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American Reprographics Company: A Company with Negative Book Value

October 12, 2010 | About:
Stockmanmarc

Saj Karsan

20 followers
American Reprographics Company (ARP) provides document-management services primarily to the architectural, engineering and construction (AEC) industries. Since those are cyclical industries, demand for ARP's services has taken a beating, but not as much as the company's stock price. The company trades for $360 million, but has generated operating cash flow superior to that over the last four years, and expects to generate at least $65 million in cash flow this year as well.

The company's earnings picture is not so pretty, however, as it has taken large charges as a result of both Goodwill writedowns and annual intangible amortization. But these are non-cash charges, so while they make the company's P/E look high and/or negative, they are for items the company has already paid for, i.e. they do not affect current cash flow.

These "items the company has already paid for" are other firms ARP has acquired. ARP's strategy is to grow by acquisition and benefit from economies of scale that such a market share advantage allows (including spreading out R&D costs over more customers, lowering equipment purchase prices etc). The company is doing well in that regard, as it has approximately nine times as many locations as its nearest competitor.

But despite the fact that the company is profitable in a trough-revenue environment and trades cheaply relative to its cash flow, there are some risks facing potential investors of this stock. First, the company financed its acquisition growth using debt. While the company's strong cash flow has allowed it to reduce its total debt by almost $75 million in the last five quarters, it still has a net debt position (including operating leases) of around $300 million. Much of that debt is due in just over 2 years. As a result, if things turn south for the economy or the company, it does not have a lot of financial leeway. On the other hand, management has stated that if revenues do drop further, it does have the ability to reduce expenses by closing the least profitable of its almost 300 locations.

In general, the company hasn't made great decisions with respect to capital allocation. It did a stock buyback in 2007 when the share price was much higher, and now has to focus on debt repayment when the stock price is much lower. Furthermore, it ratcheted up its Goodwill balance during the boom years by buying high (resulting in recent writedowns), and now lacks the gumption to make acquisitions while target companies likely sit at much more attractive prices.

As a result, the company's tangible assets are actually negative! Therefore, one really has to believe in the earnings power of this company before one invests. That requires understanding this industry, including the technological risks that are both threats and opportunities for this company. (Technological advances are making it cheaper to print higher quality documents, for example. This could increase volumes for the company, but could also be a disruptive force in the industry if the company is not on the ball.)

Management incentives do seem aligned with shareholders, as the CEO effectively owns 17% of the company's shares, dwarfing his salary (which is a good thing). Many executives also took temporary pay cuts over the last two years as part of the company's cost reduction plan. At the same time, however, it should be noted that the company did exchange a bunch of options with exercise prices averaging $24.50 for options with exercise prices of just $8 during April of 2009, when the stock market was in rough shape. This reeks of an employee cash grab, but was fully expensed, and considering the CEO's ownership position and subsequent pay cut, may have been an important incentive offering on his part to retain key employees through the downturn.

Finally, it is worth noting that the company is managing to increase market share despite the drop in revenue. This is because of new initiatives ARP has been pushing, including expanding in markets outside of AEC by taking advantage of technological advances that are lowering colour printing costs. The company is also growing (albeit from a small base) in its Chinese operations, and has been successful in a new initiative where it offers services at the customer's own location. As such, management is confident that the company is well-positioned to grow revenues once the AEC market returns to normal.

When tangible book value is low (or in this case, non-existent), investors cannot rely on a margin of safety in the form of assets. Only if the company falls within the investor's circle of competence can he properly evaluate whether the company's earnings power does in fact offer that margin of safety. If earnings in the future are as they were in the past, this company is a strong candidate for a value investment.

Disclosure: None

Saj Karsan

http://www/barelkarsan.com



Rating: 2.5/5 (4 votes)

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