Eastman Kodak-What If Tomorrow Never Comes?

Value investors tend to congregate around distressed companies much like drivers rubberneck on the turnpike to observe an accident. Some truly brilliant managers such as Bill Miller at Legg Mason (who remains brilliant however his portfolio ranks this year relative to the S&P) and Bruce Sherman of Private Capital Management have been adding to their positions in this name.

One of my favorite expressions is, "The obvious should not be an impediment." Sometimes, the obvious demise of a business or at least in this case, a segment of a business evokes more sentiment than reason, more hope than sense. Fallen angels require investors to have a backbone not a wishbone! Is the demise of this business just too obvious?

The more I look at the challenges that confront Eastman Kodak (EK,) the more I sense continued deterioration rather than progress. I really prefer to be optimistic but facts should supercede opinion.

What prompts this note is an announcement from Canon (CAJ) earlier today.Canon announced that it would consider halting the development of new film cameras as it focuses its resources on digital models. The company would consider whether it needs to continue producing both compact and single lens reflex (SLR) film models because the market for both is shrinking.

Earlier this year, Nikon announced that except for a few professional products, it would stop producing film cameras. Konica Minolta also came to the same conclusion this year. The exit of Agfa and Konica from the production of film should have removed excess capacity from the industry, but it appears at least anecdotally that Fuji has been dropping prices to maintain share. So much for pricing discipline in a duopoly.

I know the argument that there is a ton of conventional photography equipment out there but year to date, Kodak rolled film volume is down 38.4% versus last year (to end of March) Single use camera volume is down almost 25% for the same time frame. Fuji's numbers are slightly worse.

Film and photofinishing systems represented 32% of revenues for Kodak in the first quarter of this year. Photofinishing services were down 50%. EBIT dropped almost 60% from $71 million to $29 million on $916 million in sales, a 3.1% operating margin.

In a Wall Street Transcript interview, Kyle Legg of Legg Mason describes the investment in Kodak as, "We currently own Eastman Kodak (EK), a company that is still widely viewed as dependent on a dying industry, traditional film manufacturing. Our view, on theother hand, is that Eastman Kodak is a business that is leveraging its powerful global brand recognition and strong relationships withretailers to make the transition from traditional film company todigital imaging company, and that once it becomes clear that EastmanKodak will successfully complete this transition, the market will reward it. Although we were certainly early in identifying this opportunity,we're confident that Eastman Kodak is very attractively priced."

Consumer Digital Imaging represented 17% of revenues for Q1. Pricing erosion and slowing sales already seem to be a challenge in this business. Revenues in this segment were down 10% versus last year's quarter, gross margins fell, and the unit lost $94 million versus $58 million, in the first quarter of last year. The notion of turning the digital camera business into a razor/ razor blade business that will drive the consumption of consumable products such as color ink jets is not yet working. The penetration of digital cameras in American households is somewhere around 50% but the conversion of all of those shots into a "snapshot" is happening in far different ways than are helpful to EK's profitability. Hewlett Packard's Snapfish and privately held Shutterfly seem to be capturing share, again from anecdotal evidence. Attractive images of family, friends and faraway places are stored in my hard drive and rarely hit paper for most of us.

Graphics Communications represented about 30% of revenues in the first quarter and appears to be driving and defining success at EK. As the commercial printing market becomes increasingly digital, EK is well positioned here. Many parts of this business have been acquired in just the last year and a half or two years but the operating profitability has increased to $31 million in Q1 06 versus a loss in the corresponding quarter last year. Gross margins have significantly expanded though operating margins are still small at 3.6%.

The Health Group represents about 20% of revenues. A few years ago, this was ballyhooed as the crown jewel, but now management is looking for strategic alternatives for this biz. Operating margins here were almost 8% and in fact represented over half of the operating profits of the entire business. Not so long ago, this was viewed as potentially a mid teens operating margin business, just last year it was 12%. Traditional radiography, X-Ray film probably represent about one third of this business, the remainder being digital archiving and various esoteric digital forms of radiography. Parts or all of these businesses could be sold.

The digital transformation of this company has been unbelievably difficult. The parts of the business that represent the future represent very new, largely non-integrated entities. Silver prices and petroleum products prices impact costs of goods negatively.

Compounding the difficulties is the credit side. To quote the Fitch Rating: "Fitch downgraded EK's Issuer Default Rating (IDR) to 'B' from 'BB-' and the company's senior unsecured debt to 'B-' from 'B+' on May 16, 2006. The Outlook remains Negative. The ratings reflect Fitch's growing concern regarding EK's ability to generate profitable organic digital revenue growth and sufficient free cash flow to offset continual declines in the company's traditional business." This was last rated investment grade by Fitch in May of 2003 (BBB)

The leverage ratio (assets/equity) is 6.7 times and long term debt represents about 56% of total capital. Free cash flow per share is negative for the TTM at about -$2.00. Work through the Altman score on this company for yourself. The number I came up with is not very assuring. Kodak debt 9.95% of July 2018 maturity is trading at just under 10% yield to maturity. There is a message in that too.

Geoff Gannon, who publishes that marvellous blog Gannon on Investing wrote exactly a month ago "On Inflexible Enterprises" where he said, businesses put down roots. The deep-seated roots at EK as in so many companies forestalled or impeded acceptance of what seems so perfectly obvious now. The obvious should not be an impediment. The gradual transition at Kodak into the digital world was what Geoff call "the tempting possibility." But it seems that the technological shift has been too rapid, the areas where the company has strengths seem to lack scale, and the sub-normal returns persist if not worsen. Reduction in capacity does not appear to have helped.

As I said wishbone rather than backbone.

Hopefully, the business transition strategy can ward off the ills that the historical numbers indicate. But in the cold hard competitive world hope can be a dangerous word.

Bill Miller is infinitely brighter than I am and willing to accept the risk. Bruce Sherman at Private Capital is also a terrific "discretionary cash flow" investor. He owns the stock. But remember that for Miller, this is a 2.75% of portfolio position. For Sherman, 3.22%. For those who wish to "hope," make sure that the weight of this name in your portfolio is similar. In my view, the risks are high and the outcome highly uncertain.

Disclaimer: Neither I, my family, or my clients currently have a position in Eastman Kodak.