ARC Document Solutions, If You Loved Seabiscuit

ARC Document Solutions Inc. (NYSE: ARC), a small digital printing and graphics imaging company, will remind you why you fell in love with investing, i.e. finding those undiscovered small companies that fell on hard times when no one was looking and few believe that they will come back and regain their lost glory.

“You don’t throw a whole life away just cause he’s banged up a little”

Seabiscuit, Movie, 2003

As a small investor, one has an edge over large institutions in opportunities like these since a lot of institutional investors don’t have a mandate to invest in stocks trading below $5 or micro caps.

Last week, ARC Document announced that results for the third quarter would be stronger than previously expected. But the announcement was more significant than a usual pre-announcement on the upside. It highlighted the turnaround that was first sighted during the second quarter numbers is firmly established, with revenue growing by 9% sequentially and EBITDA growing over the third quarter last year as well as sequentially.

Now that there aren’t any threats to the survival of the business, this might be a good time to look at the opportunities that the company can monetize, especially with strong cash flows, a decent balance sheet, and a growing topline. 

Why is it worth looking at such a tiny company?

I’m as dismissive about micro-cap value traps as any other investor who’s been burned by a one, ever in their careers. The key question is whether the ‘return on invested brain damage’, a term coined by Bill Ackman, is worth it? And in this case, the answer is a firm yes.

This one is interesting for a few reasons and the top one is because the business has already turned the corner and growing while generating decent cash flows.

Second, the valuation at which the stock is trading is just ridiculous. At the current enterprise value of approximately $95-100 million, the stock is trading near 2x EV/ adjusted EBITDA and 5 times EV/ cash flow from operations during the last quarter. Yes, you read it right, quarter, and not a year.

Third, the company has done buybacks and given dividends in the past and open to the idea of transferring cash back to shareholders.

Four, the company is playing it responsibly with the newfound power, i.e. cash. Instead of opting for short-term measures to boost the stock via hefty dividend or big buyback that may end up limiting liquidity, management is building a balance sheet, something that always comes in handy in an industry where small local players constitute a big portion of the market and struggling. 

Threats, not there anymore

Just a few months back, the company was struggling for survival. The pandemic hit when the management was busy restructuring the business that was in a secular decline with traditional digital printing and graphics imaging companies with physical store presence facing pressure from digital entrants while competing with local vendors on pricing. The stock that traded near $10, 5-6 years ago, was struggling to stay above $1, resulting in delisting threats.

But the business seems to have overcome all three of the major threats, i.e. survival of the business, delisting, and decelerating revenue base.

The new ARC is a business that is generating $280 million (Q3 annualized), with 32% gross margins, 15% adjusted EBITDA margins, and decent free cash flow, given the business requires limited capital expenditure, $1.5 million last quarter.

Continued listing on the NYSE would require the stock to trade above $1 for 30 days before the end of the current year and looking at the fundamentals, it might not be too difficult to achieve the same, especially after the company delivers results next week.

They’ll come for value and stay for growth

Valuation and cash flows are of limited interest for investors when yields are close to all-time lows, which is why I waited to enter the stock till the business is back to growing its top line again.

Yes, one quarter doesn’t make the trend, even if the performance was during the worst phase in the history of the industry, but what got me excited were sustainable growth catalysts, namely

  • New verticals
  • A bigger share of the customer wallet
  • Opportunity to lead consolidation in the industry

New verticals

Just like Cloud, streaming, gaming, and social media benefitted from lockdown in the digital space, signage printing and graphic industry have benefited from Covid-19 related precautions in the physical world, with a huge increase in notices and signage posted for social distancing, disinfectants, safety, etc., in all physical locations.

Growing use of signs in the physical world. Image source: ARC Document Solutions

ARC Document Solutions used to be heavily dependent up architectural, construction, and workplace markets, but post-pandemic, there is a significant jump in business from healthcare facilities, schools, grocery stores, car dealers, real estate managers, shopping malls, etc. Besides growth, the change will help the company diversify its revenue base as well.

A bigger share of the customer wallet

Another favorable trend for the company, post-pandemic, will be the customers, especially large ones, opting for tech-savvy players with a national presence who can deliver large orders to all their locations, efficiently and remotely.

Launching creative new products. Source: ARC Document Solutions

ARC Document has already launched touchless printing and converted most of its print ordering systems to the web and mobile apps, which combined with nationwide delivery and a footprint of 190 locations will pose a serious challenge to small local players in the post-Covid world.

On top of that, the company now, with an improved balance sheet, will have resources to compete by offering creative products and quick turnaround times.

Opportunity to lead consolidation

Even though the management has made it clear that acquiring small players will not be a great use of capital right now, but there is no denying that the industry will churn out the weak players over the coming months and ARC, if the current performance momentum continues, will be in a position of strength.

Even if the company avoids acquiring competitors, building a bigger portfolio of related services can also help create value for the shareholders.

DISCLOSURE: We are Long ARC Document Solutions Inc. stock. Before writing a note, we usually ask (via Twitter and Stocktwits) for things readers would like us to cover in the note, please do share your views for our next note. This is purely an academic exercise for our internal use and you should NOT invest based on this note.

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