Why I Bought A Few Shares of ARC Document Solutions

ARC Document Solutions is A Fair Company at a Wonderful price

Published on:
March 9, 2018
Written on:

About The Author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Noam worked as a Vice President in Capital Markets at Silvergate (publicly traded on NYSE under SI since Nov-2019.) At SI, which he joined in 2010, Noam was responsible for advisory services to family offices,  private companies, and financial advisors.

It takes a long time to know another person’s inner thoughts. But it doesn’t take much to know if you would even be interested in knowing those thoughts in the first place.  And what is true in real life often applies to the abstract world of investing. This week, looking at stocks that traded at a 52-week low, I found a company that had all the right qualities.

In the following paragraphs, I will briefly go over what led me to buy shares in ARC Documents Solutions, which I will refer to as ARC.

At a price of about $2, ARC’s purchase price is less than 10 times the adjusted earnings per share

 To arrive at the adjusted earnings per share, I changed the reported figures. Specifically, I added back the depreciation expense and goodwill impairment expense to net income. From that number, I deducted the annual capital expenditure to arrive at what I estimated were normal earnings for the company. If you look at the reported income statement, you will see that ARC had a loss of $65 million in 2017, a loss of $13 million in 2016 and a loss of $27 million in 2015. 

Some of the reported losses were nonsensical to me. Take the deduction of the goodwill amortization as an example - it is an expense with little economic reality in the case of ARC. So, after subjective adjustments, I had estimated that ARC earned an average of $30 million or $0.65 per share over the past three years. 

Discount to book value

 I estimated that the 2017 tangible equity was $116 million or $2.52 tangible equity per share and that in 2016, the tangible equity per share was $119 million or $2.58 tangible equity per share. Similar to the reported income statement, my estimate was different than what was reported in the annual report. I adjusted the balance sheet in two ways. First, I completely removed the goodwill account from the asset side of the balance sheet; second, I added back 50% of the accumulated depreciation related to property and equipment.

Reasonable financial leverage

 For every dollar of debt, ARC earns about two dollars of free cash flow. It is not a stellar financial leverage coverage ratio - a coverage ratio of five times the interest expense is more befitting of a conservative company - but a fair one. I estimated the company's free cash flow using the following formula: cash flow from operations minus capital expenditures minus capital lease expense. Over the past five years, the average free cash flow was $12 million, compared to an interest expense of $6 million.

As a side note, I do not expect the 2017 capital lease expense of $66 million to be repeated over the next few years. While I rarely prognosticate about future capital expenditures, I make this prediction based on ARC’s historical record. Between 2016 and 2011, the capital lease expense range was $12 to $25 million.

A stock price at a ten-year low

 Here is the “biography” of ARC’s stock: the company listed its shares to the public in 2005 at about $30 per share. For the following two years, the stock price climbed to $35 and descended to $15. With the Great Recession, ARC lost its popularity, and during the next five years, between 2008 to 2012, the average price of the stock was $8. The following five years were even worse in terms of quoted price: between 2013 to 2017, the average price of the stock was $6.

Let us look more carefully at 2017. In that year, ARC’s stock traded as low as $2.30 and as high as $5.55. As I write these words, the stock is trading at about $2.20. If you look at the period between 2007 and 2017, you will be able to count four periods in which ARC traded at roughly twice the current price. And more importantly, in each year, the stock price climbed back to twice that level.

Capable management

Kumarakulasingam Suriyakumar, boss of ARC, has been with the company in various roles for over 25 years. The technology officer, Rahul Roy, has been in the reprographics industry since 1993. It should be obvious: the two of them are industry veterans. Compare that to yours truly, who had to look up the word “reprography” (the science and practice of copying and reproducing documents and graphic material). 

Given my abysmal knowledge of the industry and its prospects, I rely on management. I trust management when they explain ARC’s competitive position:

No other national service provider possesses the document management and technology expertise that we have. Construction professionals have highly specialized needs in document capture, short-term storage, management, fulfillment, distribution, and archival services. We believe our domain expertise is unmatched thanks to our legacy in reprographics and software development. 

Reasonable product

ARC focuses on a niche segment. I do not believe the company faces an immediate threat from competitors such as Dropbox or Box. The latter two companies focus on businesses and individuals to store their files while ARC is a brand name in the architecture, engineering and construction industry, where “customers look for a partner that can manage the scale, complexity and workflow of their documents management,” reports management.  Click here to see a video of what ARC does.

Higher expected yield than a three-year certificate of deposit

 And finally, I expect that over the next three years, ARC will earn more than I would receive if I was to purchase a 3-year certificate of deposit. As I wrote in the past, my goal in 2018 is to save and to allocate to stocks $20,000. And whenever I purchase a stock, I compare its expected return over a three year period compared to what I would earn if I passively purchased a certificate of deposit. Last time I checked, the three-year CD yield ranged between 2.40% and 2.55%. In buying shares in ARC, I expect to earn at least 25%.  

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