Kodak's Digital Dilemma

The growth is in minilabs--where Big Yellow lags behind

Daniel A. Carp knows better than anyone how exasperating it can be to print digital photos at home. The chairman and CEO of Eastman Kodak Co. (EK ) missed almost the entire third quarter of this year's Super Bowl because he was sitting in front of a computer, printing pictures for his guests instead of watching the game. Carp's verdict on home processing: "It's a miserable experience."

Slow and cumbersome as it is, most people still print their digital photos on their PCs. That won't always be the case, though. Industry experts see more and more consumers dropping digital cards off at a store counter, as they now do with film, because it's familiar and easier than home printing. You might think that would give Kodak a golden opportunity to stake out digital leadership -- after all, for years about the only processing option camera buffs had was to leave film to be processed by Kodak labs. But after a costly misstep, Kodak badly lags in the crucial war for customers' dollars at America's drugstores and discount chains. Unless Kodak can get more of its equipment into retail venues, the film giant risks falling further behind in the consumer end of digital photography.

Kodak's status as an iconic brand name could well depend on how it recovers. The company spent years developing digital cameras, only to wind up third in the U.S. market behind Sony (SNE ) and Olympus (OLYOY ) with a 12% share, says research firm IDC. It continues to suffer from the shift toward digital -- Kodak's U.S. film sales fell 5% in the fourth quarter, and its overall sales fell 3% for the year, to $12.8 billion. Profits rose to $770 million, from $76 million in 2001, when they included $659 million of restructuring costs.

If Kodak is to get back on the growth track, it needs to identify the killer app -- or apps -- in digital processing. To be sure, there are other ways to get digital prints: at self-serve kiosks, through online services, or, as Carp tried, at home. And Kodak has a hand in all of them. Right now, 82% of all digital camera users print with a home PC, says Photo Marketing Association International. Only 7% use retail outlets.

But that's almost certainly going to change. As digital photography goes mainstream, consumers increasingly will want somebody else to make their prints. Lyra Research Inc., an imaging research outfit in Newtonville, Mass., projects a $7 billion market for digital processing by 2005, with 32% of that done at retail. Says Edward Lee, a Lyra senior analyst: "Over the next two years, as the soccer parents move to digital imaging, they will look to retail for their photos. They don't want to mess with them."

Unfortunately, Kodak is playing catch-up in the most crucial retail segment, minilabs. These are the $100,000 computer and processing machines, located behind store counters, that can spit out 2,000 4x6-inch prints per hour. Rival Fuji Photo Film Co. (FUJIY ), with more than 5,000 labs in place, already has 60% of the U.S. digital minilab market, including deals to put machines in 2,500 Wal-Mart (WMT ) and about 800 Walgreen (WAG ) outlets. Those two chains handle about 40% of the U.S. photo-processing market.

Kodak has only about 100 digital minilabs in service now. Why so few? Its hopes were tethered to a 1997 alliance with German imaging company Gretag, which would make the hardware while Kodak provided software. But Gretag filed for bankruptcy in 2002, and Kodak landed a new partner, Japan's Noritsu Koki Co. "We've only begun our collaboration with Noritsu," says Daniel P. Palumbo, president of consumer imaging at Kodak.

Despite the slow start, Kodak projects that it will sell 1,000 minilabs this year. Expansion may be tough. With some of the biggest customers in the Fuji camp, Kodak has to line up smaller chains, mom-and-pop stores, and non-traditional retailers. But it believes that growth in the marketplace will offset that difficulty. Only 21% of households now own digital cameras.

The segment of retail processing Kodak does dominate -- self-service kiosks -- is one that several analysts think will decline. Since 1994, Kodak has installed 23,000 kiosks at U.S. locations such as CVS (CVS ) and Target (TGT ). It wants to install even more. The earliest models enlarged film prints. Today, about 80% of them make digital prints too.

Consumers, however, can be intimidated by kiosks. Helen Kaplan, a 48-year-old Atlanta attorney, usually drops off her memory card at her local Eckerd (JCP ) drugstore and gets her prints two days later. She used a kiosk only once, when she had to have pictures that night. The machines, she says, "seem too complicated and time-consuming." They will likely lose out to countertop models linked to in-store minilabs. Users would choose their own specs, but get minilab speed.

Kodak does have other digital irons in the fire. In 2001, it bought online processor Ofoto Inc. for $58 million. Ofoto's 6.5 million members can store photos there or request prints, which Ofoto mails to them. But while Ofoto is the market leader, Kodak says it has yet to make money. And online photo transfers can take forever without a high-speed Internet connection. As for home printing, Kodak will introduce a $199 printer in May that links directly to its EasyShare digital camera. But it won't make digital printing any cheaper. Kodak figures prints will cost 50 cents to 75 cents a pop -- at least 75% more than at Wal-Mart. Meanwhile, rival Canon Inc. (CAJ ) sells a $99 machine that does both general purpose and photo prints.

Analysts see the least upside in those markets. No matter. Carp still thinks Kodak should place wagers in every segment. "I think our best bet is the sum of the parts," he says. Let's hope he does better than he did at the Super Bowl. Carp bet on the losing Oakland Raiders and had to treat his friends to doughnuts. If he loses this wager, the cost to Kodak will be a lot more painful.

Read a Letter to the Editor about this story.

By Faith Keenan in Rochester, N.Y., with Cathy Schottenstein in Atlanta

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