Description

Business Description

Catalina Marketing Corporation provides a wide range of strategic, targeted marketing solutions for consumer goods companies, pharmaceutical manufacturers and their respective retailers. The targeted marketing services of the Company are provided by interrelated operating groups that strive to influence the purchasing behavior of consumers wherever and whenever they make purchasing decisions. Through their operating groups, Catalina Marketing is able to reach consumers internationally and domestically either in-store using incentives, loyalty programs, sampling and advertising messages or at-home through direct mailings and online.

Short Thesis

· Catalina is facing a Softening Operating Environment – Catalina’s two most profitable business lines, Catalina Marketing Services (POS’s core business) and Health Resource Publishing (HRP), are both facing an increasingly difficult operating environment. The core business is still a differentiated solution that is currently best of its breed, but is facing pressure both in terms of growth in installed base and pricing power. HRP has hit a complete standstill in its business and faces a more difficult path back to growth than either management or the sell-side anticipates.

· Supermarket / CPG trends will hurt POS – Financial troubles at Ahold and other major supermarket retailers do not bode well for POS’s core business. Major supermarket chains make up the vast majority of their revenue and profits, and the industry is in a prolonged slump which is, according to buy-side analysts covering the sector, likely to extend for the indefinite future. The two types of stores gaining traction with consumer packaged goods (CPG) companies and market share with consumers are Wal-Mart and discount / dollar stores. These trends provide a formidable challenge to POS’s core business as both Wal-Mart and dollar stores will not do business with POS – shrinking their potential revenue base, and constraining growth.

· Pricing Power is being Compromised by Intense Competition – Although POS holds a strong, and impressive patent portfolio on its core technologies, current substitutes, such as in-store promotions and the Sunday paper freestanding insert are driving prices down. Additionally, supermarket chain woes have forced purchasers of POS products to reevaluate their relationships. Perhaps most dangerous to POS from a competitive point of view is the belief of industry insiders that new companies are developing technologies to bypass Catalina’s position in stores – threatening the POS value proposition, driving down margins, and eating away at POS’s current competitive advantage.

· HRP Weakness will be Long Lived – The weakness in HRP’s business, once thought to be the most promising growth engine for POS, has been attributed to criticism of DTC marketing by pharmaceutical companies, reduced advertising and promotional spending, and some pushback from retail pharmacies. My industry insider indicates that these trends are far from playing themselves out, and as this person’s company does a good deal of work with CVS and Walgreen’s, he stated that “Catalina will experience nowhere near their historical growth in this market, and are up against tremendous pricing pressure.”

· Management is facing a Credibility Gap – In its meeting with analysts to establish 2004 guidance March 6 & 7, Catalina management presented the most somber picture of their business to date, sharply in contrast to their trumpeting of 20-30% growth rates some 12 months ago. They are clearly trying to reestablish credibility since they guided down estimates on 10/02/2002, resulting in a one day decline of 36% in market capitalization. Despite their posturing, management has continued to remain optimistic about business conditions for each division until forced by the numbers to reveal weakness to analysts. They still forecast 9-14% core business growth for 2004, which both business trends and my industry insider would argue is considerably aggressive. And while insider sales have not been heavy, there has been no substantial buying by executives to indicate that the stock would be a value at these levels. With management overconfident and not purchasing stock, the likelihood of further negative earnings surprises / downward guidance will intensify pressure on the stock.

· Deteriorating Financial Strength and Low Quality of Earnings – For the last two quarters, Accounts Receivable Days Sales Outstanding (DSO) have increased significantly year-over-year:


Q3 2002 Q3 2001 Q2 2002 Q2 2001
A/R ($ mil) 74.26 55.5 72.3 57.9
Revenue 119.11 114.7 113.2 104.0
DSO 57 44 58 51

Other quality of earnings problems plaguing Catalina are the reduction in net installations (reflecting the decline in potential revenue base) for the past few quarters, declines in deferred revenue (result of less collection in anticipation of new promotions), reduction in depreciation expense (temporarily inflating earnings per share figures), inflated FCF due to decreased CapEx, and the disclosure of an off-balance sheet SPE for the financing of the company’s corporate headquarters. This has all been overseen by a CFO who has been in his position since only late June 2002.

The Bull Case – Risks

· The bull case for POS hinges on the belief that at current historical low PE levels, and given the defensive nature of its sector, the stock is attractive. The company maintains a defensible niche in its market, for the present time, and generates a substantial amount of free cash flow (FCF). Catalina management insists that the company’s core business will regain some of its growth, and is confident that HRP revival and an increased European presence will fuel future earnings growth. Additionally, the company has little debt and is not at great risk of a credit situation or exclusion from the S&P Midcap 400 index. Should there be an unforeseen positive catalyst, much of the short interest of 3,387,950 (ratio of 6.00) would be forced to cover, exacerbating share appreciation.

Catalyst

Over the long term, Catalina’s business is in trouble. They are facing a softening operating environment, pricing pressure from substitutes, and a secular trend away from their core customer base. Wal-Mart’s move into the grocery business threatens their core supermarket customer. Their main growth engine, Health Resource Publishing (HRP), has ground to a standstill in terms of growth, and to compensate, Catalina has become increasingly aggressive in their accounting practices. The growing credibility gap of management, decline of the business, and subsequent shenanigans to cover up the weakness have left the company (at 21x earnings, no less) at the precipice of a serious decline. The company missed a 15 day extension to file their 10K from 3/31/03 on 7/15/03, and a will face a difficult quarter originally scheduled to report on 7/23/03, as pricing in the FSI markets is squeezing POS.