Entities are omitted from the output with the code above.  
The symptom was that   
-- which should work with UTF-8 encoding -- 
did not even get to XSLTProcessor, let alone through it.
After too much hacking I discovered the simple fix:
set substituteEntities to true in the DOMDocument for the XSL file.
That is, replace the loading of the xsl document with

<?php
   $xsl = new DOMDocument;
   $xsl->substituteEntities = true;    // <===added line
   $xsl->load('collection.xsl');
?>

However, this fails when data entries have HTML entity references. (Some database entries may even contain user generated text.) libxml has the pedantic habit of throwing a FATAL error for any undefined entitiy. Solution: hide the entities so libxml doesn't see them.

<?php
function hideEntities($data) { 
        return str_replace("&", "&amp;", $data); 
}
?>

You could just add this to the example, but it is tidier to define a function to load data into a DOMDocument. This way you don't need entity declarations in catalog.xsl, either.

<?php
// Added function for  Example #1  

/** Load an XML file and create a DOMDocument.
Handles arbitrary entities, even undefined ones.
*/
function fileToDOMDoc($filename) {
    $dom= new DOMDocument;
    $xmldata = file_get_contents($filename);
    $xmldata = str_replace("&", "&amp;", $xmldata);  // disguise &s going IN to loadXML()
    $dom->substituteEntities = true;  // collapse &s going OUT to transformToXML()
    $dom->loadXML($xmldata);
    return $dom;
}

// Compare with  Example #1 Transforming to a string

// Load the XML sources
$xml = fileToDOMDoc('collection.xml');
$xsl = fileToDOMDoc('collection.xsl');

// Configure the transformer
$proc = new XSLTProcessor;
$proc->importStyleSheet($xsl); 

// transform $xml according to the stylesheet $xsl
echo $proc->transformToXML($xml); // transform the data
?>