ARC Document Solutions (NYSE:ARC) is barely followed on the Street, but this small cap document services company has undergone some pretty compelling changes even as its traditional core market (reprographic services for architecture/engineering/construction) has seen severe stress over the last six or seven years. With the company still generating around three-quarters of its revenue from that AEC end market and non-residential construction picking up, there could be good revenue and margin growth potential for a company that has already shown a good knack for maintaining FCF through tough times.
Changes For The Better
ARC Document's core (traditional) reprographics business still has not recovered, as revenue fell more than 2% in the fourth quarter of 2013. To add some scale to the discussion, consider that traditional reprographics revenue has fallen from $225 million for the full year 2009 to $117 million for 2013 (a fall of 48%), as overall sales have fallen about 20%. Gross profits have fallen 25% and operating income is still down about 40% over the stretch (after adjusting for impairments and other charges), but I would argue that many companies have done much worse under similar circumstances.
ARC Documents has responded to challenges in its core market in a variety of ways. Growing the onsite services business has been a significant part of that, as revenue has grown about 25% since 2009 and grew 12% year-over-year in 2013. This is a higher-margin business than its traditional reprographics services, and it tends to be stickier as well as it offers meaningful convenience and cost containment options.
ARC Documents is also using that as a platform for addition services. The company has been expanding its managed print services operations (or MPS), and using its foothold in the AEC industry as a strong starting point.
MPS is pretty simple on the face of it. Companies like Xerox (NYSE:XRX) and Hewlett-Packard (NYSE:HPQ) basically come in and manage a company's printing and document needs, saving them about 10% to 30% a year on their printing and document costs (which are typically about 1% to 3% of revenue). At the midpoints, 20% of 2% isn't much, but think about what an extra half-point of operating margin can mean to companies desperate to show the Street that they can streamline and reduce costs.
Although this does not appear to be a particularly high-margin business on its own, I suspect the incremental margins are quite a bit more attractive when ARC Documents moves from facilities management at existing AEC clients to include MPS - they're already "in the building" so to speak.
Can Service Growth Outside Of Reprographics Move The Needle?
ARC Documents definitely positions itself as more of a universal document services company. The company's digital services include functions like archiving and organizing documents and "digital shipping" where companies can use ARC Documents' various service centers to avoid shipping physical documents over long distances. It sounds simple, but it's not something that a lot of companies want to do for themselves (think about a smaller company tasking someone with scanning and archiving drawers full of old documents and files).
Color printing services are also a meaningful (20%) component of revenue. It's my understanding that this is one of the operations with a larger non-AEC customer mix, and that offers some diversification. There is always going to be a need for high-quality color printing, particularly when it involves specialized formats that go beyond your basic 8.5 x 11 spiral-bound presentation material.
I don't see these services being a major growth opportunity (Xerox's document outsourcing business has grown 4% and 2% over the past two years), but they strike me as credible incremental opportunities. By and large ARC Documents already has the capability to offer these services in place at its service centers, so as long as the incremental business is profitable, why not go for it?
Can A Construction Recovery Fuel Better Growth?
ARC Documents' core AEC market has certainly undergone changes over the last decade, with many clients increasingly moving from hard copies to digital copies. Just as there is yet no such thing as a truly paperless office, this migration is not 100% for the company's customer base and there is still an opportunity to stay involved with digital document management and so on.
I expect a recovery in non-residential construction to spur demand for the company's reprographic services, as well as its digital services and MPS. I'm looking for double-digit revenue growth over the next five years (albeit just barely), with long-term growth still in the mid-to-high single digits. I'm also looking for a meaningful improvement in free cash flow margins, though I have my concerns as to whether the changes in the reprographics market and the shift to MPS and digital services will allow a return to mid-to-high teens FCF margins. As it is, though, I'm looking for low teens free cash flow growth as the company rebounds.
The Bottom Line
Those basic assumptions still support over a dollar of additional upside to today's share price, and if the non-residential recovery really does bring back the good old days (including double-digit FCF margins), then a low-to-mid teens share price seems possible. These shares have already tripled from their late 2012 and early 2013 lows and while it is sometimes hard to buy a stock that has already had such a big run (and I'm certainly not expecting another short-term triple from here), there seems to be enough upside to make a closer look worthwhile.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.