Description

ARC provides document management services to non-residential architecture, engineering, and construction firms. Lukai did a terrific write up of ARC last year, making a compelling argument for buying shares based on growing free cash flow and modest valuation. Unfortunately, the comment section went off the rails into a discussion of capital lease accounting. While insightful, this discussion missed the larger point that ARC was growing the top line, expanding margins, and paying down debt, and these trends were highly likely to continue over the foreseeable future. Fast-forward 14 months, and the shares have gone from $5.90 to $10.67, before falling back to $6.98 today. All the while, the business has continued to improve in a predictable fashion, and the shares trade at 10x 2015 free cash flow. Later, I’ll dig into how I define free cash flow for ARC, since that was a topic of debate after the previous write up.

ARC’s specializes in digital document creation, sharing, printing, and storage for the architecture, engineering, and construction (AEC) industry. A growing base of recurring revenue generates ample free cash flow and has allowed management to simultaneously de-lever the balance sheet and invest in promising new product lines. At the current valuation, ARC trades at a modest 10x 2015 free cash flow with minimal contribution from two of the most promising new product lines, AIM and Skysite. Not only will the existing base of recurring revenue continue to grow and support further FCF growth, but early evidence of growth in AIM will expand margins and support further debt reductions. Recent growth has been impressive, with eight quarters of strong sales growth and a rapid improvement in free cash flow. Gross margins have improved 560bps (from 30.4% to 36.0%) over the last two years, while operating margins improved 1,100bps (-0.2% to 10.8%) over the same period. The product development and marketing changes that created these changes are only beginning to take hold and should accelerate growth in the coming years. The shares are worth $10.50 today based on a modest expansion of exiting product lines, and could be worth more in a strategic acquisition.

ARC classifies its business lines into 3 main divisions, Managed Print Services (MPS), Customer Document and Information Management (CDIM), and Archiving and Information Management (AIM).

MPS

MPS (32% of total sales) provides long-term outsourced management of office and job site printing for firms in the AEC industry. This division has over 8,000 customers, including 22 of the top 100 firms in the AEC industry, ranking ARC as the ninth largest managed print provider in the world. The marketing pitch to customers is relatively simple, ARC can install state of the art print hardware, manage supply procurement, accurately assign print jobs to specific customer accounts, and modify unnecessary printing activity, all while delivering 25% savings over in-house print management. This provides steady, year-round revenue based on 3-5 year contracts, and offers ARC a platform on which it’s built a broad suite of high-margin, industry specific software and service offerings. Customers are provided ARC’s Abacus software platform, which tracks billing and makes suggestions to modify printing behavior. MPS has seen 11% annualized sales growth since 2011. Growth softened in Q2’15 to 3.9%, and should remain in that range for the remainder of 2015. ARC hasn’t won any new Top 100 accounts this year, and even if one were announced today, it would be a 2016 revenue event. Regional account growth has been strong and supports the low/mid single digit growth rate. New regional business development teams and improved processes for evaluating and implementing MPS in new accounts should accelerate growth in regional markets. The set up for 2016 looks very strong if ARC can secure 1 or 2 large accounts, and continue to execute on smaller accounts. Gross margins are around 33%, and should expand very modestly over the next two years as ARC gets better leverage over its depreciated asset base.

CDIM

This division encompasses a wide array of services provided at ARC’s 199 retail service centers around the world, and contributes 27% of ARC’s total revenue. These offerings include production of large format color marketing materials, traditional reprographic services, customized AEC print work, and overflow from MPS. CDIM also contains Skysite, a construction project management platform that debuted in January 2015. Skysite offers construction firms a software product that brings together their project documents and allows them to be accessed by all stakeholders in real-time via customized tablets and large touch screen devices. Workers on the upper floors of building can note changes that are instantly updated for those on other floors, in the trailer, and at the home office. Currently, AEC firms are addressing this need through a patchwork of solutions (Dropbox for sharing, Samsung/Apple for devices, and ad-hoc solutions for project management software) that offer limited interoperability and minimal industry specific design. Skysite is the first platform that brings together hardware and software specifically designed for the commercial construction industry. It also offers easy access to older documents stored by AIM, and the print functions of Managed Print Services. ARC’s future growth relies on cross selling this trio of products, each of which offer compelling competitive advantages. Supporting this cross selling effort is ARC’s 26-year history as a trusted provider of document services to nearly every firm in AEC industry. Sales growth for CDIM has been in the low single digits, with strength in color production offset by flat sales in reprographics. Gross margins are roughly 36%, and should improve in the coming years.

AIM

AIM, the most exciting growth area for ARC, offers digital document storage for AEC customers. The immense volume of documents produced in the AEC industry largely ends up in either an Iron Mountain type facility, or (more commonly) in the closet/basement/attic of the AEC firm for an indefinite period of time. AIM looks to provide a third option, where ARC utilizes its existing retail storefronts to scan customer documents and store them in the cloud. ARC’s advantage in this space is the AEC specific categorization and search functions that allow quick retrieval of documents. The leading competitors, Dropbox and Box, provide rudimentary search and categorization functionality that requires substantial effort on the part of customers to set-up, and no industry specific search functionality for quick document retrieval. More importantly, the Abacus software powering MPS allows easy additions to the AIM database so new documents can be seamlessly stored. Gross margins move from roughly 38% for the initial 3 years of an account, to over 85% thereafter. Revenue in 2014 was $8.5M; marking the first time AIM sales were reported. Sales were up 15.6% in Q2’15, and should accelerate through the remainder of 2015. Early adopters include AEC firms like AECOM, and a broad array of other corporate and municipal users, including the State of Hawaii, Shell Oil, Chevron, and dozens of smaller firms.

Balance Sheet

Over the last four quarters, ARC paid down $22M of long-term debt, brining total net debt (including capital leases) to $173M. 2014 marked the first time management paid down principal on the debt beyond required payments. The company’s term loan was refinanced twice in the past 18 months, bringing the interest rate down from a fixed 10.5% to LIBOR+250bps, saving over $5M annually. Covenants restrict a buyback until net debt falls to 1.5x EBITDA, which should happen in mid/late 2016. This puts management in the insane position of paying down debt costing <3%, while their stock has a FCF yield of 10%. Over $90M of operating loss carry forwards will shield taxable income for the next several years. Cash taxes will be less than $1M in 2015.

Free Cash Flow

In MPS, ARC retains ownership of most of the print equipment installed at customer locations. This equipment is either capitalized or financed through capital leases. Terms on the leases are matched to the length of the initial customer contract. Useful life on the equipment generally outperforms depreciation, and causes margins to rise on renewed contracts. The mix between cap-ex and capital leases incurred varies by quarter based on a myriad of factors. Using OCF less Cap-ex to determine FCF doesn’t reflect the true costs of operating this business because capital leases are added to the balance sheet in place of cap-ex running through the cash flow statement. Depreciation has tracked fairly closely to the sum of cap-ex and capital leases incurred, and offers a better proxy for the true cost of buying equipment. Using OCF less depreciation for FCF shows ARC generated $0.30 (2013) and $0.53 (2014) in FCF/share, and should be at $0.70 in 2015. Cash flow has been aided by the NOL, but that will remain in place for roughly 3 more years. At that time, pre-tax income will have grown, net debt will be closer to $100M and the share count will be greatly reduced.

Concerns

·      MPS growth slowed considerably in Q2’15 to 3.9%, from a range of 8% - 11% in the preceding four quarters.  ARC hasn’t added a new client from the Top 100 firms in the AEC industry in several quarters and this has caused the deceleration. Management hints that they are close with several firms, but they will not contribute to 2015 revenue. ARC has invested heavily in their regional business development teams over the last year and this should bump up the growth rate from smaller clients.

·      The printing of physical documents will slowly decline over time. This is a valid concern, but I believe ARC’s role in facilitating the sharing, storage, and viewing of digital documents will increase through AIM, Skysite, and other new initiatives. These products have embedded ARC in the work processes of their clients and generate long-term recurring revenue. Even the decline in physical printing is overstated. A recent ARC study found that 24% of AEC professionals personally printed 200-499 documents per week. MPS helps curtail print costs, and offers ARC a platforms to cross-sell their other products.

·      Skysite and AIM might be total flops. While this could be true, AIM sales are growing fast off a small base. It’s too early to tell for Skysite (released in January 2015). Even if both products fail, it won’t have a meaningful effect on free cash flow. AIM will contribute about 3% of total revenue in 2015 and Skysite will be <1%. At 10x 2015 FCF for the entire company, you’re paying a bargain price for MPS and CDIM, and getting the new initiatives for free.  If they work out, growth will accelerate in 2016 and beyond, but it’s a free call option.

Valuation

Rapidly improving free cash flow and a strengthening balance sheet cause ARC to screen poorly on trailing earnings (16x P/FCF, 24x EV/FCF). If we make conservative assumptions about 2015 free cash flow and debt pay-down, ARC trades at a far more attractive 10x 2015 P/FCF, and 15x 2015 EV/FCF. Without any clear comps for valuation comparison, we need to look at the quality of the earnings stream and determine if 10x P/FCF offers a clear margin of safety. In 2015, nearly 60% of sales will be recurring based on long-term contracts. Margins will likely expand going forward with MPS growth and continued expansion of AIM and Skysite. Management hasn’t shied away from investing in product development, sales and marketing, which should support continued growth. In short, we view ARC as a high quality, growing company with a dominant position in a niche industry trading at a valuation far lower than the market average. At 15x 2015 FCF (still a discount to the S&P 500 at 18x), ARC shares would be worth $10.50, a 50% premium to the current price. We’d argue that the quality of ARC’s earnings growth deserves a higher multiple, but use a more conservative 15x to illustrate the extreme valuation disconnect at today’s share price.

Catalyst

• A high probability of continued sales growth, margin expansion, and debt pay-down.
• Large percentage of recurring revenue.
• Growing free cash flow production to pay down debt, and buy back shares starting in 2016.
• Innovative new products and services that haven't yet contributed meaningful revenue, but will add to future growth.
• Low P/FCF multiple on current year earnings, that doesn't incorporate any contribution from new prodcuts.