ARC Document Solutions, Inc.
Q3 2008 Earnings Call Transcript

Published: 1 Dec 2008

[Operator:]

Welcome to the American Reprographics Company third quarter 2008 results conference call. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. David Stickney, Vice President of Corporate Communications. Thank you, Mr. Stickney. You may begin.

[David Stickney:]

Thanks, Doug and good afternoon everyone. With me today are Suri Suriyakumar, our Chairman, President and Chief Executive Officer; and Jonathan Mather, our Chief Financial Officer. Earlier today we distributed a press release reporting our financial results for the third quarter 2008. Our call today will review and expand on the information contained in the press release, after which we’ll open up the call to your questions. You can access the press release and the company’s other releases from the Investor Relations section of American Reprographics Company’s website at www.e-arc.com. A taped replay of this call will be made available beginning about an hour after its conclusion and you can access the call any time within seven days from today. You can find the dial-in number for the replay in our press release. Please be advised that we are webcasting our call, and that a replay of the webcast will also be available on our website. This call will contain forward-looking statements that fall within the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, regarding future events and the future financial performance of the company, including the company’s financial outlook. Bear in mind that such statements are only predictions and actual results may differ materially as a result of risks and uncertainties that pertain to our business. These risks are highlighted in our quarterly and annual SEC filings. The forward-looking statements contained in this call are based on information as of today, November 6, 2008 and except, as required by law the company undertakes no obligation to update or revise any of these forward-looking statements. Finally, this call will contain references to certain non-GAAP measures. The reconciliation of these non-GAAP measures is set forth in today’s press release and in our form 8-K filing. With that housekeeping out of the way, I’ll turn the call over to our Chairman, President, and CEO, Suri Suriyakumar. Suri.

[Suri Suriyakumar:]

Thank you, David and good afternoon everyone. Amid the chaos and calamity in the financial markets, I am happy to announce that our company performed well under the difficult circumstances in the third quarter. There were no surprises or shocking revelations from a market perspective, although we are indeed disappointed that the markets declined much more than we expected. The disappointment I’m sure we share with every one of you. I’ll begin with a brief review of our quarterly performance. Net revenue for the third quarter of 2008 was $174.6 million, compared to $176.2 million in the third quarter of 2007, a slight decrease of 0.9%. The company’s gross margin for the third quarter was 40.1% compared to 41.2% in the same period in 2007. The company’s EBITDA margin for the quarter was 23.6% from 24.7% in the same period last year. Earnings per share for the period was $0.33 per fully diluted share with $0.03 derived from income tax credits that Jonathan will explain in more detail later in the call. As we noted in our press release, our cash position continues to be very strong with the year to date cash flow from operations at more than $95 million. We are maintaining our forecast for annual revenues at $700 million to $710 million, and annual earnings per share at $1.36 to $1.40. As we look forward into the fourth quarter and beyond, we certainly expect the residential and non-residential markets to slow down significantly, along with the current trend in the overall economy. As this slow down will no doubt cause our revenues to suffer, what is the best course of action for us under these circumstances, what are we as a management team focused on? We believe that there are two key elements that are critical for a company’s survival during economic times like this and these elements form the basis of our plans for the future. The first is financial discipline and the second is generation of cash. For those of you who have followed the company for any length of time, these should be familiar themes. As I have stated before, financial discipline is part of ARC’s corporate DNA and is directly responsible for the company’s healthy gross margins and profits. Generating cash has also been a central theme of our business goals from the beginning. Our business model emphasizes cash flow from operations and this remains the basis for our strong capital structure. A close look at our historical numbers will show that we have always generated ample cash for our operating activities as well as our acquisitions. Our bank debt is largely due to the recapitalization of the company in early 2000, prior to our public offering. However, you’ll notice since IPO in 2005, we have reduced this debt by more than 10%. The good news is that nearly a year ago, we began refining our best practices even further, demonstrating the financial discipline I mentioned earlier by implementing programs such as search and destroy deadwood, a pro active management of our labor cost in every market, the consolidation of back offices and expenses. As we are aggressively pushing for full recovery charges and passing on material price increases as we receive them. While we aggressively managed our costs and cut expenses, we also heightened our focus on increasing sales of digital services, pursuing and successfully acquiring new premier accounts, ramping up the use of domestic and international distribute and print programs and further penetrating non-AEC markets by offering a huge variety of services in digital color including signage, presentation materials and point of purchase displays. These efforts have already yielded positive results. ARC’s efforts in cutting our costs, managing our expenses and aggressively pursuing new sales, combined with very selective acquisitions that continue to expand our market share will allow us to operate through this period of uncertainty with confidence. The clear indication of this confidence is our current cash position. As noted we have already generated over $95 million in cash flow from operations and we expect it to exceed $100 million by the year-end. This means we will have generated more than $2.20 per share in cash for the year. A truly is a remarkable accomplishment. There is no better way to judge how well a company can perform during economic crisis, caused by the lack of credit than by how much it generates. In closing, I’m happy to report to our shareholders that in spite of the challenging economic times American Reprographics continues to demonstrate the excellent management skills of its executive team by delivering solid operational performance, financial discipline and generation of cash necessary to see through the difficult times ahead. With that, I’ll invite Jonathan to give you some color on the financials. Jonathan.

[Jonathan Mather:]

Thank you, Suri. I’ll spend the next few minutes segmenting our revenue, quickly review our SG&A costs and highlight a few balance sheet items for your reference. After that I’ll shed some light on the income tax credits Suri mentioned earlier, and then we’ll move onto Q-&-A. We’ll begin with revenue by product categories. In quarter three 2008, reprographics services declined approximately 3.2% compared to quarter three in 2007. Digital services, which are included in our overall reprographic services, grew 33.2% year-over-year. They contributed 8.2% of total revenue in this quarter compared to 6.1% over the same period last year. Facilities management grew 5.9% compared to quarter three 2007. In 2008, revenue from equipment and supplies increased by 5.5% compared to quarter three 2007. Primarily due to increases in equipment and supply sales contributed by UDS, our Chinese joint venture. Revenue and revenue trend by geographical segment in this quarter was as follows; Southern California $38.5 million, down 19.3%; Northern California $23.5 million, down 6.1%; Pacific Northwest $12.1 million, up 9.8%; South $45.2 million, down 3.3%; Midwest $25.9 million, up 34.4%; and finally Northeast $27.4 million, up 4.1%. For the first time we are reporting international revenue comprised solely of UDS sales. This quarter, our Chinese venture generated $1.9 million in revenue. Finally, overall revenue from acquisitions was approximately 7.4%. Organic growth for the quarter was down at negative 8.3%. Our gross margin in the third quarter was 40.1%, a decline from 41.2% the same period of 2007. The decline was driven largely by the decrease in revenue and some dilution from our operation in China, which is currently driven by equipment and supply sales. UDS returned the gross margin this quarter of approximately 16%. SG&A expense as a percentage of revenue came in at 22.2% during the third quarter of 2008. This compares to 21% in the third quarter of 2007. In quarter three ‘08, bad debt expense increased by $1 million compared to prior year due to recent liquidity issues experienced by some of our customers. Stock based compensation is included in the SG&A expense. In quarter three 2008 stock based compensation was $1.1 million compared to $1 million in quarter three 2007. It was $1.1 million in quarter two of 2008. In the third quarter 2008 total depreciation, amortization, and interest was $19.1 million. This figure is made up of depreciation at $9.9 million, amortization expense at $3 million and interest expense at $6.2 million. This compares to quarter three 2007 of $17.4 million with depreciation at $8.1 million, amortization at $2.4 million and interest of $6.9 million. In reviewing the balance sheet, we ended the third quarter of 2008 with working capital of $40.7 million or approximately 5.6% of trailing 12-month revenue. This compares to $33.6 million of June 2008 or approximately 4.6% of trailing 12 month’s revenue. Day sales outstanding (DSO) was at 50 days in the third quarter of 2008. This compares to 53 days in the third quarter of 2007 and 50 days in the second quarter of 2008. Total debt, including capital leases at the end of third quarter 2008 was $364 million, up from $363.1 million for the second quarter of 2008. The ratio of debt to trailing 12 month EBITDA at the end of third quarter was two compared to 1.9 at the end of second quarter 2008. As Suri mentioned, cash flow from operations was $95.3 million in 2008 or $2.10 per fully diluted share. This compares to $71.1 million in the same period of 2007. 2008 cash payments for acquisitions and payments associated with acquisitions including earn-outs to sellers amounted to $18.2 million. This compares to $97.8 million in the same period last year. The upshot, of course is that we have ample working capital for the foreseeable future. When our cash position is viewed in combination with our current credit facilities, which are secured through 2012, we are quite satisfied with our capital structure. Finally, the prior year’s income tax credits we mentioned earlier in the call were granted primarily for hiring employees and purchasing fixed assets in areas of California considered disadvantaged. These are areas where the state government created incentives for investment and revitalization efforts. That concludes our financial discussion. At this point I will turn the call back Suri.

[Suri Suriyakumar:]

Thank you, Jonathan. Operator, at this time we are available to take our caller’s questions.

[Operator:]

(Operator Instructions) Our first question comes from Kevin McVeigh - Credit Suisse.

[Kevin McVeigh:]

Suri, I wonder if you could give us your thoughts on the current business environment today versus when you updated the guidance intra quarter.

[Suri Suriyakumar:]

I would say Kevin, the current business environment. If you’re really talking current, current since we updated the quarter has significantly deteriorated. Now, when I say that, the impact of the deterioration, I’m talking about obviously the financial conditions in the market and what impact it really has on our business, we wouldn’t know for the next three to six months, because as you know even as we are talking about the third quarter results, since third quarter the market has continued to erode. Now, we don’t see a huge impact on our day-to-day activities today, but we know it’s in the pipeline. So, we aren’t able to assess what is in the pipeline or how it is going to affect the projects which are currently in the pipeline.

[Kevin McVeigh:]

Jonathan a question for you, between the credit facility and the cash on the balance sheet, how much do you have in terms of capacity overall?

[Jonathan Mather:]

As of the end of the quarter, if you look at our balance sheet we had cash in hand of $34.6 million. Of that $34.6 million, $12.6 million is our China JV. So, basically $22 million cash in hand and we also have a revolver, which we have not touched, $75 million, and the $4 million letter of credit. So, $71 million plus $22 million cash in hand at the end of the quarter, plus $12 million for China.

[Kevin McVeigh:]

Suri real quick and I’ll get back in the queue. Do you see any impact from the Boeing strike intra quarter in terms of revenue that you expect might come back?

[Suri Suriyakumar:]

Not really. We saw some slowness but not a whole lot.

[Operator:]

Our next question comes from David Manthey with Robert W. Baird.

[David Manthey:]

Suri, could you tell us what you’re doing in order to make PlanWell the [Inaudible] digital standard in the industry and if you could give us an idea on a scale of 1 to 10, with what level of intensity are you working to make this happen?

[Suri Suriyakumar:]

Fundamentally all of our customers in all of our divisions use PlanWell in order to access the documents and maintain the documents. I’m quickly looking for some numbers here in terms of the number of documents in PlanWell. We are posting about 600,000 to 650,000 documents per month. Last quarter we posted about 800,000 documents a month. This just shows the fall off in the activity. In addition to this, we also have available about 610 locations where we are using PlanWell. That is, ARC locations and peer locations. As you know, we license PlanWell. So, that’s the second area we continue to enhance the influence of PlanWell on our customers. Thirdly, what we are doing is we are also making PlanWell work seamlessly with various types of different output devices. So, which means if you have output devices such as [Osay], KIP, Canon we want to be able to work with them seamlessly. We already work pretty comfortable with Osay, KIP, and Xerox. Obviously we want to continue to build this. We have now got that same level of integration with also Canon. In addition to that, we are also working with other software developers in order to make sure that transferring these documents between our PlanWell platform and our customer’s other software platforms, whether it is project management software or collaboration software or billing software or take off software. We have a variety of software’s in the various spaces, which means in the design space, in the bid space and the bill space. Almost with every one of the well known recognized manufacturer we have some agreement going at various levels of integration. So that we can move documents in and out of PlanWell, into other software programs our customers are using. One last aspect of that is when we have programs, which are tracking programs, or bidding programs or programs which are related to cost management, we are trying to tie all of that into PlanWell as well. So, this is generally trying to make the document management, construction document management services well connected to almost every other aspect the construction touches, that’s fundamentally our strategy and not only we do it, but we also do it through our peer members. I think you had one more question, isn’t it? Did you say on a scale on 1 to 10 you wanted to know where we were?

[David Manthey:]

I was just wondering how important it is to you to win that particular part of the game.

[Suri Suriyakumar:]

I mean on a scale of 1 to 10 from a future perspective, I would say it would be anywhere between 7 and 8. I mean we really place a lot of emphasis because we really think as the technology continues to take foothold in the construction documentation segment, I think it’s critical that we dominate that. I mean it’s definitely one of the focuses we have. In all of the efforts we are trying to do, for example in places like China and in London. The significant piece of our business will be driven by PlanWell, because that’s how we transfer documents and access documents and move documents. For example, in our international print programs we now offer these services, construction documentation, distribute and print, which means the customers don’t have to print all the stuff and ship it through FedEx or UPS, or go through all the customs and the documents get delayed. We can provide that service now in something like 27 countries virtually in a couple of days. In some instances on the same day by simply uploading the documents into PlanWell and making sure that those documents are printed and delivered whether in Moscow or in London or in Dubai. So, that is again a very important element of our business. That’s the growing segment of our business. The aspect that we talk about, selling digital services is primarily related to that and I think this quarter we are up to 8%, and one of the biggest drivers of that is PlanWell. It is also a very profitable segment of our business, David.

[David Manthey:]

Okay, thank you for that. Just two more quick questions, could you tell us how much you spent on programming and development of PlanWell in the past 12 months and then the final question, Suri, just before I hop off here, when you gave the updated guidance several weeks ago, did the $0.03 tax benefit factor in at that time or was that something that happened after that?.

[Suri Suriyakumar:]

I mean in a nutshell, snapshot, Jonathan jump in here. In terms of PlanWell, over the last I would say ten years or so we have nearly invested $100 million plus. I’m not referring to the investment we make in divisions to run PlanWell. I’m really talking about our technology centers in Fremont and of course our operation in Kolkata in developing research and development and writing code. So, that’s about $100 million in the last ten years and I would think this year in the last 12 months --

[Jonathan Mather:]

We spend generally $4 million to $6 million on various software developments.

[Suri Suriyakumar:]

So, that’s the number David. What was the last question David, you had?

[David Manthey:]

When you updated your guidance, did you already know that you were going to get the $0.03 tax benefit or was that after the fact then?

[Jonathan Mather:]

We didn’t take that $0.03 into account when we gave you the guidance of 1.36 to 1.40.

[Operator:]

Our next question comes from Andrew Steinerman - JPMorgan.

[Andrew Steinerman:]

Could you tell us about pricing? Particularly in your core business what’s been the trends in pricing? And then you already gave us a little flavor of digital services that is now 8% to revenues. Could you just talk about receptivity for new clients to accept pricing for digital services?

[Suri Suriyakumar:]

In terms of pricing, this has been somewhat surprising for us. We have not seen a huge pricing pressure up to now and I think one of the main reasons, I think there are two reasons, Andrew. One is that since early this year, actually late last year we have been in the process of pushing the prices up a little for several reasons, because at that time there were two aspects which were really compelling us to push the prices up. One is fuel prices, because the gas prices are going up and we were actually going back to the customers with higher prices. Then the second was that we felt traditionally over a period of time that the prices have not been pushed high enough to meet the increases in paper and toner pricing etc. Now, obviously because of our size and scope we might be able to deflect that, but we obviously wanted to stay with the market prices. So, what we did is we pushed the prices up through the early part of this year and we haven’t seen a significant erosion of that just yet. Now, I must tell you though, I was telling somebody the other day during the 2001, 2003 downturn, in about a year we did feel there was pricing pressure. We haven’t felt that yet in this time’s downturn, although it could be in the way. With regard to the digital services, it has been well received. I think there are two reasons. I mean there is great attraction for digital services, the attraction is increasing. Obviously there is a lot more to go from an industry perspective, construction industry perspective. Obviously in the design side it’s significantly digitized, but when you go to bid and build, that process is still happening at the early stages, but there is suddenly acceptance for digital services charges from those customers who are starting to use it. Secondly they find it very attractive because it’s reducing their cost at this point of time. So, more and more customers are more receptive to actually paying those digital charges, but improving the efficiency.

[Andrew Steinerman:]

Just to get the first point clear. When you said you had been pushing pricing up due to higher fuel charges, higher pricing of paper, higher prices of toner, was that a straight pricing increase or was that a temporary surcharge?

[Suri Suriyakumar:]

No, I mean there were times in the fuel charges we gave temporary surcharges, but with regard to everything else, it has been regularly pushing the pushing the prices up. Meaning straight price increases. Now, just so that you know in the reprographics industry, traditionally the customers try to avoid pick up and delivery charges, that’s how it used to be. So, for those customers where we charged pick up and delivery charges, we would actually add on a fuel charge, a surcharge, but for those customers to whom we have not charged before, we have been taking the opportunity and saying we cannot provide that service anymore and stated actually charging them for pick up and delivery, which is the right thing to do. So, those would be straight.

[Operator:]

(Operator Instructions) Our next question comes from Scott Schneeberger with Oppenheimer.

[Alla G:]

Hi, this is [Alla G] for Scott Schneeberger. You made five acquisitions during the quarter. So, can you just discuss a bit about your acquisition pipelines and do you plan to remain this aggressive on your acquisitions? Regarding your ideal target is it still about the size of high single digit revenue run rate?

[Suri Suriyakumar:]

Okay, so the five acquisitions we did are in Denver, Colorado; Northern New Jersey, that was a platform acquisition obviously Hawaii; Boise, Idaho; and Fort Wayne in Indiana. Those are the five we did. In terms of the acquisition strategy, what we are planning to do right now, especially given the significant decline we have in the marketplace, we are doing acquisitions, but we are doing it much more cautiously and much more selectively. In other words, we are not just doing the acquisitions on the same basis as we did previously, because obviously the companies we acquire now, we are certain their revenues will go down. So, we are looking for a lower multiple of a lower EBITDA number, projected lower EBITDA number. Not everybody will be excited about selling their companies with a downturn ahead of them, but that’s exactly how we are doing the acquisitions. So, we are being very selective. So, we will only do acquisitions, which we think are purely accretive and we are basically focusing on the small acquisitions. Number one; there aren’t too many large acquisitions in the US. There are very few companies like that, but even if we did one, we are going to be very selective. That’s our strategy.

[Alla G:]

A follow-up on that, you have a share repurchase authorization. Will that be one of your considerations?

[Suri Suriyakumar:]

The original share repurchase we talked about. In our banking facility, we had up to $15 million authorization and when we started doing the share repurchases this is going back December, we did about $7.7 million. So, we have a little bit left there out of the $15 million. So, we have another $7 million plus worth of share repurchase that we can do, but we did not exercise our options to go ahead with the large share repurchase program for which we got permission from the bank and the Board. We pulled it out early this year and we don’t plan to do that for now.

[Alla G:]

One last one, your SG&A is up year-over-year. I noted you have your cost of savings plan, but also mentioned several sales promotions, such as sales promotions in digitals in new premium accounts. So, is that going to be the case going forward that maybe more likely your sales and marketing spending will more than offset your cost of savings?

[Suri Suriyakumar:]

No, I do not think so. I’ll get Jonathan to explain exactly why that SG&A went up, but in general our additional incentives or additional efforts to go after premier accounts or sell digital color should not actually drive our SG&A up. Jonathan.

[Jonathan Mather:]

The SG&A year-over-year, to your question you’re right, went up. Last year we were at 21%, this year we had 22.2%. The main cause of that, two reasons, one is bad debt. As I pointed out, bad debt expense in this year because of customer liquidity issues etc, and we are being careful, conservative went up about $1 million year-over-year. In addition to that is the overhead absorption in the SG&A. A large percentage of that is compensation related costs of G&A sales organization etc. So, that’s another reason why the SG&A as a percentage didn’t go down to the same level.

[Operator:]

Our next question’s a follow-up question from the line of Kevin McVeigh - Credit Suisse.

[Kevin McVeigh:]

Suri, it’s actually pretty interesting because it seems like digital actually reaccelerated year-over-year, albeit modestly and obviously it was a tougher environment. I know part of that is cost savings on the part of the clients. Can you remind us kind of the pricing mechanisms that you use in digital?

[Suri Suriyakumar:]

Right, I mean the digital part of it Kevin, if you think about it; it is an aspect which is growing anyway and given the size of the industry and the amount of digital work we do, obviously we are still scratching the surface so to speak, because there is a huge amount of areas to be digitized in the construction industry. So, what we do is like I said, barely scratching the surface. So, it’s a very small start. However, because it does make the customers more efficient, as customers subscribe to changing onto this digital model more and more, we expect this to grow, albeit it’s of course a very tough marketplace. The next question you were asking about the pricing, Kevin?

[Kevin McVeigh:]

Yes.

[Suri Suriyakumar:]

Yes, with regard to pricing. The structure of that is we do have a [Inaudible] of digital services we have, whether it is scanning or whether it’s uploading, setting up a file. A variety of services related to uploading and storing, archiving. All of these services we have started offering and customers are starting to make use of that more and more.

[Kevin McVeigh:]

Do you charge them per usage or how do you generate the revenue, the fees for that?

[Suri Suriyakumar:]

Sorry if I misunderstood your question. Yes, it is usually per file per use charge is what we are doing. Now, traditionally as you know, when we kicked off PlanWell our strategy was to incorporate, for example scanning and uploading charges into the print charges. That is how we started off originally and then because of this transition, which is occurring, since last year, we have started identifying these charges separately and we charged those customers separately. So, as a result it is per sheet, for example if it is setting up charges or uploading charges, or scanning charges it will be per sheet. If you are doing transfer, it’ll be per file. So, we do have actually a tariff for all those services.

[Kevin McVeigh:]

That’s very helpful and then just one other quick question, I’ll get back in the queue. Jonathan, I apologize, I think you said this but I’m still not clear. The $0.03 tax benefit is that in the guidance or the $1.36 to $1.40 excludes the $0.03 tax benefit?

[Jonathan Mather:]

The guidance that we gave back in September, the $1.36 to $1.40, when we did that, we did not take into consideration the potential of getting this tax credit, but even with this tax credit of $0.03, Suri and I, we discussed it we’re not changing our guidance of $1.36 to $1.40. What we are trying to say is, don’t now go back and say, oh it should be $1.39 to $1.43.

[Operator:]

(Operator Instructions) Gentlemen, there are no further questions. I’d like to hand it back over to you for closing comments.

[David Stickney:]

Ladies and gentlemen, at this time we will conclude our call. Thanks very much for your attention and continued interest in American Reprographics Company. Have a great evening.

[Operator:]

Ladies and gentlemen, this does conclude today’s teleconference. Thank you for your participation. You may disconnect your lines at this time.