This report was originally published 10/6/09.

ARP shares are off sharply today in response to a press release in which the company announced it was lowering guidance for the year and had recently completed an amendment to its credit facility.  You can find all of the details here.  Overall, the  company reduced its full year EPS guidance from $0.50-$0.75 to $0.27-$0.33, but more importantly in our view, maintained its full year cash from operations target of $70-$90 million. As fate would have it, we were just in the process of finishing our checks with reprographers for the quarter and their outlook for the remainder of 2009 and 2010.  The feedback received from independent reprographers corroborates what ARP’s current guidance suggests – non-residential construction activity, the lifeblood for the reprographics industry, remains weak and has yet to show signs of improvement.  As the chart below demonstrates, the Architecture Billings Index has not shown a month-to month increase in activity since January 2008, even though new project inquiries have increased for six consecutive months.  In light of the weakness in the AIA Billings Index and the feedback from reprographers, it is not a surprise that ARP reduced guidance for FY09.

Source: AIA

As a reminder, any reading below 50 suggests that overall activity declined from the previous month. In general it is unusual for the new project inquiries to have a reading above 50 for this period of time without a subsequent increase in the overall billings index.  We would characterize the current environment for reprographers as a very large “air-pocket”.  Work related from projects commenced in the first half of 2008 has come to an end or is winding down and there is not enough new activity to fill the gap.  As a result, ARP 2H09 results will be as weak, if not weaker than the first half from a YOY change perspective even though comparisons get materially easier starting with the fourth quarter.

If ARP is a “Cash Cow” As We’ve Stated, Why Did the Company Need to Amend Its Credit Facility?

In our original report on ARP, we argued that the company was a “cash cow” and that the company would be well positioned to navigate the current economic environment (we also argued that business trends had stabilized, which was a flawed premise).  Even though management has lowered EPS guidance, the company is still on track to generate more than $70 million in free cash flow (FCF), which would put the FCF yield at 20% based on the current stock price. One of the questions we have been asked today is: if ARP is such a strong free cash flow generator why did they need to seek out covenant relief?

First, let’s take a look at the company’s capitalization pro forma for the $35 million payment on the company’s term loan. The company’s debt to cap has been reduced from 51.8% as of 6/30/09 to less than 49% as of 9/30/09.  Investors should keep in mind that the company has not yet conducted its annual goodwill impairment test.  We think additional impairtments to goodwill are almost a certainty at this point, which will result in a higher debt/cap for the company early in 2010.  Overall, the  company’s total debt level of $295 million is at the lowest level since 1Q07.

ARP’s credit agreement has three primary financial covenants: a total leverage covenant (total debt/EBITDA), an interest coverage covenant (EBITDA/interest expense), and a fixed charge coverage covenant.  Of the three covenants the company’s total leverage covenant has become the most restrictive.  Based on management’s revised guidance we estimate that the company will finish 3Q09 at 2.7x total debt/EBITDA, up from 2.5x in 2Q09.  However, the company’s total leverage will continue to increase despite the debt reduction.  We forecast that ARP’s total leverage could peak as high as 2.9x based on our 4Q09 and 2010 forecasts.  This left the company with little to no wiggle room if trends worsen.  Based on our free cash flow estimates, we expect the company to repay an additional $50-$60 million in debt in 2010, which would reduce total leverage to 2.0x.  We do not expect the company’s fixed charge or interest covenants to impair ARP’s financial flexibility at all over the next 12-18 months.

The Outlook For Reprographers Now

We  recently (the past 2-3 days) conducted a survey of reprographers.  In general, the feedback about YTD and 3Q09 trends was consistent with ARP’s revised guidance for FY09.  Most reprographers have witnessed a decline in revenues thus in 2009 in excess of 20% and in many cases more than 30%.

Source: PAA Research

Third Quarter Trends Show No Improvement

The reprographics firms we surveyed witnessed little improvement in sales trends in the third quarter.  60% of respondents witnessed a YOY decline in revenues in excess of 20%.

Source: PAA Research

Reprographers SLIGHTLY More Optimistic About the Fourth Quarter

The fourth quarter will represent an easier comp for ARP and other participants in the reprographics industry.  ARP witnessed a 0.7% YOY decline in revenues in 3Q08, followed by an 11.5% decline in 4Q09.  In general reprographics firms have a few months of visibility into their revenue opportunities based on when they are engaged and at what stage a particular project is in.  We are somewhat encouraged that 25% of respondents to our survey expect 4Q09 sales to be flat YOY, while another 15% expect to generate a postive comp.  The vast majority of respondents expect sales to be down, but it should be noted that none expect the decline in sales to exceed 30% YOY (compared to 30% of respondents who witnessed a 30% decline in 3Q09).  This suggest some early signs of stability.  Historically, revenues in the fourth quarter have declined as much as 2-7% sequentially from the third quarter.  The feedback from our survey suggest that revenues for ARP could buck the seasonal trend and be close to flat from 3Q to 4Q (management is not guiding to that).

Source: PAA Research

Reprographers Are Cautiously Optimistic About Stability and the Potential for Modest Growth in 2010

Most reprographers we surveyed describe the market as “poor”.  However, there is some level of enthusiasm about the possibility of a modest increase in revenues in 2010.  48% of respondents indicated that they expected revenues to increase in 2010, while another 26% anticipate revenues could be flat.  While there are no clear signs of an imminent recovery in non-residential construction spending, the combination of our feedback from reprographers and the AIA new project inquiries index indicates that revenues could show stabilization if not modest improvement in 2010.

Source: PAA Research

Other Interesting Observations from Our Proprietary Survey of Reprographers

We wanted to provide you with other key observations from our survey of reprographers:

• Most reprographers feel that access to capital remains the biggest impediment to a recovery in non-residential construction spending
• 53% of respondents have not seen any work related to projects backed from the stimulus package. 42% of witnessed “a little bit” of work related to the stimulus package
• Pricing pressure does not appear to be a big issue in the space. 70% of respondents indicated that they had witnessed “some” pricing pressure in the past year.  Only 15% have wintessed a great deal of pricing pressure
• 55% of respondents have already made the  “necessary” changes to their organization to navigate the current economic environment
• Interestingly enough, the reprographers we surveyed are slight more optimistic about a recovery in non-residential construction activty than they are for a rebound in residential construction activity
• In order to combat the economic downturn, many reprographers are making a bigger push to target non-AEC (Arcithecture, Engineering, and Construction) clients

ARP Is Still a Cash Cow and Appears Undervalued On a FCF AND EPS Basis Now

We have revised our revenue and EPS estimates for 2H09 and 2010 to better reflect the feedback we received from independent reprographers and ARP’s revised outlook.  For ARP’s 3Q09, we now expect revenues to decline 32% YOY to $118.5 million and EPS of $0.04. For 4Q09, we expect revenues to decline 27.2% YOY to $112.2 million and forecast ARP will generate break-even EPS.  For 2010, we have assumed flat YOY revenues (appears reasonable to slightly conservative based on our survey) and EPS of $0.58.  We anticipate ARP will restore gross margins to 38.5%, compared to 35% for the back half of 2009.  From 2001-2003, ARP generated $415-$420 million in revenues annually, but still generated generated gross margins in excess of 39.5% on average.  Additionally, ARP generated an aggregate of $140 million in FCF in the three year period during which revenues plateaued.  The company’s management has a strong track record of aggressively paring costs to preserve margins in a downturn.  Outside of the company’s fixed lease costs and equipment, management can reduce staff levels and the number of shifts to preserve margins.  Most importantly, the company remains on pace to generate more than $70 million in free cash flow in 2009.  At the current stock price this implies a free cash flow yield in excess of 70%.  The stock now trades at 13.8x and 9.6x our FY10 and FY11 EPS estimates, which only include a modest recovery in revenues in FY11.

Source: PAA Research

ARP continues to generate robust free cash flow which should enable the company to delever over the course of the economic downturn.  We think this should position the company to be able to make selective acquisitions in the traditional reprographics space and expand its service offerings to ancillary end-markets.  Today’s announcement is clearly a disappointment, but we think this has created another compelling entry point for the stock.  From 2009 to 2011, we expect ARP to generate a total of $210 million of free cash flow.  A normal yield for a traditional business services company is 10%, if not lower.  At a 10% yield, ARP shares would trade anywhere between $12-$15.

As always, please act accordingly….