While ARC Document Solutions (NYSE:NYSE:ARC) has reported three straight years of higher free cash flow, the underlying performance trends in the business haven't been as encouraging. It doesn't seem to be leveraging a better commercial construction environment, and it looks as though the company is likely to struggle to make a real dent in the managed print services opportunity. While archiving has been growing for ARC, I believe the company is going to have a hard time making real competitive inroads into this market.
It's tempting to say that the worst is over. The shares have bounced off their low, the short interest is pretty small, commercial construction activity looks okay, and the shares seem to trade at low multiples to book, EBITDA, and revenue. That said, I'm concerned that the company is going to continue to struggle to find real traction with its projected growth drivers, and I don't see enough evidence yet to be very positive on this name as a dumpster-diving candidate.
Better Construction Activity Isn't Carrying Over
While ARC Document has been trying to diversify away from its traditional architecture, engineering, and construction reprographics markets, this business still generates around half of the company's revenue on a quarter-to-quarter basis. Although 2015 was a generally solid year for commercial construction, ARC Document's results don't seem to have kept pace.
The company's CDIM segment (which houses the legacy reprographics business) saw a 1% decline in the fourth quarter and less than 1% growth for the full year. That was despite a strong construction backlog (as reported by the Associated Builders and Contractors), with an eight-month backlog in commercial/institutional projects. Construction spending was likewise solid throughout the year, and commercial/institutional architectural billings (as reported by the AIA) were healthy throughout the year.
Looking at the results, management noted that what growth there was in CDIM largely came from outside the reprographics business (specialized color printing services), as technology adoption continues to replace traditional reprographics. While management has been signing up customers for the company's SKYSITE cloud/mobile document service (400 paid subs for the fourth quarter versus 150 in the third quarter), I don't see the service as achieving much more than replacing what is being lost in traditional repro services.
Managed Print Doesn't Look Particularly Fit
Managed print services was, and is, supposed to be the next real growth engine for ARC Document. The idea here is that enterprises typically spend around 1-3% of their revenue on a variety of printing expenses, but many of these costs are avoidable, or at least reducible. Through careful analysis and monitoring of usage, greater adoption of paperless alternatives, and more careful spending on equipment and supplies, managed print services can reduce those costs by up to a third. Given how many companies are willing to go to almost any lengths to boost margin, reclaiming 1% of revenue is worthwhile to many managers.
The problem comes from monetizing the opportunity and gaining share. Terrier Investing has covered some of this in detail already, but ARC Document seems to be struggling to gain traction, and it's not entirely clear to me that this is an especially attractive market to target as a growth driver.
While MPS service providers can be paid in different ways, the two most common approaches seem to be per-page (with a monthly minimum) or a share of savings generated. Either way, there's an inherent problem - after the customer achieves that initial savings, the revenue prospects for the business aren't that attractive, as the business is either producing fewer pages or generating a smaller chunk of savings.
This introduces another issue I have with ARC Document in this business. Large rivals and leading players in the MPS space, like Xerox (NYSE:XRX), Lexmark International (NYSE:LXK), HP Inc. (NYSE:HPQ), and Ricoh (OTCPK:RICOY), can offer a host of services that clients value, including security, process optimization, process outsourcing, and analytics. What's more, companies like Xerox, Lexmark, and HP have developed more specialized service offerings for industries like legal, financial services, and healthcare, whereas ARC Document doesn't have much specialization outside of its traditional architectural/engineering target market.
Relative to Xerox, HP, Ricoh, and Lexmark, ARC Document comes up short here - so much so, in fact, that IDC, Quocirca, and InfoTrends don't even list the company on their market landscape graphs, and Gartner has the company in the middle of the lower-left square - the one place on the Gartner Magic Quadrant graph you don't want to be. Say what you will about the Gartner Magic Quadrant methodology, it may be flawed and overrated, but a lot of companies pay attention to it when they're evaluating providers. What's more, the fact that ARC Document doesn't merit so much as a mention in the other analyses can't be regarded as a very promising start. While the company does have the advantage of being "platform-neutral", as it has no printers, copiers, or supplies of its own to push, that doesn't seem to be a particularly compelling advantage relative to its more limited value-added service offerings.
As Terrier Investing also noted, there are valid reasons to worry about the real growth potential of this market. A CompTIA study suggested that the market was already more than one-third penetrated, with large enterprises already more than 50% penetrated. Given that almost no market ever achieves 100% penetration, that would suggest a fair bit of the low-hanging fruit has been picked.
With that, I'd note that ARC Document reported a 2% revenue decline in fourth-quarter MPS revenue, while Xerox reported 3% growth in its overall Document Outsourcing business (which includes more than MPS), and Lexmark reported a 4% decline to $233 million (more than six times the size of ARC Document). As the smaller player, ARC should be able to find growth where Lexmark and others cannot, and it seems difficult to support management's prior projections that MPS could be a high-single digit (or better) grower on a long-term basis.
Archiving May Have A Similar Problem
Unlike the document management (or CDIM) and MPS segments, ARC's archiving and info management (or AIM) business did grow in 2015 - up 22% in the fourth quarter and full year. There is no doubt that many companies in a wide range of industries need archiving services and the ability to quickly retrieve those documents electronically. The problem is that I see no particular defensible specialty here. Iron Mountain (NYSE:IRM) offers automated archiving and cloud/digital retrieval, and HP offers some of these services as well. With no obvious edge in service offerings, how does ARC make a dent here unless it is willing to accept lower margins (competing on price)?
The Bottom Line
A year ago, I was more bullish on ARC Document's prospects for offsetting the limited growth potential of traditional reprographic services with other offerings like MPS and archiving. Since then, it has become more clear to me that not only is the MPS market not likely to be a great opportunity for growth on the whole, but that ARC Document is really facing an uphill climb against the likes of Xerox, HP, et al. I expect the same to prove true in archiving, with revenue growth likely to slow in the not-so-distant future. In short, ARC didn't deliver the performance I expected over the last twelve months, and I don't see a particularly compelling argument for how or why that will reverse.
Given the scant expectations that seem built into today's price, I suppose it is fair to argue that a meaningful upturn in revenue and margins will be well rewarded, and it's worth noting that the company has improved its gross margin by four points since 2012 and restored operating margins to the high-single digits. Ordinarily, that would be something investors should really be excited about. The "but" is the more lackluster revenue growth prospects and the corresponding not-so-exciting outlook for growth in economic profits. While the low valuation makes this arguably a name worth watching for signs of improvement, I just don't have the confidence in the MPS and archiving business to want to own it today.
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