ARC Document Solutions, Inc. (NYSE:ARC) Q3 2022 Results Earnings Conference Call November 7, 2022 5:00 PM ET
Company Participants
David Stickney – VP, Corporate Communications & IR
Kumarakulasingam Suriyakumar – Chairman and Chief Executive Officer
Dilantha Wijesuriya – President and Chief Operating Officer
Jorge Avalos – Chief Financial Officer
Conference Call Participants
Operator
Good afternoon. My name is Abby and I will be your conference operator today. At this time, I would like to welcome everyone to the ARC Document Solutions Quarter Three Earnings Report Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions].
Thank you. Mr. David Stickney, Vice President of Investor Relations, you may begin your conference.
David Stickney
Thank you, Abby. And welcome, everyone. On the call with me today are Suri Suriyakumar, our CEO and Chairman; our President and Chief Operating Officer, Dilo Wijesuriya; and Jorge Avalos, our Chief Financial Officer.
Our third quarter results for 2022 were publicized earlier today in a press release. The press release and other company materials are available from our Investor Relations pages on ARC Document Solutions’ website at ir.e-arc.com.
Please note that today’s call will contain forward-looking statements and are only predictions based on information as of today, November 2, 2022, and actual results may differ materially as a result of risks and uncertainties that we highlight in our quarterly and annual SEC filings. Any non-GAAP measures discussed today are reconciled in our press release and Form 8-K filing.
I’ll now turn the call over to our Chairman and CEO, Suri Suriyakumar. Suri?
Kumarakulasingam Suriyakumar
Thank you, David. Good afternoon. And thank you all for joining us. Today, we are reporting our sixth consecutive quarter of growth in sales, operating income and earnings. Our balance sheet is rock solid. Our debt is low. Our Cash Generation is high. And we are well positioned to build on this progress in the coming quarters.
The strategy we put in place during 2019 created opportunities for ARC to grow in virtually any environment, primarily because we made diversity and resilience the keys to our success. The proof has been in our performance as we adapted to the economic pressures of the pandemic and growing inflation during these past several months.
The various markets we serve support our vision. Today, our customers’ desire to communicate is greater than it has ever been. And a few companies offer the kind of visual excitement, creative application and effective branding message that a digital print company like ARC does. Best of all, we think we are only scratching the surface of the market.
This, of course, is good news, whether the economy is headed for a slowdown or not. While the macro trends can put pressure on any organization, healthy businesses don’t communicate less during a downturn. Most of them actually communicate more. They compete harder for their slice of the economic pie and they need innovative partners to both make their messages tick and keep costs under control. We do both of these things extremely well.
To put our performance in perspective, I’ll turn the call over to Dilo and Jorge will follow with a financial review.
Dilantha Wijesuriya
Thank you, Suri. As we expand our customer base and continue to improve our marketing efforts, we have kept more qualified leads in the hands of our sales force throughout the quarter.
Our diversification strategy has many benefits, as demonstrated by the sales growth we have experienced in the past year-and-a-half. But our strategy is equally effective when we look ahead. Should the country enter a recession, we can shift our target among the wide variety of industry verticals we now address and sell to those customers who need us most. We can also choose among a wide variety of services to find solutions for customers, regardless of their budgets or the nature of their projects.
In the third quarter, our sales were up year-over-year in spite of volatile market conditions. Digital printing services, managed print services and document scanning services performed well.
Some of the new customer verticals we focused on provided us good results and we saw year-over-year growth in many of them. Our construction customers also stayed busy as the building environment remained steady. Our ability to introduce and sell a wider portfolio of services to our longstanding customers in construction helped us to secure a higher level of spend from them.
Sales from digital printing during the third quarter may appear to be light, but they represent a very successful effort to offset unusually large sales volume from last year. Sales of managed print services grew moderately as customers continue to bring back employees to the workplace. That said, we think it is likely that starting level will remain consistent in the remaining months of the year. As such, printing volume in the fourth quarter will likely remain steady as well.
Scanning and archiving has strong gains again in the third quarter. Because we are coming from a small base in this business line, the increase in dollar volume is what excited us most during this period. We are seeing many of our customers increase their desire for paper to digital document conversions used in day to day business operations. But we are also creating more and more digital archives to replace long term warehoused paper documents storage.
ARC’s customer satisfaction remains high as shown by the thousands of reviews on our website and on Google. Many of our jobs require close personal attention by our operations staff, as well as our sales people, and we go out of our way to exceed the increasing expectations of our customers.
We are fortunate to have built a reputation and culture that embraces and reward efforts to delight our customer. It is becoming a significant differentiator in our marketing efforts.
The headwinds we faced earlier in the year over hiring and supply chain constraints are improving. Finding good people is always a challenge, but we are seeing more and better candidates compared to last year.
Getting equipment and supplies has also become easier, though, we are still battling higher pricing for certain materials. These are issues that can have an impact on profitability, and thus we are managing them very closely.
In all, ARC remains on the right track. And we are well positioned to extend our progress in the near future. I’m also confident we have the people, the services and to demonstrate our value and to keep our customers engaged and interested in working with us.
With this as an operational backdrop for the quarter, I’ll turn the call over to Jorge for a review of the financials. Jorge?
Jorge Avalos
Thank you, Dilo. The sales profit and cash regenerated not only produced healthy performance in the third quarter, but it also helps solidify our capital structure.
Gross margins for the period were nearly 34%, representing 110 basis points increase, and $1 million increase in gross profit year-over-year. Increased costs affected our SG&A, but are within the range we expected. And most increases for materials and supplies continue to be passed on to our customers. As a result, our operating income rose more than 16% and our operating margin was up more than 100 basis points and our diluted EPS was $0.01 higher than the prior year.
As expected, cash flows from operations accelerated in the third quarter and we remain confident we will meet or exceed last year’s cash flows of $36 million.
Adjusted EBITDA was affected by higher labor and other inflationary increases, but was still over $11 million and resulted in a healthy margin of 15.3%.
We remain confident that sales will continue to grow within the normal constraints of seasonal performance. Q4 is usually the softest quarter for us, given fewer working days in the period, but we still think sales of $70 million or more are within our reach. And we are maintaining our annual EBITDA expectation of an average of $10 million or more per quarter.
As we look at ARC’s capital structure, our net debt to EBITDA ratio remains well below 1. Cash on our balance sheet is once again above $50 million, more than offsetting the $42.5 million outstanding on our revolving line of credit.
During the quarter, we continue to use available cash to manage our interest expense. As a result, we don’t think of ourselves as having any bank debt or exposure to variable interest rates.
As projected, finance lease payments for equipment continue to fall as our need for equipment declines. The third quarter finance lease payments of $3.8 million represent a $600,000 or 13.5% decrease from prior year.
All of this makes it easy to return shareholder value through our annual dividend of $0.20, which, based on our current stock price, is yielding more than a 7.5% return.
As I stated before, I like the new company we have created. Sales continue to grow month over month, quarter over quarter, and our opportunities and pipeline remain strong.
Our optimized and scalable cost structure allows us to maximize profit and grow margin. Cash outflows continue to drop as the need for new MPS equipment has decreased and we leverage our existing production fleet to accommodate growth and digital color printing. All of this increases the funds available to return shareholder value.
ARC and its investors are in a great position as we look forward to the end of the year, and even better one when considering our prospects for 2023.
Suri?
Kumarakulasingam Suriyakumar
Thank you, Jorge. Operator, we are now available to our listeners’ questions.
Question-and-Answer Session
Operator
[Operator Instructions]. Your first question comes from the line of David Marsh [ph] from Singular Research.
Unidentified Participant
Good quarter. I guess just wanted to talk to you a little bit about liquidity, which is obviously pretty healthy at this point. As the market continues to chug along and you guys continue to make progress, are there any acquisitions that you guys might potentially target with your liquidity position? Other players that maybe aren’t doing as well where you might be able to tuck them in and grow your business that way?
Dilantha Wijesuriya
We always keep our ears and eyes to the ground about acquisitions. We haven’t come across any good opportunities yet. But, however, we are always looking at possibilities. We don’t require any new locations, right? When we are looking for acquisitions, we want it to be very strategic about it. And because we have the locations, we have the equipment, we have the staff, so we don’t need another location and another set of equipment and so forth. So we are mostly looking for acquisition of customer lists and so forth to enhance our sales portfolio and really get a good healthy margin from those acquisitions. So, that’s our strategy, but we always look for them based on the opportunities that are available in the market.
Jorge Avalos
And you added a key point there that our leverage is really good right now. That is something that we’re not willing to do as a company to highly lever ourselves in this environment.
Unidentified Participant
That makes a lot of sense with the cost of debt going up. CapEx continues to be very, very modest. Are you having any supply chain delays on any equipment or any parts or anything that you need for any repairs for your equipment?
Dilantha Wijesuriya
No, there are no delays with regard to equipment requirements. It has improved a lot. But, however, our equipment requirements for large production centers and so forth. We are very well equipped. In the last probably three, four years, we’ve done a good job in modernizing our fleet of hardware in the past. So we don’t see much requirement for equipment in the coming maybe a year or two. But we always look for newer technology when it is required, but they are all well under control.
Unidentified Participant
Would you say that the current run rate cap acts as kind of a maintenance level for your business?
Jorge Avalos
Yeah, we think that the current level is definitely our maintenance level.
Unidentified Participant
That sounds good. Again, with regard to the cash, any opportunities around potentially either reducing leverage or other ways of perhaps returning funds to shareholders through incremental equity repurchases or perhaps a higher dividend?
Kumarakulasingam Suriyakumar
Basically, it’s opportunistic. We’re going to see how the market evolves, what the stock price is, and how much cash we have left. And depending on that, we obviously have three different types of – three areas, right? Obviously, dividends is one, buying back stock is the second one, and then, of course, reducing the debt. But as Jorge clearly said, there’s not a whole lot of debt to be reduced. So, it’s a question of opportunistic buying back shares and also dividends. And depending on the conditions and where the stock price is, we will do the needful to make sure we continue to maximize shareholder value. That’s our focus. That has been the focus for the last two, three years.
Jorge Avalos
As you heard on my script, we have $50 million in cash, we have a very flexible revolver that you can draw on it or pay back at any time, which is at $52 million. So the kind of question of delevering or to paying down debt, from our perspective, we look at it as we don’t have bank debt, we kind of offset those two and use available cash to reduce our interest rate or interest expense. Hence, we look at ourselves as not having exposure to variable debt.
Operator
[Operator Instructions]. Your next question comes from the line of Abigail Zimmerman.
Unidentified Participant
We’re just wondering, so it looks like you have really strong free cash flow and cash flow from operations. Do you think you guys can grow that over the next year or two? Is that a possibility? Any color there will be helpful.
Jorge Avalos
We definitely think we could grow it over the next couple of years. Twofold. Our EBITDA is increasing and we would expect our cash flow from ops to increase as our EBITDA increases. Then the other important fact is that, right now, we’re still saddled with capital leases that we had entered into kind of pre-pandemic four years ago, five years ago. Those are getting paid down. Hence why you see the big drop in capital lease payments. As I mentioned in my script, this quarter, we paid $3.7 million or $3.8 million in capital lease payments. Last year, that number was $4.3 million. So you combine those two factors, increasing cash flows with a decrease in cash outflows, that’s only going to make your free cash flows become bigger.
Unidentified Participant
And more to get the compensation. So just want to make sure we understand this. So looks like your net debt is only like $18 million and it looks like you could be debt free pretty soon. Are we understanding that correctly?
Jorge Avalos
There’s twofold. Kind of like I said before, we don’t view ourselves as having any bank debt because the cash we have on hand more than offsets the revolver we have outstanding.
The other debt we have in our books is roughly $25 million on capital leases. There’s a prepayment penalty on those better said. So, those will just kind of get paid off as the years progressed. But every year, we’re entering into new capital leases to the tune of roughly $8 million a year. What we’re paying down from historical leases is a much larger number. So, you will see that number drop, just as we make the required principal payments. You’ve seen a drop in the last 12 months, probably about $6 million to $8 million. You’ll see a drop in that range again for the following year. Does that make sense?
Unidentified Participant
Yes, that makes sense. Thanks for the clarity there. Those are the only two questions. Congrats on the quarter.
Operator
[Operator Instructions]. There are no further questions at this time. Mr. David Stickney, I turn the call back over to you.
David Stickney
Thanks, Abby. And thanks, everyone, for joining us today. Thanks for your ongoing interest in ARC Documents Solutions. And we look forward to talking with you again next quarter. Thanks so much. Bye-bye.
Operator
This concludes today’s call. You may disconnect.
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