A Tense Kodak Moment

Low-margin digital sales aren't picking up the slack of disappearing film profits, and debt is coming due

Eastman Kodak (EK ) sells 22% of the digital cameras in the U.S. annually, making it the biggest player. Its 65,000 yellow, blue, and red printing kiosks seem to be everywhere. And on Sept. 27 the 125-year-old company shipped what it says is the world's first Wi-Fi pocket camera, which lets consumers send good-quality photos directly to the Internet. So you might imagine that the Rochester (N.Y.) company has made a seamless transition to the digital age from the messy analog world of film and chemicals.

Kodak's financial reports show a much darker picture. The company is barely breaking even on its digital cameras. It is scrambling to drum up enough cash both to shut down most of its film and paper capacity -- at an estimated cost of nearly $1 billion over this year and next -- and to repay $750 million of debt that comes due next year. Its credit ratings, which fell below investment grade in April, were marked down again on Sept. 30 by Standard & Poor's (MHP ) even as it is finalizing a $2.7 billion loan facility.

Senior executives at Kodak concede that the company's balance sheet is "stressed." But they say Kodak will turn up from this financial low point in its massive transformation to digital. By the end of 2006, according to Chief Executive Antonio Perez's plan, the total $1.5 billion cash cost of laying off workers and shutting down factories will be pretty much paid. Besides, no significant amount of Kodak's remaining $2.7 billion of debt is scheduled for repayment until 2010. Chief Financial Officer Robert H. Brust says earnings will start to turn up sometime next year. "We're at a difficult point, but coming along pretty good," he adds. "As digital earnings start increasing faster than traditional [film] earnings are falling, we will repay debt."

Investors have heard such predictions before. But the company's forecasts have often been unreliable, says S&P. About a quarter of Kodak's consumer film business is disappearing each year -- more than three times faster than executives envisioned in September, 2003, when they declared they would transform the company into a maker of digital products. Kodak missed its targets for operating earnings in the first two quarters of this year and has now stopped issuing them at all. Profits from consumer digital products -- cameras, home printers, kiosks, and the ink and paper for them -- are scant two years after they were held up as the salvation of the core consumer business. And the health-care division, often portrayed by the company as a future source of big profits, stumbled recently on several counts, including a delay in getting a digital radiography product to market and the slow installation of software being sold to hospitals. Executives warned on Sept. 28 that Kodak will fall short -- they didn't say by how much -- of their July projection that digital products would produce $275 million to $325 million of operating earnings this year, vs. $46 million in 2004. Brust says forecasting amid so much change is difficult. "There are a lot of moving parts, but we're more in a steady state now," he says.


Kodak's woes highlight the financial strains faced by established companies when disruptive technologies erode their traditional revenue streams. As many media companies, music retailers, and video-rental chains can attest, the problems are compounded by the speed at which digital technology spreads around the globe. "Digital was supposed to be the promised land, and it is turning into a swamp," says James S. Chanos, founder of money manager Kynikos Associates, who is betting that Kodak shares will fall. "Businesses with these major paradigm shifts to digital products just see their cash flows from analog products evaporate much faster than people are used to."

At Kodak, executives had hoped that emerging markets such as China would give them more time to wind back the film and photographic-paper business as Americans switched to digital cameras. Instead, buyers in new markets skipped over film and went straight to digital. So in July, Kodak raised its layoff target from the 15,000 announced in January, 2004, to as many as 25,000 jobs. It vowed to eliminate $2 billion, or two-thirds, of its traditional business assets by the end of next year. It is even cutting capacity in China.

The speed of the collapse of its traditional business lines has pushed Kodak into a cash bind. Severance and other restructuring bills will gobble up $300 million in the second half of this year and $650 million more next year, when the $750 million of debt comes due -- for a total of $1.7 billion. At the beginning of July, Kodak had just $553 million in cash on hand. Brust predicts he will have enough money to close the gap. Typically, Kodak generates most of its cash in the second half of the year -- $1.1 billion last year. He plans to raise $600 million by selling real estate and patent rights; he's also liquidating inventory and cutting capital expenditures.

Then there's Kodak's surprising decision to make fewer consumer digital cameras and printers in case holiday sales falter. Even so, Brust is taking no chances. He has negotiated a bank commitment to refinance $500 million of debt if he needs to.

Should things not go as planned, Kodak would be unlikely to find it easy to raise cash in the bond or stock markets. Its shares are down 27% this year, to 2003 levels. Bond investors are dumping the company's debt, too. Besides the missed projections, what's frustrating them is that Kodak is giving banks security for the new loan package and putting their $2.2 billion of unsecured debt at a disadvantage. Pessimists such as Chanos think Kodak's write-offs will continue and that the company will ultimately have to restructure its debt -- in or out of bankruptcy court.

Not everyone on Wall Street is down on Kodak. Bill Miller, chief executive of Legg Mason (LM ) Capital Management and portfolio manager of Legg Mason Value Trust (LMVTX ), the only mutual fund to beat Standard & Poor's 500-stock index for the past 14 years straight, is a big fan. He holds some 42 million Kodak shares, 15% of the company's equity, including 3 million bought earlier this year. Despite having lost money on the stock -- he began buying in 2000 when it was twice as high as its recent $23 -- he believes the shares will turn around. "Once these cash charges are gone, we expect [Kodak] will have free cash flow of more than $1 billion, conservatively," says Miller. He figures that will make the company worth more than $16 billion and $50 a share. Then, Miller says, double-digit profit growth will kick in, thanks largely to Kodak's commercial-graphics business. Built up with a half-dozen acquisitions over the past two years, the division is getting ready to sell more machines capable of personalizing slick junk mail and printing everything from colorful store merchandising banners to lottery tickets. "The real payoff begins after 2008," Miller predicts.

All the same, there are risks to his rosy scenario. Some people are turning away from printing photos at home or anywhere else. Doctors in U.S. hospitals are increasingly viewing X-rays on video monitors, while youngsters are looking at one another's digital pics over the Internet without bothering to make prints.

Kodak executives, while exuding optimism, are preparing a change in the company's organization that could make it easier to sell off assets. Starting in January they'll divide the company into four distinct units -- consumer digital, commercial printing, health care, and traditional film -- each with its own financial report. "It will be up to the board to decide what is the best option," CEO Perez recently told securities analysts. "We don't have anything for sale." At least not yet.

By David Henry in New York

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