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Kodak's Many Negatives

By Richard Stice, CFA It has been quite a year for the S&P Photographic Products Index, which rose 22% in 2004, more than doubling the 10% rise of the S&P Composite 1500 Index. And Eastman Kodak (EK) was a clear standout. Its shares are now trading at $32.11, up 32% from their 52-week low of $24.25. The industry benefited all-around from investor optimism over digital photography.

Kodak, which dominated the traditional film era, understands that the world is changing. To its credit, it has embraced digital photography and made good progress adopting a sensible strategy for the future. While the scope of these changes may seem daunting at first glance, we at Standard & Poor's Equity Research Services believe Kodak has made progress in the first year of its transition. It has undertaken and integrated several acquisitions, rolled out new products and gained share in the digital-camera marketplace.

However, we think the ultimate success of the plan remains uncertain, and we aren't convinced that it will result in improved earnings performance. That's why we rate the stock a sell. We have set a 12-month price target of $25, and we expect it to underperform the S&P 500-stock index over the next 12 months.

FRESH START. The era of digital photography is well under way. After surpassing sales of film cameras in 2003, the demand for digital devices continues to swell. According to market research firm IDC, during the first nine months of 2004, U.S. shipments of digital still cameras grew by close to 50%, vs. the same period in 2003. Conversely, we think U.S. shipments of traditional film cameras declined at a double-digit rate in 2004, and we expect a similar drop in 2005.

Determined to face reality, Eastman Kodak commenced a major transformation a little more than one year ago. In September, 2003, it announced a new strategy to address the digital marketplace. Kodak anticipated spending $3 billion on acquisitions through 2006, which we view as a sizable number when compared with the outfit's $13.3 billion in total reported sales for 2003. In addition, in January 2004, Kodak detailed a new cost-reduction program that's expected to result in restructuring charges of between $1.3 billion and $1.7 billion over a three-year period.

The bulk of the charges are being allocated toward severance pay, with some 12,000 to 15,000 layoffs expected to take place. Kodak anticipates that the plan will yield cost savings of $800 million to $1 billion by 2007.

There's no question that Kodak will be an important player in the digital world. But it still faces a tough time meeting its financial goals. And the success that it enjoyed in the stock market in 2004 will be hard to duplicate in 2005.

FIERCE BATTLE. The environment will be marked by severe price competition, making it difficult for all players to make money. According to the Consumer Electronics Assn., the average unit price for a digital camera decreased by over 50% from 1999 to 2003. We expect this trend to continue as industry participants introduce new products, discount older inventory, and maneuver to take market share from their peers.

Kodak enters the fray with a major disadvantage. It continues to generate the majority of its sales in the traditional film market, which is experiencing long-term decline. Although we think the move to lure customers toward its digital offerings makes strategic sense, the near-term impact is being somewhat mitigated by what we view as the cannibalization of Kodak's film offerings.

And Kodak won't have any of the advantages that worked to its favor in the traditional film market, where it was the dominant player. In the third quarter of 2004, an IDC study indicated that seven companies, including Kodak, each hold market share of anywhere from 7.6% to 20% of U.S. digital-camera shipments. We believe this dynamic will have a negative impact on margin performance as the rivals jockey for market position via pricing discounts.

Given the dynamics of the market, Kodak will have a tough time meeting its forecasted long-term gross margin target in the range of 30%. We think a mid-20s margin is more likely.

CLOUDED PICTURE. We expect profits to decline, too. We anticipate operating earnings per share of $2.40 in 2005, a 6% decline from our 2004 estimate of $2.55. For 2005, we are projecting sales growth of approximately 4%, to $14.2 billion. This estimate may be aided by a favorable foreign-currency impact as Kodak derives over half of its sales from overseas. This factor added 3 percentage points to third-quarter 2004 financial results.

An upside surprise is possible. Risks to our recommendation and target price include the integration of new acquisitions at a faster-than-expected pace, a slower than anticipated decline in demand for traditional film products, improving margin performance, and gains in market share.

But plenty of uncertainty surrounds Kodak's ability to complete its aggressive strategy shift. We view impending margin pressures with concern. That's why we think Kodak shares are unattractive on a valuation basis.

Note: Richard Stice has no stock ownership or financial interest in any of the companies in his coverage area. All of the views expressed accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed. Price charts and required disclosures for all STARS-ranked companies can be found at Analyst Stice follows photographic products for Standard & Poor's Equity Research

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