ARC Document Solutions is a managed print services provider in the construction and engineering space with high market share, pro-cyclical economics, macro headwinds, and trades at a pre-COVID FCF yield to equity of 25% and a pre-COVID FCF to enterprise value of 16%. The company has built a track record in the last several years of accruing value to shareholders despite a continued shift to digitization in the Architectural, Engineering, and Construction (AEC) industry. Because of large financing leases on large scale printers, the stock doesn’t screen well and it can be tricky to parse out the true economics of the business. In a normalized environment, I think they can get back to GDPish growth over a full cycle on the top line,
I won’t get into a lengthy discussion on business segments, as there are other articles on the site that have done so and the presentation hasn’t changed much in the last 5-6 years, but a quick refresher:
CDIM--Construction Document and Information Management (63% of gross profit)
This segment is the scary cyclical one. Revenues primarily come from AEC printing jobs that are sent to ARC’s physical service locations, so revenues are very dependent on construction activity. They also print signage instead of just traditional reprographics (building drawings), and 10% of the revenues here come from software related services.
MPS--Managed Print Services (29% of gross profit)
ARC will typically sign a 3-4 year agreement with an AEC firm to manage their on-premise printing needs. Since they have years of experience as the number one player in reprographics, they’ve build software that tailors to the needs of AEC firms, so while they do compete with printer OEMs for MPS revenue, they have better capability to service their niche. To acquire the printers for these contracts, they will either purchase the printer themselves up front, or they will lease the printer over a timeframe that matches up with the life of the contract. (This is why I like to deduct the new finance leases each year like capex, and it’s also why I think the business is significantly less capital intensive than it may look like at a glance from the balance sheet--they take on the leases when they have a contract in place.) In 2014-15 this part of the business began to show decent growth, as investors hoped that the company could offset less printing by offering more recurring revenue with added software capabilities. That really hasn’t played out, as the segment has declined at a low single digits clip for the last several years.
AIM--Archiving and Information Management (4% of gross profit)
ARC, in addition to managing your print needs, will also provide archival services to AEC firms for their old drawings, and they will store them in the cloud through their SKYSITE software program. This part of the business is small, but has grown mid-single digits since 2013.
E&S--Equipment and Supplies (4% of gross profit)
This is low margin, tangential revenue that comes from reselling printers to their customers, nothing to be excited about.
For a $35 mil market cap company, this isn’t your typical hype-cycle co. where every incremental dollar generated gets transferred into the pockets of management. They are not frequenters on the sell-side conference circuit, and analysts have abandoned the name because ARC hasn’t raised equity capital since 2007. Suri, the CEO and co-founder, owns 11% of the outstanding and has reasonable comp at about $1.7 mil in 2019. In response to the COVID situation, he’s taken a 50% salary reduction. While I wouldn’t describe the operational results as exceptional over the years, they have paid down an average of $22 mil in long-term debt per year since 2013, bringing the year end 2019 number to $43 mil from $177 mil in 2013. (In the 1st quarter, though, much like many other companies with the ability to do so they did draw down their revolver in response to COVID, which brought their March 31 long-term debt to approximately $58 million as of 3/31/20.) The company has simultaneously been buying back stock--diluted shares outstanding peaked at about 47.5 million at the end of 2015 and sit at roughly 43.8 million today.
Capital Lease Treatment
Some of the confusion and hesitancy on the part of investors comes from ARC’s capital lease liabilities. ARC uses capital leases to finance large scale printers that they use predominantly in their MPS business, and these lease terms and depreciation schedules largely match the life of the customers they serve.
My preferred treatment of the economics is to look at the FCF to the firm and deduct the annual lease payments as an expense. Since the company lumps debt paydown and lease paydown together on the cash flow statement, it can take some cross-referencing to figure out what went where. As a quick proxy, I’ve found that since ARC’s capital spending is basically all maintenance capex, I use depreciation and amortization (which includes the depreciation from the lease assets) as cash expense to deduct from cash from ops (which has the interest part of the lease already taken out). Deducting stock-based comp and adjusting for changes in non-cash working capital as well, I get about $8.7 million in adjusted FCF for 2019, a 25% yield on the current market cap. Treating it this way, the true enterprise value currently sits at $55 mil ($35 mil market cap + $58 mil LT Debt - $38 mil cash as of 3/31/20). EBITDA numbers, though, in this treatment are basically useless.
ARC has been deemed an essential business during COVID, and therefore has been allowed to be open for the most part this year. Revenues were down 9% yoy in the first quarter, and they have reduced workforce by 30%, have been granted rent deferral in 60% of their locations, and cut back on capex. I expect them not to burn much if any cash over the next several quarters, as the cost structure is pretty variable--they managed to stay cash flow positive post-GFC despite revenues declining 42% peak to trough. It may take a year or two, but I expect ARC to get back to their steady-state revenues in the $400 mil range with between $8-15 mil of adjusted FCF on an enterprise value of $55 million.
For a misunderstood, (now) penny stock, underfollowed, capital light, high ROIC business, trading at by far a record low EV/Sales (0.14x by my math), even without much in the way of growth prospects, I think equity holders will get paid well owning ARC in any non-bankruptcy scenario.
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I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.