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American Reprographics Company (NYSE:ARC)

Q1 2011 Earnings Call

May 3, 2011 5:00 PM ET

Executives

David Stickney – IR

Suri Suriyakumar – Chairman, President and CEO

Jonathan Mather – CFO

Jorge Avalos – VP - Finance, Chief Accounting Officer

Analysts

David Manthey – Robert W. Baird

Scott Schneeberger – Oppenheimer

Andrew Steinerman – JP Morgan

Operator

Good afternoon. My name is David and I will be your conference operator today. At this time, I would like to welcome everyone to the ARC 2011 first 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 would now like to turn the call over to Mr. David Stickney. Sir, you may begin your conference.

David Stickney

Thank you operator. 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 financial results of our first quarter were published 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 www.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 seven days after the call. You can find the dial in number for this replay in today’s press release. As usual, 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 3, 2011 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. As noted in our earnings release, at the end of the first quarter of 2011, we delivered revenue of $106.5 million, a gross margin of 31.3% and $4.6 million in cash flow from operations. Operating cash flow was temporarily affected by the timing of collections around weaker months of the year.

We are re-affirming our annual forecast today. We expect annual EPS to be in the range of $0.01 to $0.15 and cash flow from operations to be in the range of $40 million to $60 million.

While the first quarter results were in line with our expectations, sales in March show that project related repographics activity in non-residential construction is at its lowest point ever and it will likely continue to remain challenged for the balance of the year.

As was reported in February, construction spending was at its lowest level since July 2000. Given those statistics, it is not surprising that our project related revenues are low and will likely remain that way for several quarters.

However, what is exciting is the significant progress we are making in the meantime on our management services, global solutions and color businesses. Revenue growth in these areas significantly offset the decline in our traditional revenue.

From our perspective, the revenue stream generated by MPS is pretty clearly encouraging. This is brand new business in the design and engineering segments of the construction industry, and interest is growing. It has been strongly fueled by major consolidation in the industry, which in turn, has been driven by the downturn in the economy.

We have a unique position in the management services market, especially in the construction space. Our distinct advantage is driven by our technology, but as we all know, the impact of digital document management and the desires of our customers to go green, will lower our print volumes over a period of time.

However, what is noteworthy is that both global solutions and our MPS initiatives have allowed us to expand our market share in the industry. Today, we already work with 15 of the top 50 construction companies in the United States. As the markets return to normal and these customers engage in more project related work, the growth in our market share will keep our traditional document management services healthy and robust.

Our ability to provide total document solutions to large AEC customers is unmatched. Combining the services such as MPS, onsite and offsite product related document management, project collaboration, technology and consulting, distributing print services, what is becoming known commonly as Cloud printing, meaningfully separates us from a coupon manufacturer and other repographers. It gives us tremendous fire power in the marketplace to secure large comprehensive contracts.

All this simply means change. While our customers remain the same, how we deal with information is evolving quickly. This means we have to restructure our company to meet these needs.

In our announcement in April, we mentioned actions we are taking to restructure the company to address the changing business environment. We are also continuing to restructure our staff and branch network related to our traditional revenue streams, some of which is related to the duplicate production facilities that came to us from our aggressive acquisition program in the past.

These activities are also being influenced by the fact that we have begun operating under a single, unified brand and are consolidating our presence in major metropolitan areas around the country.

As our customers look to consolidate their document solution needs under a single technology enabled provider, we want to be responsive to their needs by making the necessary changes in our organization. Our branches should be smaller with higher capacity equipment and they should be more strategically located in major metropolitan areas.

Our production staff needs to be more unified and streamlined management team. Our technology services need to be more widely deployed and more consistently applied. As such, we’ll be rationalizing our footprint, especially where we have remaining redundancy of all our served markets, and we will also reduce our head count at the local management level.

In addition, the same kinds of consolidation will take place in our corporate offices, bringing the talent in our finance function under the same roof as our operations team to facilitate better communication and greater responsiveness to our customers and business needs.

These changes will take place over the next few quarters to (inaudible) the market, when it returns to normal while making sizeable cuts in our operating costs. In fact, by the time we have completed the program of action, we expect our efforts in restructuring ARC to result in $14 million of annualized savings.

Finally, it is important to note that our search for a new CFO is proceeding apace. In the meantime, Jonathan is continuing his excellent work and contributing his experience and energy to the success for planning and execution of our transition into a single corporate headquarters.

With that said, I’ll now turn over the call to him for some more insight with our financial position in the first quarter. Jonathan.

Jonathan Mather

Thank you Suri. As Suri mentioned, the most significant revenue trends in the first quarter of 2011 was the decline of large format black and white printing and the increase in global services revenue, FM revenue of which MPS is included and color.

In quarter one, our customer mix stayed relatively fixed. Nonresidential construction delivered 71.7% of our revenue. 5.6% of our revenue came from residential construction and 22.7% came from non AEC customers.

65.7% of our revenue was generated by reprographics services, of which 8.9% was derived from digital services. Project management, which includes MPS, delivered 22.7% of our revenue while equipment and supplies supplied 11.5%.

There were 64 working days for the first quarter of 2011 versus 62 days in the fourth quarter of 2010 and 63 days in quarter one of last year.

On a regional basis, our year over year revenue performance declined but at a much slower pace. The pace of decline in southern California arguably our hardest hit region, improved considerably, down just .6%. Northern California was down 6.95%. The Pacific Northwest was down .5%. Our southern region was down 9.5%. The Midwest was down 3.1% and the Northeast was down 8.4%.

That said, we saw average daily sales for the quarter increase sequentially quarter over quarter in all but our southern region and northern region. Our Chinese operation saw a return to its seasonality with quarter one being weak due primarily to the many holidays.

While we continue to absorb labor and overhead in light of the lower revenues, our gross margin of 31.3% was not affected as much by the contribution of lower margin equipment and supply sales.

Amortization of intangibles increased by $2.1 million for the quarter ended March 31, 2011 compared to the same period in 2010. This increase is due to the revised useful lives assigned to trade names during the fourth quarter of 2010.

Net interest expense was $8.2 million during the quarter compared to $5.9 million in the same period in 2010. The increase of $2.3 million includes the effects of amortizing the interest rate swap. We also incurred a higher effective interest rate due to the issuance of the high yield notes on December 1, 2010.

In reviewing the balance sheet, we ended the first quarter of 2011 with a cash balance of $22.7 million. Day sales outstanding or DSO were 51 days in the first quarter of 2011 as compared to 47 days in quarter one of 2010 and 45 days in quarter four of 2010. Some of our early work on consolidation of branches in certain markets had a temporary effect on collections.

Total debt including capital leases at the end of the first quarter 2011 was $247.8 million, up from $239.6 million in the fourth quarter of 2010 primarily to a draw on our revolver to pay off the interest rate swap contract.

The ratio of debt to trailing 12 month adjusted EBITDA at the end of the first quarter was 3.6. Cash flow from operations in the first quarter was $4.6 million. Operating cash flows were temporarily affected by the timing of ARC collections.

That covers the fundamentals for the moment, so at this point, I’ll turn the call back to our CEO, Suri.

Suri Suriyakumar

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

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from the line of David Manthey of Robert W. Baird.

David Manthey – Robert W. Baird

Hi guys, good afternoon.

Suri Suriyakumar

Good afternoon.

David Manthey – Robert W. Baird

First question, you mentioned the March trends and how that is impacting your view for the year. Any comment on how April shaped up?

Suri Suriyakumar

Hard to say. April I think, we are still wrapping up the numbers so we don’t actually have the exact numbers in April in hand, but the trend hasn’t changed substantially. In other words, the project related revenues are still challenged so that’s not surprising. But the early activity in the construction industry is pretty significant and what is generating active revenue or growth for us is the MPS color and the global solutions segment.

David Manthey – Robert W. Baird

Okay, thank you. And when we look at the cost cutting, the $14million of run rate benefit you expect to see there, when do you hope to achieve that full run rate this year and if you could talk about the split between cost of sales and SG&A, where that would most be concentrated, if you could give us percentages where you think it will fall out.

Suri Suriyakumar

Okay. So $14 million is actually annualized savings. I’ll let – Jonathan, will you break that down?

Jonathan Mather

Sure. So of the $14 million, we believe particular to your question, we will get that $14 million run rate by the fourth quarter, but in this year, we expect to achieve about $10 million to $11 million, which has been included in our – it’s within the guidance range or EPS that we have shared with you.

You other, basically to the question about $10 million to $11 million we should expect definitely realized based on the reductions we have identified and kicked off to make it happen this year. Now during the year, as we go through the year, we see other opportunities, our CO (inaudible) we may see additional costs.

David Manthey – Robert W. Baird

Okay thanks. And could you give us a breakdown of where you think those costs will come out percentage wise between cost of sales and SG&A?

Jonathan Mather

The OpEx costs are 70% that we expect from the cost of goods sold and 30% in the SG&A. And that 70% being made up of 50% in direct labor and 20% being indirect overhead.

David Manthey – Robert W. Baird

Okay. All right. And then final question, as we’re looking at SG&A in the first quarter were there any sort of unusual costs that went in related to these cost reductions because SG&A by my calculations were up about $700,000 year over year and about $2 million relative to the fourth quarter which seems unusual given the volume trends. Was there anything in there that would be non-recurring?

Jonathan Mather

In the quarter over quarter, in fourth quarter last year as we said I believe in the last call, we had a program that required the employees to take their vacation that have been built up so we required them to utilize their vacation, take time off during the slow period. That made up a larger part of it.

And in quarter one compared to quarter four, another factor is you have all the FICA taxes coming into play in quarter one. Now as to the $700,000 that you referred to year over year, there was really nothing I recollect being abnormal for the cost to be higher. That could have been, and I don’t have the answer to that one in particular. When you put up the queue, we will get that. It’s likely something like a bad debt reserve or something that affect could have been.

I’m asking our CAO Jorge if you know of quarter one, which is quarter one prior year $700,000?

Jorge Avalos

I think basically the two items you mentioned.

Jonathan Mather

Right. So in terms of any charges for the restructure we did, that’s certainly not included in the first quarter numbers.

David Manthey – Robert W. Baird

Got it. Thank you.

Jonathan Mather

You’re welcome.

Operator

And your next question comes from the line of Scott Schneeberger of Oppenheimer.

Scott Schneeberger – Oppenheimer

Thanks. I’ll pick up on seasonality questions. Jonathan you mentioned because this is a seasonally quieter quarter, first quarter in China on holidays, less of an impact on margin mix, gross margin mix in particular. Could you give us a feel for how you think that will shift 1Q to 2Q gross margin line, specifically the China and supply sales in general.

Jonathan Mather

Jorge is answering.

Jorge Avalos

Again, what we will see is if revenue is better than – we don’t provide quarterly revenue guidance, but basically if we see revenue as we should expect better than quarter one, that will be the leveraging of expenses so we should see a slight improvement in gross margin in quarter two.

But other than that, we don’t see significant shift because quarter two in China is not the same as quarter four in China. So quarter four is actually the best quarter because that’s the highest quarter every year, most amount of sales with regard to equipment and supplies.

And then quarter one goes very quiet because of the holidays etc. and then quarter two becomes normal. So it’s the highest quarter is actually fourth quarter and the lowest quarter is the first quarter so that’s where you see such a big difference, but in quarter two we should get back to normal.

Scott Schneeberger – Oppenheimer

Right, thanks. And then on a bigger picture, obviously Suri you mentioned with the pre-announcement that March was softer than hoped. That’s a big quarter for you. You mentioned earlier that you haven’t yet seen the pickup in April. This question here is, you’ve kind of said well we’re going to assume within our guidance that we don’t see it this year. I guess there’s still hope that you may, but that’s certainly not in the guidance. Could you I guess possibly tying in AVI something that comes up every few quarters on this call where, how you think you correlate timing wise with the AVI which has now seen I think five months of plus 50 and when you would hope to expect to see something on the broader construction front. Thanks.

Suri Suriyakumar

Sure. So I can give you a little more color on what I said. So when we talked about it last quarter, we always see March as a better month because it is the strongest month in the year and often an indication as to how the rest of the year is going to proceed in terms of product activity.

So what we have reported in the pre-announcement is that March didn’t seem to have a lot of product related activity. In fact, revenues related to product actually continued to stay down. And that’s kind of not surprising. It is in line with all the statistics we know. In fact, census bureau commentary was that in December construction dollars was lowest ever in ten years. So it’s all in line with what we expected Scott, so no surprises there.

All I was saying was April hasn’t changed a lot. The same trend is continuing. But the positive part is, if you look at our SM’s, activity is up, which means early stage work design development, all the checkpoints activity is up, which basically indicates the pipeline is filling up. Work is coming along. It’s just that nobody had broken down and poured concrete or wanting to big, big time.

So there are two elements which is working to our favor. One obviously is the management services where we are gaining market share, color, and global solutions with our large national accounts, which we have a distinct advantage over most people. So that part is doing very well. In fact, it’s offsetting some of the negative impact of the fact that product related revenues are down.

What is positive is just so that you know, all of these activities, which is happening in our customer’s offices, including that little activities that you see on the ABI positive side, will translate to project related work in later part of the year. We just don’t know the volumes of the projects, what sizes are they, how they will come, but the activity is definitely there.

So later part of the year, early part of next year we’ll see that project related activity kick up nicely and what we are encouraged about is the fact that because we have already gained market share, and we already have revenues which is making up for the shortfall, when this project related activity kicks in it’s going to be healthy.

Scott Schneeberger – Oppenheimer

Thanks Suri. One final one. I think I heard earlier Jonathan mentioned if more costs need to be rationalized you guys have the capability to do that, certainly streamlining the footprint as necessary right now. Some of the things you mentioned were getting more centralized, solving redundancies. Continuing to have to play defense also obviously, but is there going – will we see new branches as well where some come off and some come on or right now is it much more of a defensive mode until you see something more on the top line?

Suri Suriyakumar

So actually that’s an interesting question. I’m glad you asked it Scott. Now previously, I’d been saying because the business is challenging, we’ll do what it takes. If the market continues to stay down and if we are continually challenged from a revenue perspective, we know how to cut costs. We can actually cut branches. We want to make sure we are not all doing that to position the business. That’s exactly what I said all of last year with regard to cost cutting exercises.

What we are doing now, why this question is interesting, what we are doing now is not really – I wouldn’t classify it as a defensive action. It’s more positioning the company for growth. What we are starting to sense Scott, especially in the last two, three quarters is how the business is changing.

A greater mix of MPS related revenues are starting to kick in. Our global solutions customers are acquiring different services. It’s often wrapped around and bundled with technology such as collaboration software or planned rail or management services, Cloud printing. Different customers have different flavors, but more and more we are seeing our business change and in that environment, in light of the fact in the meantime our product related revenues are down, we are restructuring the company.

This is not a restructure in the traditional sense where we are completely changing the configuration of the company in order to save cost and make the company viable. No. I mean it’s completely different. Our business itself is transitioning and changing. Our customers are expecting slightly different things.

And what we are finding is all those hundreds of branches we had in some places all lapping each other because of the fact that we acquired so many companies, are not necessarily going to be functioning the same way as it has happened in the last decade.

So we are changing that and you know like I mentioned, this branding of becoming a unified brand, ARC, we’re actually making all those changes. For example, I’ll give you a quick example in San Francisco. If you have previously five or six locations, we are now streamlining those locations and creating two strong locations. They might be smaller, but we’ll have greater capacity, greater amount of technology.

So this what we are doing increasing. That’s what Jonathan said. We will continue to do that because that is what we should be doing because as the business changes, we meet those requirements of our customers in a way that it makes meaningful sense.

Scott Schneeberger – Oppenheimer

All right. Thanks for all the color and taking my questions.

Suri Suriyakumar

All right. Thank you.

Operator

Your next question comes from the line of Andrew Steinerman of JP Morgan.

Andrew Steinerman – JP Morgan

Hi Suri. When you look at some of the faster growing new service lines do you think that they have the same operating margin potential as your base business?

Suri Suriyakumar

Yes. The only exception to that Andrew is the color business because that’s actually pretty competitive out there. However, having said that, we’re not going after the larger color market. The color business is a pretty large business, in excess of $50 billion if you throw in the signage business and offset business.

What we are going after and who is largely large format work related to graphics marketplace and then marketing materials, point of purchase, that kind of stuff. So they’re not as challenged and yet it’s still a competitive market.

But other segments such as management services and global solutions we are like I said in my script, we are unmatched in that area. We are unique so we certainly believe our margins will be as good and in some instances where we are using technology, would be slightly better.

Andrew Steinerman – JP Morgan

Right. And did you just say tech services margins will be better than your base business?

Suri Suriyakumar

Oh yeah. Obviously on the technology side, the gross margins are going to be much better.

Andrew Steinerman – JP Morgan

No, I mean operating margins including all the investments you need to make to keep competitive in that area.

Suri Suriyakumar

Yes, because Andrew, what happened is in our business as you know our business a little bit more, we have made these investments and expensed all these things over ten years so we have already put in $100 million. And most of those investments we did in order to make our branches more efficient.

What we are doing now is we’re using the same technology to make the customers more efficient. So while it has not kicked out large dollars, the revenues we generate are very attractive because there is very little cost to it.

Andrew Steinerman – JP Morgan

That makes total sense. Thank you.

Suri Suriyakumar

You’re welcome.

Operator

(Operator Instructions)

David Stickney

Operator, we’d like to make one clarification on the first question that was asked by Dave Manthey at R.W. Baird. Jonathan, would you like to ...

Jonathan Mather

Yes. Dave you asked a question about comparing the SG&A expense quarter one 2010 to quarter one 2011 why the increase of $700,000. That was mainly coming from as you may recollect, we invested in the sales organization as we got into color and into global solutions. We hired sales teams, strong sales team as you may recollect, in the second quarter, third quarter of last year and those expenses are in 2011 and not in 2010 quarter one.

So the main increase $700,000 that you referred to earlier is coming from the selling organization of the company in these new initiatives in particular.

David Stickney

Operator that concludes our comments at this point. Are there any other questions?

Operator

I’m showing no other questions in queue at this time.

David Stickney

All right. Ladies and gentlemen thank you very much for your attention this evening and your continued interest in ARC. Have a great evening. We’ll talk with you soon. Bye, bye.

Operator

Ladies and gentlemen, this does conclude today’s conference. Thank you for your participation. You may now disconnect.

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