In April, we argued that the reprographics industry was showing signs of imminent revenue stabilization, despite what continued to be weakness in the macro-economic data related to non-residential construction activity in the US.  Over the course of the second quarter few signs pointed to stabilization in construction activity.  According to the US Census Bureau, construction spending during May declined 8% YOY, while the total amount of expenditures through the first five months of the year declined 12% compared to 2009.  Additionally, as the chart below indicates, the AIA’s Architecture Billings Index (ABI) continues to suggest that work related to future non-residential construction activity declined sequentially from the first quarter to the second quarter.  As a reminder, any reading in the ABI below 50 indicates that billings activity declined from the prior month.

Most prognosticators and economists expect overall construction spending to bottom in 2010.  Based exclusively on the macro-economic data it would be difficult to point to any reasons for cautious optimism among reprographers.  However, three months after we initially argued that revenue trends in the reprographics industry were on the cusp of stabilization, it appears our prognostication came to fruition, despite broad-based weakness in construction spending.

We recently conducted a survey of 25-30 independent reprographers to gain a better understanding of industry-wide trends during 2Q10, their outlook for 3Q10 and the rest of 2010, and how their positioning their companies for future growth. In general the results of our survey suggest that revenue trends stabilized during the second quarter and many actually generated positive sales growth for the first time in more than two years.

As a reminder, gold and institutional subscribers can download the full survey on the “Surveys” page.

Revenue Trends Stabilized For Most Reprographers in 2Q10, Many Even Generated Growth

In our Spring 2010 survey, approximately 60% of the reprographers that responded witnessed a YOY decline in revenues in the first quarter, while only 28% generated positive sales growth.  For our Summer 2010 survey, 26% of respondents indicated that revenues for 2Q10 were flat YOY, while another 26% generated positive YOY revenue growth.  If ARP’s results are any proxy for revenue trends in the reprographics industry, then the easiest explanation for the overall improvement in revenue growth trends would be “easy comps”.  While we think this likely represents the principle factor contributing to stabilization in revenue trends, we think many reprographers have taken steps to expand growth opportunities during the downturn into ancillary markets such as color printing and by increasing their focus on non-AEC customers.  Additionally, we cannot rule out that the strength in the new project inquiries index from the AIA for the past 13-months has started to manifest itself in initial bidding activity.

Sequential Improvement in Revenues Closely Resembles Normal Seasonality

From 2002 to 2007, ARP generated an average sequential increase in revenues from 1Q to 2Q of 7.3%.  Generally speaking, the second quarter has typically represented the high point in the year for ARP’s revenues. The bidding and design work associated with construction activity during the summer months reaches its highest levels during the second quarter. In 2008 and 2009, ARP witnessed a 1.3% and 6.0% sequential decline in revenues from 1Q to 2Q as the overall magnitude of the economic downturn more than masked typical seasonal patterns.  In what we can only describe as a positive sign for the industry, it appears that many reprographers witnessed normal seasonal trends in revenues from the first to the second quarter.  According to our survey, approximately 40% of respondents generated a sequential increase in revenues from the first to second quarter, while another 30% witnessed no change.  Clearly there are still many reprographers who have yet to benefit from any return to “normalcy” in their end-markets, but we are encouraged by the percentage of operators that have witnessed an increase in revenues on an absolute basis and more typical sales trends on a seasonal basis.

Capacity Utilization Improved Substantially from 1Q Levels, but Still Remains Relatively Weak

As we discussed in a recent report, the overall reprographics industry has been combatting a decline in revenue-per-branch and capacity utilization for 6-8 years now due to the secular shift in the number of prints ordered per project.  The economic downturn exacerbated this trend and has taken capacity utilization to almost unsustainable levels.  If capacity utilization did not improve from the levels witnessed in the second half of 2009 and first quarter of 2010, we anticipate many reprographics firms would be forced to close their doors.  In our Spring 2010 survey, an astounding 45% of respondents witnessed capacity utilization of less than 50% in the first quarter.  In our Summer 2010, only 15% of respondents indicated that capacity utilization during the second quarter fell short of 50%.   Additionally, more than a third of reprographers utilized more than 70% of their capacity during the second quarter, compared to only 18% in the first quarter.  Many reprographics firms have closed branches or shut down altogether during the downturn.  Companies such as ARP, should benefit from capacity rationalization in the long term, although we would hardly say the industry is “out of the woods” at this point given the low levels of absolute branch utilization.

Reprographers Continue to Push Color, Target Non-AEC Clients

Over the past 6-9 months APR has introduced a number of initiatives to enhance branch capacity utilization. The company has started to target more non-AEC clients and introduced “Riot Color”, it’s color printing solution for both AEC and non-AEC clients. It appears the company is not alone in these strategic pursuits among reprographers. According to our survey, the majority of respondents have increased their focus on non-AEC clients and expanded of color printing capabilities to offset the secular decline in prints ordered per project. It is clear that ARP is not alone in its efforts to expand beyond traditional reprographics services.  50% of respondents to our survey indicated that they have targeted more non-AEC clients, while another 60% have expanded color printing capabilities as a way to position their firm or branch for future growth during the downturn.

Given its national scale and superior technology platform, we think ARP has unique advantages in these endeavors. ARP already generates 15-20% of its revenues from color printing services.  The majority of the reprographers we surveyed generate at least 10% of their revenues from color printing . Demand for color printing services has remained relatively strong during the downturn. Approximately 80% of respondents to our survey generated revenue growth from color prints in the second quarter.  We anticipate ARP’s focus on color prints could boost revenue growth by as much as 2-4% over the next 12-18 months.

Cautious Optimism Emerges Among Reprographers

It appears that an element of cautious optimism has started to permeate the minds of some of the reprographers we surveyed on the heels of what likely represented the first quarter in two years in which many firms could point to flat YOY sales or even an increase in revenues.  Given the company’s market share and geographic footprint, we think ARP’s results serve as a reasonable proxy for the entire reprographics industry even though the company has likely performed better than the sector overall.  On a two-year stacked basis, ARP’s revenues declined (-12.9%), (-26.3%), (-32.3%), and (-35.9%) in 1Q09, 2Q09, 3Q09, and 4Q09, respectively.  Simply stated: comps get much easier from here.  Clear signs of stabilization in the second quarter combined with the prospects of easier comps have made reprographers considerably more bullish about revenue prospects for the third quarter, a sharp change in sentiment from only three months ago.  52% of respondents expect revenues to increase on a YOY basis for the third quarter, while another 19% anticipate sales will be flat compared to 3Q09.    Keep in mind current consensus for ARP for 3Q10 calls for a revenue decline of 1.8% YOY.

Survey Results Support Our 2Q10 Estimates for ARC, At Long Last a Revenue Inflection Point?

The feedback from our survey suggests that ARP is well positioned to beat consensus revenue and EPS expectations for 2Q10.  At this stage we don’t think management will go as far as to raise guidance for the full year, given ongoing economic uncertainty.  However, we think it is possible management could raise the lower end of its full year EPS guidance of $0.15-$0.30.  We currently forecast revenues of $123.7 million and EPS of $0.10 for 2Q10 compared to consensus of $115.8 million and $0.05.  Consensus revenue forecasts contemplate an 11.7% YOY decline in revenues for the second quarter, which we think is overly conservative in-light of the feedback we have received from privately held reprographers.  One could argue that our revenue forecast for a 5.7% YOY revenue decline could also be conservative, but we think ARP’s large exposure to California could prevent the company from generating positive revenue growth.  Our EPS estimate is based on a gross margin forecast of 34.7% for the second quarter. Improved revenue trends combined with capacity rationalization and other cost cutting efforts over the past 6-12 months should enable the company to generate a 150-200 bps of gross margin improvement quarter to quarter.

For the third quarter, we conservatively forecast revenues of $118.8 million and EPS of $0.08.  Our revenue estimate, if achieved, would be inline with 3Q09 levels. As we mentioned earlier, a high percentage of reprographers now expect 3Q10 revenue levels to increase on a YOY basis.  Improvement in traditional reprographics volumes along with growth in color, printing for non-AEC clients, facilities management contracts, and consulting fees for RCMS all could enable ARP to top our current forecast.

Key Questions Heading Into the Earnings Conference Call

Here are some of the questions that we would like management to address on its upcoming earnings conference call:

1. What are the company’s plans to manage its branch capacity for core reprographics services? Over the past 18-months, we estimate ARP has reduced its branch capacity by approximately 15%.  As we discussed in a recent report on ARP, the company’s revenue-per-branch has declined from a peak of $3.2 million/year in 2000 to what we expect to be a low of $1.2 million in 2010.  We are interested to learn more about how the company plans to manage its branch network going forward.  While we expect revenue-per-branch to increase in conjunction with a recovery in non-residential construction spending, the magnitude of recovery is likely to fall below that witnessed in prior economic expansions.  ARP has a number of initiatives that could enhance revenue-per-branch even in the face of a secular decline in the number of prints ordered per project.
2. How much progress has ARP made with its “Riot Color” initiative?  On the company’s 1Q10 earnings conference call, ARP management indicated that it had rolled out its separate “Riot Color” initiative to a total of 8 branches.  Although ARP already generates 15-20% of its revenues from color printing services, the company elected to create a separate brand to enhance market awareness of its color printing capabilities.  We anticipate growth in color printing services could add 2-4% to ARP’s revenue growth rate over the next 12-18 months.
3. Are acquisitions back on the table?  Recently Servicepoint (a Spain based reprographer, with a significant presence in the US) announced its intention to resume acquisition activity over the next 3-6 months.  Additionally, ABC Imaging (privately held) acquired a firm in San Francisco. It is clear that some of the company’s competitors have re-commenced acquisition activity in order to expand their geographic footprint.  Acquisitions have always been an integral part of ARP’s growth strategy, although we expect them to play a smaller role going forward. There are a few geographic areas in which ARP still does not have a meaningful presence.  We are interested to learn if the company plans to deploy capital to pursue acquisitions in the traditional reprographics business or will it seek to further diversify its offerings related to color printing, BIM, or managed print services though M&A activity.
4. What progress has the company made towards positioning itself for the transition towards BIM? The acquisition of RCMS Group significantly enhanced ARP’s enterprise knowledge and service offerings for clients evaluating business information modeling (BIM).  RCMS provides consulting services to architects, construction firms, and engineers as they implement BIM solutions.  RCMS group now markets its services under the “iBIM” brand. In the past, ARP management has indicated that the revenue opportunity for the RCMS Group was relatively small, $8-$10 million annually.  Has the company determined other ways in which it can monetize its increasing BIM expertise?  We know ARP now hosts “BIM boot camps” in cities across the country, which has helped increase the awareness of ARP as a leader in the field.  We’re interested in learning more about the company’s endeavors in the broader BIM arena.
5. Is the company any closer to monetizing Planwell?  Planwell, ARP’s internet based planroom now hosts more than 38 terabytes of data and 15 million drawings. ARP has invested $10’s of millions in the platform, yet for the most part has done little to monetize it.  Management has expressed an interest in exploring opportunities to monetize Planwell which could include a subscription fee and project work related to the conversion of 2-D documents into 3-D, BIM ready images.  Any monetization of PlanWell would  represent upside to our estimates.
6. How soon will ARP become a full-fledged managed print services provider?  ARP’s expansion into managed print services appears to be a natural evolution for the company given its extensive geographic footprint and vast experience providing facilities management services to large companies.  We view ishipdocs as the company’s first endeavor towards evolving into a managed print services provider.  We know that ARP has recently hired seasoned executives in the managed print services space to further accelerate the company’s shift into that marketplace.

ARP Shares Remain Attractively Valued

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 6x prior peak cycle earnings and have a 2010 free cash flow yield of 14%. 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….