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American Reprographics Company (NYSE:ARC)

Q2 2011 Earnings Call

August 4, 2011 5:00 PM ET

Executives

David Stickney – President, Corporate Communications

Suri Suriyakumar – Chairman, President and CEO

John Toth – CFO

Analysts

David Manthey – Robert W. Baird

Andrew Steinerman – JPMorgan

Ryan Davis – Oppenheimer

Operator

Good afternoon. My name is Kristin, and I will be your conference operator today. At this time, I would like to welcome everyone to the ARC’s Second Quarter 2011 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. At this time, I would like to turn the call over to your host Mr. David Stickney, Vice President of Corporate Communications. Please go ahead, sir.

David Stickney

Thank you, Kristin. I’d like to welcome everyone to our call today. Joining me are Suri Suriyakumar, our Chairman, President and Chief Executive Officer and John Toth, our new Chief Financial Officer who joined us in mid-July.

The financial results of our second quarter 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 ARC’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. And a replay of the webcast will be available for 90 days on the company’s 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, August 4, 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. As we reported earlier today, the second quarter of 2011 delivered $109.6 million in revenue, a gross margin of 32.6% and $7.3 million in cash flow from operations. Adjusted earnings per share for the quarter came in at $0.00. Unfortunately, the first half of the year turned out to be disappointing, macroeconomic conditions caused by the recovery to stall and based on the current industry projections it appears that the rest of the year will remain challenged.

The good news, however, is that we continued our progress in restructuring the company which resulted in significant improvements in our operating results and advancements on our key initiatives. Here are the highlights. In the second quarter of our revenue increased by $3.1 million while our adjusted EBITDA went up by $3.4 million, clearly demonstrating that our efforts to eliminate costs are producing immediate results.

Our MPS FM revenue is up 13.1% year-over-year and these revenues make up more than 23% of our overall revenues now. Our color revenue grew 2.5% year-over-year. Our global solutions team continues to making rules into the top 50 AEC companies. In July, we opened our first location in Hong Kong.

In the first six months after launching plan will collaborate, we placed 100 seats a month on average, during the time we’ve added 907 projects, 335 project files, and expose the product to more than 10,000 construction team members.

And later this month we will be releasing version 2.0 of ishipdocs adding to our Cloud based printing and file sharing application. While these products have yet to make meaningful contribution to our revenues is clear that our products and services are increasingly integrated into our customers work flow.

None of these things could have been accomplished as we not being bold enough to restructure our organization, and investing some of our new initiatives, in fact our results would have been entirely different. The company we were would have been a company with an oversized infrastructure with weak sales, struggling to find a way to maintain its profitability and size.

The company, we are have sized itself appropriate to the demands of the market generates excellent margins, strong cash flow and its position for growth. The management team at ARC is as nimble now as it ever has been, while current market conditions remained difficult. We are stronger, faster and more decisive knowing well that is necessary for all well-being now and for our future.

During the past seven months, we are engaged in a significant and ongoing restructuring that optimizes our operational and management structure for changing market conditions. Including the continuing technology transition occurring in our industry.

The consolidation of our brand has given us excellent opportunities to eliminate redundancies in share markets and to pool resources across geographical boundaries in ways we never considered in the past. By rationalizing our footprint, we’ve been able to bring more efficiency and productivity to our production teams and streamline our middle management. Again something we had not done previously. The difficult market conditions also appear to be accelerating the use of technology in document management.

This gives us the opportunity to further address infrastructure and operations to not only save money, but also to position our digital solutions and the company for recovery. As you recall during the last earnings call, we were well on our way to annualized savings of $14 million, today I can tell you that we plan to achieve approximately $26 million in annualized savings for 2011 with $16 million to $17 million realizing this year, a truly remarkable accomplishment.

I would also point out, that one of the biggest challenges in restructuring a company under conditions like this is make sure that we don’t cut cost too aggressively and jeopardize our opportunity to grow when the recovery takes all.

That does become less of a concern in light of what we are experiencing in the marketplace, with our continuing use of and development of technology closer ties to our larger customers, greater adoption of MPS, more flexibility in outsource services and document distribution schemes, as well as our ability to compete and we know a large competitors in the MPS space. I have few reservations, when considering additional restructuring of our management team and operations to position the company for success. The market has changed. It has changed aggressively and ARC is changing with it.

Finally, it is important to note that our search of a new CFO was successful and culminated in the hiring of John Toth, who joined us just a few weeks ago. I’m happy to introduce same to you, now for a review of our quarterly numbers and then we will open the call to your questions, as usual. John.

John Toth

Thank you, Suri. I am very glad to be here and to be part of this team. And I am looking for to getting to know our investors and analysts in the months ahead. For now however, I will provide some of the details about our second quarter. Our customers mix had non-residential construction customers delivering 71.3% of our revenue. 5.6% of our revenue came from residential construction customers and our non-AEC customers provided 23.1% of our revenue.

In terms of product and service lines Reprographics services provided 64.3% of our overall revenue. As many of you know digital services are embedded in this service line, and delivered 8.9% of our overall revenue.

Facilities management, which includes Managed Print Services or MPS delivered 23.4% of our overall revenue, while equipment and supplies produced 12.3%. There were 64 working days for the second quarter of 2011 versus 64 working days in that first quarter. Likewise, there were 64 in quarter two of 2010.

On a regional basis, our year-over-year revenue performance continue to decline, as we might expect considering the weak demand in the market. Northern California was down 5%, the Pacific Northwest was down 5.8%. Our southern region was down 8.7%. The Midwest was down 2.2%, the Northeast was down 5.6% and Southern California was down 7.2%.

While the year-over-year comps remain challenging, once again we saw average daily sales increase sequentially in all but one region. Our Chinese operation produced a strong year-over-year comparison in the second quarter posting 14.7% revenue growth. I should also point out that the adjusted EBITDA increase Suri mentioned earlier represents an expansion of our adjusted EBITDA margin from 13.9% in the first quarter of this year to 16.7% in the second quarter of this year, a 280 basis points increase. It’s a metric that was difficult to achieve and one which we are very proud of. The ongoing restructuring of our business and continuing focus on cost reductions produced a gross margin of 32.6%, a healthy improvement over the first quarter’s gross margin of 31.3%.

Amortization of intangible assets for this second quarter increased $2.2 million when compared to the same period in 2010. As a reminder, this is caused by the revision of useful lives assigned to trade names we made during the fourth quarter of 2010. The period of accelerated amortization for these items will be complete in April of 2012.

Net interest was $7.7 million during the second quarter compared to $5.8 million in the same period in 2010. As you may recall, the increase of $1.9 million includes the effect of amortizing our former interest rate swap, and the incurrence of a higher effective interest rate due to the issuance of the high yield notes on December 1, 2010.

There are two other significant items on the P&L that are worthy of some explanation, the first is a goodwill impairment of $23.3 million, and second is a deferred tax asset valuation allowance of $64.3 million. The goodwill impairment is the result of an analysis, we believe was required primarily to the economic environment, and its effect on our performance and forecasted earnings, normally we conduct this analysis at the end of the September.

The results of the company’s analysis indicated that six U.S. based reporting units had a goodwill impairment, and we recorded a pre-tax non-cash charge to reduce the carrying value of goodwill by $23.3 million. The deferred tax asset valuation allowance was the result of previous impairments and other charges ARC has taken over the past three years that had a negative impact on our GAAP earnings. The result of the allowance is a reserve against $64.3 million in deferred tax assets on our balance sheet and a corresponding non-cash tax expenses you seen on our P&L. The $57.9 million you see on the P&L for the quarter includes certain tax benefits we were able to record prior to the allowance.

You can find the reconciliation for these numbers on the tables in today’s earnings release. It is important to note that the deferred tax asset valuation allowance is a reserve and that’s the deferred tax assets themselves remain available to us for use in the future.

Moving on to the balance sheet, we ended the second quarter of 2011 with a cash balance of $21.9 million. Day Sales Outstanding or DSO were 50 days in the second quarter of 2011 down from 51 days in the previous quarter. Total debt including capital leases at the end of the second quarter 2011 was $245.7 million down from $247.8 million in the first quarter of 2011 and the ratio of debt to trailing 12 months of adjusted EBITDA at the end of the second quarter was $3.7 million. Cash flow from operations in the second quarter was $7.3 million.

And I think that covers the basics, so at this point, I will turn it back to Suri.

Suri Suriyakumar

Thanks, John. Operator, at this time we are available to take our caller’s question.

Question-and-Answer Session

Operator

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

David Manthey – Robert W. Baird

Hi, guys good evening.

John Toth

Hi, good evening.

David Manthey – Robert W. Baird

First half, I think you give us a percentage of AEC versus non-AEC, I don’t forgive me if it’s in the release, but could you give us the year-to-year change in each of those categories, and then just anything anecdotal around what you are hearing and sort of the tone of business in each of those categories as well?

Suri Suriyakumar

So the non-AEC is at – AEC non-residential revenue is 71.3 million, am I right John? And AEC residential part of it is 5.6 and the non-AEC is 23.1. Okay, and a year-over-year second quarter 2010 our non-residential AEC was 69.7%, which is now at 71.3%, and residential AEC that is residential portion of it was 5.8, it is at 5.6 now. And the non-AEC which is at 24.6, you said 23.1 now that’s a mix.

David Manthey – Robert W. Baird

Okay, thanks that will help us get there. In terms of the costs that you have cut out, are there any cost related to the restructuring in the second quarter, even if you are not calling them out are there some cost that theoretically if things stabilized might come out of the P&L. And as you can – can you describe some of these costs today in terms of closing locations or eliminating positions or equipment or what are you getting these the $26 million run rate of costs from?

Suri Suriyakumar

Okay. So fundamentally, it is whatever we have there David is largely related to some severance, related to closing branches and so on that we have not taken any hits on that but I’ll let John to give you a little bit color on that, John.

John Toth

Yeah, for Q2 it’s again as Suri said is primarily severance related and so we’ll go away and we have no restructuring charges in Q2.

Suri Suriyakumar

Is that clear David, anything else on that?

David Manthey – Robert W. Baird

I’m good. Thank you very much.

Suri Suriyakumar

Well, you’re welcome.

Operator

Your next question is from Andrew Steinerman with JPMorgan.

Andrew Steinerman – JPMorgan

Hi, could you tell me about the profitability of digital services and I know it’s only 9% of revenues now but as – as it scales what do you think the profit margins couldn’t should be?

Suri Suriyakumar

Okay. So you know if you take basically the digital services, at its early stages Andrew. But I think as we continue to enhance that business as revenues pick up, I think our gross margins will be continue to increase much, much more than our traditional gross margin. So right now, the digital services – do you have either number George on gross margins – in the 60s? Yeah, so it would be in the range of 60s, Andrew. So I would image as we continue sell more seat licenses and sell more ishipdocs. It could actually grow not the 60s into the 70s and further up.

Andrew Steinerman – JPMorgan

And how about profitability at the EBIT line, is it profitable right now given the gross margins?

Suri Suriyakumar

Well absolutely, right now it’s profitable because again most of our digital services are built over a period of time. We started investing in it very, very early. So most of this expenses – you know most of them are expensed out but at the profitability level it certainly profitable.

John Toth

Majority of that 60% would go down at the bottom line

Suri Suriyakumar

So what George is adding is...

Andrew Steinerman – JPMorgan

It’s already highly profitable.

Suri Suriyakumar

Yes. Because we – what we have done is and you know that from a historical perspective, we started developing all our plant – the platforms and so on in 2000, early part of this decade and over a period of time we would actually use those tools largely to support our branches and improve our operations. And now what we are doing is we are starting to actually expand on those products, which we continue to invest on the digital technologies but the expenses themselves are not so great.

Andrew Steinerman – JPMorgan

Great. And then there is not a sales force behind digital services, I mean I don’t understand why the profitability drops so quickly from gross margin to EBIT for digital services?

Suri Suriyakumar

And so typically what happens is on the digital services side, our existing sales force actually sells most of the digital services because it is added on to as part of Reprographics but we do have some sales people for our new products like ishipdocs. We have sales people looking there.

Andrew Steinerman – JPMorgan

Okay. All right, much appreciate it. Thank you and welcome John.

John Toth

Thank you.

Operator

(Operator Instructions). And your next question is from the line of Scott Schneeberger with Oppenheimer.

Ryan Davis – Oppenheimer

Hey, all. This is Ryan Davis showing in for Scott. I just got a quick question here on the cash flow, operating cash flow and EPS guidance you gave us. What type of revenue and margin expectations are kind of embedded in that?

Suri Suriyakumar

Ryan, obviously, we don’t give revenue guidance and the whole reason for not giving the revenue guidance is because of the volatility which revolts around the marketplace today and it’s even more pronounced during this time. So our guidance is largely built on the fact that EPS guidance that we can continue to adjust cost and restructure. So unfortunately, I won’t be able to give you a specific guidance on the revenue numbers, but yeah, all over the place as you can see.

Ryan Davis – Oppenheimer

Right, got enough, thank you guys, thank you. Okay I guess another question more qualitative you know kind of one of the people in the store front – your people in the store front on the street saying I mean is ABI right, can you get – kind of get some color there?

Suri Suriyakumar

You are referring to the Architectural Billing Index, ABI?

Ryan Davis – Oppenheimer

Yeah, I mean, where is everyone – what’s your – the end markets, the customers saying kind of to your people in the storefront, are you kind of hearing much in them?

Suri Suriyakumar

Well, I mean you know certainly in the early part of the year, Ryan, we were certainly expecting a certain amount of recovery to happen and it was actually on its way, we thought based on coming into this year. It suddenly seem like the curves are starting to turn, and it right now what was happened is it just caught stalled.

So what we are hearing from the branches is people are kind of putting things on hold temporarily, until such time things become better, and that typically happens in a downturn like this, when the markets get a little tricky or face some sense of discomfort in the market, people tend to put things on hold. That is what we are experiencing right now. So the projects which we thought will get off the ground by mid-year is kind of – is still delayed, that is a kind of sense we are getting.

Ryan Davis – Oppenheimer

Okay, okay, all right, well again I think that’s all I got for you guys. Thanks very much.

Suri Suriyakumar

All right. Thanks Ryan.

Operator

(Operator Instructions). And I’m showing there are no further questions. Mr. Stickney, do you have any closing remarks?

David Stickney

Thank you very much Kristin, and thanks everyone for your attention in this evening. We appreciate your continued interest in ARC and we look forward to talking with your soon. Have a great night. Bye-bye.

Operator

Thank you this does conclude today’s conference call you may now disconnect.

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