Kodak Rating Cut

S&P cites doubts about the profit potential of the photography giant's move into digital imaging, and its need to reduce debt

Note: Because of an editing error, the headline of an earlier version of this article incorrectly characterized Eastman Kodak's current credit rating from Standard & Poor's as below investment grade. The company's current 'BBB-' rating remains investment grade.

On Sept. 25, 2003, Standard & Poor's Ratings Services lowered its long-term and short-term corporate credit ratings on Eastman Kodak (EK ) to 'BBB–' and 'A-3' from 'BBB' and 'A-2', respectively, and removed them from CreditWatch. The current outlook is stable. The Rochester, N.Y.-based photography company had $2.99 billion in debt on June 30, 2003.

The downgrades reflect concern about Kodak's earnings and business profile due to declining prospects for its core conventional imaging businesses as these markets transition to digital technologies; doubts about the profit potential of digital imaging relative to conventional photography; and the need to reduce debt which remains elevated given Kodak's rising business risk and investment strategies.

The stable outlook reflects Standard & Poor's expectation that Kodak's 72% dividend cut will support its credit profile by enabling it to meaningfully reduce gross debt over the near term while still investing for growth in existing and new imaging businesses.

Results for Kodak's photography segment, which represents about 70% of sales, have been under pressure since 1999 due to soft economic and travel conditions, intense competition, and digital substitution. Numerous restructuring actions over this time have been inadequate and photography unit's EBITDA (before restructuring, impairment, and other charges) dropped 41% from 1999 to 2002.

Kodak recently acknowledged that digital substitution is accelerating in consumer imaging markets in developed countries, and is happening sooner than anticipated. This is likely to continue as digital camera household penetration grows and the convenience of digital image printing improves. Kodak recently announced additional restructuring costs to significantly reduce related overhead and infrastructure costs, and further reductions will be needed over time to adjust costs to gradually eroding conventional imaging sales.

Stabilizing the cash flow from these businesses quickly, while continuing to increase sales and profits from health imaging and from conventional imaging in emerging markets is critical for Kodak's credit profile. In addition, Kodak's consumer digital imaging businesses will need to continue to demonstrate strong growth and reach profitability in the near term.

The ratings on Kodak reflect its leading position in the U.S. and global markets for traditional photography products and services, its good geographic diversity, solid position in health imaging, and the expectation that Kodak will steadily reduce gross debt to its target of $2 billion during the next few years. Ratings also recognize Kodak's high business risk, intense competition in its traditional and digital imaging markets, and the financial burden of its significant unfunded postretirement benefit liabilities.

Kodak's discretionary cash flow has been strong for the past few years, benefiting from working capital reductions that are not sustainable despite higher accounts receivable and inventory turnover rates. Given Kodak's increasing business risk, the company will need to continue to generate consistently positive discretionary cash flow and maintain stronger key credit ratios than similarly rated issuers.

Steady debt reduction is important because lease-adjusted debt to EBITDA and EBITDA to interest ratios of 1.7 times and 10.3 times, respectively, at June 30, 2003, will likely weaken slightly by year-end due to additional earnings weakness, pressure on debt from recent cash acquisitions, and only a partial year benefit in 2003 from the dividend cut and recent restructurings actions. Additional cash-financed acquisitions that impair credit measures or Kodak's ability to reduce debt are likely to lead to an outlook revision to negative or a further reevaluation of the ratings.

Kodak's unfunded postretirement liabilities, which totaled about $3.2 billion on an after-tax basis at the end of 2002, are a further burden on its credit profile. Cash funding requirements for these obligations are not expected to change significantly in 2003. Still, continued significant growth in these liabilities or in required cash contributions could pressure ratings. Unfunded postretirement obligations, on an after-tax basis, raise lease-adjusted debt to EBITDA to about 3.4 times at June 30, 2003 (using data on postretirement obligations from 2002).

Liquidity: At June 30, 2003, Kodak had $838 million in cash and $888 million in commercial paper outstanding. The company has $2.225 billion in committed revolving credit facilities, consisting of a $1 billion 364-day facility that expires in July 2004 and a $1.225 billion facility that matures in July, 2006. These facilities provide sufficient backup for Kodak's commercial paper borrowings and other short-term and contingent obligations. The cushion relative to Kodak's debt to EBITDA covenant remains comfortable. Kodak's solid discretionary cash flow also aids liquidity.

Kodak has already expressed the intention to reduce its reliance on short-term debt and has $2.65 billion in unused shelf filings to facilitate this process. Maintaining good liquidity is crucial to Kodak's credit profile.

Outlook: The outlook is stable. Maintenance of the ratings relies on Kodak's ability to stabilize its earnings and business position quickly, generate meaningful discretionary cash flow, and show steady progress in reducing debt towards its target of $2 billion. Shortfalls from these expectations are likely to lead to an outlook revision or downgrade.

Ratings could also be pressured by additional deterioration in the company's business profile; a significant increase in the company's unfunded postretirement liabilities or related cash funding requirements; or more than moderate-sized cash-financed acquisitions.

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