B and consumer brands verticals by $3.1 million, or 28.2%, and $0.7 million or 5.9%, respectively, as a result of increased demand.
Six months ended June 30, 2020 vs. Six months ended June 30, 2019
Revenues declined $31.7 million, or 27.9%, in the six months ended June 30, 2020, compared to the six months ended June 30, 2019. These results reflect the impact of declines in most of our industry verticals. Revenues declined in our retail, financial services, transportation, healthcare and consumer brands verticals by $14.3 million, or 62.4%, $10.2 million, or 40.6%, $6.8 million, or 84.0%, $1.5 million, or 15.7%,and $0.4 million or 1.7%, respectively. These declines were primarily due to lost clients and lower volumes of sales from existing clients. These declines were partially offset by the increase in the B2B vertical of $1.6 million, or 6.5%.
Operating Expenses
Three months ended June 30, 2020 vs. Three months ended June 30, 2019
Operating expenses were $47.5 million in the three months ended June 30, 2020, compared to $61.3 million in the three months ended June 30, 2019. Production and distribution expenses declined $7.3 million, or 41.0%, compared to the second quarter of 2019 primarily due to lower revenue and cost reduction initiatives. Labor costs declined $6.2 million, or 19.4%, compared to the three months ended June 30, 2019, primarily due to lower payroll and consulting expense from lower revenue and our expense reduction efforts. Advertising, Selling, General and Administrative expense decreased $2.0 million, or 28.5%, compared to the three months ended June 30, 2019, primarily due to $0.6 million lower business services expense, $0.5 million of lower facility service expenses as well as $0.3 million of lower employee expenses associated with lower revenue. Depreciation expense declined $0.3 million, or 22.5%, compared to the prior year quarter, primarily due to lower capital expenditures.
The largest components of our operating expenses are labor, mail transportation expenses and outsourced costs. Each of these costs is, at least in part, variable and tends to fluctuate in line with revenues and the demand for our services. Mail transportation rates have increased over the last few years due to demand and supply fluctuations within the transportation industry. Future changes in mail transportation expenses will continue to impact our total production costs and total operating expenses and may have an impact on future demand for our supply chain management services.
Postage costs for mailings are borne by our clients and are not directly reflected in our revenues or expenses.
Six months ended June 30, 2020 vs. Six months ended June 30, 2019
Operating expenses were $93.1 million in the six months ended June 30, 2020, compared to $131.4 million in the six months ended June 30, 2019. Production and distribution expenses declined $17.1 million, or 41.8%, compared to the second quarter of 2019 primarily due to lower revenue and cost reduction initiatives. Labor costs declined $15.9 million, or 24.3%, compared to the six months ended June 30, 2019, primarily due to lower payroll and consulting expense from lower revenue and our expense reduction efforts. Advertising, Selling, General and Administrative expense decreased $3.6 million, or 24.4%, compared to the six months ended June 30, 2019, primarily due to $0.5 million of lower professional services expense primarily audit fees, $0.5 million of lower facility services as well as $1.3 million of lower business services expense due to the reduction in IT services expenses including data processing fees, software license fees and online service expenses. Depreciation expense declined $0.6 million, or 21.0%, compared to the prior year quarter, primarily due to lower capital expenditures.
The largest components of our operating expenses are labor, mail transportation expenses and outsourced costs. Each of these costs is, at least in part, variable and tends to fluctuate in line with revenues and the demand for our services. Mail transportation rates have increased over the last few years due to demand and supply fluctuations within the transportation industry. Future changes in mail transportation expenses will continue to impact our total production costs and total operating expenses and may have an impact on future demand for our supply chain management services.
Postage costs for mailings are borne by our clients and are not directly reflected in our revenues or expenses.
Operating Loss
Three months ended June 30, 2020 vs. Three months ended June 30, 2019
Operating loss was $5.9 million in the three months ended June 30, 2020, compared to $6.6 million in the three months ended June 30, 2019. The $0.7 million improvement was primarily driven by the impact of restructuring activities with a $13.8 million decline in operating expenses which was largely offset by $13.1 million of lower revenue.
Six months ended June 30, 2020 vs. Six months ended June 30, 2019
Operating loss was $11.0 million in the six months ended June 30, 2020, compared to $17.6 million in the six months ended June 30, 2019. The $6.6 million improvement was primarily driven by the impact of restructuring activities with a $38.3 million decline in operating expenses which was larger than the $31.7 million decrease in revenue.
Interest Expense, net
Three months ended June 30, 2020 vs. Three months ended June 30, 2019
Interest expense, net, in the three months ended June 30, 2020 decreased $0.1 million compared to the three months ended June 30, 2019 due to lower interest rate compared to prior year period.
Six months ended June 30, 2020 vs. Six months ended June 30, 2019
Interest expense, net, in the six months ended June 30, 2020 remained consistent compared to the six months ended June 30, 2019.
Gain on sale
The gain on sale for three and six months ended June 30, 2019 was the result of $5.0 million earn out we received related to the qualified sale of 3Q Digital.
Other Expense
Three months ended June 30, 2020 vs. Three months ended June 30, 2019
Other expense, net, decreased $0.3 million in the three months ended June 30, 2020, compared to the three months ended June 30, 2019 mainly due to lower pension expense.
Six months ended June 30, 2020 vs. Six months ended June 30, 2019
Other expense, net, decreased $1.1 million in the six months ended June 30, 2020, compared to the six months ended June 30, 2019 mainly due to lower pension expense.
Income Taxes
Three months ended June 30, 2020 vs. Three months ended June 30, 2019
The income tax benefit of $1.5 million in the second quarter of 2020 represents an increase in income tax benefit of $1.5 million when compared to the second quarter of 2019. Our effective tax rate was 19.6% for the second quarter of 2020, increasing from a rate of 1.35% for the second quarter of 2019. The effective income tax rate calculated for the three months ended June 30, 2020 differs from the federal statutory rate of 21.0%, primarily due to the change in valuation allowances recorded on our deferred tax assets for federal net operating losses incurred as a result of the enactment of the CARES Act during the three months ended June 30, 2020. These losses will be carried back to tax years when the federal statutory rate was 35%, resulting in an additional tax benefit.
We have in general historically calculated the provision for income taxes during interim reporting periods by applying an estimate of the annual effective tax rate for the full calendar year to ordinary income or loss for the reporting period. However, we used a discrete effective tax rate method to calculate income taxes for the three months ended June 30, 2020 and June 30, 2019 because we determined that our ordinary income or loss cannot be reliably estimated and small changes in estimated ordinary income would result in significant changes in the estimated annual effective tax rates.
Six months ended June 30, 2020 vs. Six months ended June 30, 2019
The income tax benefit of $12.8 million in the six months ended June 30, 2020 represents an increase in benefit of $13.5 million when compared to the six months ended June 30, 2019. Our effective tax rate was 92.0% for the six months ended June 30, 2020, increasing from a rate of negative 4.4% for the six months ended June 30, 2019. The effective income tax rate calculated for the six months ended June 30, 2020 differs from the federal statutory rate of 21.0%, primarily due to the change in valuation allowances recorded on our deferred tax assets for federal net operating losses incurred, as a result of the enactment of the CARES Act during the six months ended June 30, 2020. These losses will be carried back to tax years when the federal statutory rate was 35%, resulting in an additional tax benefit.
We have in general historically calculated the provision for income taxes during interim reporting periods by applying an estimate of the annual effective tax rate for the full calendar year to ordinary income or loss for the reporting period. However, we used a discrete effective tax rate method to calculate income taxes for the six months ended June 30, 2020 and June 30, 2019 because we determined that our ordinary income or loss cannot be reliably estimated and small changes in estimated ordinary income would result in significant changes in the estimated annual effective tax rates.
Liquidity and Capital Resources
Sources and Uses of Cash
Our cash and cash equivalent and restricted cash balances were $36.4 million and $34.1 million at June 30, 2020 and December 31, 2019, respectively. On April 20, 2020, the Company received PPP Loan proceeds in the amount of $10 million. On August 5, 2020, we received $3.3 million federal tax refund related to our 2018 NOL carryback. We also expect to receive additional tax refunds of $5.7 million and $3.6 million in 2020 and 2021, respectively as a result of the change to the tax NOL carryback provisions included in the CARES Act.
On June 26, 2019, we received $15.9 million in aggregate federal income tax refunds related to carryback of capital losses. On May 7, 2019, we received a $5 million Contingent Payment related to the Qualified Sale of 3Q Digital. Our principal sources of liquidity are cash on hand, cash provided by operating activities, and borrowings. Our cash is primarily used for general corporate purposes, working capital requirements, and capital expenditures.
At this time, we believe that we will be able to continue to meet our liquidity requirements and fund our fixed obligations (such as debt services, operating leases and unfunded pension plan benefit payments) and other cash needs for our operations for at least the next twelve months through a combination of cash on hand, cash flow from operations, and borrowings under the Texas Capital Credit Facility. Although the Company believes that it will be able to meet its cash needs for the foreseeable future, if unforeseen circumstances arise the Company may need to seek alternative sources of liquidity. To date, the COVID-19 pandemic has not had a material impact on the Company’s liquidity or on the Company’s ability to meet its obligations under the Texas Capital Credit Facility, including its ability to comply with all covenants. We will continue to closely monitor the impact the COVID-19 pandemic has on the Company’s liquidity and assess whether any additional cost saving measures, including capital expenditure deferral or human capital decisions, are needed.
Operating Activities
Net cash used in operating activities for the six months ended June 30, 2020 was $7.4 million, compared to net cash provided by operating activities of $15.3 million for the six months ended June 30, 2019. The $22.7 million year-over-year decrease in cash provided by operating activities was primarily due to the $15.9 million tax refund and $5.0 million earn out related to the Qualified Sale of 3Q Digital we received in the second quarter of 2019.
Investing Activities
Net cash provided by investing activities was $1.8 million for the six months ended June 30, 2020, compared to the net cash used in investing activities of $1.3 million for the six months ended June 30, 2019 The change was due to $1.5 million sale of Direct Mail equipment to Summit and less capital expenditure activities for the six months ended June 30, 2020 as compared to the same period in 2019.
Financing Activities
Net cash provided by financing activities was $8.0 million for the six months ended June 30, 2020, compared to $3.7 million net cash provided by financing activities for the six months ended June 30, 2019. The $4.3 million year-over-year increase was primarily due to the $10 million PPP loan we received in the second quarter of 2020, which was partially offset by the repayment of $1.5 million of the borrowings outstanding under our Texas Capital Credit Facility in the second quarter of 2020 as well as $4.5 million borrowing under the Company’s Texas Capital Credit Facility in the first quarter of 2019.
Foreign Holdings of Cash
Consolidated foreign holdings of cash as of June 30, 2020 and 2019 were $2.3 million and $4.0 million, respectively.
Credit Facilities
On January 9, 2018, we entered into an amendment to the Texas Capital Credit Facility that increased our borrowing capacity to $22.0 million and extended the maturity by one year to April 17, 2020. On May 7, 2019, we entered into a second amendment to the Texas Capital Credit Facility which further extended the maturity of the facility by one year to April 17, 2021. On May 11, 2020, we entered into a third amendment to the Texas Capital Credit Facility which further extended the maturity of the facility by one year to April 17, 2022 and decreased the borrowing capacity to $19.0 million. The Texas Capital Credit Facility remains secured by substantially all of our assets and continues to be guaranteed by HHS Guaranty, LLC. We pay HHS Guaranty, LLC a quarterly fee as consideration for the guarantee of 0.5% of the value of the collateral actually pledged to secure the facility, which for the three months ended June 30, 2020 amounted to $0.1 million.
At June 30, 2020, we had letters of credit in the amount of $1.7 million outstanding. No amounts were drawn against these letters of credit at June 30, 2020 These letters of credit exist to support insurance programs relating to workers’ compensation, automobile, and general liability. We had no other off-balance sheet financing activities at June 30, 2020.
As of June 30, 2020 and December 31, 2019, we had $17.2 million of borrowings outstanding under the Texas Capital Facility. As of June 30, 2020, we had the ability to borrow an additional $0.1 million under the facility.
On April 20, 2020, the Company received loan proceeds in the amount of $10 million under the Small Business Administration PPP. The PPP, established as part of the CARES Act, provides for loans to qualifying businesses for amounts up to 2.5 times of the average monthly payroll expenses of the qualifying business. The loans and accrued interest are forgivable so long as, over the eight-week period following the receipt by the Company of the PPP Loan, the Company uses the loan proceeds for eligible purposes, including payroll, benefits, rent and utilities, and maintains its payroll levels. The amount of loan forgiveness will be reduced if the borrower terminates employees or reduces salaries during the eight-week period.
The unforgiven portion of the PPP Loan is payable over two years at an interest rate of 1%, with a deferral of payments for the first six months. The Company used the proceeds for purposes consistent with the PPP. While the Company currently believes that its use of the loan proceeds will meet the conditions for forgiveness of the loan, we cannot assure you that we will not take actions that could cause the Company to be ineligible for forgiveness of the loan, in whole or in part.
Outlook
We consider such factors as total cash and cash equivalents, current assets, current liabilities, total debt, revenues, operating income, cash flows from operations, investing activities, and financing activities when assessing our liquidity. Our management of cash is designed to optimize returns on cash balances and to ensure that it is readily available to meet our operating, investing, and financing requirements as they arise. We believe that there are no conditions or events, considered in the aggregate, that raise substantial doubt about our ability to continue as a going concern for the 12 months following the issuance of the Condensed Consolidated Financial Statements.
Critical Accounting Policies
Critical accounting policies are defined as those that, in our judgment, are most important to the portrayal of our Company’s financial condition and results of operations and which require complex or subjective judgments or estimates. Refer to the 2019 10-K for a discussion of our critical accounting policies.
Our Significant Accounting policies are described in Note A, Overview and Significant Accounting Policies, in the Notes to Condensed Consolidated Financial Statement.
See Recent Accounting Pronouncements under Note B of the Notes to Condensed Consolidated Financial Statements for a discussion of certain accounting standards that have been recently issued.