This report was originally published on 1/20/10.

We introduced ARP (7.64 ↓1.93%)as an investment idea approximately 9-months ago. At that time we thought the stock had considerable upside based in large part on the company’s market leadership position and strong free cash flow generation.  This would enable the company to weather the current economic downturn through strategic cost cutting and debt reduction.  For the most part, our investment thesis has played out.  ARP has reduced G&A spending from a 2008 annual run-rate of $166 million to $125 million in 2009.  Additionally, the company has closed approximately 30 branch locations and cut back overhead at its remaining locations. As one industry insider stated a few weeks ago: “It really is amazing how strong ARC’s (Industry parlance for ARP) EBITDA margins are considering how weak non-res (non-residential) construction has been”.

ARP has used its solid EBITDA generation and stringent working capital management to reduce its outstanding debt. Net debt outstanding has declined from a peak of $365 million as of 3/31/08 to what we expect to be $240 million as of 12/31/09.  Over the course of 2009, we estimate ARP generated $88 million in free cash flow even with a 28% decline in revenues. Not too shabby.  Considering how well ARP  has executed over the past 9-months we are surprised the stock has only appreciated 22%. This is nothing to be ashamed of for sure, but ARP has underperformed both the  S&P 5 00 (up 32% over the same time frame) and other service oriented companies that have meaningful exposure to non-residential construction activity (CBG (13.99 ↑1.16%), JLL (67.46 ↑1.12%), ADSK (29.2 ↑0.59%) etc.).

The reprographics industry and ARP in particular are not widely followed in the investment community (we’ve asked around).  As a result, we anticipate that shares will only witness meaningful upside when there are clear signs that non-residential construction activity has bottomed and it starts to be reflected in ARP’s financial results.  For the first time since we introduced ARP as an investment idea, we think we are approaching that inflection point.

Revenue Upside for ARP for 4Q09 Appears Likely, FY10 Consensus Looks More than Achievable

We recently conducted a survey of approximately 30-35 independent reprographic firms located across the country.  We think the results of our survey offer unique insights into fourth quarter revenue trends, strategic changes for operators in the reprographic industry, credit availability for construction firms, and the outlook for the first quarter.  Below we will discuss some of our key findings.

According to Independent Reprographers the Decline in Revenues Lessened in 4Q09, Relative to the Full Year Trend

As we stated earlier, our initial call on ARP was not predicated on a rapid recovery in non-residential construction spending.  2009 was a brutal year for architecture, engineering, and construction (AEC) firms.  Most reprographers generate approximately 60-80% of their revenues from the AEC industry. As a result, the average reprographer witnessed at least a 20% YOY decline in revenues for the full year 2009.

Source: PAA Research

As difficult as 2009 overall was for the reprographic industry, it appears that 4Q09 was slightly “less bad”.  According ot the independent firms we surveyed, approximately 30% had generated a modest increase or flat YOY revenues in the fourth quarter.  This compares to only 3% of respondents that witnessed flat or an increase in revenues for all of 2009.  The median YOY revenue decline witnessed by the reprographics firms we surveyed for the fourth quarter was approximately 10-20%.  This compares to current consensus revenues for 4Q09 for ARP of  $102 million, which implies a 33.6% YOY decline. Based on the feedback from our survey it appears that consensus 4Q09 revenues for ARP could be too conservative.  We currently forecast $112 million in revenues for ARP’s 4Q09, which would represent a 6.4% Q/Q decline a 27.5% YOY decline.

Source: PAA Research

Independent Reprographers Witnessing Revenue Stability in 1Q10

Perhaps the most surprising finding from our survey was the relative level of revenue stability that independent reprographics firms expect for the first quarter.  The magnitude of revenue visibility in the reprographics industry is not particularly high, but most firms have a sense for what projects they will be working on over any 2-3 month period.  The nature of the business is such that new projects can pop up at anytime and conversely work can be cancelled at the last minute.  In short, these results should be taken with a “grain of salt”, but they are encouraging none the less.

Approximately 36% of independent reprographics firms that we surveyed expect to witness a YOY increase in revenues for 1Q10 compared to 1Q09, while another 39% expect revenues to be flat YOY.  We would hardly characterize these results as a clear sign that non-residential construction activity is poised to surge, but it clearly points to stabilization against what are easy comps.  This is the first time in the past year that a vast majority of independent reprographers have indicated that they expect revenues to flatten out at a minimum on a YOY basis. Based on the results of our survey, it appears that 1Q10 revenue estimates for ARP, which imply a 23.3% YOY decline, are far too conservative.  We currently forecast $122 million in revenues for 1Q10 (compared to consensus of $107 million), which would represent a 12.7% YOY decline from 1Q09 and a 35% decline from 1Q08 levels.

Source: PAA Research

Other Key Observations from Our Survey

We wanted to share with you a few other key observations from our survey, which focus more on the state of the reprographics industry and the direction the industry could take over the coming quarters and years.  Here are a few of our key observations:

• More and more reprographics firms are making a push to target non-AEC clients.  As we mentioned earlier, AEC (architecture, engineering, and construction) clients make up the lionshare of revenues for most reprographers.  Over the past 6-9 months, ARP management has made it clear that the company plans to make a bigger push to capture revenue opportunties from non-AEC clients in 2010.  With its national footprint and experienced sales force, we think ARC is uniquely positioned to capture revenue opportunities from non-AEC firms.  The leverage on fixed capacity that is currently being utilized at low levels, should be meaningful.  More than 85% of reprographics firms indicated they were making a bigger push to target non-AEC clients.
• The pricing environment remains competitive, but not any different from that 3-6 months ago.  Approximately 80% of respondents indicated they had witnessed some form of pricing pressure from competitors.  Only 20% indicated they were experiencing a “great amount” of pricing pressure.  These results are consistent with our previous surveys.  ARP is better positioned than almost any other operator in the reprographics industry to weather a tighter pricing environment given the company’s operating efficiency.
• Capacity utilization levels remain low, more reprographics firms will go out of business.  Approximately 50% of the firms we surveyed are currently operating at less than 60% capacity utilization.  Should those levels continue, we think a number of companies could be forced to close additional branch locations or shut down altogether.

Source: PAA Research

• Credit availability to the clients of reprographers has not improved meaningfully over the past three-months.  Better earnings prospects for banks has yet to translate into higher lending activity.  While 27% of respondents indicated that credit availability for their clients had “improved a little bit”, another 21% thought that availability had decreased over the past three months.  Vacancy rates in commercial real estate continue to surge higher, but we still believe that improved credit conditions would lead to a meaningful increase in project activity.
• Overall sentiment among independent reprographers remains poor, although it has improved slightly in the past three months.  On a scale of 1 to 10, the respondents to our survey rated the state of the reprographics market a 3.5, which represents a slight improvement from our fall survey.  Anecdotally we know that many reprographers are struggling to keep their business afloat and are hoping that 1H10 brings revenue stability and 2H10 some revenue growth.

AIA Billings Index for December Was Another Disappointment, Could January Finally Bring Some Improvement?

The American Insitute of Architects released their Architecture Billings Index today.  The AIA billings index for December increased from November, but the results still indicated that overall activity at architecture firms declined month to month.  The ABI rating for December was 43.4 compared to 42.8 in November and 46.1 for October.  The new project inquiries index remained above 50 for the 10th consecutive month, but declined slightly from November levels to 55.3.  Credit availability remains a major impediment to project related work.  The results of our independent reprographers survey suggest that the AIA Bililngs Index is poised to increase as soon as January.  We anticipate the index could cross over 50 at some point in 1Q10, which would represent the first positive reading for the index since January 2008.

Source: AIA

Revenue Stability Is the Key for Multiple Expansion for ARP -  FY10 Should Bring Potential Revenue and EPS Upside, Continued Deleveraging , and Perhaps Acquisitions

As we mentioned earlier, excellent execution, rapid deleveraging, and strong free cash flow generation for ARP over the course of 2009 has largely been overlooked by investors.  We think the appreciation prospects for shares will be increasingly tied to signs of revenue stability in 2010 (and eventually a resumption of growth).  Based on the results of our survey, it appears we are closer to revenue stability for ARP than is currently reflected in consensus estimates.  We expect 2010 to be another strong free cash flow year for ARP, although it seems unlikely that the company will be able to replicate the $85-90 million generated in 2009.  A combination of stabilizing project activity levels, the benefits of 2009 cost-cutting, expansion into non-AEC  markets, and the potential for a resumption of acquisition activity should set the stage for ARP to top consensus expectations over the course of 2010.  To arrive at our FY10 EPS estimate, we have assumed the company can generate a 60 bps improvement in gross margins compared to 2009.  In the table below we compare our current estimates for 4Q09, 1Q10, and 2010.

Source: PAA Research, Yahoo Finance

The setup for ARP shares for 2010 appears to be favorable. In our view, estimates are more or less “washed out” and the stock does not yet reflect what appears to be growing signs of stability in ARP’s end-markets.  From a valuation perspective, ARP shares remain remarkably cheap on an EV/EBITDA and free-cash-flow basis.  In our view, we think ARP shares can trade as high as 20-25x FY10 EPS (similar to the current valuations for CBG, JLL, and ADSK) to the extent that a stabilization in the company’s revenues becomes apparent.  At 7.5x our FY10 EBITDA estimate or at a 10% yield on our FY10 free cash flow estimate of $48 million, ARP shares would trade north of $10.

As always, please act accordingly…