ARC is a capital-light business with high-teens margins that will generate half of its market value in free cash flow over the next 2.5 years – if not more. ARC owns its space, has solid management, and tangible opportunities for growth.

If ARC’s enterprise value remains the same, its equity will mechanically increase 50% via FCF generation through 2016, at which point the shares would still trade for only 8x P/FCF. ARC’s current enterprise value however, fails to reflect the business’ ongoing transformation from a project-based, cyclical business to a portfolio of contractual, recurring services. Further, its legacy business (now less than 30% of revenue) has considerable built-in leverage, is currently operating at 50% capacity, and $0.70 of the incremental dollar falls to the bottom line. We see a conservative path to $10 vs. today’s $5.90 print, with highly open-ended upside from there.

Company Background
ARC’s legacy is as the largest reprographics (large-format blueprint) company in the United States by a factor of 10. In fact, ARC used to be named American Reprographics and was the result of a decades-long rollup dating back to the 1980s. With the only nationwide footprint, American Reprographics established relationships with nearly every potential customer in the Architecture, Engineering and Construction (“AEC”) industry. With more than 200 service centers spread across North America, The Company also employed capacity to provide AEC/non-AEC customers with nationwide color-imaging (Tradeshows, Indoor/Outdoor signage). By 2004, American Reprographics had grown to a $440m business and its PE sponsor levered the equity, paid itself a dividend, and readied The Company for IPO. Shares debuted at $13 in February ‘05, surged into the $30s, and remained there until mid-2007…we know how that chapter ends.

Non-res construction traditionally lags homebuilding, and The Company’s reprographics business did ok from 2008 – 2010 with existing projects limping toward completion. As activity continued to grind lower however, the “repro” business was reduced to less than 1/3 of its peak. By FYE2010, the writing was on the wall – not only were projects down, but volume per project had compressed and American Reprographics had to adapt to an evolving industry. Fortunately The Company was well positioned to adapt: it was already providing Facilities Management (“FM”) at thousands of AEC client sites. With an expansive client base, nationwide footprint, and internally developed technology, American Reprographics could pursue the budding Managed Print Services (“MPS”) opportunity, with a focus on the AEC vertical. [more on MPS and FM below]

Whereas traditional reprographics is project-based and highly cyclical, MPS and FM (“Onsite Services”) are contractual, predictable, and recurring. As American Reprographics shifted focus toward these services (especially MPS), The Company rebranded itself ARC Document Solutions, rationalized a quarter of its service centers, and ultimately refinanced its debt in late 2013.

Today, 31% of ARC’s revenue comes from Onsite Services, 28% from Traditional Repro, 21% from Color Printing, and the balance from equipment, supplies, and file management. ARC has also recently introduced its Archiving & Information Management service (“AIM”), a significant new high-margin opportunity.

Meanwhile, operational and balance sheet restructurings have dramatically improved ARC’s free cash flow profile. The Company will generate $40m of FCF this year even with non-res construction in the trough. ARC’s stock currently trades for 6.5x our projected P/’14 FCF, 5.7x 2015.

Why Does the Opportunity Exist?
The primary reason is that investors aren’t looking. On the face of it, ARC appears to be a highly-indebted, capital-intensive, cyclical business levered to reprographics. However, ARC’s debt is not a result of its operations (rather, the PE dividend), capex is 3.5% of trough revenue, its business mix is shifting toward predictable long-term contracts, and traditional reprographics is now less than 30% of its business.

From a trading standpoint:

1. JP Morgan led the Dec ’13 debt refinance which closed on 12/23/13, then dropped equity coverage the next day. A few days later, ARC’s CEO who currently owns 9% of the company, sold stock to pay capital gains taxes that were involuntarily generated (according to management). Despite the refinancing which will save ARC more than $7m in cash interest per annum, shares came under significant pressure. 
2. ARC positively preannounced and subsequently beat 4Q13 profitability expectations when it reported in February. Shares began to recover until the Russell 2000 started its mini-implosion bringing ARC’s stock from the high-$7s to the high-$5s on no company-specific news. 
3. ARC’s 1Q14 report in May again handily surpassed profitability estimates but revenue missed by $600k or ~0.6%; unsurprisingly due to inclement first-quarter weather. ARC’s shares have slowly drifted down since.

THE BUSINESS
ARC performs a variety of services for its client base; each a logical extension of its traditional business with existing AEC clients. ARC’s services in descending order of contribution are:

Onsite Services (31% of revenue)
ARC’s Onsite Services segment represents 31% of ARC’s revenue, is growing at a 10% organic CAGR, and generates 30-35% gross margins. ARC has 7,900 Onsite contracts that fall into two buckets:

1) Facilities Management (~50% of Onsite Customers and revenue): Fifteen years ago, large-format plotters were half the size of a room and prohibitively expensive. During design work, anytime an engineer needed to print a dozen sheets for a meeting, he/she would employ an offsite service center like ARC’s to print and deliver the tubes. Technology began driving the size and cost of plotters down and ARC started placing machines at customer locations, servicing them out of its local centers, and charging on a per-print (“click”) basis. For larger AEC’s, ARC might place 10 machines and a dedicated person at the client site.

A key selling-point of FM was providing a client the ability to account for all print activities and collect reimbursable costs by project – either in a single office or a firm’s entire organization. This helped AEC’s reduce overhead, and in some cases turn a cost-center into a profit-center. In order to satisfy customer demand and manage a growing fleet of equipment, ARC developed its Abacus software. Abacus has since evolved to control a firm’s entire document management infrastructure, optimize equipment utilization and machine footprint, and even influence the printing and document management behavior of employees. ARC’s onsite presence and growing involvement in client workflows not only lead to “sticky” customers, but formed a beachhead at the client site providing ARC with a logical migration path into MPS.

2) Managed Print Services (~50% of Onsite Customers and revenue): MPS is an expanded onsite service where ARC installs (or takes over) a complete document solution platform at a client’s offices on an outsourced basis under 3-5 year contracts. ARC uses Abacus to capture, control, manage, print, account for, and store documents. The Company also supplies, maintains, and manages a firm’s printing network, including equipment. ARC’s typical annual MPS revenue for a mid-sized AEC customer is $10-15k, with large customers at $20k+.

ARC is the only MPS provider in Gartner’s Magic Quadrant that isn’t an OEM and is among the top-10 global MPS providers with just a fraction of its target AEC vertical. The Company has closed high-profile clients including a recent exclusive contract award from CH2M Hill, a $7bn global AEC firm. We estimate that ARC has ~4k MPS contracts, including 20 of the top 100 AEC firms in the world. ARC is just five years into MPS and with over 90k clients, there is plenty of runway here and ARC owns AEC.

A prominent anecdote demonstrating ARC’s domination of the AEC space is as follows: ARC was being gouged on lease rates and so Jorge Avalos, ARC’s CAO, came up with the following strategy – stop leasing in favor of capex to deprive lease finance companies of revenue until they cry uncle. ARC’s annual purchases were large enough that “Uncle” could eventually be heard. ARC’s equipment lease rates subsequently dropped from 11% in 2012 to 6-7% currently. As a result, ARC has signaled that it’ll go back to a 50/50 capex/lease structure, improving forward cash flow.

In addition, ARC’s OEM-agnostic position allows it to provide the most suitable equipment at the best price with a service tailored specifically to AEC customers. Printer OEMs can’t provide an entire solution (e.g. no OEM has service centers that can augment capacity, many don’t have one or more required plotter size, etc.) ARC is able to bare-knuckle (CFO John Toth’s words, not mine) OEMs in the AEC space by shutting an OEM out of a bid if it tries to undercut ARC on price. Further, we met with ARC’s sales manager for the Chicago market who had previously sold XRX’s MPS solution. In his words, XRX’s guys are paid to move printers; MPS is an afterthought.

Traditional Reprographics (28% of revenue)
This segment represents 28% of revenue, generates 35-40% gross margin (70% incremental), and its decline has finally begun to abate after five years of pain. This segment operates 170 offsite service centers in major metros that provide high-volume and overflow capacity to onsite customers, as well as local support and maintenance staff for onsite clients. Centers also provide local AEC customers with high-volume, project-related printing of construction docs (other than blueprints).

In 2008, repro generated $360m of revenue; in 2013, $115m. After consolidating a quarter of its service centers, repro is operating at 50% capacity, and this business can double without additional capex. ARC is already paying all indirect costs (machines, rent, maintenance) and therefore 70¢ of the incremental dollar falls to the bottom line.

With the non-res construction downturn mostly behind us, this headwind will flip to a tailwind at some point, and any uptick will increase value. For example, if repro added $20m in sales, it would still be well below 2011’s depressed levels, yet would generate an additional $14m of Ebitda. At 6x, this is $84m of value relative to ARC’s $276m market cap. That said, we’re conservatively taking a glass-half-empty view of this business. Our FCF estimates assume repro declines a few points this year, is flat in 2015, and grows a couple of points in 2016. If non-res activity ticks up, this could prove to be conservative.

We obviously don’t have an edge in knowing when the non-res cycle is going to pick up. We figured that the best use of time would be to gain a reasonable level of comfort that things aren’t getting substantially worse. To that point:

1. For 30+ years non-residential building has averaged 1.3b sqft. whereas activity has been less than half of that rate in the past few years. 
2. CBRE puts out a quarterly report on office, industrial and retail vacancy rates which have been dropping consistently for the past 2-3 years. Declining vacancies and a strengthening labor market will help move non-res in the right direction. 
3. The Architectural Billings Index (“ABI”), a leading economic indicator of construction activity, jumped three points in May to 52.6. Again, given the severe winter, this isn't surprising. Also  encouraging was the new projects inquiry index which came in at 63.2, up more than three points month-to-month. Further, The American Institute of Architects, which publishes these indices, recently introduced a new index that measures the value of signed design contracts. This metric spiked to its highest recorded level in April and remains elevated in May. The latter two indices should provide support for the ABI going forward. 
4. Public and private non-residential construction tends to lag residential activity on both ends of the cycle. We have already seen an uptick in residential construction and the Fed’s April 2014 Senior Loan Officer Opinion Survey indicates both an easing of bank standards, and a spike in demand, for commercial real-estate loans. 
5. ARC’s Traditional Repro business had gotten absolutely hammered over the past five years but has seen its decline slow to low single-digits in the past two quarters, including 1Q14 during which weather was an issue throughout the right-half of the country.

Color Printing (21% of revenue)
“Color” generates low-30s gross margins and has fluctuated between $80-85m of revenue for the last five years. ARC is the largest provider of color printing services to the AEC industry. The Company leverages its nationwide footprint to provide printing, finishing, and assembly of graphic materials to non-AEC clients as well. Color services are provided under the “Riot Creative Imaging” brand and the segment has a dedicated sales force.

Other (20%)
Sales of equipment and supplies (11% of revenue) is just as it sounds. This segment has generated low/mid-$50m revenue for the past five years. At ~20% gross margin, this isn’t a large contributor to the business.

ARC also offers “digital” services (<10% of revenue) which allow AEC’s to distribute files electronically and print them locally rather than shipping physical documents. ARC performs this service under the iShipDocs brand. Margins in this bucket are substantially above the corporate average, but this segment remains a small piece of the overall business.

AIM, A High Margin Growth Opportunity (nil% of revenue)
Archiving & Information Management (“AIM”) is a new service whereby ARC physically pulls a customer’s existing documents from file rooms or Iron Mountain for scanning / indexing, then stores the digital files in its proprietary content management software. The files are hosted in ARC’s [dare I say it?] cloud. ARC has already closed some key AIM deals, including AECOM, the largest architecture firm in the world.

AIM not only allows ARC to better utilize its service centers (assets, labor to scan already there), but it’s priced on the basis of a steep discount to traditional storage (e.g. Iron Mountain) while providing an AEC firm with hosted, indexed, digital access to its entire library of documents. Further, when AIM is coupled with MPS, customers can flip a switch and have all new documents indexed, archived, and retrievable in real-time.

AIM is priced to undercut traditional storage for the first few years while amortizing the cost of scanning, and then drops substantially thereafter on a perpetual, recurring basis. A common case study that management likes to throw out is JCJ Architecture paying IRM $12k monthly. ARC pulls boxes and imports all documents into AIM, then amortizes the cost over three years while charging JCJ $10k per month ($2k customer savings upfront). At the end of the amortization period, the monthly fee steps down to $6k. JCJ saves money on day one, and ultimately ends up saving 50%+, in addition to avoiding gross inefficiencies.

Inefficiencies faced by AEC firms today are comical: $300 per hour senior engineers crawling through basement file rooms looking for old drawings; or IRM charging per cubic foot, and tacking on administration, receiving, entry, retrieval, delivery, refiling, and interfiling fees. AIM is a pretty clear win for an AEC firm. For ARC, gross margins are 40% during the scan-cost amortization period, then step up to 90%+ on a recurring basis thereafter.

MANAGEMENT
ARC’s senior management and board have demonstrated a strong commitment to the success of the business during a difficult time for its industry. The Company took deliberate and sometimes painful steps to transform ARC from a branch-driven reprographics company to a comprehensive provider of technology-enabled solutions. Others have tried and failed. ServicePoint, a $200m repro business in Europe talked a big game regarding its long-term evolutionary plan right up to its bankruptcy filing, at which time repro was still 70% of revenue.

ARC’s management has steadily executed on transformational promises. The Company has invested $130m in technology over the past decade, and has developed a successful roadmap for monetizing its internal R&D:

• Abacus – a powerful tool to manage / improve all print and document processes of an organization
• PlanWell – a suite of applications that combine reprographics with hosted tools for collaborating, organizing, distributing, and tracking plans (iPads, iPhones, large touch displays, etc.) 
• Building Information Modeling (“BIM”) – generation and management of digital representations of physical and functional characteristics of places.
• Archiving & Information Management ("AIM") – Scan / Index / Archive document library, go-forward archive building via MPS/Abacus

Despite the weak industry backdrop, ARC’s overall business has bottomed over the last few quarters, and has begun to show signs of comparable growth for the first time in years. ARC’s mix-shift toward steady, recurring services caused overall revenue to buck the seasonal trend in 4Q13 for the first time in company history. Meanwhile, restructuring programs have added 300bps+ of gross margin.

ARC’s executive officers have taken voluntary salary reductions that have lasted years. Suri, ARC’s CEO and the architect (no pun intended) of the company dating back decades, took as much as a 50% salary cut. Management just received its first round of bonuses in five years. What’s more, the board realized that management shouldn’t be compensated on EPS accretion as a result of the recent refinancing, so incentive comp packages were changed to an Ebitda-based structure.

Meanwhile, dilution from option grants has been negligible and ARC’s share count has remained relatively unchanged since its IPO.

THE NUMBERS
ARC has a $276m market cap, and $200m of net debt. The Company will generate $70m of Ebitda this year, resulting in a 6.8x multiple. After interest and capex, ARC will generate $42m of FCF during 2014, representing a P/FCF multiple of 6.5x. Taxable income is offset by a $90m NOL. Fully taxed, ARC’s 2014 P/FCF multiple would be 7.7x.

ARC’s FCF multiple isn’t considerably different in the absence of its NOL because OCF substantially outpaces net income. Depreciation runs at nearly twice the rate of capex due to capital lease accounting. Thus, ARC’s full 38% rate would impact cash flows by less than 20%. This also means that ARC’s NOL tax shield will last longer than its cash flow would suggest.

ARC refinanced debt in December 2013 bringing its interest rate from 10.5% to 6.25% and saving The Company $7m cash interest. ARC is currently at 3.2x Debt / TTM Ebitda. Wells has indicated that once ARC reaches <3.0x (we project by 4Q14), it can move to a Term A with current rates near 3.5%. ARC is paying down debt faster than its $10m annual principal requirement so debt is a moving target. Nonetheless, we expect a refinance below 3.0x could add another $5m of FCF, give or take. When pressed however, CFO John Toth will not readily commit to refinancing until the bank allows The Company to begin returning cash to shareholders.

We see a conservative path to $10 for ARC’s shares (70% upside). First, we estimate that ARC will generate $140m of FCF from the three-quarter 2014 stub period through 2016. This will bring net debt from $200m today to $60m. $140m of value accruing to equity represents 50% upside. We assume ARC’s overall business is essentially flat through 2016, adding only $1.5m of MPS related Ebitda, and $1m of digital with the digital-mix shifting toward AIM.  We [internally] allocate opex under two scenarios - by segment revenue, and by estimated segment gross profit - then apply an Ebitda multiple to each. The blended result is an *8.4x overall multiple, or $10 per share, representing only 8.9x P/2016FCF.

This scenario is conservative (as in shares would still be cheap even at $10). Not only do we view a sustainable business trading at less than 9x FCF as “cheap,” our projections fail to reflect the fact that AIM could experience meaningful growth beginning in mid-2015. In addition, any pickup in non-res would be dramatically accretive. As usual however, we look for a satisfactory return on conservative numbers with open-ended upside from there.

*Note: 4x equipment/supplies, 6x repro, 7x color, 10x onsite, 12x digital; Also, we’re not adding back stock-based compensation.

CONCERNS

• Although offsite repro has declined to <30% of total revenue, the business still generates three quarters of its revenue from the AEC industry, which is ultimately levered toward non-res construction. If the industry backdrop gets substantially worse, ARC’s numbers could suffer. At 5x Ebitda/Interest expense however, it would be tough to kill this business. Even in the darkest days of the non-res industry, Ebitda margins remained in the mid-teens, and ARC has had only one FCF negative quarter since its IPO.
• ARC’s segment reporting is confusing. Management emphasizes recurring, technology driven growth yet ARC’s filings maintain a reporting segment titled “Digital” that is unrelated to these initiatives. Digital will eventually contain ARC’s nascent recurring AIM business, but will continue to include iShipDocs revenue. Thus, despite healthy MPS performance and strong rhetoric surrounding new initiatives, ARC’s underwhelming “Digital” segment performance obfuscates the picture.