We recently had the opportunity to speak with senior management of ARP.  Although we discussed a number of issues that will impact ARP shares in the near-term, our primary focus was on the strategic direction of the company in light of the increased usage of Building Information Modeling (BIM) technology within the architecture, engineering, and construction (AEC) community.  Investor concerns about reduced printing volumes and an increase in digital production of drawings, plans, blueprints and other wide-format documents are certainly not new.  ARP management has faced these issues since the company began marketing its initial public offering in early 2005.  At a time when many cyclicals are trading at 13-15x prior cycle peak earnings, ARP shares now trade at a paltry 5.1x the company’s peak EPS in 2008 of $1.57.  We attribute the valuation discount to two primary factors: 1) the largest end-markets which ARP serves have yet to show any meaningful signs of improving fundamentals, and 2) investor concerns about the impact that BIM and an overall reduction in printing volumes could have on ARP’s fundamental earnings prospects.  It is this last factor that we plan to discuss the most in this report.

What is Building Information Modeling (BIM)?

Deke Smith FAIA, Executive Director of the buildingSMART Alliance described BIM as:

“A Building Information Model (Model) is a digital representation of physical and functional characteristics of a facility. As such, it serves as a shared knowledge resource for information about a facility forming a reliable basis for decisions during its life cycle from inception onward.

A basic premise of Building Information Modeling is collaboration by different stakeholders at different phases of the life-cycle of a facility to insert, extract, update or modify information in the Model to support and reflect the roles of that stakeholder. The Model is a shared digital representation founded on open standards for interoperability

Some have identified BIM as dealing with only 3D modeling and visualization. While important and true, this description is limiting. A more useful concept is that a Model should access all pertinent graphic and non-graphic information about a facility as an integrated resource. A primary goal is to eliminate re-gathering or reformatting of facility information; which is wasteful.”

BIM is probably best known as a 3-D representation of a 2-D plan or design, but it really represents a process through which architects, engineers, and contractors can implement digital technology to improve the planning and construction process.  The technology supporting BIM solutions has been around for some time.  In the past 2-3 years, adoption of BIM technology through such software tools as Autodesk’s Revit has accelerated and reached a critical inflection point.  Now the US government requires BIM on all of its new projects.  Going forward, we expect BIM software and platform tools to continue to gain widespread acceptance.

Proliferation of BIM Will Accelerate ARP’s Transition Towards a Managed Printing Services Provider

As we mentioned earlier, ARP management has been answering questions about BIM and the overall transition towards digital production of printed documents since the company went public in 2005, and probably well before that.  BIM is somewhat unique in that it is a technology platform that specifically changes the printing needs of ARP’s core customers.  Proliferation of BIM will not completely eliminate the need for printed plans, drawings, and other documents, but it certainly will impair demand.  We anticipate BIM will further accelerate the ongoing transition in the broader document production industry from “print and distribute” solutions to “distribute and print” service offerings.

Eleven years ago, ARP was a regional reprographer with 69 branch locations that each generated approximately $2.9 million in annual revenues on average.  The company did not have any facilities management contracts and PlanWell, the company’s digital document storage platform, was still in the planning stages.  In short, ARP was effectively a west-coast based company that served the local printing needs of AEC clients.  Over the past decade, ARP has accomplished two key strategic objectives: 1) built a national network of reprographic print facilities, and 2) positioned the company to fulfill the needs of its clients in a world increasingly focused on “distribute and print” solutions.

In the chart below, we compare revenue-per-branch and the number of facilities management contracts for ARP over the past eleven years.  Based on ARP’s annual revenue per branch location, it appears easy to argue that demand for document production among AEC clients has been in secular decline for more than a decade now.  Conversely, demand for facilities management services has exploded. Through facilities management contracts ARP handles all of the document production and printing equipment needs of a client at the customer’s offices.  We characterize a facility management contract as “managed printing services-lite”.  Clients who are facilities management customers are likely to use ARP for a large portion of their reprographic printing needs and in some cases all of their printing requirements.  There is no better visual representation of ARP’s transition towards a managed printing services provider than the chart below. It should be noted that in a decade in which ARP generated approximately $700 million in free cash flow (compared to a current enterprise value of $608 million), the company ALREADY successfully managed through a significant shift in the printing consumption behavior of its primary clients.

Source: Company reports

ARP’s Answers to BIM (For Now)

There is no question that the usage of BIM continues to gain momentum despite the economic downturn.  ARP management is acutely aware of the changing landscape for printing services from its core AEC clients. As we discussed above, it’s an issue the company has been facing for almost 10-years now.  Anecdotally, we know that the number of prints per job continues to decline and some percentage of projects are completed almost entirely through digital production.  On the surface these trends would lead one to believe that ARP could suffer a similar fate to companies like Handleman (CD distribution), Blockbuster, or the newspaper industry.  However, in our conversations, management expressed confidence that the proliferation of BIM and acceleration towards distribute and print services could actually enable the company to diversify its revenue streams and increase its market share in the reprographics industry.  Although management was not yet willing to “show all of its cards”, here are the ways in which we think ARP can mitigate revenues lost from BIM and lower print volumes.

Expansion Into Color

Within the past 3-6 months, ARP has started to make a bigger push into color through its “Riot Color” brand.  It might come as a surprise to many investors, but ARP already generates approximately $75-$80 million in annual revenues from color production, primarily for AEC clients.  According to R.R. Donnelly, the commercial printing market in the US is approximately $75-$80 billion, which implies it is 15 times the size of ARP’s traditional reprographics market.  ARP plans to target both AEC and non-AEC companies with its color initiatives.  Given the company’s strong relationships with AEC clients and large national footprint, we expect the investment in Riot Color to yield strong results.  As we mentioned earlier, branch capacity utilization has suffered over the last several years due to economic weakness and a secular shift in the way in which clients fulfill their printing needs. We think incremental margins on color production could be very high and would require almost no additional capital investment on the part of ARP.  As the  chart below demonstrates, gross margins for ARP were 5-6% lower in 2009 than they were in the prior recession at similar revenue levels due to lower capacity utilization (as expressed by average revenue per branch).  Expansion into color could enable ARP to achieve historical gross margins over the next 2-3 years even if demand for traditional reprographics printing services does not improve meaningfully.

Source: PAA Research, Company reports

Facilities Management Contracts

Over the past decade, the number of facilities management contracts that ARP has secured has increased at a compound annual growth rate of 22.8%.  In the past two years, ARP has added more than 1,100 facilities management customers despite the severe economic downturn.  Facilities management contracts are effectively “managed print services-lite” in our opinion.  Customers are increasingly likely to consolidate the number of printing vendors they work with going forward as corporations increasingly move towards “cloud printing” solutions.  ARP will have a huge advantage compared to other reprographers and commercial printing services providers given its track record with its FM clients.  Expansion of ARP’s FM client base will not completely mitigate the impact of BIM.  Customers will likely print less at their own locations as well.  However, the proliferation of BIM will likely lead to more companies seeking to arrange FM contracts or secure “cloud printing” solutions. In this scenario, ARP will directly benefit given its national branch network and established track record.  Additionally, we expect ARP to increasingly secure FM relationships and full managed printing services contracts with non-AEC customers, similar to the deal the company has with Boeing.

Market Share Gains in Reprographics

According to the International Reprographics Industry, the reprographics industry in the US is approximately $4.5 billion in size.  This implies that ARP has approximately 12-15% market share in an industry comprised of more than 3,000 firms.  There are still hundreds of “mom and pop” local reprographers.  While these reprographers will benefit from an eventual recovery in commercial construction activity, the amplitude of the recovery will be lower than those in prior economic expansions.  That will leave many reprographers with the difficult decision to sell or eventually close.  Over the next 5-7 years, we expect the company to generate significant market share fains from smaller reprographers as their footprint shrinks and in select cases are forced to sell to ARP.

RCMS Group – A Gateway to More Managed Printing Services Contracts?

ARP announced the acquisition of RCMS Group in October 2009.  RCMS Group is a BIM consulting services provider.  K.P. Reddy, the company’s CEO is widely viewed as a leading expert in BIM technology.  The acquisition itself is unlikely to have a huge direct impact on ARP’s financial position.  Management believes the division could grow to $8-$10 million in revenues over the next several years as demand for BIM consulting services grows as more and more companies transition to BIM oriented technology platforms.  While the addition of 1-2% revenue growth for ARP would justify the acquisition alone, the strategic contributions are likely to be far more important.  ARP and the RCMS Group have started to host BIM “boot camps” for industry professionals.  From a monetary perspective the boot camps are not material, but they do alter the perception of ARP in the marketplace from just a reprographics company to a full fledged outsourced printing services provider.  ARP management presented us with an example of a meeting recently conducted with the CIO and CEO of a large corporation. In the past, ARP would never secure such a meeting, but the client’s concerns about the dynamic nature of BIM facilitated the tete-a-tete.  At the meeting, the discussion ranged beyond BIM and into how ARP might be able to help the company more efficiently manage its printing costs.  Companies are increasingly looking for “cloud printing” solutions and dynamic printing platforms.  The RCMS Group could be the gateway for ARP to expand its client relationships beyond traditional reprographics.

Monetizing PlanWell

ARP launched its internet based planroom, PlanWell in 2000.  The company has invested tens of millions of dollars in the platform at this stage and it now hosts more than 38 terabytes of data and 15 million drawings, most of which are in 2-D.  PlanWell hosts the drawings and plans of more than 130,000 customers.  Thus far, the company has done little to monetize PlanWell’s extensive repository of information.  The company does license the platform to other reprographers, which provides a modest revenue stream.  Based on our conversations with management, it appears that the company is close to potentially charging customers a subscription fee for storing their documents on PlanWell. This would be an immediate source of high margin recurring revenues for the company.  In addition, ARP has a large opportunity over the next several years to help clients convert the 2-D drawings residing in PlanWell into 3-D, BIM ready files. We anticipate ARP could pursue ways to monetize PlanWell in a more meaningful manner in the next 12-18 months.

ishipdocs – A Global “Distribute and Print” Platform

Approximately one-year ago, ARP launched ishipdocs.com, a global, digital document distribution platform targeted at the reprographics industry.  Ishipdocs is the ultimate distribute and print platform. Customers can upload documents for a multi-national project in a city in the US and have them produced locally in more than 40 countries.  Clients benefit from lower shipping costs and faster document delivery.  Reprographers that join the ishipdocs network benefit from higher print volumes. Ishipdocs now offers fulfillment in more than 40 countries at 400+ reprogrpahic locations.  The business model is similar in spirit to that of Innerworkings (without the RFP process, and noise surrounding the company).  We anticipate ishipdocs could gain further momentum as more and more large companies seek “cloud printing” solutions.  The direct benefit from a revenue perspective to ARP will be relatively modest, however the tangential capacity utilization impact to the company’s branch locations could be sizeable.

Thinking About ARP as a Debt Free Company

As long as we have followed ARP, the company has been highly leveraged.  Over the past 10-years the company has carried a total debt burden of $250-$400 million comfortably, for the most part.  On a total debt/LTM EBITDA basis, leverage has ranged from 2.0-4.5x, and stood at 2.7x as of 12/31/09.  Over the past 24-months, ARP has reduced its total debt outstanding by approximately $120 million.  The company recently secured an amendment to its credit agreement which will give ARP some more wiggle room in 2010 in which to operate.  We do not expect the company’s total leverage covenant to hinder ARP’s strategic initiatives or operating flexibility in any way.  Based on management’s operating cash flow and CAPEX guidance for 2010, we think the company can generate as much as $60 million of free cash flow in 2010.  Of this amount, we expect another $50 million to go towards debt repayment.  This would bring the company’s total debt outstanding and total debt/cap to its lowest levels in the past eleven years.

Source: PAA Resesarch

Based on our conversations with senior management, we think debt reduction will continue to be ARP’s primary allocation of excess cash flow over the next 12-18 months.  There are some investors who think that the company should consider swapping its bank facilities into longer term high yield paper given the recent liquidity in the bond markets. We think this would be a major mistake.  We see no reason as to why ARP would swap relatively low cost floating rate debt that it can rapidly repay into higher cost fixed rate paper that it will not be able to tender for without penalty.  As the company’s total debt outstanding approaches $200 million towards the end of 2010, we think investors will increasingly start to think about ARP as a debt free company that can start to enhance shareholder returns through share repurchase and other mechanisms.

Acquisitions Could Play a Reduced Role in Growth Going Forward

Acquisitions have been an integral part of ARP’s DNA and growth strategy over the past 10-years.  The company has completed more than 140 acquisitions over the past 10-12 years.  While the acquisition of established reprograhpers in local markets has been a fruitful strategy for the company in the past, we expect this approach to play a reduced role in ARP’s growth going forward. Management made it clear that acquisitions of smaller reprographers are likely to remain on the back-burner for some time until fundamentals improve meaningfully.  ARP is now in a position to acquire smaller reprographers for as little as 2-4x cash flow, which will make those deals highly accretive once fundamentals improve. However, given our view that many small reprographers will not be able to navigate a “distribute and print” world dominated by BIM, we think ARP will be incredibly judicious in who they decide to acquire.  Outside of the company’s traditional acquisition strategy, there are no specific technology platforms or solutions providers that management views as a must have at this point.  We think the stock could witness significant multiple expansion if ARP were to complete an acquisition that dramatically expanded its BIM service offerings.  Overall, we expect acquisitions to become a much smaller part of ARP’s growth strategy going forward.

Weakness in AIA Billings Index and Negative Impact of Weather Suggest Normal Seasonal Uptick in First Quarter Revenues Could be Muted

Yesterday, the American Institute of Architects released the Architecture Billings Index for February 2010. Overall the results suggest that non-residential construction activity remains weak.  The index increased slightly from January to 44.8, but the overall level of the index indicates that activity weakened on a sequential basis from January to February.  For the 12th consecutive month, the new project inquiry index remained above 50.  There is no historical precedent for the new project inquiry index to exceed 50 for this extent of time without a corresponding positive reading in the overall billings index.

Source: AIA

The latest data from the AIA suggests that the typical seasonal uptick in revenues witnessed by ARP from the fourth quarter to the first quarter might not be as strong in 2010.  Additionally, the company’s branch locations in the Northeast and Mid-Atlantic were closed for as much as 5-10 days during the quarter due to the blizzards.  This could negatively impact revenues by $1-$3 million in the quarter.  Current consensus for revenues implies flat revenues quarter to quarter, or $111 million. Estimates appear conservative enough inlight of the one-time weather issues during the quarter and the relative weakness in overall non-residential construction activity.  We do not expect ARP’s Riot Color initiative to become a meaningful revenue growth driver for the company for at least 3-6 months.

ARP’s Transition to a Managed Printing Services Provider Could Lead to Meaningful Multiple Expansion

There is no question that ARP faces considerable operating challenges over the next 5-10 years as more and more companies adopt BIM as their primary drafting and planning technology platform.  We think investors are quick to dismiss ARP’s future revenue, earnings, and free cash flow prospects as a result of these challenges.  We would argue that ARP has experience navigating the transition towards digital solutions and the distribute and print model for more than a decade. Most industry insiders we speak to think that ARP has the national footprint, existing technology platforms, and quality of management to deftly navigate increasingly uncertain waters for the reprographics industry.

We anticipate ARP could emerge as a key player in the cloud printing landscape over the next 3-5 years, which could result in significant multiple expansion for shares. As the company reduces its debt burden over the next several years, ARP’s sizeable free cash flow generation should enable the company to simultaneously pursue strategic tuck-in acquisitions and return capital to shareholders.  ARP shares trade at 5x prior peak cycle earnings and have a 2010 free cash flow yield of 17%.  The company has generated aggregate free cash flow over the past four years that exceeds its current market cap. It is clear that investors are not yet willing to assume that ARP can achieve prior peak earnings.  We think shares could witness significant valuation expansion should ARP gain traction with ancillary revenue streams such as color, expand its facilities management contracts, monetize PlanWell, establish ishipdocs as a leading “cloud printing” reprographics platform, or continue to gain market share.

As always, please act accordingly….