ARC Document Solutions, Inc.
Q2 2013 Earnings Call Transcript

Published: 7 Aug 2013

[Operator:]

Good evening. My name is Lea and I will be your conference operator today. At this time, I would like to welcome everyone to the ARC Document Solutions Second Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions) Thank you. I’d like to now the call over to your host Mr. David Stickney. Sir, you may begin.

[David Stickney:]

Thank you, Lea, and welcome everyone. Please be advised that this is not the (Gap) Inc., conference call but ARC Document Solution. We had a little hiccup with our provider here. On the call with me today are Suri Suriyakumar, our Chairman, President and Chief Executive Officer; Dilo Wijesuriya, our COO; John Toth, our Chief Financial Officer; and Jorge Avalos, our Chief Accounting Officer. Our financial results for the second quarter of 2013 were publicized earlier today in a press release. In order to enhance the efficiency and focus on our earnings call please note that some of our supplemental statistical information about the quarter historically presented in our prepared remarks has been instead furnished in our press release under the sub-head 2013 Second Quarter Supplemental Information and will no longer appear regularly in our prepared remarks. Our press release and other company releases are available from our Investor Relations pages on ARC Document Solution's website at e-arc.com. A taped replay of this call will be made available several hours after its conclusion. It will be accessible for seven days after the call. The dial-in number is in today's press release. Per our usual practice, we are also webcasting our call today and the replay of the webcast will also be available on ARC's website. Today's 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, August 6, 2013, 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. At this point, I'll turn the call over to our Chairman, President and CEO, Suri Suriyakumar. Suri?

[Suri Suriyakumar:]

Thank you, David, and good afternoon. Our second quarter performance provided further evidence that we are solidifying our position as a leading document solutions provider in our space. The overall revenue performance of the company demonstrates the strength and momentum we are gaining in the marketplace and our margins for the period clearly show that the benefit from last year’s restructuring are not sustainable but also making a material difference to our bottom-line. As we highlighted in our earnings release, second quarter revenue was $104.6 million, our gross margin was 34% 220 basis points higher than our gross margins in Q2 of 2012. Adjusted EBITDA margin was 17.5%, 140 basis points higher than a year ago and cash flow from operations for the quarter was $8.1 million or approximately $0.18 a share. Earnings per share were $0.04 for the quarter. Given the strength of our performance we are revising our annual EPS forecast for the full year of 2013 to be in the range of $0.06 to $0.09. We anticipate cash flow from operations to remain unchanged and be in the range of $38 million to $45 million. In the second quarter, onsite services delivered more than $30 million, which represents a year-over-year revenue increase of 11%. Given the trends we are currently experiencing and as we expected it is very likely that our onsite services will be our dominance sales category in the near future. The continuing enhancement of Abacus, the software that powers our MPS offering is a major contributing factor to our success in this business line. Traditional Reprographics also delivered more than $30 million in sales declining 11% year-over-year. This category continues to feel the pressure of our hesitant non-residential market, changes in customer behavior and the adoption of technology. Color delivered $21.8 million in revenue and reflected the actions we have taken to improve operations and sales over the past several quarters. I’m happy to report success in this area as we achieved year-over-year growth of more than 6%. Digital sales experienced a year-over-year decline of 8.6% in the second quarter as you may know historically what we categorized as digital services are largely title the work we do with traditional project documents typically associated with scanning, uploading and indexing of project documents, file conversion and some digital distribution work. As a result, these sales decreased along with our traditional reprographics sales. It is important to recognize that revenue attributed to Abacus, in our MPS engagement is tracked as part of our MPS revenue and is not reflected in our digital services revenue category. As we described last quarter, we are continuing to expand our service offering in document solutions to our customers outside project related work. The most obvious example is our archiving and information management service which we call AIM. AIM innovative approach in both service and pricing continues to provoke strong interest with clients all over the country and we are developing a robust pipeline for engagement as we introduce it to our new and existing clients. Equipment and supply sales declined 9.7% year-over-year primarily due to unfavorable comparisons with the second quarter of 2012. Aggressive vendor promotions offered to our customers last year along with some large non-recurring sales made a significant impact on our performance both in the U.S. and in China. During the first half of 2013, we are beginning to take our ground as a dominant document solutions company in our space. We are not only a different company than we were prior to the recession but our obsession of the future is significantly more inclusive and diverse than it has ever been. Our expanded portfolio of services driven by our technology is creating significant value to our customers and dramatically increasing the size of our addressable market. Our new technology services investments in a better trained and better staffed sales force and tighter controls throughout the business are providing the means to pursue new business in existing new ways – in exciting new ways, I apologize. During the last half of 2013, we not only expect to continue our new business trajectory but we also expect to see year-over-year margin improvement from our restructuring efforts and improving sales performance. ARC has always been a strong cash performer but clearly we are going to be more active with our use of cash in the near future preferring to put excess capital to work primarily against our debt. As we noted in July, we repurchased $7 million worth of our bonds on the open market on a full year basis, this achieved an annual interest saving of nearly $0.75 million. We will continue to look for ways to reduce our debt obligations in the future and improve our capital structure. While I’m certainly not offering a specific forecast for the years ahead, I do expect to see improvements incremental otherwise in our nation’s economy and I also expect that we will benefit from them. With regard to the AEC industry itself, construction activity forecasters don’t expect significant expansion in the non-residential market during the last half of 2013, though they do anticipate appreciable gain in 2014. Whether or not these predictions hold true, our revenues are likely to grow given the expansion in our addressable market space. In closing, a meaningful component of our future growth will come from customers continuing to adapt our technology driven services. While, we will always provide print related services and equipment to our customers who need them, it is our ability to provide digital document management solution that will determine the quality of our sales and that’s the quality of our earnings and value to our stakeholders. With that as a background for future discussion, I will turn the call over to John for a (inaudible) view of our financial details and then we will take your questions. John?

[John Toth:]

Thank you, Suri. The revenue performance of each of our business lines were in line with current trends. The most significant of which as Suri pointed out were the equal and opposite directions in which traditional reprographics and onsite services travel. I should note that on a dollar basis, our onside services actually surpass our traditional reprographics for the quarter and therefore is our largest revenue line. This is a milestone that has been very gratifying to reach. As noted in our press release today, our 34% gross margin demonstrates the ongoing power of the restructuring effort which we began in the fourth quarter of last year. I should note that the year-on-year gross margin increased in Q2 up 220 basis points, occurred despite $1.6 million less in revenue and while driven in large measure by the restructuring, our focus on improving our color margins and optimizing our service centers contributed as well. Focus on all of our variable costs led to a year-over-year contribution margin expansion of roughly 210 basis points from 55.2% in Q2, 2012 to 57.3% in the Q2, 2013. Our business mix also played a role in this improvement as we had lower material costs, on lower sales in equipment and suppliers. Our SG&A for the second quarter of 2013 was $24.9 million, an increase of approximately $900,000 versus the same period in 2012. We increased our selling and marketing expenses by $700,000 as we continued to invest in sales resources and training to drive growth. As we mentioned last quarter, we anticipated minimal additional restructuring expenses for the balance of 2013. As a reminder, the initial restructuring expense incurred in the fourth quarter of 2012 was $3.3 million. In the second quarter of this year, we incurred an additional $0.6 million of restructuring expenses from additional service center closures. Including the $0.5 million of additional expense in Q1 of this year, this brings our total restructuring expense to $4.4 million. From a restructuring liability perspective as opposed to an expense perspective, for 2013 in total, it increased the liability by $1.1 million and made $2.6 million in payments towards the restructuring. The net result is a restructuring liability of $800,000 at the end of Q2. In spite of these payments, our cash is up roughly $4.4 million versus the end of December and up roughly $9.1 million versus a year ago. Net interest expense for the second quarter was $6.1 million compared to $7.3 million for the second quarter in 2012. As a reminder, the amortization of our interest rates swap ended in December 2012 and this reduction is the benefit of a year-over-year comparison. The result for the quarter was net income of $722,000 or a GAAP EPS of positive $0.2 for the quarter. Adjusted to exclude certain tax items and the restructuring expense, our adjusted net income was $1.6 million or an adjusted EPS of plus $0.4. Adding back interest, tax, restructuring expense and depreciation and amortization to get to our adjusted EBITDA, our adjusted EBITDA was $18.3 million for the quarter or 17.5% versus a year ago when our adjusted EBITDA was only 16.1%. The improvement of our adjusted EBITDA margin cascade directly from our strategic management of our gross margin but it is offset somewhat by the relatively fixed cost of our SG&A. Cash flow from operations was $8.1 million for Q2 of 2013 versus $4.4 million for Q2 of 2012; this is a $3.7 million increase despite $1 million in cash payments made in the second quarter related to the restructuring. The increase in cash flows from operations again was primarily due to our increased financial performance. Capital expenditures were $4.4 million in the second quarter versus $5.4 million in the same period of last year, as we have mentioned before in 2013, we are in the process of shifting our buy versus lease mix of equipment back to a 50-50 balance. Total debt including capital leases at the end of Q2, 2013 was $220.8 million down from $224.4 million for the same period last year, as we shift our equipment purchasing toward capital leases versus CapEx, I expect our debt excluding the bond to increase very modestly over the remainder of the year. On a final note and to reiterate Suri’s comments we were gratified to repurchase $7 million of our bonds. The open market repurchase was made in the early part of July and thus will not appear in our financials for the quarter. The repurchase was intended to reduce ARC’s long-term debt and annual interest obligations and made no use of the company’s $50 million revolving credit facility which continues to remain undrawn. This is the first public step in our longer term campaign to delever to the company. As a reminder our $200 million in bonds was due to a dividend to our owners prior to our IPO. This debt was not generated by the operations of the business. In the future we may consider additional steps to further reduce our debt and interest obligations provided conditions favor the company and as our financial performance and the economy continue to improve. With this overview as a basis for a discussion in question I’ll turn the call back over to Suri.

[Suri Suriyakumar:]

Thank you, John. Operator, at this time we are ready to take the questions.

[Operator:]

(Operator Instructions) And you do have a question from the line of Andrew Steinerman (JPMorgan).

[John Toth:]

Andrew, are you on the line?

[Molly McGarrett:]

Hi, this is Molly McGarrett for Andrew.

[Unidentified Company Speaker:]

Hi, Molly.

[Molly McGarrett:]

Hi there. Can you discuss post restructuring where you are in terms of capacity for future top-line growth and how you will think about building out infrastructure potentially with top-line growth going forward?

[Suri Suriyakumar:]

Are you referring to, Molly are you referring to capacity in terms of capacity in our service centers, is that what you are referring to and then how the restructure affected them, is that the question --

[Molly McGarrett:]

Right.

[Suri Suriyakumar:]

Okay, no, yeah. So the restructure fundamentally what we’ve done is because most of our service centers were designed originally to handle a certain amount and certain types of work which was primarily related to the project related work. The restructure we’ve done is in order to make sure those service centers are now adequately equipped to do also flow work related to management services or AIM-related work or the other services, expanded service offerings we have through our customers. So in terms of the capacity itself we have a fair amount of capacity left. For example simply put we still operate only a single shift in each one of these service centers. So if we need we had growth in the market and we needed we actually expand our capacity, we could do that without any major investments basically.

[Molly McGarrett:]

Okay. Thanks. And then if you could also just give a comment on the pricing environment and whether pricing power is helping you on the gross margin side and where you see that trajectory going forward?

[Suri Suriyakumar:]

There is no change in the pricing environment overall from a market perspective at least up till now because if you are referring to pricing in the non-traditional, the traditional reprographics work we do in the project related work because non-residential market is not really kicked in full gear we haven’t gotten into that situation yet. As the market starts to come back and the demand for the services increase that might be an opportunity, but I also might point out that during this downturn the pricing didn’t get affected as much as it has been in the previous environment.

[Molly McGarrett:]

And then in the – in your newer service lines I know last quarter you talked a bit about the color marketplace and that being a bit more competitive on the pricing side. Can you just discuss your newer service lines as well?

[Suri Suriyakumar:]

Sure. So when we talk about the color market space simply because in comparison with the other services we have color margins are challenged relatively speaking because it’s a very competitive market space that’s the market space in which you have a lot of small operators operating in local market areas. We’re trying to distinguish our services by going to larger customers who require the same services in multiple cities, which is something that we are capable of offering and too many color service providers can offer that, that’s how we differentiate our services. And before they are knocked by the technology services we provide in order to do file transfer event, shipped documents digitally. So in that sense we have the advantage however when it comes to color services typically they are a little more challenged or competitive compared to for example in MPS or AIM-related service.

[Molly McGarrett:]

Okay. Thank you very much.

[Suri Suriyakumar:]

All right, welcome.

[Operator:]

Your next question comes from the line of Scott Schneeberger.

[Unidentified Analyst:]

Good afternoon. This is Joshua (inaudible) for Scott.

[Suri Suriyakumar:]

Hi, John.

[Unidentified Analyst:]

Hey so you guys have your people on the street and indicators have an overall strong lately. Just in terms of the non-res construction market, what you guys need to see for you to say things are picking up there and have you guys seen any positive signs there yet?

[Suri Suriyakumar:]

There are certainly positive signs out there but largely it revolves around vacancy rates, right. In the non-residential market space it’s all to do with the vacancy rates and unemployment that’s what we always talk about it traditionally. So in terms of the vacancy rates it really haven’t picked up as much as we would like it to pickup in terms of the numbers mentioned earlier. For example in the office space according to CBRE quarter two 2013 its still 15.3% vacancy rate, right. It’s down 20 basis points but its still 15.3% which is on the high side. On the industrial side it is at 12% down 30 basis points and in retail its 12.2% down 30 basis points. So its moving in the right direction but in order for it to really kick into full gear these vacancy rates have to come down further and once it comes down further then you will find a lot of people will start investing in, we’ve said this in the past that the non-residential construction is largely driven by private investment and for that to happen vacancy rates have to go down and that usually goes in tandem with the unemployment rates.

[Unidentified Analyst:]

Okay. Thank you. Just in terms of seasonality how is the month of July trended and does the second quarter say anything about the rest of the year for you guys?

[Suri Suriyakumar:]

The second quarter sales for the rest of the year, well, but you see they will be in the kind of first strong first half of the year but strong. So we certainly expect the same trend to continue during the second quarter, we don’t see necessarily because of the seasonality, we necessarily won’t see any growth in the second quarter as compared to the first quarter, first half.

[Unidentified Analyst:]

The second half of the year –

[Suri Suriyakumar:]

As it for the first half of the year as John said, we are trying. That’s exactly what I meant. So the second half is going to be in the same lines, we don’t based on everything what we are hearing in the marketplace and the sentiment in the economy we don’t expect anything to go down drastically neither do we expect to see any growth as basically predicted by all of the non-residential staff. So we think it will remain flat, am I right in saying that John, any thing to add on that?

[John Toth:]

No, I think that that captures it perfectly we expect our – the trends you see which is Q2 is typically our strongest quarter and Q3 tends to be a little weaker, we expect that trend to continue as you see.

[Suri Suriyakumar:]

Yes, I mean, in terms of seasonality Q4 there will be always be a drop and so that we expect the same as well.

[Unidentified Analyst:]

Okay, great. And just last question, if you guys could speak to the international efforts in the Middle East, if you guys have any updates there?

[Suri Suriyakumar:]

In the Middle East nothing different about what we arrived in the past, our strategy there has been Josh always, if our customers have projects there and require our services, they find a way to support that. Dilo, would you like to add there?

[Dilantha Wijesuriya:]

Yes, Middle East again, we don’t have our own ARC presences there but we worked very with our partners – wide network of partners in the Middle East and obviously Middle East is picking up some work. But, we channel it through our partners and we are able to fulfill for our customers.

[Unidentified Analyst:]

All right. Perfect. Thank you guys very much.

[Suri Suriyakumar:]

You are welcome.

[Operator:]

Your next question comes from the line of (Brendan Dobell).

[Unidentified Analyst:]

Thanks. Good afternoon guys.

[Suri Suriyakumar:]

Good afternoon, Brendan.

[Unidentified Analyst:]

Couple of just, I guess kind of metrics or details, you gave us some numbers around the onsite business from customer and contract perspective, there is two things there, the 175 contracts that you mentioned was that a year-on-year increase or a sequential quarter increase?

[John Toth:]

That is a sequential increase.

[Unidentified Analyst:]

Okay. Of two of this year, sorry, Q1 of this year, would it have been just shy of 7100 or so, we are on to 100?

[John Toth:]

Yes.

[Unidentified Analyst:]

Got you. Any sense what the number looks like last year?

[Suri Suriyakumar:]

We don’t have that number at our finger tips.

[Unidentified Analyst:]

Okay.

[Suri Suriyakumar:]

But, we had – I believe that we had this trend of roughly 150 grows sequentially for the past three quarters.

[Unidentified Analyst:]

Okay. All right. That’s helpful. And then the onsite business, it seems those, I guess the average customer if there is one in that business probably doing in some place, $15,000 to $20,000 a year annually, is that the right way to think about that average contract size? And if that is, that changed a lot the couple of years or are you seeing good same customer growth?

[John Toth:]

So, first that is a pretty good way to think about it.

[Unidentified Analyst:]

Okay.

[John Toth:]

That’s a pretty average. And in terms of change over time, I think its too early to tell frankly. It seems pretty stable for us, but really we have been in the business hard for only about 2 years.

[Unidentified Analyst:]

Right.

[John Toth:]

So, I think its little early to speculate.

[Suri Suriyakumar:]

Yes. Are you talking about the two groups of customers, John are you bundling the both things together?

[John Toth:]

Really bundling the whole thing together.

[Suri Suriyakumar:]

So, Brendan, another way to think about it, just as a snapshot is that, you are referring, does he referring to the management services business, right?

[Unidentified Analyst:]

Right.

[Suri Suriyakumar:]

So, if you look at the management services business Brendan, you can actually group them into two. One of the global solution customers, which are the large customers, nationwide customer or global customers, where the contracts are very large. The number of customers are not as many but the size of those contracts are large.

[Unidentified Analyst:]

Right.

[Suri Suriyakumar:]

And in the second group is part of – they were 100,000 customers across the company and that number, the FM contracts we have – the FM, MPS is now up to 7300, I think we added 200 additional new contracts overall for the second quarter. So those are actually would say 5000 to 10,000 average, John what would you say? John is looking after the numbers. So those are the smaller contract.

[John Toth:]

15,000.

[Suri Suriyakumar:]

15,000 average for those contracts. So you can – those are all average numbers. And then, so you understand where those revenues come from.

[Unidentified Analyst:]

Okay. So, if you look out, let’s say a couple of quarters from now, the metrics you provided this quarter about AEC versus non-AEC customer, should we expect that AEC proportion to continue to go lower or as I guess, the onsite services part of the business, is that dominated by also by AEC customers so even though the non-res construction market may not recover, you’re still going to see good AEC growth?

[Suri Suriyakumar:]

Right. I mean that’s a good question, Brendan. So, one of the things we have been talking about is how we already have this solid customer base, we’ve been largely doing project related work and that is what historically we have been doing and what we have done is, over the last few years in expanding our services into management services and now aim more and more, we are capturing that non-projects related work. So, even from our existing customers, we are capturing work which are not as cyclical but which is also new revenues from ARC perspective because that revenue we have not had before. So, that’s one of the reasons why we say because of the new services we are now offering our customers, we had continued to -- we are able to continue to grow in those spaces even though non-traditional might not kick into full gear just yet.

[Unidentified Analyst:]

Okay. And then final one, I would assume that the part of the increase in the EPS guidance would just be the impact of slightly lower debt for the back half of the year. Is there anything else that’s – that I’m missing in terms of what would drive the upper revision to EPS?

[Suri Suriyakumar:]

So, fundamentally, there is margin improvement we’ve had in the first half of the year.

[Unidentified Analyst:]

Right.

[Suri Suriyakumar:]

Because of restructuring efforts and continuing to fine tune the operation and we are staying focused on that. So, I think that will contribute, continue to contribute. So, that’s our theme for this year. We want to see margin improvement this year while laying the ground work for revenue expansion next year in terms of introducing these services and getting the customers used to these new additional services we offering such as MPS and what you call AIM services. Of course, what we have done with our pre-purchase of bonds will help a little. John, would you like to --

[John Toth:]

Yes, exactly what Suriya said that the lion share of the improvement is from the margin expansion efforts --

[Unidentified Analyst:]

Okay.

[John Toth:]

And the terrific work our operations team has done and our sales teams have done. The bond repurchase will save us about $750,000 per year given there is only six months left in the year that’s about billing --

[Unidentified Analyst:]

Yes. So --

[John Toth:]

So there is some minimal occurrences.

[Unidentified Analyst:]

Yes, maybe a penny in the back half of the year kind of savings?

[John Toth:]

Yes, not even that from that.

[Unidentified Analyst:]

Okay.

[John Toth:]

It’s $300,000 on 45 million -- 46 million shares. So, it’s really, it’s -- our operations team has done a phenomenal job of executing the restructuring efforts and continuing to maintain the pressure to expand our margin.

[Unidentified Analyst:]

Okay. And then final one, you mentioned the tough year-over-year comparison for the equipment sales part of the business. Should we expect anything in the back half of the year like Q3 to Q4 last year, was there anything like that as well and as you move towards kind of 50-50 split between capital leases and purchased equipment. Should we expect that to influence what the revenues or the growth rate in that segment -- that sub-segment I guess looks like in the back half of the year?

[Suri Suriyakumar:]

So, the 50-50, I’ll let John comment on that. Don’t think that actually, largely impacts. What happens with equipment manufacturers is that depending on the manufacturers promotions they have and often, they put out their own promotion, different manufacturers and sometimes those promotions are extraordinary given the circumstances or if they are trying to close out a model, they would have all kinds of different promotions which is going on. And it is also typical in China that Q4 in terms of equipment and supplies, they tend to have a strong Q4 relatively speaking –

[Unidentified Analyst:]

Okay.

[Suri Suriyakumar:]

Compared to the U.S. So, all that might help. So, there is a chance that we could see a bump up in those numbers. But again, very much depends on what the equipment manufacturers and the people in that space (inaudible) that business is going. John, would you like to comment also on the -- what you call 50-50 of the leases?

[John Toth:]

Yes, everything in line with what Suriya said that the mix of leasing versus purchasing really doesn’t impact the business, the sales of the business much because we price the capital whether it’s from our own balance sheet or somebody else’s --

[Unidentified Analyst:]

Okay.

[John Toth:]

Very much in line with the market. So, minimal affect from that.

[Unidentified Analyst:]

Got it. All right. Thanks guys. Appreciate it.

[John Toth:]

You’re welcome.

[Operator:]

And there are no further questions at this time.

[Suri Suriyakumar:]

Ladies and gentlemen, thanks very much for your attention and continued interest in ARC Documents Solutions. Have a great evening.

[Operator:]

Thank you, ladies and gentlemen for participating in today’s conference call. You may know disconnect at this time.