Donald & Co., Securities, Inc.|
December 22, 1998
The Source Information Management Co.
(SORC - NASDAQ)
Rating: Strong Buy
Strategic moves position Source as the first complete front-end 'solution' provider.
ICN expands role as 'the' communication interface between retailers and vendors.
Raising FY2000 earnings estimate and target price
Source provides information gathering, processing, consulting and other information-based services to operators of mass merchandise, grocery, convenience and pharmacy stores throughout the US and Canada, including Wal-Mart, K-Mart and Food Lion. These services, which currently pertain mostly to retail magazine sales, should get extended to other items through its complete front-end solution services for these retailers as a result of its proposed acquisitions in the front end manufacturing industry. Source also sells this much-needed information to the publishing community. Source's web based Interactive Communications Network (ICN) is the only electronic information exchange mechanism between the publishing and the retail communities, which should also get extended to other merchandise categories.
- Source's recently announced 3QF99 results were in line with our expectations. Earnings per share were $0.10 on approximately 50% more shares outstanding versus $0.06 last year. Revenues were just about $4 million and net margin increased to about 24%. We are comfortable with our FY2000 revenue estimate from core operations of 20 million and expect margins from these to improve.
- As part of a strategic move to increase its shares of retail checkout space activities Source has recently announced four acquisitions of companies with an annual revenue base of $60 million per year. All four acquisitions are expected to be accretive to Source's net income per share. These moves position Source as the only provider of a complete front-end package solution to the retailers. They will allow Source to take advantage of natural synergies. It also raises the barriers to entry into this space by other competitors.
- The prospects for ICN look very promising. ICN could become the marketing communication interface of choice between vendors and retailers as it is the first and only vehicle available to vendors for direct promotion to store buyers via the internet, and for retailers to make on line purchase decisions. We expect significant vendor generated advertisement page revenues to Source from this service.
- The proposed acquisitions will create a substantially higher base of revenues and assets. The higher margin information based revenues should continue to grow at a rapid rate in the year ahead, although overall margins will be reduced due to the large percentage of hardware revenues.
- Based on acquisitions, and significant ICN revenues expected next year, we are raising our FY2000 EPS estimate ot $0.68 from our own previous $0.53. Source's expanding reach within the retail store and with general merchandise vendors puts it in an enviable position at the front-end with a steady annuity-type revenue stream. We continue to rate SORC a strong buy and are also raising our 18-24 month price target to $14.
We expect Source's core operations in magazine rebate processing, related advance pay, periodical information network and management of front-end space to continue growing with estimated revenue at $20 million in FY2000 versus $14.5 million this year.
Historically Source has had strong relationships in the publishing and retail industries due to its status as a mediator among them on various issues related to retail magazine sales. As part of this function the company has been managing the marketing for magazines at the checkout locations in retail stores. On the strength of its understanding of front-end dynamics, in FY1999 Source started its activities in the front-end management area with its K-Mart contract which provided for the company to manage the design, installation, display pocket billings and monitoring of front-end for 1200 K-Mart locations. Source's front-end management program accelerated with the success of the "SOURCEPRO" front-end management software and it currently has in excess of 20,000 retail locations under contract.
As part of its front-end activity Source has been managing the manufacturing part of the contracts through arrangements with various fixture manufacturers. Front-end fixture manufacturing sector is estimated at about $100 million in annual sales. In a series of strategic moves, Source has announced four acquisitions in the past two months in the front-end fixture-manufacturing sector. With these proposed acquisitions, which should be consummated by the first calendar quarter of 1999, Source would be acquiring approximately $60 million in annual revenues, four geographically distributed manufacturing locations that total over 500,000 sft., a salvaging company for old fixtures, a trucking company to transport the fixtures and an experienced group of people who understand the retail front-end business. It brings together all the elements of retail front-end marketing for the first time and enables Source to provide a complete solution to the retail customer. We believe that this would result in substantial short and long-term advantages for the company both in terms of sector positioning and operational synergies and efficiencies.
Fixture manufacturing includes the design process, which has to account for the marketing aspects of various general merchandise items at the checkout space. Historically, these manufacturers have managed this aspect for non-magazine items and have therefore developed strong relationships with vendors such as Mars, Wrigleys and Gillette. Source would inherit these relationships with the acquisitions. Specifically, in Jim Gillis, now named President of Source, a seasoned front-end marketer who was once a competitor. Source gets fifteen years of top-level vendor relationships. On the operational side, the integration of various elements under one entity would result in savings arising out of the "SOURCEPRO" based design process, efficient utilization of plant capacities, implementing robotic manufacturing techniques developed by one of the acquired entities, reduction in shipping costs (usually a significant part of total costs) due to improved logistics and overall better scheduling and co-ordination across various process elements. We believe that Source's increased competitiveness would result in further market share gains in this business while significantly improving upon historical margins available to the manufacturers.
Interactive Communications Network (ICN)
ICN was originally conceived as a procedure to allow accurate updates of magazine UPC's, which change frequently and have a high error rate. The solution could not be implemented through the traditional magazine distribution channel as it is slow and fragmented. The publishers deemed it necessary to have a direct communication mechanism to interface with the retailers to avoid paying error-related fines. Due to its historical relationship with both the retail and the publishing community and now having the critical mass required for something like this to be workable across the whole industry, Source was a natural choice to implement this communication network. Early on in the process of developing the system, the company realized that this was the first and only direct channel of communication between vendors and retailers and could therefore be used to communicate a variety of messages in addition to the UPC correction list. ICN is now fully developed as a secure and private internet based communication interface between vendors and retailers, which can be used by the vendors for direct market promotion to store buyers via the internet and for retailers to make on line purchase decisions.
Since its implementation in October, the network is now accessible by over 20000 retail locations and so far has reported a higher than anticipated usage rate by retail managers. Usage in this sense would be measured by the frequency of logging on into the network for information retrieval, UPC update or on line magazine purchase management. A higher frequency of usage achieved at this early juncture indicates that store managers find it easy and convenient to use. The value of the network to a marketer is also directly proportional to the usage rate, enabling Source to receive a good price for use of the network for sales promotion purposes by the vendors. To the vendor, this is an excellent channel to communicate a promotion directly to the prospective purchaser. In one stroke, the message reaches a captive audience across geographies and retail formats for a very small fraction of what it would cost to reach them through traditional communication channels. Vendors can make their sales forces' efforts efficient and focussed by concentrating on those purchase managers who have failed to respond positively to a promotion displayed on this network.
The suggested pricing model for the magazine industry is a basic fee of $1000 per title per year, which includes UPC services. Advertisement view pages (pages last for a fixed duration, a week for a weekly magazine issue for example) are charged at $1000 per page. The company has mentioned that two publishing clients have already signed up for the program and active negotiations are underway with many publishers. The size of the total market is approximately 6000 titles at present. The general merchandise category also represents a huge marker opportunity for ICN. As mentioned before, with the front-end program Source has started interacting with and managing certain marketing issues for these vendors. One of the important strategic values of the recent acquisitions in the front-end arena is the inheritance of strong relationships with non-magazine vendors. We believe that these acquisitions would accelerate the conversion of general merchandise vendors into ICN customers.
Source plans to make the acquisitions for approximately $16.5 million in cash and about 4 million shares. The company's bank line with Wachovia would be used to fund the cash requirements. In addition, some existing debt of the acquirees (including a mortgage) is to be consolidated into this line. We expect debt utilization in FY2000 to be in the $25 million range. With the acquisitions we estimate Source's FY2000 revenues to be over $77 million. Revenues this year from current operations are expected to be $14.5 million. Its asset base would grow to $100 million. There would be approximately 14 million shares outstanding after the acquisitions are consummated. Most of the stock being issued during the acquisitions is locked up for at least one year. The acquired companies should generate a gross margin of over 30% in FY2000 with further improvements anticipated down the road. We believe that the post acquisition mix of businesses available to Source should allow it to reduce its high tax incidence from 43% to 39%.
Although we do not have any reason to believe that these acquisitions will not be consummated, future events are never certain. A delay in the acquisition timetable can also not be ruled out.