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ARC > SEC Filings for ARC > Form 10-K on 13-Mar-2013All Recent SEC Filings

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Annual Report

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the other sections of this Annual Report on Form 10-K, including Part 1, "Item 1 - Business"; Part I, "Item 1A - Risk Factors"; Part II, "Item 6 - Selected Financial Data"; and Part II, "Item 8 - Financial Statements and Supplementary Data."

Business Summary

ARC Document Solutions provides specialized document management services to businesses of all types, with an emphasis on the non-residential segment of the architecture, engineering and construction ("AEC") industry.

We help our customers reduce their costs and improve efficiency in the use of their documents, improve their access and control over documents, and offer a wide variety of ways to print, produce, and store documents.

In an effort to increase the visibility into the nature and changing dynamics of our consolidated business, we have categorized our service and product offerings to better report distinct sales recognized from our Onsite Services, Color Services, Digital Services, Traditional Reprographics Services, and Equipment and Supplies Sales. Under our previous revenue reporting structure, the categories of Traditional Reprographics, Color Services, and Digital Services presented below were combined and reported as "Reprographics Services."

Onsite Services, consists of placement, management, and optimization of print and imaging equipment into our customer's facilities, relieving them of the burden of owning and managing print devices and print networks, and shifting their costs to a "per-use" basis. Onsite services sales are driven by the ongoing print needs of our customers, and are less exposed to the episodic large-format printing needs associated with construction projects. This category has been renamed from "Facilities Management", but the service offerings reported in this category remain unchanged.

Color Services consists of specialized color printing and finishing services to marketing departments, regional and national retailers, and our traditional AEC customer base. This includes services provided under our Riot Creative Imaging brand.

Digital Services consists of digital document management services of all kinds, including archive and information management (AIM), "digital shipping" and managed file transfer, software licensing, and technology consulting services.

Traditional Reprographics consists of the management, distribution and print-on-demand of black and white construction drawings (frequently referred to as "blueprints") and specification books, and derives a majority of its revenue from large-format black and white printing.

Equipment and Supplies consists of reselling printing, imaging, and related equipment to customers primarily in the AEC industry. This category remains unchanged from prior filings.

Traditional Reprographics, Color Services, and Digital Services were previously disclosed as "Reprographic Services" sales. We believe the updated presentation of our sales categories reflects the drivers of our consolidated sales and will provide greater insight into the opportunities and risk diversification provided by our portfolio of service and product offerings.

We are diversifying our business beyond the services we have traditionally provided to the AEC industry and are currently focused on growing managed print services, digital color imaging, and technology-based document management services, as we believe the mix of services demanded by the AEC industry continues to shift toward document management at customer locations (represented primarily by our Onsite Services), and away from its historical emphasis on printing of large-format black and white construction drawings "offsite" in our service centers (represented primarily by our Traditional Reprographics). We deliver both our traditional and evolving services through a nationwide network of service centers, locally-based sales executives, technical specialists, and a national/regional sales force known as Global Solutions, which is managed from our corporate offices in Walnut Creek, California.

Acquisition activity during the last three years has been minimal and did not materially affect our overall business.

We believe ARC Document Solutions offers a distinct portfolio of services within the AEC industry that include its legacy reprographics business as well as its newer offerings in Onsite Services, Color Services, and Digital Services. Our customer base for these services, however, is still distinctly related to the AEC industry. Based on our analysis of our operating results, we estimate that sales to the AEC industry accounted for approximately 76% of our net sales for the year ended December 31, 2012, with the remaining 24% consisting of sales to non-AEC industries.

Historically, our local production facilities have operated under their acquired brand. In response to changes in our markets, consisting primarily of the consolidation of our larger customers and prospects as noted above, we branded all of our operations "ARC" in 2011 to highlight the scope and scale of our services, and refined our identity further at the end of 2012 by renaming our Delaware corporation "ARC Document Solutions, Inc." Our non-AEC Color Services are branded separately as Riot Creative Imaging to facilitate marketing to a specialized customer base.

We identify operating segments based on the various business activities that earn revenue and incur expense. Since operating segments have similar products and services, classes of customers, production processes and economic characteristics, we are deemed to operate as a single reportable segment. See Note 2 "Summary of Significant Accounting Policies" for further information.

Costs and Expenses. Our cost of sales consists primarily of materials (paper, toner and other consumables), labor, and expenses for facilities and equipment. Facilities and equipment expenses include maintenance, repairs, rents, insurance, and depreciation. Paper is the largest component of our material cost. However, paper pricing typically does not significantly affect our operating margins due, in part, to our efforts to pass increased costs on to our customers. We closely monitor material cost as a percentage of net sales to measure volume and waste. We also track labor utilization, or net sales per employee, to measure productivity and determine staffing levels.

We maintain low levels of inventory. Historically, our capital expenditure requirements have varied due to the cost and availability of capital lease lines of credit. During 2012, we were more frequently electing to purchase equipment for our facilities and onsite service installations rather than lease equipment due to the availability of cash to fund capital expenditures and interest savings. As we continue to foster our relationships with credit providers and obtain attractive lease rates, we may increasingly choose to lease rather than purchase equipment.

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Research and development costs consist mainly of the salaries, leased building space, and computer equipment that comprise our data storage and development centers in Fremont, California and Kolkata, India. Such costs are primarily recorded to cost of sales.

We believe customers are increasingly (1) adopting technology and digital document management practices, and (2) changing their document and printing needs. While the construction market appeared to begin its slow recovery in 2012, we believe that there was a growing body of evidence by the third quarter of 2012 that proved Traditional Reprographics sales, produced at our service centers, would not recover at the same pace due to these factors.

To ensure that the Company's costs and resources were in line with our current portfolio of services and products, and that our primary offerings were tied to growing markets, management initiated a restructuring plan in October of 2012. The restructuring plan implemented in the fourth quarter of 2012 included the closure of 33 of the Company's service centers, which represents more than 10% of our total number of service center locations. In addition, as part of the restructuring plan, we reduced headcount and middle management associated with our service center locations, streamlined the upper management team, and allocated more resources into growing sales categories such as managed print services and digital services. The reduction in headcount totaled approximately 300 full-time employees, which represents approximately 10% of our total workforce.

In the fourth quarter of 2012, our gross margins improved by 20 basis points compared to the third quarter of 2012, which we attribute to our restructuring efforts initiated in October. The improvement was in contrast to historical decreases in fourth quarter gross margins due to weather, the number of working days and related issues, and as such, suggest continuing margin expansion in future periods.

Non-GAAP Financial Measures

EBIT, EBITDA and related ratios presented in this report are supplemental measures of our performance that are not required by or presented in accordance with accounting principles generally accepted in the United States of America ("GAAP"). These measures are not measurements of our financial performance under GAAP and should not be considered as alternatives to net income, income from operations, or any other performance measures derived in accordance with GAAP or as an alternative to cash flows from operating, investing or financing activities as a measure of our liquidity.

EBIT represents net income before interest and taxes. EBITDA represents net income before interest, taxes, depreciation and amortization. EBIT margin is a non-GAAP measure calculated by dividing EBIT by net sales. EBITDA margin is a non-GAAP measure calculated by dividing EBITDA by net sales.

We present EBIT, EBITDA and related ratios because we consider them important supplemental measures of our performance and liquidity. We believe investors may also find these measures meaningful, given how our management makes use of them. The following is a discussion of our use of these measures.

We use EBIT and EBITDA to measure and compare the performance of our operating segments. Our operating segments' financial performance includes all of the operating activities except debt and taxation which are managed at the corporate level for U.S. operating segments. As a result, we believe EBIT is the best measure of operating segment profitability and the most useful metric by which to measure and compare the performance of our operating segments. We also use EBIT to measure performance for determining operating segment-level compensation and we use EBITDA to measure performance for determining consolidated-level compensation. In addition, we use EBIT and EBITDA to evaluate potential acquisitions and potential capital expenditures.

EBIT, EBITDA and related ratios have limitations as analytical tools, and should not be considered in isolation, or as a substitute for analysis of our results as reported under GAAP. Some of these limitations are as follows:

They do not reflect our cash expenditures, or future requirements for capital expenditures and contractual commitments;

They do not reflect changes in, or cash requirements for, our working capital needs;

They do not reflect the significant interest expense, or the cash requirements necessary, to service interest or principal payments on our debt;

Although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and EBITDA does not reflect any cash requirements for such replacements; and

Other companies, including companies in our industry, may calculate these measures differently than we do, limiting their usefulness as comparative measures.

Because of these limitations, EBIT, EBITDA, and related ratios should not be considered as measures of discretionary cash available to us to invest in business growth or to reduce our indebtedness. We compensate for these limitations by relying primarily on our GAAP results and using EBIT, EBITDA and related ratios only as supplements.

Our presentation of adjusted net income and adjusted EBITDA over certain periods is an attempt to provide meaningful comparisons to our historical performance for our existing and future investors. The unprecedented changes in our end markets over the past several years have required us to take measures that are unique in our history and specific to individual circumstances. Comparisons inclusive of these actions make normal financial and other performance patterns difficult to discern under a strict GAAP presentation. Each non-GAAP presentation, however, is explained in detail in the reconciliation tables below.

Specifically, we have presented adjusted net loss attributable to ARC and adjusted (loss) earnings per share attributable to ARC shareholders for the years ended December 31, 2012, 2011 and 2010 to reflect the exclusion of goodwill impairment charges, amortization impact related specifically to the change in useful lives of trade names, restructuring expense, loss on early extinguishment of debt, interest rate swap related costs, and the valuation allowance related to certain deferred tax assets and other discrete items. This presentation facilitates a meaningful comparison of our operating results for the fiscal years ended December 31, 2012, 2011 and 2010. We believe these charges were the result of the current macroeconomic environment, our capital restructuring, or other items which are not indicative of our actual operating performance.

We presented adjusted EBITDA in 2012, 2011 and 2010 to exclude stock-based compensation expense, loss on early extinguishment of debt, the non-cash impairment charges and restructuring expense. The adjustment of EBITDA for non-cash adjustments is consistent with the definition of adjusted EBITDA in our credit agreement; therefore, we believe this information is useful to investors in assessing our financial performance.

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The following is a reconciliation of cash flows provided by operating activities to EBIT, EBITDA, and net loss income attributable to ARC Document Solutions:

                                                                Fiscal Year Ended
                                                                   December 31,
                                                     2012              2011             2010
                                                                  (In thousands)
Cash flows provided by operating activities
(1)                                                $  37,552        $   49,168        $  53,924
Changes in operating assets and liabilities             (463 )          10,152              955
Non-cash expenses, including depreciation,
amortization and restructuring                       (68,554 )        (192,428 )        (82,469 )
Income tax provision (benefit)                         2,784            50,931          (14,186 )
Interest expense, net                                 28,165            31,104           24,091
Net loss attributable to the noncontrolling
interest                                                (503 )              21               88

EBIT                                                  (1,019 )         (51,052 )        (17,597 )
Depreciation and amortization                         39,522            47,876           45,649

EBITDA                                                38,503            (3,176 )         28,052
Interest expense                                     (28,165 )         (31,104 )        (24,091 )
Income tax (provision)benefit                         (2,784 )         (50,931 )         14,186
Depreciation and amortization                        (39,522 )         (47,876 )        (45,649 )

Net loss attributable to ARC Document
Solutions                                          $ (31,968 )      $ (133,087 )      $ (27,502 )

(1) For the twelve months ended December 31, 2012 cash flows provided by operating activities includes $0.9 million cash payments related to our restructuring activities.

The following is a reconciliation of net loss attributable to ARC Document Solutions to EBIT, EBITDA and Adjusted EBITDA:

                                                                 Fiscal Year Ended
                                                                    December 31,
                                                      2012              2011             2010
                                                                   (In thousands)
Net loss attributable to ARC Document Solutions     $ (31,968 )      $ (133,087 )      $ (27,502 )
Interest expense, net                                  28,165            31,104           24,091
Income tax provision (benefit)                          2,784            50,931          (14,186 )

EBIT                                                   (1,019 )         (51,052 )        (17,597 )
Depreciation and amortization                          39,522            47,876           45,649

EBITDA                                                 38,503            (3,176 )         28,052
Special items:
Stock-based compensation                                1,999             4,271            5,922
Loss on early extinguishment of debt                       -                 -             2,509
Goodwill impairment                                    16,707            65,444           38,263
Restructuring expense                                   3,320                -                -

Adjusted EBITDA                                     $  60,529        $   66,539        $  74,746

The following is a reconciliation of our net loss margin to EBIT margin, EBITDA margin and Adjusted EBITDA margin:

                                                      Fiscal Year Ended
                                                         December 31,
                                          2012 (1)         2011 (1)         2010 (1)
  Net loss margin                              (7.9 )%         (31.5 )%          (6.2 )%
  Interest expense, net                         6.9              7.4              5.5
  Income tax provision (benefit)                0.7             12.0             (3.2 )

  EBIT margin                                  (0.3 )          (12.1 )           (4.0 )
  Depreciation and amortization                 9.7             11.3             10.3

  EBITDA margin                                 9.5             (0.8 )            6.4
  Special items:
  Stock-based compensation                      0.5              1.0              1.3
  Loss on early extinguishment of debt           -                -               0.6
  Goodwill impairment                           4.1             15.5              8.7
  Restructuring expense                         0.8               -                -

  Adjusted EBITDA margin                       14.9 %           15.7 %           16.9 %

(1) Column does not foot due to rounding.

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The following is a reconciliation of net loss attributable to ARC to unaudited adjusted net (loss) income attributable to ARC and loss per share to adjusted
(loss) earnings per share (in thousands, except per share data):

                                                                   Fiscal Year Ended
                                                                     December 31,
                                                       2012                2011              2010
                                                         (In thousands, except per share data)
Net loss attributable to ARC                       $    (31,968 )       $  (133,087 )      $ (27,502 )
Goodwill impairment                                      16,707              65,444           38,263
Change in trade name impact to amortization               3,158               9,475            1,579
Restructuring expense                                     3,320                  -                -
Loss on early extinguishment of debt                         -                   -             2,509
Interest rate swap related costs                          3,440               5,691            1,241
Income tax benefit, related to above items               (7,676 )           (16,053 )        (14,758 )
Deferred tax valuation allowance and other
discrete tax items                                       11,311              67,556               -

Unaudited adjusted net (loss) income
attributable to ARC                                $     (1,708 )       $      (974 )      $   1,332

Loss Per Share attributable to ARC (Actual):
Basic                                              $      (0.70 )       $     (2.93 )      $   (0.61 )

Diluted                                            $      (0.70 )       $     (2.93 )      $   (0.61 )

(Loss) Earnings Per Share attributable to ARC
Basic                                              $      (0.04 )       $     (0.02 )      $    0.03

Diluted                                            $      (0.04 )       $     (0.02 )      $    0.03

Weighted average common shares (Actual)
Basic                                                    45,668              45,401           45,213
Diluted                                                  45,668              45,401           45,213
Weighted average common shares (Adjusted)
Basic                                                    45,668              45,401           45,213
Diluted                                                  45,668              45,401           45,383

Free Cash Flows

Free Cash Flows ("FCF") is defined as cash flows from operating activities less capital expenditures. FCF is a useful measure in determining our ability to generate excess cash flows for reinvestment in the business in a variety of ways including acquisition opportunities, the potential return of value to shareholders through stock repurchases or the purchase of our own debt instruments. As such, we believe this measure provides relevant and useful information to our current and potential investors.

The following is reconciliation of cash flows provided by operating activities to FCF:

                                                          Fiscal Year Ended
                                                             December 31,
                                                  2012           2011           2010
                                                            (In thousands)
  Cash flows provided by operating activities   $  37,552      $  49,168      $ 53,924
  Capital expenditures                            (20,348 )      (15,553 )      (8,634 )

  Free Cash Flows                               $  17,204      $  33,615      $ 45,290

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Results of Operations

                                                   Fiscal Year Ended                      2012 Versus 2011               2011 Versus 2010
                                                     December 31,                       Increase (Decrease)            Increase (Decrease)
                                        2012 (1)       2011 (1)        2010 (1)           $              %             $ (1)            %
                                                                         (In millions, except percentages)
Traditional reprographics              $    126.8      $   145.4      $    173.4      $   (18.6 )        (12.8 )%    $    (28.0 )       (16.1 )%
Color                                        79.1           84.1            81.6           (5.0 )         (5.9 )%           2.5           3.0 %
Digital                                      35.6           38.0            39.6           (2.4 )         (6.3 )%          (1.6 )        (4.0 )%

Subtotal(2)                                 241.4          267.5           294.6          (26.1 )         (9.8 )%         (27.0 )        (9.2 )%
Onsite services(3)                          108.8          100.7            90.0            8.1            8.0 %           10.7          11.9 %
Equipment and supplies sales                 55.9           54.5            57.1            1.4            2.6 %           (2.6 )        (4.6 )%

Total net sales                        $    406.1      $   422.7      $    441.6      $   (16.5 )         (3.9 )%    $    (18.9 )        (4.3 )%
Gross profit                           $    123.5      $   134.3      $    142.3      $   (10.8 )         (8.0 )%    $     (8.0 )        (5.6 )%
Selling, general and administrative
expenses                               $     93.1      $   101.3      $    107.7      $    (8.2 )         (8.1 )%    $     (6.4 )        (5.9 )%
Amortization of intangible assets      $     11.0      $    18.7      $     11.7      $    (7.7 )        (41.2 )%    $      7.0          59.8 %
Goodwill impairment                    $     16.7      $    65.4      $     38.3      $   (48.7 )        (74.5 )%    $     27.1          70.8 %
Restructuring expense                  $      3.3      $      -       $       -       $     3.3          100.0 %     $       -             -  %
Interest expense, net                  $     28.2      $    31.1      $     24.1      $    (2.9 )         (9.3 )%    $      7.0          29.0 %
Loss on early extinguishment of debt   $       -       $      -       $      2.5      $      -             0.0 %     $     (2.5 )       100.0 %
Income taxes provision (benefit)       $      2.8      $    50.9      $    (14.2 )    $   (48.1 )        (94.5 )%    $     65.1        (458.5 )%
Net loss attributable to ARC           $    (32.0 )    $  (133.1 )    $    (27.5 )    $   101.1          (76.0 )%    $   (105.6 )       384.0 %
Adjusted net (loss) income
attributable to ARC                    $     (1.7 )    $    (1.0 )    $      1.3      $    (0.7 )         70.0 %     $     (2.3 )      (176.9 )%
EBITDA                                 $     38.5      $    (3.2 )    $     28.1      $    41.7        (1303.1 )%    $    (31.3 )      (111.4 )%
Adjusted EBITDA                        $     60.5      $    66.5      $     74.7      $    (6.0 )         (9.0 )%    $     (8.2 )       (11.0 )%

(1) column does not foot due to rounding

(2) For comparison purposes to public reporting prior to December 2012, this subtotal agrees with the "Reprographics Services" revenue line historically reported.

(3) Represents services provided at our customers' sites, which includes both Managed Print Services (MPS) and Facilities Management (FM).

The following table provides information on the percentages of certain items of selected financial data compared to net sales for the periods indicated:

                                                                As a Percentage of Net Sales
                                                               Fiscal Year Ended December 31,
                                                      2012 (1)             2011 (1)           2010 (1)
Net sales                                                  100.0 %             100.0 %            100.0 %
Cost of sales                                               69.6                68.2               67.8

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