ARC - ARC Document Solutions: After Many Years Paying Off Debt It Is Time To Enjoy The Reward

2023-03-25 01:57:07 ET

Summary

• ARC Document Solutions provides digital printing and document-related services to customers in a growing variety of industries.
• The slow decline in its legacy business forced the company to be financially disciplined, dramatically reducing its net financial debt from 2009 to 2020.
• The company started a strategic transformation in 2019, which prepared its legacy business for the coronavirus crisis.
• After reducing the debt, the company started to distribute important dividends, even in the middle of an important crisis.
• Currently, its market capitalization is lower than its equity attributable to shareholders and net income is improving, offering a high earnings yield.

Looking for hints of a successful turnaround

ARC Document Solutions ( ARC ) stands out for its financial transformation in the last two decades. It went public in 2005 and was highly indebted at that time, which increased the impact of technology and economic changes that were stopping the growth of printing services. As a consequence, its financial situation deteriorated and it was forced to follow a highly disciplined financial policy. ARC had not been able to distribute any dividends until 2020, and some small share repurchases were the only shareholder retribution between 2014 and 2019.

However, this conservative policy and the modest continuation of printing services gave the company room to financially restructure and transform its operating business. Nowadays, ARC is looking for new revenue sources and diversification across different kinds of customers and industries. After dramatically reducing its net debt, the majority of its assets are financed with equity, therefore, the amortization process without losses allows a high free cash flow available to shareholders. This makes the current dividend sustainable, in fact, dividend increases seem likely in the future.

We disclose details on these data below.

Business model and transition

ARC Document Solutions provide digital printing and document-related services to customers in a growing variety of industries. Its legacy business was based on specific services for business documents, especially in the construction industry.

Regarding leasing of printing equipment, ARC differentiates itself by offering more flexibility for the use of its equipment. While large providers lease their equipment on a fixed cost basis, ARC places its equipment based on current needs of its customers, closer to a “pay per use” model:

Unlike in the past, we don't see customers using their capital to purchase print equipment for long term use. Most specially, our construction customers are moving to short term rentals of print equipment. Our ability to supply print capacity on an as needed basis is well suited to meet their needs.

ARC Document Solutions, Inc. ( ARC ) CEO Suri Suriyakumar on Q1 2022 Results - Earnings Call Transcript

Lately, the company has started to offer new digital services and redirect its assets to new business lines. Its legacy business is not simply about printing, as it includes document management and archives, therefore, the company is currently transforming these services into a digital format. Scanning, digital archives and orientation towards graphic services are some of the pillars of the new strategy.

According to the 2022 Annual Report, ARC served more than 40,000 customers in a wide variety of markets including retail, technology, energy, education, hospitality, public utilities, and others. Traditionally, the construction industry represented a significant share of the total revenue, but it is diminishing as the company is looking for revenue in other activities. Diversification is also coming from the sale of new services to its traditional customers, as illustrated in the following transcript:

Greg Burns

Just had a couple of follow-ups. You're talking about the diversification of your business within the AEC verticals. Can you just give us like what the revenue mix is there? Like, what percent of revenues is that kind of legacy traditional document reproduction versus maybe some of the other newer services you're providing to that – those customers?

Suri Suriyakumar

Yes. Go ahead, Dilo.

Dilo Wijesuriya

Yes. So if you take the AEC architects engineers construction and subcontractor verticals the type of work that we do for those key verticals has completely changed over the last five years. I would say in the past probably about a good 80% of that work came from traditional plain client printing. But today probably that's about almost 20%, 30%. Rest of it comes from signage and other services that we provide; scanning, document scanning, on-site services, supplies that we provide them and digital color graphic services that we provide.

ARC Document Solutions, Inc. ( ARC ) Q4 2022 Earnings Call Transcript

In summary, ARC offers:

• Digital printing on demand in its own facilities

• Managed printing services in the client’s facilities

• Scanning, digital imaging and documentation, including software services

• Resale of equipment and supplies

The transformation since 2019

The new modest business opportunities have allowed the company to stabilize its sales and operating profit since 2020, when the pandemic hit the business. Meanwhile, ARC is still progressing in its operating restructuring and technological transition.

This strategic transformation began in 2019, and it was perfect timing as it prepared the business for the pandemic and the acceleration of the legacy business slowdown. This was highlighted in the Q4 2020 Earnings Call:

When we reconfigured this business in the third quarter of 2019, the plan was to create a company that was smaller, but held more potential for the future. We know the changes we made were significant, far reaching and impactful. Little did we realize what awaited us in 2020?

ARC Document Solutions, Inc.'s ( ARC ) CEO Suri Suriyakumar on Q4 2020 Results - Earnings Call Transcript

We highlight some paragraphs from the 2019 Q3 earnings release transcript, when management was exploring new opportunities and outlining the new plan:

While there is no threat of print revenues completely disappearing anytime in the future, we will continue to feel the impact on our revenues until we are able to offset these secular challenges with some of our other initiatives we have discussed in the past.

Two of these initiatives are notable. One, the use of technology to differentiate our services, sustain and grow market share, especially in MPS and the archival business. And second, the increase use of color as we discussed in our Q2 report. Especially important is how we use technology to sell aggressively to a broader segment of the digital color market. Both these businesses have the potential to help us offset the erosion or decline in our traditional revenues.

[…]

Similarly, in the broader segment of the digital color market, we have made significant inroads into a variety of retail, hospitality, healthcare, and other verticals that have shown great promise. We need to prove our capabilities with these high profile customers. And during the past three months, we went a long way forward doing so.

[...]

On the imaging side, this includes things such as corporate team building graphics, adaptable artistico, educational classrooms, and common sense messaging, and HR and other company culture displays. These niche areas represented growing market, while graphic applications are in high demand, and we are well positioned to supply them.

ARC Document Solutions, Inc. ( ARC ) CEO K. Suriyakumar on Q3 2019 - Earnings Call Transcript

ARC has also changed its cost structure, being able to earn money with less sales volume. This has been proven in recent years, as the company has increased profits while reducing revenues.

Debt reduction, wealth accumulation and new dividend policy

The slow decline in revenue forced ARC to be financially disciplined, reducing its net financial debt - financial debt minus cash and equivalents and financial assets - from $244 million in 2009 to less than $50 million in 2020 - data from annual reports. Then, coronavirus hit the business, but the company had already strengthened its balance sheet. In fact, it was able to execute some share repurchases at prices below $1 per share. As free cash flow has maintained at around $30 million in recent years - cash from operations minus CAPEX and stock-based compensation -, ARC has started to distribute significant dividends, currently offering investors a 6.5% dividend yield. This was our first financial overview of the company, and it was corroborated by management in the Q2 2022 Earnings Call:

I want to take a few minutes and recap something I stated a few quarters ago, which validates our position today.

As many of you know, the company experienced tremendous growth through acquisitions since going public in 2005. Then in 2008, the great recession brought about the secular change that devastated the entire reprographics industry for the next 10 years. Many of the reprographers did not survive. Laden with heavy acquisition debt of nearly $360 million and double-digit revenue erosion, ARC battled through these years.

These were remarkable times, and it was an extraordinary feat to keep the company profitable, generate strong cash flows and meet our debt obligations in order to maintain a healthy balance sheet. By 2018, after 10 of the most difficult years in the company's history, we had reduced our debt by more than 65% to $127 million.

In 2020, we were challenged again. The pandemic threatened our very existence, or at least that's what everyone thought.

ARC Document Solutions, Inc. ( ARC ) CEO Suri Suriyakumar on Q2 2022 Results - Earnings Call Transcript

Although net income has been historically low - even negative - cash generation has been significantly higher and stable.

This is a consequence of large initial investments in equipment and assets that had to be constantly paid off. As prospects for printing technologies started to decline, the company significantly reduced its CAPEX and optimized its physical equipment - improving its cost structure. Its client portfolio is still valuable and competition is reducing, therefore, consolidated companies can increase margins and profitability in a declining industry.

A high free cash flow does not necessarily mean a high remuneration for shareholders, as a fraction of it should be used to pay off debt. Notwithstanding, ARC made a great effort in the past to reduce debt, therefore, a large share of its current free cash flow is available for shareholders and reinvestment. Meanwhile, its legacy business continues to generate positive profits and cash generation, with no indication of going out of business soon.

This phenomenon is illustrated in the comparison between its balance sheet and its market capitalization. As of March 21, 2023, market capitalization was $139.3 million, a 10% discount over its book value at the end of 2022 - attributable shareholders’ equity in the balance sheet.

Some assets are not directly liquidable - intangible assets and goodwill -, but it shows how this operating restructuring could unlock value for shareholders. As the company is far from operating losses - even improving its net income -, a higher asset amortization than CAPEX means higher free cash flows. Some fixed assets are gradually converted into cash, of which just a tiny fraction is required to pay off liabilities. As the restructuring gets ahead, free cash flow and net income should converge - in our view, net income should moderately increase and free cash flow slightly decrease.

While this process unlocks value compared to the current share price, the company is working on a technological transition and adapting to new market realities, offering new services and scaling its current client relationships.

Financials may have bottomed out, at least, the most relevant ones

It is not easy to reach a clear conclusion about the current trend of sales. It is necessary to differentiate between the coronavirus cycle and the long term cycle from a technological point of view. The direct impact of working from home is partially temporary. On the other hand, this new reality may have structurally changed the demand for certain services, many business teams may return to office, but not full time.

We observe a direct hit in gross profit by the pandemic in 2020, larger than other previous decreases. In 2022, gross profit moderately rebounded, reflecting the recovery of the business activity in physical offices. However, this recovery does not represent a complete return to the pre-coronavirus situation. For that to be true, sales and gross profit should have rebounded more.

The restructuring of its operating assets and a more adequate cost structure are, however, allowing a higher operating profit:

And this is the key: as long as the company does not lose money and generates healthy profits, the trends explained above favor shareholders at the current share price. The improvement is significantly larger in net income because interest expense has almost disappeared - due to a strong debt reduction. This gives more margin and opportunities to adapt the company to new business models, while remunerating shareholders and finally paying off the remaining debt.

In the Q4 2022 Earnings Release, management set forth expectations to achieve a double-digit growth of earnings per share for 2023, sustained on a moderate improvement of sales, a more adequate cost structure and the easing of inflationary pressures. As a consequence, gross margin is estimated to be 50 basic points higher. This points out that the convergence between net income and free cash flow will be achieved - at least partially - by increasing net income.

Assessment and valuation

We often use the attributable profit to shareholders to calculate the company’s earnings yield. Notwithstanding, this case needs to incorporate the phenomenon explained above, which produces a higher free cash flow with low debt to pay off. Therefore, a portion of this excess of free cash flow will be available for shareholders. In other words, earnings yield has to be adjusted upwards.

ARC is achieving a $30 million free cash flow, where $12 million thereof, in our view, should be reserved for debt reduction, future CAPEX increases or just simply a deterioration of the business. Then, we estimate that the company is generating a $18 million adjusted attributable income to shareholders, which is higher than the current figure, but lower than the current free cash flow.

After that estimation, we obtain a 12.9% earnings yield for a company that is stabilizing and improving, while simultaneously remunerating shareholders. It will reach a zero net debt in 2024, with its technological transition underway. The downside is limited thanks to the residual value of many of its legacy assets, which are undervalued when compared with its balance sheet figure, after comparing them with the current market capitalization.

In our opinion, this is an attractive company when taking into account its current earning yield and qualities. This is explained by the financial discipline executed by the company during two decades, and shareholders have recently started to receive the reward.

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