Kodak: Is This the Darkest Hour?

Losses are up and the stock has tanked. But if the photo giant can make its digital unit click, the picture could brighten

For investors, the picture at Eastman Kodak (EK)—once one of America's premier blue chips—keeps getting darker. On Aug. 1, the already depressed stock plunged some 14%, to $19.20, after the company reported it lost $282 million in the second quarter, nearly double the $155 million it lost a year earlier. Kodak's stock is now trading at levels last seen in 1980, when the overall stock market was trading at a small fraction of today's levels.

But Chief Executive Antonio Perez argues the market is missing the big picture. The Spanish-born Perez, who loves to tell colorful stories to make his point, compares Kodak's turnaround to taking a reluctant horse out for a ride. "When you ride the horse out of the stable," he says, it moves slowly. "But when it senses you are going back to the stable, it starts to trot and then gallop."

Similarly, even though Kodak's stock is falling, "we have already turned the horse to the stable," Perez argues. Indeed, Perez predicts that much better days lie ahead for one of world's best known brands (see BusinessWeek.com, 5/12/06, "A Digital Warrior for Kodak").


  Is he right, or is this just wishful thinking? To his credit, Perez makes a powerful case that by some key measures—including Kodak's heavy debt load and its crushing restructuring charges—things will soon improve for the Rochester (N.Y.)-based giant. But the market is likely to remain unimpressed until Perez delivers on his promises of significant earnings from Kodak's burgeoning digital businesses. So far, it hasn't (see BusinessWeek.com, 1/31/06, "Kodak's Comeback: Still Undeveloped"). In fact, in the second quarter, Kodak made a mere $4 million on its $1.8 billion in digital revenues.

The strongest argument made by Perez is that Kodak is nearing the end of the painful downsizing of its film business. With film sales in freefall, Perez aims to cut Kodak's film assets by 75% to some $1 billion by the end of next year. The huge restructuring charges associated with closing factories and laying off up to 27,000 employees have accounted for most of Kodak's losses. In the second quarter, for instance, restructuring accounted for $214 million of Kodak's net loss of $282 million. And this year, Perez estimates the restructuring tab will total $1.15 billion.

But since Kodak has already gotten rid of 20,500 workers since the process began in early 2004, by next year, Perez says, "the restructuring charges will be cut in half." And by the end of 2007, he adds, "that will be the end of it." In turn, the end of these charges should be enough to stanch the flow of red ink at Kodak and push the company back into the black. After all, the film business remains profitable, even though it's shrunk to a shadow of its former self.


  The second major point in Perez' favor is that he's continuing to move ahead with his plans to sell or find a partner for Kodak's health-imaging business, which had $2.7 billion in sales last year. "This is a complex carve-out," Perez cautions, partly because the health business—ranging from film-based X-rays to digital imaging—has long been intertwined with Kodak's other businesses. Even so, Perez insists, "we have lot of interest" from potential buyers or partners, "and I have a strong interest in getting it done before the end of the year."

The unanswered question is how much Kodak might fetch for this unit. Ulysses Yannas, a broker at Buckman, Buckman & Reid, who has followed Kodak since 1967, argues it could bring $4 billion or more. But others worry the price could be just half that. The business doesn't have strong growth prospects, in part because of competition from larger competitors such as General Electric (GE) and Siemens (SI). Still, it throws off steady cash, with operating margins of 12% in the latest quarter, which is one reason that the most likely buyer is a private equity firm.

Even if Kodak fetches $2 billion for the business this would represent an enormous cash infusion. And Perez, who says he already plans to cut the company's debt by $800 million this year, promises, "we will use most of those proceeds (from a sale of the health business) to pay back debt." Indeed, Kodak's covenants require it to pay off at least $1.2 billion in debt in the event it sells the health business.


  That would be a huge step forward for a company now burdened by $3.5 billion in debt. This debt load, combined with heavy losses, has led Standard & Poor's, like BusinessWeek a unit of the McGraw-Hill Cos. (MHP), to slash Kodak's credit rating to B+ with a negative outlook, deep into junk-bond status (see BusinessWeek.com, 10/17/05, "A Tense Kodak Moment"). That's a humiliating comedown for a company that maintained an investment-grade rating until April, 2005. But if Perez completes a sale of the health business and then pays off the required $1.2 billion, "We would have cut our debt more than in half," he says.

So far, so good. But what the market is really waiting for is evidence that Kodak can earn good money from its growing digital businesses. To his credit, Perez has transformed Kodak into a digital company. In the second quarter, digital revenues accounted for over 54% of Kodak's $3.4 billion in sales. But so far profits have been elusive. Last year Kodak promised that it would earn some $300 million from the digital initiatives in its commercial printing, health, and consumer operations. Instead, they came in at only about a third of that goal, at $118 million. This year, Kodak is making even bolder promises, saying it will earn around $400 million from digital.

Kodak is already making money from digital in its health and commercial printing businesses. And those profits should increase in the second half, especially in commercial printing—which is still in the process of integrating several major acquisitions. The big concern is Kodak's consumer digital business, which is supposed to replace the declining film business. Consumer digital lost $79 million in the second quarter, up from a $52 million loss a year ago, partly reflecting competitive pressures in the digital camera market.

On Aug. 1, Kodak announced it will turn over the huge job of manufacturing and distributing its digital cameras to Flextronics International (FLEX). That should help improve margins both by cutting costs, and improving Kodak's ability to respond quickly to changing market conditions.


  Despite the weak first half Perez is sticking with his promise that digital will make some $400 million this year. Clearly the Street is saying, "prove it." Take Jack Kelly, an analyst at Goldman Sachs (GS). Like many analysts, he's been down on the stock for three years, since Perez announced his ambitious transformation plans. "I don't deny that Kodak has come up with some great new digital products," Kelly says. "But to get more positive (on the stock), we need to have more confidence in the profitability of these products."

This is a tough time for companies like General Motors (GM) and Kodak, which are trying to execute enormous transformations even as they're graded by a stock market that has become more and more impatient. But at least at Kodak the moment of truth is approaching. After years of pleading for patience, Perez is now promising Kodak will deliver its first significant digital profits in the second half. And that should pave the way for even stronger results next year, he adds, especially as those huge restructuring charges diminish.

If Perez fails to deliver on these promises, the pressures on Kodak will only intensify. But if he's right, the dog days of August may very well mark the bottom for one of the Street's most beaten-up stocks.

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