Guest Pitch: ARC Document Solutions (ARC) – 10% upside

Expected privatization – 10% upside

This pitch was shared by Giorgi.

ARC Document Solutions (ARC) is in the process of getting privatized by its management. Special Committee is reviewing the $3.25/share non-binding offer. I would expect binding agreement to be signed over the next few weeks – this would drive the current 10% spread down to low single digits. The downside to pre-announcement levels is only about 11%, which creates an attractive risk/return, as I believe the probability of the transaction closing are significantly above 50%.

ARC is one of the largest print services providers and by far the largest reprographics company in the U.S., especially in the Architecture, Engineering, and Construction (AEC) industry. The company has been approached by its co-founder/Chairman together with several other executives, with a combined ownership of 20%. Most persons in the buyout group have been with the company for more than 20 years, clearly know the ins and outs of the business and should be able to proceed with the transaction fairly quickly.

There are two key factors contributing to the current spread: (1) the financing has not been fully hashed out yet and (2) the special committee has been reviewing the transaction since April 8. I think both of these risks are overblown, and there are reasonable mitigating explanations for each.

So let’s unpack the chain of events that has led to the current setup.

On April 8, the current Chairman/CEO (owns 11%) submitted an offer to the board and indicated that he is willing to enter into a definitive transaction within 3 to 4 weeks. In his address to the board, the Chairman noted that he would finance the transaction using upsized existing credit facilities and provided a preliminary letter from ARC’s current lender U.S. Bank. The letter was highly promising, indicating bank’s willingness to partially fund the buyout and to lead the syndication process to source the remaining funds. U.S. Bank provided the existing credit facility back in 2021, so it likely has rather intimate understanding of the business already. I think this letter is a strong indication that the financing is not an issue and will be arranged easily. Quote from USB letter:

We are pleased to inform you that, as of the date hereof, we are highly confident that, in connection with the Transaction, the structuring and syndication of the Facilities can be accomplished by us (and/or one of our affiliates, as applicable) as your lead left arranger and the sole book runner for the Facilities. We currently are considering committing to a portion of the proposed Facilities with the understanding that the balance of the Facilities in excess of our contemplated commitment would be required to be obtained from other lenders pursuant to a syndication process to be mutually agreed upon.

Neither Chairman’s offer nor bank’s letter were disclosed to the markets at the time and became public only via a 13D filing on June 28.

Since then, a number of ARC executives and one private investor have joined the buyout group. The changes to the buyout group have likely contributed to the pro-longed negotiations and review of the transaction. In the Q2 earnings call on August 8, management confirmed that the special committee continues to review the offer.

In terms of financing requirements, ARC currently has about $28m available on its existing credit facilities. They need to increase the facility by approximately $70m to be able to cashout out minority shareholders, for a total of c. $100m in new funding. This would bring the company’s total debt, including finance leases, to about $160m, or approximately $110m in net debt, putting leverage at 2.9x net debt/adjusted EBITDA, not far from pre-COVID levels. Considering that the company is generating around $25m in FCF (before repayments of debt and finance leases), this level of leverage seems to be manageable.

Barring any complications with the financing, I don’t see any reason why the special committee would reject this bid. Each of the three independent board members has been with the company for quite some time—two of them for 6 years each, and one has been on the board since 2005. Given their long tenure, It would be surprising if these board members were not leaning Chairman’s way.

I also think risk of management walking away from this privatization is minimal.

The price tag is not very demanding at only 9x adjusted forward FCF. This could be argued as fairly reasonable for a business with large exposure to a cyclical AEC industry and with the key printing business facing headwinds. Due to flat/declining financial performance, the stock has traded around the current range for most part of the last decade (except for a sharp drop and rebound during COVID).

The traditional reprographics business has been in a clear decline since 2015, a trend that was further exacerbated during COVID when the company lost almost $100m in revenue in just one year. Some of this revenue loss was a deliberate decision by management to shed underperforming contracts, downsize, and emerge from the crisis as a stronger organization focused on more promising business segments (more on this later) and diversify away from the legacy reprographics business.

Moreover, during this time, the company has substantially deleveraged, improved margins, and positioned itself to potentially regain some of the lost revenue base over the next couple of years as the construction business begins to recover. As the chairman noted in his letter to the board, despite all the improvements and capital returns (all generated cash is returned via buybacks and dividends, trades at 7% dividend yield), the company has continued to be overlooked by investors. As a result, he sees no reason for the company to remain public.

As you are aware, following our successful IPO and listing on the New York Stock Exchange in 2005, and after an initial period of strong financial growth until the 2008 global financial crisis, ARC Document Solutions, Inc. (“ARC” or the “Company”) has since experienced declining operating performance driven by ongoing erosion of its traditional construction print volumes. Interest by the investor community in ARC has not been as active as we had initially hoped. At the same time, we have continued to bear the costs of operating as a public company, burdened with compliance and applicable legal and regulatory requirements, while implementing dividend and share buy-back initiatives to maintain shareholder interest during a time of great uncertainty for our business. I believe that, as a private company, ARC will be best able to make timely decisions and navigate this difficult environment to achieve long-term value and enhance its competitive position in the global marketplace.

 

Business background

The company breaks down its business into four operating segments:

• Digital Printing is the largest segment, which is further divided into digital printing and the reprographics business. The digital printing business can provide any type of digital print on a variety of materials, including plain paper, fabric, metal, wood, etc. To put it simply, this could be a billboard print, a colored print for your gym wall, or any other marketing print that a business may need, along with ancillary services such as catalog printing, for instance. The reprographics part (which is what management considers to be legacy business) of the Digital Printing segment focuses on printing various building blueprints, primarily for use in the construction industry, and has been a key focus of the company since its inception until mid-2010s when company started to actively diversify. The company operates 146 service centers where they receive and process orders for both of the sub-segments. The majority of these locations are in the U.S., with several service centers scattered across Canada, China, the UK, and the UAE. The international business represents around 12% of total sales. Also, worth noting that 30% of the total revenues are derived just from California.
• Managed Print Services (MPS) is essentially the same business as digital printing, but it operates on the premises of the customer. In this segment, the company places owned or leased printing equipment at the client’s premises, based on multi-year service level agreements (usually 3-4 years), and charges the customer on a per-use basis, with minimum charges included in the SLA. The company operates 10,000 MPS locations.
• Scanning and Digital Imaging is the key growth area for the company, though it represents a small portion of total revenues. In this segment, the company provides two distinct services: converting paper-based files from clients into digital copies and offering document archiving and sharing software called SKYSITE, developed in the mid-2010s and specifically tailored for and upsold to its AEC industry clients.
• Equipment and Supplies Sales consists of third-party goods to customers. Revenues for this segment have steadily declined, and management does not believe this trend will reverse going forward.

With the accelerated digitization of workflows, the legacy reprographics business has been in clear decline for more than a decade. To management’s credit, they have successfully diversified, and today, the reprographics represents less than a quarter of total revenues. Moreover, the legacy business primarily served the AEC industry, and management offset the decline by not only growing new business verticals in its digital operations but also by upselling earlier clients on newer offerings such as color printing and document scanning. As a result, the share of total revenues coming from the AEC industry is now only about 50%, compared to 80% in 2018, with a large portion of those revenues no longer tied to legacy reprographics. From Q4’22 earnings call:

Analyst: Okay. And then in terms of your more traditional plan printing, did the decline slow there at all? What is the — where is that market at? And I guess, obviously, interest rates will help it out, but can you just maybe give us a little bit more insight into where that business currently is at and what trajectory it’s on?

Dilantha “Dilo” Wijesuriya (COO): Yes. So the plan paper printing is continuing to be the same, right? I haven’t seen a much change in the last 3, 4 quarters. I mean, the same trends has been there. We’ve seen a couple of projects slowing down or getting delayed. But with regard to the plan paper usage, there is still a lull in that market. And I attribute that quite a bit to the higher interest rates that we’re currently experiencing. Someday down the line, couple of quarters down the line that when we see some easement in interest rates, some of that work is going to come back, right? The homebuilding, home construction, some of the tenant improvement work, they will all come back to some level. But some of the secular changes that we see in the plan paper printing, I don’t think it’s going to come back. Those things will continue to be moving to digital workflows. So, while the business is somewhat now getting stabilized, but I think the same headwinds will be there for a while.

Management believes that its paper document digitization business will experience significant growth over the next couple of years or even for longer. Most of the growth in the Scanning and Digital Imaging segment can be attributed to this trend. Here are a couple of additional quotes from management on the business prospects in this segment:

The trend for converting paper documents to digital information that began with the pandemic continued to gain momentum throughout the year and dramatically increased demand for scanning historical documents from the office and from warehouse storage. While the short-term growth of this service is gratifying, the volume of such information and the compelling need for it to be converted are both enormous and likely to last for decades.

While plan printing is important, we are not reliant on this recovery. The transformation initiatives we implemented several years ago are proving successful as evidenced by our results. Our document scanning services have provided a notable boost in revenue. We are building our reputation by delivering projects on time with high digital accuracy. Our dual sales approach, targeting enterprise customers and offering low volume Scan by the Box services continues to be effective.

Taken all segments together, ARC appears to be positioned to deliver rather stable/flat revenues and consistent profitability margins, which have prevailed even during COVID business disruptions. So it is not surprising that the chairman is disappointed by ARC’s share price performance and wants to take this company private.