Kodak's Comeback: Still Undeveloped

Its latest results show that investors will need lots of patience as the company continues its transformation into a major digital player

Eastman Kodak (EK) Chief Executive Antonio Perez was brimming with optimism as he met with investors on Jan. 30. "2005 was an extraordinary year for Kodak, a pivotal year," he exclaimed. "We made phenomenal progress in our transition" from relying mainly on film for its growth to digital imaging instead. Perez added: "And we are positioned for very strong success in 2006."

But after years of unfulfilled promises from the Rochester (N.Y.)-based company's top management (see BW, 10/17/06, "A Tense Kodak Moment"), Perez's proclamation was met with more than a little skepticism. That's not just because earlier in the day, Kodak reported a fifth consecutive quarterly loss, capping a year when red ink totaled a staggering $1.4 billion, on sales of $14.3 billion.


  Kodak also conceded that it earned just $118 million from its swiftly growing digital operations in 2005, a far cry from the $275 million to $325 million in profit it promised previously. And worst of all, Kodak warned investors that it's likely to lose a stunning $900 million to $1.1 billion on operations in 2006.

No wonder investors are so skittish. Despite the bullish proclamation from the top on Jan. 30, Kodak's share price slumped 2.4%, to $25.75. Though that's up from the 2005 bottom of $20.77 in late October, Kodak has still lost 27% of its value since reaching last year's peak in February. Most analysts now have a hold or sell rating on the stock.

Moreover, Kodak stock is selling for well under half the value it commanded at the beginning of the decade, when the film business was far stronger. Plus, Kodak's once-pristine credit has fallen even further into the depths of junk-bond status. Last October, Standard & Poors Rating Services (which, like BusinessWeek Online, is a unit of The McGraw-Hill Companies), lowered its corporate credit rating on Kodak to B+, from BB-. S&P further warned that the outlook was negative, a suggestion that it's inclined to make further rating reductions.


  Not all the Kodak news is bad. To his credit, Perez has made remarkable strides in transforming it into a real power in digital imaging. Overall digital revenues soared 40% last year and now represent more than half of total sales for the first time ever, as film continues its precipitous decline.

And Kodak clearly enjoyed a blockbuster Christmas. Sales of its EasyShare Printer Docks -- which allow consumers to print digital images at home -- surged 95%. Sales of its ubiquitous kiosks to drugstores and other outlets were up 23%. "We have reached a critical mass that will allow us to be a profitable consumer-digital company," says Perez.

"People are going to start seeing that this company has become the leader in digital imaging, and that [Kodak doesn't] need the film anymore to succeed," says Ulysses Yannas, a broker at Buckman, Buckman & and Reid. Yannas is a Kodak bull who says the stock could surge to $40 by yearend.


 . But at least for now, the positive signs are overshadowed by the enormity and costs of the transformation under way at Kodak. Much like at General Motors (GM) and Ford (F), Kodak has far more capacity to make film than the shrinking market demands. So it has had little choice. With digital cameras quickly eating into the market for film, it had to become a major digital player -- or risk fading to irrelevance.

Kodak is now midway through the wrenching process of restructuring this business, including laying off some 25,000 workers. Problem is, this overhaul is extremely expensive -- costing $900 million in 2004, $1.1 billion last year, and an expected $1 billion to $1.2 billion in 2006. These charges are the primary reason Kodak expects to book such a big loss this year.

Further marring the outlook, Kodak has also been on a buying spree, spending some $3 billion to more than double its commercial-graphics business. Thanks to these deals, Kodak's commercial-graphic sales more than doubled to nearly $3 billion last year. But the price was steep. Kodak now has some $3.5 billion of debt on its balance sheet, up $1.2 billion in the past year. This growing burden is a key reason why Kodak's debt is no longer considered investment-grade.


  In this precarious environment, Chief Financial Officer Robert Brust may have the most important job at Kodak. He has a tough assignment in 2006. As he admitted at the Jan. 30 meeting with investors, much of Kodak's operating earnings will be eaten up by the restructuring charges -- which are likely to cost some $650 million in cash this year. On top of that, Kodak must repay $819 million in debt.

Fortunately, Kodak has $1.7 billion of cash on hand. But to preserve Kodak's options, Brust admits he'll be scrambling to sell assets -- such as land, buildings, and machinery -- as quickly as the company downsizes. "We have a lot of work to do," Brust concedes. And on top of all this, Perez must now find a successor for Brust, who plans to retire next January.

Assuming Brust can meet all these financing challenges, the key to Kodak's future is to what extent it can begin to make more money on its burgeoning digital business. The company is promising that it will earn $350 million to $450 million from its digital operations this year, a huge increase from the 2005 figure. Perez contends that as the digital business grows, Kodak can spend proportionately less on R&D and overhead, thus boosting operating margins to 4% to 5% of sales, up from a measly 1% in 2005.


  "But what worries me is that you're going to see pressure on gross margins as film declines," says Richard Stice, an analyst at Standard & Poors, who has a sell recommendation on the stock. Even though the film business plunged 18% last year, it still generated $429 million in operating earnings (before restructuring charges). And compared with film, Kodak has far more competition in digital.

For all the problems Kodak faces in 2006, some investors believe it's now one of the great value stocks. The most prominent of these champions is Bill Miller, the legendary manager of the Legg Mason Value Trust (LMVTX), which has beat the S&P 500-stock index 15 years running. He believes that once the dust settles from the downsizing, and Kodak gets its financial house in better shape, the emerging digital giant will be set to soar.

Maybe so. But until then, even true believers in the Kodak story are likely to need a lot of patience.

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