Description

Catalina Marketing (ticker: POS) is still a short and is more fairly valued at levels 30% down from here, with positive risk reward asymmetry as I believe upside in the stock is limited to perhaps 10% given the current excessive valuation of 18x forward EPS. The company’s core grocery store coupon business is undergoing long-term fundamental pressure, the potential for losses of significant customers in its grocery network exists and should be very detrimental to the business, and increased capital spending on unproven ROI projects should limit cash flows over the next 1-3 years.

Company Description:
Catalina Marketing is a marketing services company whose primary business is the delivery of in-store coupons to consumers based on purchase behavior and distributed primarily in grocery stores. The company’s core customer base consists of consumer packaged goods firms who pay a per-coupon fee to offer targeted coupons over Catalina’s distribution network. The company tracks actual purchase behavior and uses UPC-based scanner technology to target consumers at the checkout counter. In recent years, Catalina has expanded its network to include new distribution sources (besides grocery supermarkets), which includes pharmacies, retail, and direct mail.

The majority (roughly 60%) of Catalina’s revenues are derived from the printing of coupons in its network of 16,693 grocery stores. The top distribution partners include Albertsons, Kroger, Safeway and other leading grocery stores that receive a revenue share (roughly 10%) for each coupon printed. Recent and anticipated changes in the grocery store landscape pose long-term risks to both the economics and the installed store base in Catalina’s core operations.

At a recent $26, POS has a market cap $1.252 billion, an enterprise value of 1.264 billion, trades at 8.6x and 8.1x consensus FY06 and FY07 (March) EBITDA, and 19x and 18x consensus FY06 and FY07 EPS.

Short Thesis:
- A change in the grocery store landscape could impact revenue share percentage in Catalina’s core operations. Most recently, Albertsons (Catalina’s second largest partner at ~ 15%) indicated that they are exploring strategic alternatives that may involve the sale of the company to a private equity buyer (although this has been derailed for now). Other industry participants that are undergoing a change in ownership or restructuring include Pathmark, A&P, and Winn-Dixie. With these changes, a thorough review of the grocery firms’ operations could result in a tougher stance with Catalina. By way of example, if Albertson’s is approximately 15% ($50m) of POS’ grocery and pharmacy revenue and achieves a 30% revenue share with POS, this implies $15m of revenue to Albertson’s. While $15 million in revenue may not seem like much, these annual revenues represent nearly 100% margin in a razor-thin margin supermarket business. Therefore, for Albertsons to achieve a comparable impact to its EBIT at its average 3% EBIT margin, it would need to generate an incremental $500 million in sales which are obviously real numbers. Given the leverage of grocers in Catalina’s value chain (grocers are its distribution channel) and the restructuring of the grocer industry, Catalina’s revenue share percentage should worsen over time. Facilitating this is that roughly 1/3 of retailer arrangements mature each year, and the last time another large customer, Kroger, renewed, it was on worse terms. As renewals recur, I’d expect other partners to pressure Catalina and seek “me too” economics. As the core grocery business is the top contributor to Catalina’s revenues and EBIT (approximately 60%), this impact on firm profitability should be significant. Finally, a revenue share reduction to Catalina should flow through directly to its bottom line, as no variable cost would be saved when the economics are reduced.
- Store count is subject to decline with grocery store closings. With the likely fallout from changes at Albertson’s (perhaps closing 500 stores) and store closures at Winn-Dixie (bankrupt biz closing 326 stores), Catalina’s retail network is declining. The majority of the company’s core business revenue is derived on a per-coupon-printed basis. Thus, with less stores in its network and less foot traffic, sales will decline. In addition, the company’s network of grocery stores has been losing market share for several years to Wal-Mart, Costco, and Target – all of which do not share their data in the Catalina network.
- Growth opportunities saturated in core operations. Catalina has struggled to expand its grocery store base in recent years, as it has penetrated nearly all of the top grocery players in the U.S. This saturated level (network installed in 28 of the top 34 grocery chains) will make growth prospects more difficult in the future. Existing hold-outs - such as Wal-Mart, Costco, and Publix – will not likely participate due to the guarded nature with which they hold their proprietary customer purchase data. In the most recent September quarter, Catalina’s grocery store count totaled 16,693, down 951 from 17,644 the prior year.
- Company investing in printer technology, but increased economics unlikely. Catalina recently announced an agreement with Epson under which the company will spend a minimum of $88 million over the next few years for the development and supply of color printers. As such, the additional costs will pressure the company’s cost structure in the short to mid term. To recoup the investment, Catalina would need to raise prices on its coupons in the mid to high single digits. Catalina’s ability to raise prices is questionable, given the relatively mature stage of the coupon product and recent pricing pressure exhibited by competitive coupon providers (Valassis lowered guidance on 10/20/05 due to pricing pressures from P&G/Gillete and others).
- Rich valuation at current stock prices. At $26 per share, Catalina currently trades at 18x FY2007 (March) EPS and 8x FY2007 EBITDA. I view this valuation as rich, given the limited growth outlook and potential challenges. Assuming mid single digit store declines in the grocery segment and slight deleveraging of operating expenses, POS would earn $0.15 lower than current ’07 consensus. Assuming the previous and a 5% increase in revenue share in grocery would result in approximately a $0.30 EPS hit. Both scenarios at a 15x multiple put the stock at $18-$20, or a 20-30% decline.

Key Risks:
- Historically strong cash flow generator. Catalina has averaged approximately $75million (6% yield) in free cash flow over the past three years. The primary use of cash flow has been the repurchase of POS shares, in which 1.2 million shares for $29 million were repurchased in the most recent September quarter alone. The company currently has $86m million remaining in its share repurchase authorization. In addition, Catalina also pays an annual (October) dividend of $0.30, yielding 1.1%. Despite the foregoing, investors are likely to overlook the current strong cash flow generation if the future cash flows deteriorate due to renegotiated revenue shares or declining store count. Also, Catalina capex will increase dramatically in the next two years – rising from $22 million to an expected $50 million in FY 2006 and $80 million in 2007 – due to the build-out of Walgreens front-end and introduction of color printers. As a result, POS should only generate $30m in FCF in FY07 (March). I am skeptical that colored coupons versus black and white will generate either pricing leverage or increased usage to recoup these dollars, and eventually investors will pay attention to the reduced FCF generation.
- Largest shareholder could push for sale of business. Catalina’s largest shareholder, ValueAct Partners, owns 15% of the company and could push for a sale of the company or other changes. ValueAct has a history of “activist” moves in other stock holdings, including its proposed buy-out of Acxiom (ACXM) – another company involved in the marketing services sector. If shares fall under considerable pressure, ValueAct could try to put the business in play to potentially interested parties, such as Valassis (VCI) or News Corporation (NWS). Despite this, potential acquirers should be leery of Catalina’s declining trends in its grocery store distribution network. Neither VCI or POS has enough cash or debt capacity to acquire one or another outright and similarly I don’t think POS would attract much interest in the private equity market. Arguably with both businesses in transition, a stock for stock deal would be tough to consummate.
- Wall Street sentiment is already low. Eight of nine analysts that cover Catalina have a neutral or negative opinion of the stock. As such, a short position would likely not benefit from a reversal of sentiment.
- Leveraged recap potential. Catalina has a clean balance sheet with $23 million in cash and $35 million in debt. Management had discussed the potential of doing a leveraged recapitalization/tender offer of shares, which would be accretive to EPS given cheap financing. Despite that, management has already walked away from this option in favor of trying to generate organic growth, share repurchase, dividend and acquisitions.

Catalyst

Closing of stores in grocery customer base
Renegotiations of existing grocery agreements at lower price points
Declining margins as a result of increased revenue share