ARC Document Solutions Inc (ARC) 2007 Q3 法說會逐字稿

Greeting, ladies and gentlemen, and welcome to the American Reprographics Company third quarter 2007 results conference call.

(OPERATOR INSTRUCTIONS)

It is now my pleasure to introduce you to your host, Mr. David Stickney. Thank you. You may begin.

Thank you, Jan, and thanks to everyone on the call today for joining us. With me today are Suri Suriyakumar, our president and CEO, and Jonathan Mather, our CFO.

Earlier today the company issued a release reporting financial results for the third quarter and year ending September 30, 2007. You can access this release and the company's other releases from the Investor Relations section of American Reprographics Company's website at www.e-arc.com. A taped replay of this call will be made available beginning about an hour after its conclusion. It will be accessible for seven days after the call. You can find the dial-in number for this replay in today's press release. This call is also being webcast live. A replay of the webcast will be available on our website for 90 days from today, again on www.e-arc.com.

Please note that this call contains forward-looking statements that fall within the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, regarding future events and the future financial performance of the company including the company's financial outlook. Such statements are only predictions and actual results may differ materially as results of risks and uncertainties that pertain to our business. These risks are highlighted in our quarterly and annual SEC filings. The forward-looking statements contained in this call are based on information as of today, November 1, 2007, and except as required by law, the company undertakes no obligation to update or revise any of these forward-looking statements.

This call also will contain references to certain non-GAAP measures. The reconciliation of these non-GAAP measures is set forth in today's press release and in our form 8K filing.

At this point it is my pleasure to turn the call over to our president and CEO, Suri Suriyakumar. Suri--

Thank you, David, and good afternoon everyone. Thanks for joining us.

Today I will begin with an overview of our performance in the third quarter, followed by an update of the key issues that have affected our business during the quarter and year-to-date. Jonathan will then provide details of our financials and then we will open the call to your questions as usual.

We has several very positive developmentss in the quarter, despite the weakness in the broader market, caused mainly by the continuing downturn in residential construction. The effect of this downturn on our performance is much greater than we originally expected, due to the exposure we have to the residential business in some of our key markets. It appears that this drag on the business will continue through the end of this year.

While we benefited from our efforts to refocus our sales teams in non-residential and non-(inaudible) markets, the ultimate effect on our numbers was minimal due to the loss of business in the residential segment which was worse in the third quarter compared to the first and the second quarters.

The good news is that the revenue for the third quarter was $176.2 million, up 15.5% compared to the same period last year. We remain excited about this aspect of our growth which is unmatched in our industry. Acquired growth for the period was approximately 10.9% and organic growth for the quarter was 4.6%, up from 4.3% in the second quarter.

Our gross margins came out at 41.2% during the third quarter of 2007, down 2.7% from the same period in 2006 when the business conditions were much different. This is mainly due to the lower absorption of our labor and overhead components caused by a loss of sales in some of our key markets. In addition, as we stated repeatedly earlier this year, our gross margins were affected by the aggressive acquisition activity during the year. While this has brought our margins down in the short-term, our history clearly shows that this will reverse shortly.

In spite of the lower revenues and depressed gross margins, the company's EBITDA margin for the quarter was a healthy 24.7% compared to 24.9% in the same period last year. Earnings per share for the third quarter of 2007 were $0.35 fully diluted. Overall, we do not expect any dramatic improvements in our core markets over the near term. We expect the impact of the residential portion of our business, which worsened during the third quarter, to remain through the end of the year.

While it appears that the fundamentals of non-residential construction remain strong, the availability of cash and tighter credit markets could have an impact on this business segment. This sentiment appears to be the same with other independent reprographers across the country. Given these conditions, we now expect our revenues for the full year to be in the range of $682 million to $687 million, with an EPS in the range of $1.42 to $1.46. This compares to our prior forecast of revenue to be in the range of $690 million to $710 million, with an EPS in the range of $1.58 to $1.62.

In spite of the softer market conditions we are experiencing in 2007 as compared to 2006, we continue to feel very good and confident about the company's performance. We continue to grow at a very healthy pace to further consolidate our dominant position in the industry. We are experiencing a record [year] acquisitions and our track record clearly shows that we are very capable of integrating these companies to successfully generate tremendous margins in a relatively short period of time.

As we continue to consolidate our position in the industry, we've become the only real choice for mega projects which are breaking ground all over the world. With more locations than any other reprographics company and a solid technology platform unmatched by anyone else, we can connect various players and their documents in a multitude of locations like no one else can. Recently we are managing documents and providing reprographic services for projects in China, Dubai, France and Japan. We fully expect this trend to continue.

Our recent entry into the Chinese market is an absolute testament to our growing technology strength in the worldwide reprographics industry. Our new partner in China, called Unisplendour, has an impressive technology pedigree thanks to its connections at the Tsinghua University, China's leading technology school and technology business incubator. Today, Tsinghua has 48% ownership stake in Unisplendour.

As the company was looking to enter the construction document management FM markets, their global search for a technology partner identified American Reprographics Company as their collaborator of choice. We believe our partnership with UNIS, a household brand name in China, will give us a tremendous opportunity in driving reprographics technology in the country for years to come. In addition, we must not forget that there are strong potential synergies with our existing business as our new relationship offers access to some of the largest construction projects in China, an undeniably attractive advantage for any large multinational construction firm who works with us.

On another technology front, we recently achieved a milestone in our industry by providing MetaPrint, our proprietary print driver software, to KIP USA, a leading manufacturer of reprographic equipment and division of the Asian electronics giant Katsuragawa Electric Company.

For years, equipment manufacturers have been providing print drivers to the reprographics industry, but, with nearly 300 locations and more than 4,100 FMs who knows print drivers than American Reprographics. By licensing this software to KIP USA, it will further advance our agenda to make our software the standard of the industry.

Finally, we are heading toward a record year in the number of acquisitions we have completed during 2007. This continues our drive to build a commanding position in the reprographics marketplace in which we already are dominant. Since our last call, we added locations in Nashville, Brentwood and Murfreesboro, Tennessee; Dayton, Ohio; Macon, Georgia; South Bend, Merrillville, Indiana; and Troy, Michigan. Last week, we were happy to welcome Cleveland's e-Blueprint, and today we are pleased to announce the acquisition of DPC Reprographics in Chicago both of which are strategic in nature. These two acquisitions add locations in Cleveland, Westlake, Beechwood and Akron, Ohio; Chicago, Illinois; and Denver and Aurora, Colorado. In all ARC now operates in 297 locations throughout North America.

With such a commanding position in the industry and unmatched leverage, we continue to be confident of our future potential. As evidenced by our record between 2001 and 2003, even when non-residential market experienced a downturn, we leveraged our position in the marketplace and took advantage of it to build market share. Furthermore, we believe our position in continuously enhanced by growing footprint and technology strength as the market continues to embrace a global working environment and the greater adoption of our technology.

Our FM count at the end of the third quarter increased by 272, in comparison with 231 in the second quarter with the total number of contracts reaching 4,195. Consistent with our belief that ARC is the only real choice for large companies operating in the AEC industry, we added two large clients to premier accounts, HKS, one of the top architectural firms in the US, as well as [Synergin] Incorporated, one of the largest contractors in the country. Nineteen well recognized clients currently fill out the roster for premier accounts.

The peer group also continues to post gains and now has 205 members with more than 380 locations. Combined with ARC's footprint our PlanWell technology products are currently available in about 650 locations around the world.

Finally, before closing, I want to briefly touch on the devastating fire which has ravaged Southern California. Thankfully all of our employees and their families are safe. However, at this time we are unable to ascertain the impact of the damage.

With that as the broad positioning of the company's strong performance and activity, I will now turn the call over to Jonathan for some color behind the financials. Jonathan?

Thank you, Suri, and good afternoon everyone. This afternoon I will provide you with some more depth to the numbers we disclosed in the earnings release today.

Beginning with revenue by product categories, in Q3 2007, reprographic services grew 18.4% compared to Q3 in 2006. Digital services, which I include in our overall reprographic services, grew 26.4% year-over-year and contributed 6.1% of total revenue in this quarter compared to 5.5% the prior period.

Facilities management grew 13.3% compared to the same period in 2006, while revenue from equipment and supplies declined 1.5% over last year. Revenue by geographical segment in this quarter was as follows - Southern California, $47.7 million; Northern California, $25 million; Pacific Northwest ,$11 million; the South, $46.8 million; Midwest, $19.3 million; and Northeast, $26.4 million.

With regard to revenue trends in Q3 2007 versus Q3 2006, Southern California was down 50 basis points; Northern California was up 6.5%; Pacific Northwest was up 36.4%; the South was up 41.1%; Midwest was up 1%; and Northeast was up 27.1%.

As Suri mentioned, gross margin for the third quarter was 41.2%, this compared to 42.1% in the second quarter of 2007 and 43.9% for the third quarter 2006. Again, we continued to experience higher than normal dilution to gross margin as a result of our large acquisitions early in the year. The dilution from these acquisitions amounts to approximately 100 basis points of margin in the third quarter. In the same period, 190 basis margin decrease was attributable to under-absorbed labor and overhead costs which includes 90 basis points from depreciation alone.

Our SG&A expense as a percentage of revenue decreased to 21.1% during the third quarter of 2007 as compared to 22.6% in the third quarter of 2006. It increased from 20.6% in the second quarter of 2007 excluding the settlement benefits recognized in that quarter. Stock-based compensation is included in SG&A expense. In Q3 2007 stock-based compensation was $1 million compared to $350,000 in Q3 2006, and $1 million in Q2 2007.

In the third quarter 2007, total depreciation, amortization and interest was $17.4 million, made up of depreciation at $8.1 million, amortization expense at $2.4 million and total interest expense at $6.9 million. This compares to Q3 2006 of $13.3 million with depreciation at $5.9 million, amortization at $1.6 million and interest at $5.8 million. The second quarter 2007 total depreciation, amortization and interest was $16.7 million, which is made up from depreciation at $7.6 million, amortization expense at $2.5 million, and total interest expense at $6.6 million. The increase in amortization and expense is due to the increased acquisition activity referred to earlier.

EBITDA for the quarter was $43.6 million, or 24.7%. This compares to 24.9% in Q3 2006 and 25.7% in Q2 2007. At this point, we will look briefly at the balance sheet. We ended the third quarter of 2007 with working capital, excluding restricted cash and current payables on the senior secured term loan of $28.1 million, or approximately 4.3% of trailing 12 months revenue. This compares to $19.3 million for June 2007, or approximately 3% of trailing 12 months revenue.

Days sales outstanding, or DSO, were 53 days in the third quarter 2007, compared to 54 days in the third quarter of 2006. Total debt, including capital leases, at the end of third quarter 2007 was $351.9 million, up from $349.1 million for the second quarter 2007. The ratio of debt to trailing 12 month EBITDA at the end of third quarter was 2.1, compared to 2.0 at the end of second quarter 2007, excluding costs from the Louis Frey litigation.

Twelve months cash flow from operations was $96.9 million as of September 30, 2007, or $2.11 per fully diluted share. Cash flow from operating activities year-to-date ending September 30, 2007, was $71.1 million compared to $72.6 million in the same period of 2006. Year-to-date payments for acquisition and payments associated with acquisition including earn-outs to sellers, amounted to $97.8 million compared to $59.2 million in the same period last year.

Finally, we continue to project a corporate tax rate for the balance of the year to be at 38.2%.

As noted in the press release, the company's is also taking steps to refinance our current debt. Among other expected benefits, this would ease restrictions on our ability to consider a stock repurchase. Our discussions with various lenders over the past several weeks have been positive and we anticipate completing the refinancing agreement by the end of this year.

That concludes our financial discussion. At this point, I will turn the call back to Suri. Suri?

Thank you, Jonathan. Operator, at this time we are able to take our callers' questions.

Thank you.

(OPERATOR INSTRUCTIONS)

Our first question comes from the line of Mike Fox with J.P. Morgan Chase and Company. Please proceed with your question.

Good afternoon, guys. Can you talk about the impact from the acquisitions in the fourth quarter in 2008 of acquisitions that you have already made?

In 2007 you mean.

Fourth quarter 2007 and then what is going to carry over to next year, the full year.

Right, right obviously. This is based on the current acquisitions we have, Mike. Obviously we have some in the pipeline as you know. We just announced that we closed Cleveland, this is e-Blueprint on Monday and then we closed DPC last night, which we just announced in Chicago. So, this is continuing -- I think the current number as it stands is -- but its flow through -- as it stands is now might be about $40 million, Jonathan?

In 2008, yes.

$40 million. Is that the question, Mike?

Yes.

About $40 million with the revenues will flow in.

Okay then, do you know the impact for the fourth quarter of '07?

Meaning the fourth quarter of '07, the impact of the acquisitions we have?

Yes

What's that number, Jonathan?

Mike, let me just clarify that question. Are you referring to the e-Blue and the DPC that we just sent out, or the acquisitions we have done year-to-date this year?

Both.

Okay. So, we disclosed the e-Blue revenue, DPC we haven't disclosed. But, I can tell you, we would expect this on the timing of these acquisitions to get $3 to $4 million from those acquisitions in this quarter. Again, we just acquired the businesses, let's say in the range of $3 to $4 million.

From acquisitions we have done this year, platform acquisitions, in the fourth quarter we are projecting in the $12 to $15 million range from those acquisitions.

Okay, so it will be about $15 million to $19 million total.

Yes, $15 million to $18 million in total.

Okay. And then, the SG&A leverage that you got, can you talk a little about that and should we expect that going forward?

Again, on fourth quarter generally seasonably for this business is a softer quarter. So, you won't necessarily get the same leverage that you would have been experiencing in say Quarter 2 '07. Again, this Q2 is a strong quarter, so seasonably yes, there might be a slight leverage but because of the seasonal, the holidays, et cetera., you won't expect to get as much of a leverage.

Okay, and then with regard to the Boeing contract. Can you discuss the progress there and can you discuss if there is any impact on margins, either gross margin or EBITDA, with regard to that contract. And then, do you see anymore opportunities within Boeing to grow that business?

Yes, Mike. Boeing business is going very well, from the time we kicked it off somewhere in the middle of the year and we originally bakedin about $1 million a month because we said it is a $12 million to $15 million contract and we expected to get $6 million-odd out of it. But, I think we will probably end up getting at least $8 million, based on the run rate that we have right now.

What we don't know about Boeing is that, because this is a brand new client, as to what their patterns of working on during the holiday season. That is yet to be established so we don't know whether they will have a larger period of time shutting down their facilities during the holiday time. But, based on what we know now, we think we would finish approximately around $8 million plus, that is an estimated number.

With regard to the gross margins itself, we expect the gross margins to be in the same lines, except for the fact that because we kicked off this operation just recently, all the expenses and so on, that might be slightly skewed, we have not gotten the full handle of it yet. But we think they are going to be around the same margins as the branch operations we have, the bureau operations, if not a couple of points lower.

Okay, then what about EBITDA operating margins for Boeing?

We expect that to be pretty similar to what we have in the bureau business, Mike.

Okay, great. And then, just one last one on acquisitions. You said that the pipeline remains pretty strong. Has the current economic environment had any impact on what companies are expecting for multiples and has that come down at all?

No. It is too early to say that. In fact, they've started making those noises just in the last several weeks, Mike. Obviously, the market has up to now on the non-residential side has remained pretty robust, so the general expectation from reprographers were that this is a good business. But, we are starting to, kind of, put a little pressure on that. But, whenever we try to do a strategic or a platform acquisition it is harder to push that down simply because of the strategic nature of the businesses. But, we expect it to come down if the market continues to remain soft.

Okay great. Thanks a lot.

Thank you. Our next question comes from the line of Mike Schneider with Robert W. Baird. Please proceed with your question.

Hi, good afternoon, guys. I just want to address what is left in the guidance here for Q4. It looks like, if I back into the numbers, that you are look for 4 to 4.5% organic growth in Q4. Is that right?

Yes.

Okay. And, sequentially, with the trends that -- or the trajectory of the trends we are on right now, is that a reasonable assumption that you guys can hold an organic growth, basically sequentially the same?

Yes, Mike. You see, what happened was, obviously as we talked about it previously, in the first quarter we had 4.5% organic growth and in the second quarter it dropped down to 4.3%, and the same question was asked whether we expect the organic growth to go up. And, we certainly did expect it to go up based on several initiatives we had in the company to redirect our sales forces to go off the non-AEC business. And, of course, the fact that Boeing business was back-loaded. However, what came somewhat as a surprise to us was that the third quarter the impact on the housing continued to go a little deeper. So, as a result we didn't get the desired results we wanted on that drive we had to generate additional sales. But, we certainly think we will hold that organic growth of 4.6% around for the last quarter as well.

Okay. Then heading into 2008, the trajectory of housing obviously isn't good and people are forecasting lower growth anywhere from plus 5 even to -10% on the non-res cycle for next year. Can you give us your early color on what you think you can hold based on what you know today, organic growth in 2008? Does it stay positive or should be expecting negative organic growth in 2008?

Mike, are you referring to the housing or are you referring to the non-res?

Well, total. Total ARC.

Total ARC. Yes, obviously we don't expect -- we certainly expect to grow, Mike. We don't expect the growth to be negative at all for the total company. We have been tracking about 4.6 this year, but of course, remember that we are comparing ourselves to a very robust period of time in 2006. So, we expect that number to be slightly better than we are doing currently, based on the information we have currently in hand.

And would that forecast assume a moderation in non-residential growth market?

Yes, I would think so. Based on what we are finding out now, although we don't have evidence on the ground, so to speak, of products getting canceled or any of the projects being put on hold, there is general softness in the marketplace given what is going on in the marketplace. For example, there was a report out in San Francisco, the vacancy rate actually went down to 9.8% from 10%, which means that it is down to single digits which is extremely attractive for vacancy rates. However, what they say is the number of deals they have closed dropped down significantly due to the credit squeeze and the cost of capital. So, I think that is a trend that we can expect given what is going on in the larger market space.

Okay, then Jonathan, the impact from acquisitions, did I hear you correctly that it is one full point on gross margins this quarter?

Yes, compared to previous year, 100 basis points was from the platform acquisitions that we have completed in the third quarter.

Okay, and given that you just closed two deals and some of these deals have come late in the quarter as well, the third quarter that is, should we expect a greater impact on gross margins as we head into Q4?

Since we don't give guidance on gross margins, it is safe to say we don't see a big improvement in gross margin for the foreseeable future because of our high acquisition rate.

Okay. And, as far as the acquisitions go, the pipeline is obviously more active than it has been in several years, have multiples come down as obviously the industry is softened here?

That is what I was answering in the previous question when Mike Fox was asking, Mike, that we haven't seen that just yet. But, it is also true that it so happened that we were fortunate enough to close fairly good acquisitions in the last three or four months. For example, earlier in the year, we finished two great acquisitions, one is MBC and ITS.

And, in Cleveland, Ohio, when we did e-Blueprint, that is the largest company in Cleveland, Ohio. So again, we were very fortunate to be able to close that one. BPC in Chicago, again we think is a significant player, one of the largest players in the Chicago marketplace, gives us access to now at a much greater depth into the Chicago marketplace.

So, the acquisitions we have done are fairly substantial, strategic places. So, so far we do acquisitions like that, we don't see a whole lot. But, if we do tuck-in acquisitions they're much lesser multiples. That is what we are doing right now. But, I suspect if the market conditions remain the same where there is - availability of cash is limited and there is a softness in the market looming, then I think there would be pressure on the price.

And, Suri, I guess if you take a step back, the stock today and presuming it is going to be down tomorrow will trade somewhere in the sixes on an EBITDA basis. Would you rather buy a market leader like yourself at 6.5 times, or buy some tuck-ins at a point or two lower, and, I guess what I'm implying is, how aggressive would you be on the share purchase program or is this going to be more of a headline program?

A couple of solutions there. With regard to acquisition of companies, Mike, if we get the companies from a footprint perspective in the right place, I think we will be aggressive. I think it fills to be aggressive, because like I said previously in my script, the real choice for larger companies today, if you want to do mega projects or big projects, are limited to basically, I think if you really want all of your documents on one platform and an efficient delivery of construction documentation, particularly with the adoption of technology, more and more companies are playing technology and they want efficiency. There isn't too much of a choice.

So, if I found a spot somewhere in the U.S., where we are not there and if that is going to be costing us 6 or 6.5 multiples, I would continue to buy it. Because, what it does is it gives us a greater strategic advantage in dealing with these customers, nationwide customers. I think that is a tremendous advantage. So, we would certainly buy that. But, I think there will be more pressure on the price as we go along because now the larger reprographic companies which are out there face a dilemma. Because, we just signed two large customers as national accounts, one is HKS and the other one is Swinerton. And, they are going to come off somebody, so -- if large reprographic companies are having these accounts in other marketplaces, then it is going to impact their business and that is a positive for us.

Okay. Thank you.

Our next question comes from the line of Scott Schneeberger with CIBC World Markets. Please proceed with your question.

Thank you. Guys, could you give us the make up of the organic growth in the quarter as best you could, how it would break out residential/non-res and other?

It is hard to do that, Scott, but I would say the non-residential part would be most of it. Because, the residential part is virtually non-existent, if not negative. I will give you a little bit of color on the residential/non-residential part. For example, if you take one of our large companies in Southern California, OCB, we are down about $8.7 million through the third quarter just in OCB alone. $3 million comes out of the third quarter. So, that is just to show you the housing impact. So, you know while we do understand the stock, what do you call our guidance have to be changed, it is largely due to concentrated situation in selected markets. It is not a phenomenon across the company or any one of our fundamentals. So, that is the part we are battling with.

Fundamentally what is happening is, because we had a commanding share in the marketplace which deteriorated in a very short period of time very significantly, we just had to take that hit. So, I think from an organic perspective, I don't think there is any housing in that segment at all. It is split between non-residential and non-AEC, because we have the Boeing business which is growing. So the split is between non-residential and non-AEC.

Oh, certainly for the positive parts those are the drivers. Could you give us an idea of how negative residential is as a contributor to the total?

Really hard to judge that, Scott. I mean, it is going to be guesswork on my part if I do that. Fundamentally, the way we see is that if you take the total business -- I just gave OCB as an example because that is a Southern California company and that is the best example we had. Like I said, they are down $8.6 million, Almost all those dollars came from residential business. So, if you extend that to the -- we could say, in that company alone we could end up losing $12.5 million. That is generally kind of giving a flavor for the amount of impact on our number due to housing.

Sure. That helps put it in perspective. So, I guess going forward to next year, and I know you are not going to be giving guidance today on what you think, but in an earlier question you alluded to the optimism that you would have improvement next year in your organic growth relative to this year. Did I infer that correctly?

Yes, absolutely. And, the only reason I am saying that, Scott, is because obviously when we talk about organic growth this year, we are always comparing ourselves to a very robust period last year. That will change because we are looking at a period which has now got impacted. So, like I said, obviously one of the challenges we have is that the expectation has always been very high given the guidance we had in place, given the market conditions we were experiencing end of last year and early this year. That has changed dramatically. But, that doesn't mean we don't have growth going on. We definitely have growth going on, and the company by acquisition -- the truth is, that we have pretty handsome growth, even this year, by any standard.

Okay, so basically as we move ahead to next year, obviously we don't know what is going to happen with res, the comps will get better as we move through the year, but would you venture out to say we have seen the trough or does that still look like it's in front of us?

If you are talking about residential, it is hard to predict that, given the fact that we had a bigger impact on the third quarter, Scott. So it is very hard to predict that. But, what we can say is that our efforts in redirecting our sales force to more towards non-AEC and non-residential is being driven hard and we certainly expect positive results from that.

Okay, thanks. And, I guess on that subject, obviously you are looking for more non-AEC work. Do you see anything potentially the size of a Boeing in the pipeline? Something that you are working on that could be that size, or is it more smaller work that you are pursuing?

We are actually working on several large accounts, Scott. Obviously we can't discuss names until we have something going. But, again like I said before -- I said this before, accounts like Boeing, that caliber, take a long time to close because of an existing contract or because of an existing commitment they have already made. But, we certainly having gotten Boeing, they are so many mega projects which are in the works. And, all of that is very encouraging to us because we really don't think there is anybody else capable of handling these mega projects. And, these projects, not all of them are in the U.S. Many of them are outside of the U.S. but large architects and construction companies in the U.S. are enrolled in these projects and, obviously, we have early disability in these projects. We cannot disclose any one of those, but there are several of those like we just disclosed two today, HKS and Swinerton, which are two large companies both of whom fairly high up in the list in terms of they are proficient in the U.S, obviously decided to go with us.

Okay. Thanks very much.

Thank you. Our next question comes from the line of Albert Kabili with Goldman Sachs. Please proceed with your question.

Hi, good afternoon, guys. A lot of the questions have been answered that I had, but circling back on some loose ends here, on the Boeing contract that you mentioned $8 million; can you break out the quarters on that? How much is third quarter versus fourth quarter?

A couple of things here, number one just so that you know, someone like Boeing is not very comfortable discussing as to how much business we get out of them just so that they don't want us to give details. But, in order to help we give some guidance. So, what we did is we baked in -- it is a $12 million to $15 million contract for three years. $12 million to $15 million per annum. So we started the contract in June, so we baked in $6 million in our original guidance. However, because the work started early because there was some hiccup with the contractor who was handling the project previously, and the fact that Boeing had started giving us more work because they are satisfied with what we are doing, we expect that number to be in the region of $8 million plus.

What we don't know, Al, is whether Boeing would have a two-week shutdown or whether they will close four days for Thanksgiving. Because, this is a brand new client for us and it is not in our history, we don't know really what their operating pattern is. So, I was just being cautious in not exactly throwing a number. But, we have about $1 million plus run rate with them, ballpark.

Okay. Got it. And then, next question would be on the housing market. And, I can certainly understand how challenging it has been, but as we look back even last year and later in the year, we had some housing headwinds that we occurring htat didn't seem to be impacting your overall organic growth like it is now. So, I guess the question is, is it possible that the non-res end of the market is slowing down more and that is what is going on, or could you help me understand that?

Sure. In the housing market last year at this time, you are right. There were headwinds already. There were signs of credit issues which were starting to show up. However, what typically happens in a construction business is whatever is in the pipeline people finish. So, for example, if you take large contractors, housing contractors who are having tracks of [form], they are, let's say, half way into the projects or three-quarter into the projects. They will continue to finish the project, because it is more costly for them to stop doing those things, particularly if they have broken ground. So, basically what happened was, all of that work got finished. And, the real impact of that shutdown, or the slowdown in the housing, we did not realize until the end of the first quarter. Suddenly at the end of the first quarter, we got a big bang.

And we have always said, Al, that we have six to twelve months early visibility and we are late in, late out. So, we do know that even though the market feels so softness, we will continue to have the work. Right now, the biggest indication we get is because we work in the early stages, which is design development, bid, build, we have a fair amount visibility into what is going on in the design area. We haven't seen a significant slowdown there, in that aspect of the business. What we are seeing, in general, is the slowness with which the products are being executed. So, we think the credit market and the availability of cash is having an impact, but we don't have any quantifiable sum to sau the non-residential market will be affected. I think the real position here is, if the market holds on non-residential will be fine. But, if the larger market gets into trouble, if the larger economic cycle gets into difficulty, then obviously it is going to affect non-residential.

Okay. And, I guess on the margin front a little bit, we talked about the diluted acquisitions hitting the margin line about 100 basis points. And then you also talked about absorption of fixed cost overhead. Yet your organic growth is still positive in the quarter, so are you just adding more overhead at a faster rate than your growth rate, or -- help me understand that dynamic.

Right. It is obviously, Al, although we have the 4.6% organic growth, the erosion in the business has come so fast we haven't made any adjustments we would actually make with the absorption of labor and the other costs, because obviously we don't want to make those cuts right away. We want to see what the real impact is. So, all the third quarter the loss of business has been pretty significant and, as a result, the absorption of the labor and all the other costs has not been at the same level as it was in 2006. So, that is the one which is affecting our gross margins, even though the organic growth on the overall market seems to be greater, the impact of the erosion of the loss of business is affecting us.

In addition to that, as we have always said, when we acquire new companies, particularly large companies, and if they have had any reason for any slippage in their numbers then it immediately impacts our gross margin. For example, when we acquired ITS, which is the $42 million company, it was part of a $120 million or $130 million company. So, when we bought the reprographics business, about $42 million, there were a lot of changes the company has to go through. We had to set up our own accounting systems. We had to set up our own collection systems. We had to set up the back office separately in Atlanta. So, all of those added costs actually did not give us a very clear visibility for at least the first 90 days. Sometimes we are faced with situations like that. In situations like that, they actually drag our gross margin down.

Okay. And then, final question for me is on pricing. What are you seeing in terms of pricing and perhaps what is the outlook as we look out into next year?

Right. There are two elements that are happening at the same time. One is, we have always said we don't have the pricing power right now, Al, given the fact that the customers have a choice to either use technology or not. Because, if today we go to a customer and obviously [has the ability] the small reprographer, the customer has the choice of not using technology at the lower cost or do we use ARC at a higher cost. So, we obviously don't want it to be at a competitive disadvantage. So, we have always we haven't got the pricing power yet and when the technology adoption gets greater and greater, we will get better pricing power.

What we are seeing is we are getting better pricing advantage in terms of larger customers, because there doesn't seem to be a whole lot of options for larger customers and this position will only improve. But, I can't see any evidence right now of being able to predict that number, but we are starting to sense that that transition is starting to happen.

Okay. So you could be seeing some inflation then on the cost side if your pricing is not keeping up with your costs. That could also be impacting your margins a little bit.

Right, but if you got to the cost itself, we -- any cost increase we have no trouble passing it over, and is exactly what all the reprographers do. For example, all the fuel increases we have been able to pass through our customers. We have fuel increase charges. And, if there is an increase in paper prices, we are able to pass that on to the customers. That, we don't have a worry about it. Needless to say, the construction cost is going up significantly but from a reprographic perspective, Al, that will not affect us. We don't ever worry about that.

Okay. Great, thank you, guys.

Thank you.

(OPERATOR INSTRUCTIONS)

Our next question comes from the line of Matt McGeary with Sentinel Asset Management. Please proceed with your question.

Hi, good evening. Just circling back to a question I think Mike Schneider maybe had. Regarding sort of capital allocation, could you sort of walk me through how you approach a potential scenario which you might see in the near future where let's say you are successful hopefully in renegotiating your debts so that you can buy back some stock. You are going to have your own very cheap stock in front of you to buy. At the same time you also probably have more M&A opportunities than you have ever seen before. So, tell me sort of how you balance that in your mind, just from the capital allocation perspective.

Sure. Obviously our first priority is to continue to do the acquisitions because that is an opportunity we have. But it is also true that we generate a fair amount of cash on our own. I mean, we do and we will generate in excess of $100 million in cash this year. In general, the cash we have-- at least in the last few years, the cash we have generated has been more than adequate for our acquisition program. However, like you said, this year our acquisition program is ramped up because obviously the pipeline is very strong and we were fortunate enough to get some really good companies to be able to add to our portfolio. Now, assuming that we will be closing our refinancing without any hiccups, obviously it is not done yet, like Jonathan said. We are talking to the banks. We are going in the right direction and it is all looking very positive. If it is done, we will suddenly look at the stock buyback, because obviously we have a very, like you said, a very attractive stock in front of us and that is the program that we want to consider.

But, what we want to first do is complete the refinancing and then decide, based on the market conditions, whether it is appropriate thing to do from a stockholder perspective. Obviously, if the stock price goes up significantly, or if in closing the finance if we found the interest rates are too high, or if there was a negative impact, then we don't want to do that. We obviously want to make sure. But if everything goes well, then you certainly consider that.

All right. Do you have a sense, I'm sure it is hard to break out, but how much of your business is directed toward the large construction projects, be it governmental or something else, versus strip mall, kind of small non-res -- if you look at just the non-res portion of your business.

Right. We actually are unable to break that down. It is not something that we do because it is hard to monitor projects. But we certainly keep track of all large projects in the nation, because that is obviously closer to our heart. Given our size of the company, we keep track of every large project. Not only just large projects, such as ballpark stadiums and airport projects, but we are talking about mega projects. If you are talking about mega projects, you are talking about projects like city center, and so on. The new project which is coming up in New York which involves the Madison Square or a very large airport development which runs in to tens of billions of dollars.

So we obviously keep track of them. However, it is hard to break because it keeps changing constantly because once we are in a mega project it could be a significant portion of that work could be attributed to the mega project, but once the project stops then it could be smaller projects. We do not have a definite breakdown between mega projects and small projects.

Great, thank you.

Thank you. Our next question comes from the line of Todd Beiley from Kayne Anderson Rudnick. Please proceed with your question.

You read off a number rates by geographic region. Could you help us understand internal growth by geographic region, exclusive of acquisitions?

Todd, that is hard to do. We don't actually break that down, because of the fact that we break -- these are obviously, these numbers that we have been historically giving because they wanted some color as to how the division, the geographical divisions break down, so we have been tracking them. But, we never actually separate them between organic growth and acquisition growth because it is a harder thing to do. And, it is a constantly moving target, Todd. So, we unfortunately don't -- that is not a metric we track.

Do you have then a general sense of where internal growth has held up versus where it has not?

In terms of the larger market space?

In terms of geography.

We do not break it down where the internal growth, but obviously we have 44 divisions. We do track the divisions individually to see how well individual divisions are performing, but that is not something we share with the public, Todd. But we keep track of each of the divisions and see how each division is performing. But, if you generally want the sense where we have had the biggest loss is area such as Southern California. Definitely Northern California was impacted but not as much as Southern California. Phoenix, Arizona, is the big spot, again we got impacted there because of the fact that the housing market impacted us there. We have definitely had an impact in Florida, in Miami specifically where there was a fair amount of residential work. In Atlanta, is another area that got impacted. So we have a general sense like when and where. When we are monitoring these divisions and we ask them what happened to your numbers, why has this happened, then we have a general sense, but that is not something we track closely. It isn't good enough and consistent enough for us to be sharing with the public market, Todd.

Do you have a general sense of four of those markets that you just named if non-residential business has held up?

Ask me that question again, Todd. Within the non-residential markets have held up?

In those geographic markets that you mentioned where there is softness, has non-residential business held up?

Yes, we think so. We do not see -- we have not seen signs on the ground in any place where the non-residential (inaudible). It is slower, but we have not seen -- we have still seen positive growth in almost all areas.

So, you area saying that in those areas, you are seeing positive non-residential business but maybe not at the same pace as other geography?

Exactly.

And, your balance sheet, your interest expense coverage. In the most recent quarter, interest expense coverage was five times by EBIT and six times by EBITDA. I wonder about your comfort level at higher leverage. It is not something that we would be comfortable seeing much more levered.

On the overall company leverage, you mean?

Yes.

We have talked about this previously, Todd, and it is our opinion that the leverage on the company is pretty low. It is also the opinion of all of our bankers and auditors. So, I don't know whether you know this historically, we were at 4.8 multiple leverage, 4.8 times leverage, one time. And, never during the history of the company, this was due to the working capital, it was purely due to the two recaps that we did. We did one in 1997 and then we did a recap again in the year 2000. Most of that obviously ended up in drawing large sums of money out of the company and we were in excess of 4.5 multiples. All of the banks we are working with currently, all of the institutions -- lending institutions, know that that has been the case. So at two and less we are really comfortable.

Todd Beiley. Thank you.

Thank you. At this time there are no further questions. Gentlemen, do you have any closing comments?

Not at this time. Thank you very much everyone for joining us. We appreciate your attentiveness and your support of American Reprographics Company. Have a great evening.