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American Reprographics Company (NYSE:ARP)

Q1 2010 Earnings Call

May 4, 2010 5:00 p.m. ET

Executives

David Stickney - VP, Corporate Communications

Suri Suriyakumar - Chairman, President & CEO

Jonathan Mather - CFO

Analysts

Andrew Steinerman - JPMorgan

Scott Schneeberger - Oppenheimer

Brad Safalow - PAA Research

Luke Junk - Baird

Operator

Good afternoon. My name is [Dawn] and I will be you conference operator today. At this time, I would like to welcome everyone to the American Reprographics first quarter 2010 earnings 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. Mr. David Stickney, Vice President of Corporate Communications, you may begin your conference.

David Stickney

Thank you, [Dawn]. I'd like to welcome everyone to our call today. Joining me are Suri Suriyakumar, our Chairman, President and Chief Executive Officer and Jonathan Mather, our Chief Financial Officer.

The call today will provide you with some insight into our first quarter, the financial results of which were publicized earlier today in a press release. You can access the press release and the company's other releases from the investor relations section of American Reprographics Company's website at e-arc.com.

A taped replay of this call will be made available beginning about an hour after its conclusion. It will be accessible for about seven days after the call. You can find the dial-in number for this replay in today's press release.

Please be advised that we are webcasting our call today. A replay of the webcast will be available on our website for 90 days from today.

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, May 4, 2010 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, everyone. American Reprographics Company continues to perform well in the face of decreased commercial construction activity. As noted in our earnings release, at the end of the first quarter of 2010, we delivered $0.02 per share and $9.5 million in cash flow from operations.

Operating cash flow was temporarily affected by the timing of anticipated tax credits and certain payables in the quarter and Jonathan will have more color on that topic in a few minutes.

We are affirming our annual forecast today. We expect annual EPS to be in the range of $0.15 to $0.30 and cash flow from operations to be in the range of $65 million to $80 million.

As I stated in my previous call regarding our 2009 results, 2010 will test our metal. While there are signs that the AEC market is finding its bottom, we expect the industry to face continuing challenges this year.

In 2010 we are likely to see incremental improvements in GDP, employment and some easing of credit in the coming months. While all of these metrics and drivers for non-residential construction activities, such improvements are likely to be in advance of recovery in the AEC market.

As we have stated previously, we expect construction to lag the general economy by nine to 12 months as it has in the past. As such, our operating plans and business forecast revolve around this timeline.

Our ability to manage costs, generate cash and meet our obligation throughout the downturn have been proven and we have every reason to believe we can continue to deliver solid performance in the coming quarters.

What is more, when the recovery begins to take hold, we expect our margins to improve dramatically due to the cost control measures put in place over the past 12 months. I expect a material portion of these cuts will be permanent, thus a greater portion of incremental revenue will fall to the bottom line.

In addition, we are reengineering aspects of the company in anticipation of changes that are likely to take place in our end markets. We will continue to explore ways to leverage our core competencies into different markets and to make the most of our technology development efforts.

For example, we recently opened our sixth [ride creating remaining center] in New Jersey and there are early signs of success in our ability to address the digital color market more effectively with a single dedicated brand.

While there is still work to do as we build our new color initiative, this is an excellent time to create it. We have excess capacity to apply to a dynamic new market. The operations have required very little new capital to develop and [write] continues to be a source of excitement and improve morale inside the company.

We also believe that as we emerge from the downturn our traditional market is likely to have a new precision for our technology production and services. Historically, reluctant to adopt technology, we think the construction industry as a whole will be forced to look at new ways to improve productivity and efficiency, especially considering that more than 2 million people have lost their jobs in the construction field.

Digital shipping, building information modeling, tools that allow project management and document management applications to communicate better and process improvement applications remain a focus of our development and sales efforts. We believe they represent significant opportunities for us to capture market share in the coming months.

Growth through acquisition remains extremely compelling but purchasing depreciating assets does not. As a result, when considering an acquisition we will re-prioritize our criteria. We will look closely at the depth of any new company's customer base, the quality of its management and the effectiveness of its sales force to help determine that value. We are well aware of the dynamic the economic environment continues to be.

However, the constant that has driven the ARC success in the past continues to remain relevant. Throughout the year you will continue to see us aggressively managing our costs, reserving cash and servicing our debt. We also intend to stay focused on productive uses of our excess capacity and emphasize business and technology issues that will deliver growth in excess of our end market's performance.

As I mentioned at the beginning of my comments, we expect challenges in the coming quarters but we are confident in our ability to meet them.

With that, I'll turn the call over to Jonathan for some insight into our financial position in the first quarter. Jonathan?

Jonathan Mather

Thank you, Suri. We continue to see a stabilizing trend in our daily sales throughout ARC. However, the effects of seasonality and continued [inaudible] in our end markets are still causing some mild fluctuations.

In quarter one, we saw an incremental change in our customer mix as a percentage of our overall revenue. Non-AEC revenue was up over quarter four by 150 basis points at 23.2%. Non-residential construction delivered 71.2% of our revenue and 5.6% of our business came from residential construction.

ARC's productive service mix also saw an incremental change. Chinese operations contributed most sales of equipment and supplies than we expected. The first quarter is typically the weakest quarter in China but the team in Beijing and Shanghai are making good progress against their sales targets regardless of the season.

12% of our revenue came from equipment and supplies in the first quarter of 2010, as compared to 9.2% in quarter one of 2009. The service management made up 20% of our revenues. Digital services delivered 9% of our sales. The remaining 59% came from our traditional base of reprographic services.

There were 63 working days for the first quarter of 2010, the same number of days in the fourth quarter of 2009. There were also 63 days in quarter one of last year.

On a regional basis, our year-over-year revenue performance declined. Southern California was down 24%. Northern California was down 17.2%. The Pacific Northwest was down 16.4%. Our southern region was down 22.3%. Midwest was down 16.6% and the northeast was down 28.4%.

That said, we saw average daily sales for quarter increase sequentially over quarter four in all but our Southern California and Northeast regions. As noted, our Chinese team is hitting their stride. They've contributed strongly to the performance of our international operations, excluding Canada, which are up 92%.

Our gross margin of 32.9% is being driven primarily by our product mix and absorption of overhead. We are also beginning to feel a slight impact for material price increase that we have yet to be able to pass on to our customers.

As a final note, on the P&L our interest expense was in line with our expectations for quarter one. It was similar to the interest expense in quarter four of 2009, excluding the one-time cost of amending our credit agreement.

In review of the balance sheet, we ended the first quarter of 2010 with a cash balance of $26.2 million even after we paid down $12 million in debt during the quarter. Daily sales outstanding, or DSO, were 47 days in the first quarter of 2010 as compared to 51 days in quarter one of 2009 and 43 days in quarter four of 2009.

Total debt, including capital leases, at the end of first quarter 2010 was $264 million. This is down from $274.2 million for the fourth quarter of 2009. The ration of debt to trailing two-month EBITDA at the end of first quarter was 2.8, excluding the good will and intangible impairments and stock based compensation.

Cash flow from operations in the first quarter was $9.5 million. Operating cash flows were negatively impacted by the timing of tax credits, certain payables in the quarter and the sequential increase of four days in our DSO which effected the collection of our receivables.

I think that covers the fundamentals for the moment. So at this point I'll turn the call back to Suri.

Suri Suriyakumar

Thank you, Jonathan. Operator, at this time we are available to take our callers' questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Andrew Steinerman - JP Morgan.

Andrew Steinerman - JP Morgan

Suri, when you talked about perspective signs of improvement in employment, vacancy rates and credit availability, were you talking about things that you hear from your customers or things that are really kind of common knowledge in the newspapers?

Suri Suriyakumar

Mostly common knowledge in the newspapers, Andrew, and also some stuff we are seeing with our customers. Some of our customers are saying they are starting to hire some staff, such as the architects, for the first time in several quarters. So that's an indication as well.

Andrew Steinerman - JP Morgan

Could you talk about the [plaisic] environment with your customers in your core business as well as in color printing?

Suri Suriyakumar

What environment did you say?

Andrew Steinerman - JP Morgan

In your core business as well in your newer color printing business?

Suri Suriyakumar

So there are two elements. One is with regard to the basic reprographics environment. The pricing continues to overall, based on the conditions we are experience are the erosion we are experiencing relative to that seems to be reasonably stable. However, I must tell you last quarter and this quarter, for the first time, we are starting to see a little more pressure and this is expected given the decrease in volume of business we have.

But, again, I have been maintaining all of last year, mostly all of last year, that pricing is relatively remaining stable. So we see some pressure in that one and we expect that to be the case in 2010.

Like I said in my call, 2010 will really test our metal, so to speak, because this is the last bridge before the market recovers and the industry will experience some difficulties and I think we will have a little difficulty from a pricing perspective, probably from the smaller reprographic companies.

With regard to the color market, Andrew, where color is concerned with the AEC market, we still have the same margins and the same pricing pressure we would expect in the black and white market. However, the color market in the AEC industry is slightly different to the color market we are getting into, like non-AEC. There margins are a little more competitive in the color marketplace.

So there is a slight difference in margin, not totally different, but that marketplace is very aggressive and very competitive. But that's a market we are entering into. But with regard to the AEC market, it would have the same pressures as it would have in the black and white business.

Operator

Your next question come from the line of Scott Schneeberger - Oppenheimer.

Scott Schneeberger - Oppenheimer

I guess first question would be, Jonathan, if we could talk about the cash flow and you mentioned tax credits, accounts payables and DSO increase. Could you take us a level or two deeper on each of those please?

Jonathan Mather

Yes, again, the best way to look at it is while we didn't provide quarterly guidance on cash flow. If you normalize, assuming equal, you could talk $15 million to $20 million is the expected cash flow on a quarterly basis, a revenue volume where we expect to be based on our EPS guidance.

This quarter we were obviously short of that, call it a $15 million to $20 million run of cash. Now there were three components. The main component, DSO, receivables, four days. We, again, while DSO is captured on a quarterly basis when you don't have visibility on a monthly basis that accounted for $3 million to $4 million of the cash flow.

Second element is the payable side, [previous] payables, including payroll accrued which you will see on the balance sheet. That accounted for, again, about $2 million to $3 million, shear timing of just the end of the quarter.

The third element is the tax credits, which we're expecting for really employment zone tax credits pertaining to years going back to 2005 to 2007, especially in California, when you ask for a refund it is - they go through a stronger review process. Then the following years we claim it against the taxes we paid and obviously, therefore, we didn't pay the tax. So that's, again, close to about $1.5 million. Those are the three main components for that cash flow being short of the expected amount.

Scott Schneeberger - Oppenheimer

I guess the follow-up question to that then is will you have - as they snap back in 2Q, will you be able to get back at or above the run rate? Obviously you've maintained the guidance. So do you think - but just a little bit of color on how you could take it forward and on things like DSO, get that improved.

Jonathan Mather

Yes, I think, again, DSO, we should get some of the cash in the quarter two, but the tax credit I will not until we see it because of California going through the review process. We'll get it sometime this year but I’m a little cautious in telling you we'll get it in quarter two.

Scott Schneeberger - Oppenheimer

Switching it up a bit - you didn't mention it and I think that's always a good thing but weather was pretty tough in February nationwide. Could you give us a feel for what type of impact you think it may have had in the quarter and how we should think about that going forward as what it may have impacted you buy?

Suri Suriyakumar

Scott, yes, that did and, again, we wanted to make sure that it doesn't come across like an excuse or anything like that. But in total we had four full days of closure in all of the east coast locations, so that did, what do you call, contribute to substantial amount of revenues, a noticeable amount of revenues given our revenues these days. I mean, during good times, if you had a typical first quarter, probably we would have sniffed at that number, but losing $3 million, $4 million would be substantial in terms of the numbers these days.

We don't have - I think we counted them as full working days [inaudible].

Scott Schneeberger - Oppenheimer

Suri, I think you just cut out on me.

Suri Suriyakumar

Sorry. We just counted them as full working [discard] is what the revenues is what we lost in all of our east coast locations.

Scott Schneeberger - Oppenheimer

Could one of you remind me how many days in each of the next three quarters?

Suri Suriyakumar

In each of the next three quarters, we can give you the exact numbers here. So in quarter two would be 64. Quarter three would be 64 and quarter four would be 62 and quarter one is 63, so total number of days would be 253. That's again 254 in 2009.

Scott Schneeberger - Oppenheimer

Just one last one if I could; how are things looking in non-AEC with regard to major contracts? I know everything is tough out there and we have a bit more to go on Boeing. This question pertains to Boeing but also just the opportunity and where you're hunting for new business and what you're seeing out on the non-AEC front.

Suri Suriyakumar

Non-AEC front across the board in terms of bringing in non-AEC business, especially we are focusing on the colors card, so that has given us a clear amount of activity on the non-AEC business. With regard to the FM and BS kind of business in non-AEC we don't have anything major to report like Boeing, but obviously we are looking at customers like that.

But in the FM and BS business our major focus obviously is related to AEC. But in the non-AEC business mostly color in local businesses such as businesses technology companies, schools, integration institutions, all the kind of areas out there looking for color and black and white business.

Operator

(Operator Instructions) Your next question comes from the line of Brad Safalow - PAA Research.

Brad Safalow - PAA Research

Just a quick question on the sequential revenue trend; historically I think you've seen a 3% to 8% sequential increase from first quarter to second quarter. I know you guys are talking about a bottoming out of revenue trend. Should we expect a normal seasonal trend over the course of this fiscal year?

Suri Suriyakumar

I would say not this year. This year is going to be challenging, 2010. Brad, this is something we always talk about because we lag the economy. Given the fact that although we are seeing positive trends out there in employment, in vacancy rates, to some extent in credit and so on and so forth, this is what we are talking about. General economy there is a tendency to pick up. But we will lag that generally eight to 12 months, nine to 12 months depending on how bad the recession was.

So from our perspective, from a reprographics perspective, we will be lagging that. For example, sequentially, from quarter-to-quarter I think we are up 0.4 but at least I am grateful that it's not a negative number. It's just that seasonally obviously we can't talk about it like growth but what we are watching now is from end of last year, month-to-month as to how our sequential revenue is performing and that is the one which gives us confidence that we are bottoming out.

Brad Safalow - PAA Research

Then I think you mentioned in the prior question that there is a $3 million to $4 million impact from weather. Can we extrapolate what you just said with the weather effect to say you will see some sequential increase just because of seasonal factors and the weather but otherwise you're on a similar revenue run rate on a month-to-month basis?

Suri Suriyakumar

Yes, exactly. Now actually, I mean, there is no question that if you do take that into consideration our first quarter should have been better. First quarters are usually much better than the last quarter but, of course, we didn't have the benefit of those days.

Brad Safalow - PAA Research

Just shifting gears - I probably should know this but what is the - does your credit agreement have a mandated free cash flow recapture for debt pay down?

Suri Suriyakumar

Jonathan?

Jonathan Mather

Not a mandated; we have a warranty we can pay down our cash as we wish.

Brad Safalow - PAA Research

Should we assume that you're going to use the lion's share of your free cash flow generation this year to repay debt?

Jonathan Mather

We'll assess that. We'll look at that very closely and I'll tell you a reason. This comes up at our board meetings. Suri and I talk about it. Yes, definitely something that if we have excess cash we will do but also you've got to take into consideration the fact that the fixed charge coverage ratio computation for the covenant, the excess cash is something that we can use if we get too close. As you know, that's the covenant that can get a little too close sometimes.

Brad Safalow - PAA Research

Then a totally separate topic, I think - I don't know if it was this past quarter or the quarter before that you made a significant hire of an executive, someone with a background in managed print services. Can you talk a little bit about what your approach is going to be to that segment of the marketplace and what your plans are, let's say, over the next couple of quarters in terms of investment there?

Suri Suriyakumar

Sure. What we're basically doing is putting together a team to go after managed print services aspect. As you know, Brad, we do have a fair amount of [advance] in the AEC industry and we provide services for customers inside their offices which is onsite services is what we call [SFM]s.

Now, if you take that and then add all of the office services, all of the small [format] copiers, fax machines, all of the other output devices, [inaudible] in printers, etcetera, and put it in one box, then that basically converts itself to the management services. So we plan to actually execute this in two levels.

One is obviously at the local levels because we have 44 locations and we have 244 divisions and 230 plus locations. So all of those locations, all of our customers, you would try to go after every FM customer and every other customer we have and try to incorporate the managed print services concept with our customers.

Then on the global solutions side where we go after national customers we'll try to incorporate the managed solutions concept to our national customers. So what we have done is we have acquired software to support those efforts to make sure we have the right processes so we can sell that concept to the customers. Of course, we need to have qualified staff who will be able to understand and sell the managed print services, all of which is what we are building right at this point in time.

Over the next two, three quarters we continue to attack that. Whether we'll have revenue benefit in this year is questionable, maybe last quarter or maybe early next year. But that certainly is an area we are investing in.

Brad Safalow - PAA Research

So you'll have both a go-to-market strategy for the AEC business, which is obviously your FM business, maybe get a more targeted approach nationally and then, just so I understand, you're going to have a very specific approach to non-AEC clients for management services, something you expect to generate revenues towards the end of this year, early next year.

Suri Suriyakumar

Yes, yes, and where we are most effective in those marketplaces, Brad, is when we have a customer who not only wants management services inside but that managed print services component includes outsource services because of the fact that we have locations underground in almost all of these major cities.

So in those areas we can compete better than anybody else because a perfect example is volume. We are in 18 locations but in almost all those 18 locations we take all the work which we don't have to do or we shouldn't be doing inside Boeing facilities to our facilities and then return that work to them, so in areas like that we are much more effective than any other provider.

Brad Safalow - PAA Research

Final question on this topic; will you integrate your fulfillment with your ishipdocs partners? Is that kind of a longer-term plan so that you can fulfill managed print services on a global basis?

Suri Suriyakumar

Absolutely, absolutely. With ishipdocs the idea is as we continue to refine the product, as we continue to add more muscle to the product, so we want to build more concept of moving documents pier-to-pier and include the technology in terms of our uploading speed, etcetera. When we do that we'll incorporate ishipdocs into virtually any and every service we provide. Why not?

I mean, that's a great tool for us to be ale to provide services to customers, especially during difficult times where you have difficulty in shipping physically. We'll be able to actually ship documents digitally and remotely and get them delivered at the location.

Operator

(Operator Instructions) Your next question comes from the line of Luke Junk - Baird.

Luke Junk - Baird

You mentioned that material price increases were a negative impact to gross margin during the quarter in addition to absorption and just the mix shift towards China. Could you maybe quantify that either sequentially or year-over-year relative to those other [drigs]?

Suri Suriyakumar

I'll let the second part of the question to Jonathan. I'm not sure he can quantify it but I'll pass it on to him. I pass on all the difficult questions to him. So with regard to the difference in material pricing, there are two elements here.

One is we had some price increases from our suppliers and given the market conditions, usually we would pass them on immediately to our customers with a little bit of time gap and, as a result, there was an impact on our material costs. That is what we referred to. So that is one.

Second thing is that equipment and supply sales in China are our largest component of the Chinese business when you compare it with the business in the United States. The business in China just because how it evolved over a period of time, more people buy it there and there's much less leasing and much less renting. Those concepts are new.

But they are becoming better. We are working on it. So as a result, what happens is whenever we incorporate the numbers from China it affects our percentages because of a different supplies segment is now a higher portion of our revenues.

Jonathan, would you like to add some color?

Jonathan Mather

Sure. The question you asked was regarding the price increase of the dollar value to our material cost. Again, we saw partial impact of the price increase in the latter part of the quarter, so we don't have an exact dollar amount but it is not significant impact in the quarter once gross margin.

However, depending on how much of that price increase that we can pass it on to our customers, it can have effect in the future quarters. Still the price increases offsetting takes into full effect. The other question was how much is the mix change?

The equipment supplies accounted for about 12% of our quarter one sales, very similar to quarter four 2009. Thereby, as you can see, the gross margin was reasonably close to quarter four. So again, $1 impact, if you go back to the quarter one of 2009 when equipment sales was 9.2% of our sales, and of course, revenue much higher, we had a 37% gross margin.

Luke Junk - Baird

Just drilling down on the negative impact that you saw from the price increases this quarter that you mentioned kind of impacting later in the quarter, given your expectations for the environment to remain challenging in 2010 would you expect to be able to push some of those price increases through to your customers, call it, in the second or third quarter or is that something that's just going to have to wait until the construction trends get a little better?

Suri Suriyakumar

No, not really. We would certainly push them to the customers. We've already started that effort and we will definitely get that done because even though the environment is tough we are determined to do that because it is something that we are to pass through. So we expect that to be passed to our customers very shortly here.

Operator

There are no further questions at this time.

David Stickney

[Dawn], I think we'll go ahead and end the call at this time. Ladies and gentlemen, thank you very much for you attention and continued interest in American Reprographics Company. Have a great evening.

Operator

This concludes today's conference call. You may now disconnect.

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