RESEARCH REPORT
Donald & Co. Securities, Inc. October 14, 1997
The Source Information Management Co.
(SORC - NASDAQ)
Provides a unique Data Management service at the front-end space in retail stores
Predictable revenues with improving margins
Revenues growing at both the collection and consumption ends of information chain
Source provides information gathering, processing, consulting and other information based services related to the front-end/checkout space to most operators of mass merchandise, grocery, convenience and pharmacy stores throughout the US. including Wal-Mart, K-Mart and Food Lion. These services, which currently pertain mostly to retail magazine sales, are being extended to other items such as candy and batteries through its active management of the front-end location for these retailers. Source also sells this much-needed information to the publishing community.
- Source has exclusive rights to gather and process information related to single copy retail magazine sales for 740 customers or approximately 70% of mass merchants in the US. Its current revenues are primarily generated through service fees for processing incentive payments on 6,000 titles sold in 70,000 stores and for advancing the merchants the amount of claims. At present, Source processes about $2.2 billion in retail magazine sales and about 10% of these dollars flow through the company.
- Source has a unique understanding of the dynamics of the retailers' front-end space. As retailers and vendors alike better understand the superior value of this space, this knowledge has started to translate into revenues for Source from consultative management of retailer's front-end. A recent K-Mart program is valued for K-Mart at $60 million and should be repeatable every three years. This also allows Source to start gathering exclusive front-end sales data on other items such as candy and batteries and perhaps sell the information to these vendors.
- Source's position as an accepted bridge between the retailing and the publishing community uniquely qualifies it to implement a system which verifies the correctness of the UPC on magazines vis a vis those on retailers' computers. This will result in significant operational efficiencies for the retailers. Source would generate revenues from implementation and sale of scanned information.
- Source has developed extensive comparing systems to handle its information processing needs Source's operations have a low labor intensity and expenses should not rise directly as a function of volume. Improving efficiencies should also compensate to some extent for overhead requirements related to new services being introduced.
- Based on Source's unique positioning in the front-end of the retail industry, the significant barriers to entry into this space, the increasing profitability of revenues -which is growing both naturally and through new services - the superior visibility of Source's revenue flows and a business which is somewhat insulated from economic cycles, we believe that a valuation multiple of 20x - 25x earnings is really quite conservative. We are rating Source stock a "Buy" with a 12 - 18 month target price of $8 - $10.
There has been a secular trend in the magazine publishing industry away from general interest titles towards specialty titles. This has profoundly changed the way magazines now need to be marketed and distributed. As magazines become more of an impulse purchase, single copy retail circulation has far greater value to the advertisers. In this highly segmented market where a hit cover and proper demographic placement can swing sales dramatically, accurate sales data is vital to achieve targeted exposure.
The structure of the current magazine distribution system, which was developed primarily to achieve stable dispersion of generic products, has a number of internal conflicts and is therefore incapable of delivering the required retail magazine sales information. The Source Information Management Company fits neatly as a neutral information bridge between the retailing and the publishing communities and serves both the collection and the consumption ends of the information chain.
Claims Processing: The process started years ago when publishers started paying the retailers an extra 10% on magazine sales after a cumbersome "claims" process was administered by the retailers. Among the services companies that developed tracking and collection systems for the retailers, were many of Source's predecessors. It was the foresight of Source's management that led to the consolidation of these entities and which, in our opinion, is the singular reason behind Source's unique current positioning.
At present, the company gathers and processes $2.2 billion of the estimated $3 billion in claimable sales. This encompasses about 6,000 titles, 70,000 stores and 710 retail customers. At 10%, about $220 million flow through Source of which the company collects a portion as fees. This number has a built in natural growth rate due to retail expansion, increase in the number of titles and rise in cover prices. We estimate that the combined effect expands the market at about 15% per year.
Advance Pay: Source has now started unburdening the retailers from the administrative process of managing small uneven bits of cash flows, which make up the sizable final amounts. This service, called Advance Pay, allows the retailer to account for the claims as a lump sum provided in advance by Source against their claims already in existence. For Source, it practically locks in the customer and dramatically improves upon the portion of the claim dollars that it retains as fees.
The attractiveness of the service to retailers is reflected in completely new customers being acquired as a result of this program. Source borrows partly on a short-term basis to fund these advances. After a few years into the cycle of advancing and collecting, the net capital involvement becomes quite small relative to the amount processed. Currently only $40 million of the $220 million claimed is under Advance Pay and it is rising rapidly.
Periodical Information Network: As mentioned before, publishers are in dire need of retail sales information. Effectively, Source is the only repository of retail sales information available to the magazine publishers. With over 70% of retail sales flowing through its system, it has the critical mass to make the information meaningful for magazine marketers. Within ninety days of a quarter's end, Source's computers consolidate and produce sales information by chain, by store and by title. It can also produce individual store schematics to graphically pin point the location of a magazine on the front-end space.
This information, which goes by the name Periodical Information Network or PIN, is then packaged in a user friendly electronic format and sold to the publishers for a quarterly membership fee plus fees for individual reports, which range from $150 to $250 per title per quarter. Schematics and other information can be provided at additional costs.
The potential market is 6,000 titles or about $3.6 million in recurring revenue per year. As this information is already generated by the company as a part of the normal business of the claim processing division, there is no additional cost incurred to sell this service other than marketing, media material and shipping costs, which is minimal.
Universal Product Code: Most items at retail are identified with a UPC, which is the key for the retailer to track product related information such as price and inventory. Magazines have a problem because the product is changing all the time. This not only forces most retailers to key in the code at the time of sale, which is a time consuming process, but also results in an unacceptable error rate caused by the variation in UPC from the retailers' computers and the code on the magazine. This basically throws the retailer's tracking and control system out of gear.
It is also a fact that only about 40% of copies delivered and billed by the distributor are actually sold, with the rest returned. The lag in accounting for these returns results in an unwanted float on part of the retailers, which is quite substantial. The time sensitive nature of magazines and the printing process is such that it is difficult for the publishers to determine the correct code as printed, until the last moment when it is coming off the press and leaving the printer. It is costly for the publisher to paste the correct UPC, if discovered after printing but before delivery. It is therefore quite clear that a system that identifies UPC discrepancies and synchronizes it on a real time basis is of benefit to both ends.
Source is perfectly positioned to do this and capable of implementing the system as it already stores and maintains magazine UPC's for its claim processing business. At a small additional capital cost a system can be put in place which would electronically synchronize magazine UPCs across publishers, printers and individual stores on a daily basis. The cost of running the system will be borne by the publishing industry and should result in a healthy margin for Source.
The system will enable Source to claim rebates on the basis of scanned sales data but more importantly, it will allow the company to provide dynamic sales data versus static historical data currently available to the publishers through PIN. We believe that the publishers would pay handsomely for this information. UPC service is currently in operational testing phase and we expect the service to be introduced some time in the second half of next year.
Front-end Management: The primary determinant of sales of an item usually purchased on impulse - is exposure. The front-end / checkout space in a store has the maximum exposure value and is therefore the most expensive real estate in the world on a per inch basis. Retailers' management is usually organized around product categories and therefore cannot manage this space, which can have hundreds of products, as a category by itself. Historically, publishers have paid a quarterly promotional fee known as the retail pocket allowance to get their magazines placed in favorable locations and have heavily populated this space. As retailers better understand the value of this space they are taking steps to maximize its contribution in terms of both promotional dollars and sales.
With its close understanding of magazine activity in this space, Source is the only entity with the information to guide retailers in this matter. On behalf of the retailer, Source designs and organizes the manufacturing of the front-end racks, allocates space and pricing of various locations and monitors and tracks information related to the activity in that space - all for a fee.
The recent K-Mart agreement, which runs for three years after which the whole exercise starts all over again, has a value of $60 million for the chain. This agreement, which we believe is precursor to other similar agreements, encompasses the complete front-end across all product lines. It will enable Source to track scores of other items vying for the right placement, with a chance to sell the data afterwards. The company is proposing this service to other retailers with the Food Lion proposal being in an advanced stage.
Financials: There are two things about the financial statements that should be pointed out.
1. The nature of Source's operations is such that it is quite difficult to allocate costs directly to services. Although the company attempts to break down the total costs into Cost of goods sold and Selling, general and administrative costs, the process is largely discretionary. We believe that the costs are largely non-variable and their correlation with revenues is not meaningful on a sectional basis. With tax rate remaining a high 43%, we expect net margin to rise with revenue.
2. The second point relates to the apparently large proportion of assets in the form of Trade receivables. This is a consequence of the manner in which the company recognizes and reports revenues. Normally, a receivable is a recognized yet uncollected revenue but Source reports only its fees as revenue even as very large sums are flowing through their system. This would be similar to a bank showing net interest margin as revenues while showing all loans as receivables. This also makes the borrowings appear higher. We expect receivables to grow in line with Advance Pay penetration of the claims processing business.
Risk Factors
- A fundamental change in the incentive process brought about by the publishers and the retailers to eliminate the current rebate system would have and adverse impact on Source's business.
- To the extent that Source uses borrowed funds to advance monies to its customers, it is sensitive to any rise in interest rates. |
