ARC - ARC Document Solutions Stock: Gaining Traction

2023-09-15 03:59:53 ET

Summary

• ARC's stock has rallied almost 11% in the past 10 weeks, outperforming the S&P and providing a sizable return.
• ARC's Q2 earnings report showed in-line earnings, despite a decrease in top-line sales. Digital color printing and scanning segments demonstrated solid growth.
• ARC's dividend is sustainable at its current level, with a trailing cash dividend ratio of 26.4%. Expected earnings growth should lead to more cash being returned to shareholders.

Intro

We wrote about ARC Document Solutions, Inc. (ARC) back in June of this year when we stated that we were looking for a keener valuation and stronger growth from the firm. This prompted us to stamp a 'Hold' rating on the stock as our study extrapolated that the company's free cash flow trends (when compared to ARC's sales & assets and also from a valuation standpoint) were not as strong as we had seen in previous years. Shares, though, have managed to rally almost 11% over the past 10 weeks, which means the total return (when one includes the dividend payment) comes in at almost 12.5%. Suffice it to say, this is a sizable 3-month return which comes in at 50% when annualized over a 12-month period. The S&P for example has only managed to return a nominal 2.55% over the past 10 weeks which means ARC investors have been able to stay well ahead of the inflation curve in recent times.

In fact, as we see from ARC's technical chart below, the stock's volume profile (turned bullish) began to change not long after we penned our June commentary. The bounce in late June this year (off the depicted multi-month trendline shown below) demonstrated fresh buyer accumulation and shares really haven't looked back since. In fact, although shares in recent trading sessions have come back down to test underside support, we expect support to hold here given how buyers have remained in the market. ARC's recent Q2 earnings report gave us insights into why investors continue to see value here, so let's delve into some of those insights we see below.

Q2 Trends Demonstrate Top-Line Growth May Be Overrated

Furthermore, what surprised us in the company's recent Q2 earnings report was ARC's ability to report in-line earnings (GAAP earnings of $0.09 per share) in what remains a challenging trading environment for the company. Top-line sales fell by $2.2 million but gross margin as well as operating profit ($6.2 million) grew in the quarter. This led to GAAP earnings of approximately $4 million, a 21% increase over the same period of 12 months prior.

Digital color printing & scanning demonstrated solid growth in the quarter with the latter segment growing by 20% due to strong demand. The planned printing segment continues to suffer but on the scanning side, for example, more scope is now available (due to additional investment in equipment at the scanning centers having come to an end) to meet customers' demands more quickly. Moreover, despite the fact that top-line growth as mentioned in Q2 came in negative over a rolling quarter basis, ARC continues to generate a sizable amount of positive cash flow with operating cash flow rising to a very impressive $10.3 million in Q2. These cash flows will continue to enable ARC to either buy or upgrade its existing digital equipment to ensure it remains competitive in its markets.

Dividend Sustainability

Although ARC's trailing dividend GAPP payout ratio comes in at an above-average 74%, investors need to remember that the company's net profit at the end of the year does not pay earnings but rather cash does. Therefore, to this point, ARC's trailing cash dividend ratio comes in at a much lower 26.4% which really demonstrates that the dividend is sustainable at its current level. In fact, if we take the current annual payout of $0.20 per share and base it off ARC's current share price of $3.35, we get a forward dividend yield of just under 6%. This means that even if there was no capital appreciation in ARC shares over the next 12 months, the investor would still return a nominal 6% which would go a long way in keeping up with rising inflation.

However, there is every possibility that capital appreciation will transpire going forward. Analysts who cover this company expect ARC to report $0.29 in earnings per share this year followed by $0.34 per share in fiscal 2024 (17% growth). Suffice it to say, expected earnings growth should lead to growing cash flow which in turn should lead to more equipment & technology investments and more cash being returned to shareholders over time (Through buybacks & dividends). In essence, as long as ARC can maintain its cash-cow status where earnings growth remains prominent, shares should rise here even in the absence of robust top-line sales growth.

Conclusion

To sum up, ARC's recent Q2 numbers demonstrated margin strength and strong operating cash-flow generation. Furthermore, although top-line sales came in negative over a rolling quarter basis, the company is growing in its key strategic areas where it knows demand will most likely stay elevated. If shares can bounce off support here over the near term, we may start scaling into ARC on the long side. We look forward to continued coverage.

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