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Eastman Kodak Company (EK)

Q1 2006 Earnings Conference Call

May 4th 2006, 11:00 AM.

Executives:

Don Flick, Director, Vice President, Investor Relations

Antonio Perez, Chairman, Chief Executive Officer

Robert Brust, Chief Financial Officer, Executive Vice President

Analysts:

Jay Vleeschhouwer, Merrill Lynch

Matthew Troy, Citigroup

Laura Starr, Equinox Capital Management

Jack Kelly, Goldman Sachs

Ulysses Yannas, Buckman, Buckman and Reid

Carol Sabbagha, Lehman Brothers

Sam Doctor, J.P. Morgan

Operator

Good day, everyone, and welcome to the Eastman Kodak First Quarter Sales and Earnings Conference Call. Today's conference is being recorded. At this time, for opening remarks and introductions, I would like to turn the conference over to the Director and Vice President of Investor Relations, Mr. Don Flick. Mr. Flick, please go ahead.

Don Flick, Director, Vice President, Investor Relation

Good morning, and welcome to this morning's conference call. I'm here with Antonio Perez, Kodak's Chairman and CEO, and Bob Brust, our Chief Financial Officer. Antonio will begin this morning's call with his observations on the quarter and the other important announcements that we made this morning, and then Bob will provide a review of our first quarter financial performance.

Before we begin, I have the usual housekeeping activities to complete. First, certain statements during this conference call may be forward-looking in nature while forward-looking statements as defined in the United States Private Securities Litigation Reform Act of 1995. For example, references to expectations for the company's earnings, revenue, and cash are such forward-looking statements. Actual results may differ from those expressed or implied in these forward-looking statements and these forward-looking statements are subject to a number of important risk factors and uncertainties, which are fully enumerated in our press release this morning. Listeners are advised to read these cautionary statements in their entirety.

Lastly, although Kodak has significantly reduced its references to non-GAAP measures, in those instances where they are used, they are fully reconciled to the nearest GAAP equivalent in the documentation that we have released this morning. Now, let me turn the conference call over to Antonio Perez.

Antonio Perez, Chairman, Chief Executive Officer

Thank you, Don. Good morning, and welcome to our call. As you know, we have a number of important announcements this morning, which I will discuss first, and then Bob will go into more detail about our first quarter financial results.

In my view, the first quarter continues to show the progress we're making in our transformation, as well as the strong seasonality of our business. Having said that, my outlook for the year remains essentially unchanged.

The summary of our performance is as follows. In CDG, the Consumer Digital Group, we face a slightly higher than normal industry channel inventory position caused by the fourth quarter that created temporary pricing pressures for all models, and some transient inventory buildup. Strategically, though, I'm pleased with the fact that our digital capture business, improved earnings from year-to-year in line with our strategy of expanded margins and that our media pricing is more competitive now.

GCG, the Graphic Communications Group, performed much better than expected based on the strong momentum created last year. I feel great about this performance which is a little earlier than expected, and ahead of the bulk of cost synergies planned for the year, and is based on good market acceptance.

FPG, the Film and Photofinishing revenue declined was an expectation, but FPG performed slightly better than our internal plan for earnings while the Health Imaging Group was slightly behind its year for goals. Overall, our digital earnings have improved year-to-year in line with the strategy. In my view, a balance which holds that keeps us on track for the year. I will come back to more detail on the businesses later.

On the strategic front, I have been working to accelerate our transformation to a digital company ever since becoming CEO last June. To this end, last July, we accelerated and deepened the risk structure and actions for our traditional businesses with major facility closures in Australia, Canada, Brazil, and the U.K., and significant reductions in the other facilities located in the U.S., the U.K., and France. We will continue to retain margins in the traditional portfolio through cost reduction, while working aggressively to monetize the assets made surplus.

I also announced in January that having achieved significant scale in our digital businesses, we are rebalancing our focus more towards margin expansion. That would take a bit of time to implement, but it's a key priority for the year, with results becoming more visible in the later part of the year.

This morning's announcements are therefore the next step in completing the creation of the new product further plan presented to you in January. As I said before, we intend to finish the restructuring during 2007, with 2006 being the year with the highest restructuring costs. As always, our focus remains on driving shareholder value.

On the other announcements, the first is the decision to pursue strategic alternatives for our Health Group. This is a very valuable business with an extremely strong brand, excellent products with market-leading positions, a tremendous heritage in the health imaging market, employees with unrivaled experience, a global customer base and strong cash flow. However, industry dynamics in this industry are re-defined in the business model and the scale required for sustained success and leadership. Because of this, we have decided that now is the appropriate time to explore alternatives, and we have initiated the actions necessary to do so. We have been preparing for this possibility for some time, and will move this process forward as rapidly as possible. Our principal objective, as you would expect, is to find a strategic option to reach the full potential of this business, becoming an even stronger supplier to our customers, and create a more valuable business with increased shareholder value.

We announced today two additional strategic actions to further implement my vision for our operating model. The division is to align the company around empowered segment general managers who have the clearest line of sight to their markets, and can quickly and effectively create a willing value proposition for the customers as well as the infrastructure levels necessary to profitably support those markets. Obviously, I'm pushing the decision right to those best able to choose the appropriate investment levels.

The first of this additional announcement is the realignment of our global manufacturing and logistical organizations by integrating these assets and operations, into the relevant business segments. This action, which was a pivotal element in our plans, has been made possible today, thanks to and enabled by the rapid and effective restructuring actions we have taken, leaving us with a manufacturing structure that can now be rationalized into the businesses they support. This action will be completed by July 1st. This is very significant operationally, and in one sense, marks the last break with the past business model, the end of the 19th Century economy of scale manufacturing model which served our traditional business so well for over 120 years. However, this must now give way to the new dynamics of today's fast-moving markets in new supply chain models. This action is consistent with my vision of aligning assets with the manager closest to the market being served. This will result in an inherently lower cost model overall, faster execution, as well as more fine-tuned distribution and logistic models.

The other announcement is the next significant step toward achieving our target business model by the end of 2007. As you know, to accomplish this, we must efficiently remove a significant amount of costs from SG&A, which ultimately is all about business simplification. Again, now that we have clearly defined business segments, the segment managers have defined how much cost is appropriate, and are quickly moving to that level. That effort at the business unit level must be matched by significant reductions at the corporate level. By removing layers of managers that once were appropriate for our previous model, I can reduce organizational complexity and achieve the reductions in corporate costs that we need. To that end, we are implementing now an aggressive plan to reduce corporate costs. We will replicate the success we have had in reducing costs in assets and manufacturing that are now on the SG&A side of the business. It is important to mention that all of these decisions, and the costs associated with them, were in our plans, and are part of this year's restructuring budget. We are now in full implementation phase.

This announcement will result in the retirement of three senior officers and the realignment of three organizational entities and their associated infrastructure. Charles Brown, Charles Valentine and Dan Meek are strong supporters of our transformation strategy which they helped me create, and have been extremely effective supporting and executing the transformation. I thank them for their contribution to products, past and present, and for the unselfish support that I've received from them in the last two years. We wish them well in their retirement.

Now, let's go back to my perspective on our business performance in the first quarter. CDG. While our market position remains very strong in CDG, you will remember the great results in the fourth quarter and we expect good results in the first quarter, too. Today's results largely reflect the normal impact of the retailers selling through excess year end inventories, as well as the impact of significant price decreases taken last year in our thermal media portfolio. From a long-term perspective, you will recall that I announced in January the primary goal for our consumer digital business in 2006 is margin expansion. Plan set in place to achieve that goal, and you can see results of this operating model already and we will see more during the balance of the year.

Phil Faraci and his management team are fully engaged in this process, with a number of initiatives moving through the system, including our go-to-market model and supply chain management. This includes reducing the current 61 countries served directly by product, to less than 20 countries with sufficient scale to permit profitable product direct participation, with a balance served more effectively by distributors. This is a very typical well-proven distribution model for low margin digital products, and we are moving rapidly to have this model largely in place before the end of this year.

We have been focused on driving revenue and scale expansion for the last two years. We are now moving quickly to convert that scale into cost synergies and margin expansion, by effectively implementing platform designs, fine tune go-to-market strategies, and improve logistics. It is possible that these steps could end up limiting our growth in the short-term but would position the Consumer Digital Group for sustained growth on a more profitable basis. In fact, we now expect that with this improvement our entire digital portfolio will be profitable during the third quarter, a full quarter earlier than last year.

The Film and Photofinishing Systems segment performed essentially on expectations, as we rapidly reduce our manufacturing assets and employment in line with revenue decline. While the first quarter results reflect the expected low first quarter revenue seasonality, we anticipate a rebound throughout the remainder of the year. I am very pleased with the better-than-expected year for performance in the first quarter, helped by operational productivity in the face of higher commodity prices.

The Health Group experienced continued growth in its key digital businesses for the future. The digital capture and the healthcare information businesses, offset by declines in traditional radiography and digital output products. The output products, although using a digital printer, are attached to the area of workflow of the hospital and therefore are declining. Digital capture and health information systems will continue to have a strong market growth. In this business, in parallel with our investigation of strategic options, we will work on adjusting its cost structure to improve its overall margin performance and continuing to drive the growth of this digital workflow portfolio. Again, this is a very valuable business by exploring all the strategic options; we will be able to reach its full potential and the maximum shareholder value.

Obviously, the best news from the first quarter came from the Graphic Communications Group. This is a great example of an ongoing success story. This is a business I envisioned when I first came to Kodak and it has become a reality within two years, thanks to a powerful strategy and an excellent implementation. I have great expectations for this business, as we continue to take advantage of costs and revenue synergies and the strong acceptance we are experiencing in the market.

Integration of our acquired business and the associated cost reductions are proceeding better than planned. We continue to see healthy industry growth for our array of digital businesses, and even more importantly, customers have embraced the breadth of the product portfolio as one that is unmatched in the industry. You may recall, we’ve recently announced that we significantly exceeded our sales goals again at the IPEX printing conference in Europe. Therefore, we have raised our expectations for the year for this business.

Before I turn the discussion over to Bob, I would like to reiterate our three critical metrics for success in 2006. Digital earnings from operations of $350 million to $450 million, digital revenue growth of 16% to 22%, and investable cash of $400 million to $600 million. We remain confident in delivering these numbers for the year.

In summary, we are sharpening the focus of the company, while continuing to create the digital business model I have described for you. And while we are fully aware of the challenges we have in front of us, we feel reassured by the clear progress we have achieved so far. Thank you, and I will turn the call over to Bob, for more details about the quarter.

Robert Brust, Chief Financial Officer, Executive Vice President

Thanks, Antonio. I will provide a bit more information around our first quarter financial results, and then Antonio and I will be happy to take your questions. As Antonio indicated, the quarter's performance reflects the seasonality of our transformation, particularly of our consumer digital business, plus the impact of several unusual headwinds. However, I will repeat Antonio's comment that our view of the full year is unchanged, from our January New York meeting.

Let me discuss three of the headwinds in the quarter. First on this list are commodity prices, we are all dealing with oil-based increases, both business and personal, but for Kodak, the most dramatic of these are the accelerating increases in silver pricing. With the average price of silver in 2005 at approximately $7.30 an ounce, increasing to an average of $9.73 per ounce during the first quarter, and currently at about $14.00 an ounce. Due to the rapid increase in silver prices, it has been very difficult to take a significant hedge position in this commodity. Silver is used across a broad range of our product portfolio, from consumer films to motion picture film, to X-ray and digital output film, to color paper. As one measure, at $14 an ounce, the negative year-over-year impact on earnings for the balance of this year would be in the range of $2 million to $225 million. During the first quarter, the year-over-year negative pre-tax impact on earnings due to silver was approximately $19 million.

Pressures also exist with aluminum pricing, a key raw material in manufacturing printing plates in our Graphic Communications Group, as well as petrochemical-based resins and general energy costs. In order to offset some of this pressure, we have recently announced broad price increases across our silver hay light buzz belt portfolio, as well as previously announced price increases for graphic plate products. These price increases will help us recover some lost margin as we go forward.

The second headwind is on the tax line. For the quarter, we recorded a tax charge of $3 million versus a tax credit of $57 million in the year-ago quarter, representing an unfavorable change of $60 million, despite a higher pre-tax loss in the current quarter. With the higher pre-tax loss, you would expect a higher year-over-year tax credit in the current quarter. However, since the initial recording of the valuation allowance in the third quarter of 2005, we are no longer recording tax benefits and therefore, 100% of our U.S. pre-tax losses are falling to the bottom line. This unfavorable year-over-year comparison will end in the third quarter, as we anniversary the initial recognition of the valuation allowance.

Lastly, I will remind everyone that we have shortened our asset useful life assumptions at mid-year last year, which has a meaningful non-cash negative impact on earnings, particularly in the Film and Photofinishing Group. Due in large part to this change, the depreciation charges are up 83 million year-over-year. This significant unfavorable comparison will also end in the second quarter, as we made this change July 1st of last year.

The total unfavorable impact of these three items represent a substantial portion of our year-over-year earnings decline. As it looks today, higher commodity prices, and in particular silver will remain a negative past the second quarter, partially offset by selling price increases. So, with these known issues impacting us in the quarter, as well as the nature of the company transformation, our first quarter results were about where we expected.

One last item before we get started. You will notice the year-ago results used today for comparison do not align with results reported in the year-ago quarter. We adjusted previous years' numbers to reflect the current reporting structures such that the performance is on a comparable basis. Most of these changes reflect the movement of costs and/or allocations between business segments or digital traditional product categories. These changes include reallocation of costs between business segments, where the acquired graphic communications subsidiaries were added to the company's corporate allocation process resulting in additional expense allocations to GCG, while reducing allocations to the other business segments.

Secondly was the movement of strategic product group between traditional and digital product categories.

Thirdly, the impact of U.S. inventory costing changes from LIFO to average cost which was implemented on January 1st this year, and unfavorably impacted the first quarter of 2005 by $8 million on a pre-tax basis.

Now, for the first quarter. Consolidated revenue growth for the company was 2%, which included a negative foreign exchange impact of 55 million, or 2%. Digital revenue growth was 29% year-over-year, primarily driven by the recent acquisitions within Graphic Communications Group, while our traditional product portfolio declined 20%. In the quarter, the company's gross profit margin was 23.5% versus 24.4% last year, a decline of 13 million, or approximately 1 percentage point. First quarter gross profit was negatively impacted by lower volumes, increased depreciation due to shortened useful life assumptions, negative price and mix, unfavorable foreign exchange, and higher material, raw material costs, partially offset by significant gains from acquired businesses and manufacturing productivity.

In the quarter, SG&A increased $28 million, or 5%, but remained essentially unchanged as a percentage of sales at 21%. This increase in dollars was primarily driven by SG&A related to acquired businesses of $117 million, which was largely offset by cost reduction activities of nearly $90 million during the quarter. This reflects the heavy emphasis on this category by Antonio and the team.

In another area of our ongoing cost reduction efforts, the company recorded first quarter pre-tax restructuring charges of 145 million, and accelerated depreciation and inventory write-downs of 83 million, following 228 million pre-tax, or $0.69 per share. This was $0.10 per share more than a year ago. This includes severance associated with the elimination of 1,175 positions during the quarter, bringing our total employment reduction against a goal of 25,000 to approximately 19,000.

The cash restructuring payments in the quarter were 135 million versus 128 million last year. We will manage full-year cash restructuring payments to not exceed $650 million this year.

On a segment basis, revenues in Consumer Digital Imaging Group declined 10% as a result of lower volumes and adverse foreign exchange and lower price and mix. In the quarter, digital capture sales declined 11%, home printing revenue was down 13%, and kiosk sales decreased 9%. The revenue declines were the result of slower sales into the channels, as retailers sold through the generally higher than normal inventory positions, while kiosks and home printing were significantly impacted by price reductions of thermal media implemented during the second half of last year. However, we remain pleased with our kiosk media burn rate and the prospects for these businesses in 2006.

Losses from the Consumer Digital Imaging Group were 96 million versus 58 million in last year's first quarter. The year-over-year decline in earnings resulting from lower earnings in kiosks, Kodak Galleries and Home Printing partially offset by a strategically important improvement in digital capture earnings. As Antonio mentioned, we are in the midst of the major overhaul of the operating model for this business. As a result, we expect improving earnings performance as we move through the second half, particularly the fourth quarter. On an organization note, our inkjet systems continue to be reported in all other.

Moving in the Film and Photofinishing Group, revenues declined 28% as a result of continuing secular declines in consumer film and photofinishing. In the quarter, the motion picture film portfolio was down 7%, largely due to unfavorable foreign exchange, more conservative release strategies by the major studios, and an increase in the proportion of independent versus studio feature film releases. However, even with the 28% revenue decline, film photofinishing earnings declined only 42 million year-over-year, with more than half attributable to the non-cash impact of higher depreciation resulting from shortened useful life assumptions. This validates our cost reduction efforts in this area.

Health revenues declined 7% in the quarter as a result of continued declines in the digital output and traditional radiography portfolios, partially offset by growth in digital capture and healthcare information systems. Earnings in the Health Group decreased from 78 million last year to 46 million this year, primarily as a result of lower earnings contributions from traditional radiology film and digital output, partially offset by improved earnings performance in digital capture and healthcare information systems. In addition, it is important to note that the health represents our most silver-intensive business. Operating margins declined to approximately 8% as a result of these factors. As Antonio mentioned, given the industry dynamics within this segment, we are now exploring alternatives to strengthen this business.

GCG revenue growth was 136%, driven by the Creo and KPG acquisitions. Cost synergies remain ahead of plan and our comprehensive portfolio of pre-pressed products continues to be well received by the market. Earnings in Graphic Communications Group increased $65 million from a loss of 34 million last year, to earnings of 31 million in this year's first quarter, driven by the contribution from the plate businesses, and strong year-over-year earnings improvement in next press.

The other income and charges category had a negative year-over-year swing of 9 million. The biggest contributor to the year-over-year change is the elimination of KPG equity income, which is now reported within Graphic Communications Group. This is the last quarter of this unfavorable comparison, as the KPG acquisition was closed on April 1st of last year.

Interest expense was 62 million in the current quarter; an increase of 22 million from the first quarter of last year, as a result of increased levels of debt associated with recent acquisitions and higher interest costs. Interest costs will decline later in the year as we pull debt down.

Total corporate traditional earnings were slightly better than expected at 46 million for the first quarter versus 105 million last year, which represents a seasonal low point of the year for our traditional business.

Consolidated first quarter digital losses from operations were $37 million, a strategically important improvement from last year's first quarter loss of 51 million, while new technology spending showed a slight year-over-year decline. As a result, Kodak reported a GAAP loss of $1.04 per share on a continuing operation basis.

This quarter's results continue to place the company well within the range needed to ensure compliance with our debt covenants. In the quarter, the ratio of debt to EBITDA was 2.76, against a covenant of 4.50. This one lower is better. The ratio of EBITDA to interest was 5.80, against a covenant of 3.00, and for this one, higher is better. The measurements are calculated on a rolling four-quarter average.

First quarter investable cash flow was a negative 576 million, compared to a negative 258 million in the year-ago quarter. It was essentially on our plan. The plan anticipated several significant negatives from last year's first quarter. We assumed the following. No asset sales in the first quarter, higher restructuring cash outflows, incentive compensation payments in the first quarter versus the second quarter of last year, a larger operating loss, and inventory build, which ended up being higher than we planned, some effect from last year's push for cash and receivables, where we had aggressive collection actions across the company and real efforts to push down past-dues. All of that added up to more than 300 million negative from last year. So, at the end of the day, lot has to do with the shifting working capital needs of the new digital business versus our traditional business, especially in inventories. We will discuss more of that in a minute.

Net cash from operating activities as determined in accordance with GAAP was a negative 481 million versus a negative 223 million in the year ago quarter, primarily as a result of the decrease in trade payables and other liabilities, earlier payment of the wage dividend, lower asset sales, higher restructuring cash costs, and lower earnings.

Cash on hand at the end of the quarter totaled 1.077 billion, which compares to 1.031 billion in the year-ago period, and is consistent with our desire to maintain approximately $1 billion of cash on hand. Although we have had a slower start on cash performance this year, we are still comfortable in achieving our investable cash performance for the year in the range of 4 million to 600 million, equating to 800 million to 1 billion in net cash provided by operating activities.

We are taking actions that will make our first half cash performance essentially even with last year. It includes the following initiatives. Inventories increased in the first quarter as a result of not keeping up with the decline in traditional products and the slow sales in consumer digital. We plan to decrease inventory levels by approximately $200 million in the second quarter, as opposed to the second quarter seasonal inventory build of approximately 200 million or so that we experienced over the years and last year. Our focus here is to begin to change the historic seasonal pattern. We need to make lower first half inventory balance part of the new seasonality of the company.

We also will have continued tight discipline on capital expenditures, a tight discipline on restructuring cash expenditures, and we expect improving earnings performance during the second quarter. These actions are expected to drive little usage of investable cash in this year's second quarter versus a use of 297 million of cash in the second quarter of last year. As a result, we should essentially be equal to year-over-year cash performance trajectory by the end of the second quarter, and on track for our full-year expectation.

As you know, we have a 500 million -- we have $500 million of debt due in June. Because of our commitment to maintain a cash balance of around $1 billion, and the strong seasonality of our cash flow, we will likely use some or all of the delayed draw option on our term loan for this 500 million of debt. I would like to remind you that this is not an increase in our debt, but rather a substitution of maturing debt with debt that will be paid in the second half of the year, when cash flow will be seasonally stronger. We remain committed to reducing our debt level by about 800 million by year-end. All in all, I feel we are well positioned to deliver our plans for the balance of the year.

In summary, as always, we will work hard on cash, especially in change in this historic inventory seasonality and levels, but we know what to do and how to do it. The second quarter should be materially better than last year, and move us closer to the goals for the year. On earnings, many of the negative year-over-year comparison we saw in the first quarter will be improved by the third quarter, as we reach the anniversaries of changes in taxes and useful life. Some headwinds and other factors will most likely improve also, such as foreign exchange, selling prices, volume, and interest expenses we begin to retire debt. And those that were positive contributors in the first quarter, such as manufacturing costs, acquisition synergies, SG&A, R&D costs, should strengthen as the year goes on. Silver is the big wildcard and we've been increasing prices to lower the impact. And now Antonio and I would be happy to take your questions.

Question-and-Answer Session

Operator

Thank you. Operator Instructions We will take our first question from Jay Vleeschhouwer with Merrill Lynch.

Q - Jay Vleeschhouwer

Thanks, good morning. I would like to ask you first about your comments regarding the health business, which has been by and large underperforming for about a year now in terms of revenue and margin. Are you in effect going to be treating that as a discontinued operation, even though you won't necessarily report it that way? You had had in mind to perhaps start putting some money back in the business, perhaps next year, if not this year, and perhaps start trying to grow it again. Is that now not your plan to try to reinvest and restimulate them, that business, and assuming you sell some or all of it, what might be your use of proceeds from the health business? Secondly, Antonio, you mentioned the changes in your manufacturing and logistics, and trying to align it more to the business groups. Would that in part make it easier to disaggregate the health business by having aligned the assets and the logistics more according to the segments?

A - Antonio Perez

Okay. Jay, you just put it there a book of questions for me. Let me see. Let me start with the first thing, that we haven't said that we're going to sell the group. What we said is that the board has authorized us to explore strategic alternatives and we will explore them all and selling will be one of them but it is not the only one. So we cannot conclude at this point of time that we are going to sell the group. Second, the manufacturing question, if I understand it well. We've been working in carving out the different parts of the business in an effort to have a much leaner organization that will be fully dedicated to customer segments, with full accountability and focus in the ability to make decisions first, and take care of the whole -- the whole, all the elements of the P&L. And I'm talking about inventory, I'm talking about supply chain, so we can be more effective. So the business as of July 1st, there will be by and large independent in the sense that we will have control over every single element of the value chain. As far as the accounting, I'm going to get Bob to answer the question. The answer is no, but you can –

A - Robert Brust

We're not going to -- I mean it is far too premature to decide how we're going to change any accounting on this thing because we have just entered into this evaluation with our advisors as to the strategic alternatives for the business so, there is no accounting change.

Q - Jay Vleeschhouwer

Last I would like to ask about your Digital EFO expectations for the year, which you are maintaining. If we strip out the consumer digital loss from the total digital profitability in Q1, that looks like about a $57 million earnings from the combined GC and Health businesses in digital, or about a 5% margin for those two businesses together. Assuming you do improve your consumer digital profitability over the remainder of the year, however, what are your assumptions for the margins for Graphics and Health? Do you need to get to a high single-digit, or 10% or more EFO margin for the non-consumer businesses to hit your numbers for the year?

A - Antonio Perez

The Health Group plan, it will be trending up from the first quarter as it did last year, and you can expect somewhere in the teens. 12 to 14 will be a good number. GCG, the original plan was only to be between 5 and 8, but as I said in my talk at the beginning, we are actually raising the expectation because they are doing much better and earlier than we thought.

Q - Jay Vleeschhouwer

Thank you.

Operator

Thank you. We will take our next question from Matt Troy with Citigroup.

Q - Matthew Troy

Good morning. Following up on Jay's question, I know you're not going to put specifics around what might occur with health imaging but I was wondering, Bob, if you could just help us broadly. If I look at that portfolio, if you could break it up between what I view as the three primary buckets, one is the traditional x-ray products and related, two the digital output, and three, the remaining digital technologies, just on a percentage of revenue basis. That would be helpful, and then I have one follow-up. Thanks.

A - Robert Brust

I really don't know those off the top of my head. We will have to get back to you on that. I just don't have that sorted that way.

Q - Matthew Troy

Okay.

A - Robert Brust

We will have Don and the Investor Relations -- oh, Don knows? Okay.

A - Don Flick

Yeah and just really broad sweeps, Jay.

Q - Matthew Troy

Yeah.

A - Don Flick

The traditional x-ray business is something in the, I think 800 to $1 billion type of range. DO is probably a little bit smaller than that, and you can divide the rest out. We don't split it any further but those are just rough figures.

Q - Matthew Troy

Okay. Second question would be just an update on the inkjet strategy. Specifically, we're approaching the back to school period, with stocking logistics probably having to begin in earnest in June, July, time frame, my admittedly anecdotal channel checks are saying retailers are not telling me anything in terms of seeing product from Kodak. I was wondering if you could give us an update. Are we still on track for back to school? Is it more, more of a seasonal issue?

A - Antonio Perez

That could be because they're keeping confidentiality.

Q - Matthew Troy

Exactly, I said admittedly anecdotal, but I'm just looking for an update. Are we still on track for back to school?

A - Antonio Perez

I never said we're going to be back to school. We're still on track with our project. We are -- I have no news really to report, and you know why I don't want to report news until the closest possible time, the latest possible time. So but we keep investing in that business. We are accelerating things and I feel that we are in good shape, but there is nothing else to report.

Q - Matthew Troy

Okay. Last question would be on the thermal media. Obviously, the pricing declines were known and largely a function of people like HP and other inkjet players bringing down their pricing on a bulk basis into the key holiday selling period last year. We should stabilize or have stabilized on a sequential basis, but what's to say we won't see another step-down? Where do you see thermal pricing stabilizing into the next holiday period? Thanks.

A - Antonio Perez

Well, I can't speak -- I can't speak for the others. We took very significant price reductions, as you know. They were anywhere between 38% and 50%. That was a very significant price reductions that we took. And the idea was to be more competitive. And obviously at the same time, we are, we've been working to reduce our own costs. So it is not that all that goes out of our profit. We feel very well, we felt that the number of units that are being sold through is high, so we think that we are very competitive now. I can't tell you this is going to happen again. If it happens, we will have to do something about it but so far, so good.

Q - Matthew Troy

Thanks, guys.

Operator

We will take our next question from Laura Starr with Equinox Capital Management.

Q - Laura Starr

I just wanted to ask a question about the film, the entertainment imaging business, was down 7% in the first quarter, but the -- we moved to the second quarter, the lineup of blockbuster sort of movies coming out this -- over the next three months seems much higher than last year. Are you expecting the comparison this year in the second quarter versus last year to be much higher?

A - Antonio Perez

Hi, Laura. Yeah, it went down in the first quarter. Most of the people that we talked to, and it is our feeling as well, most of it -- most of this is caused by content, by poor content, content that hasn't been accepted by the audiences. Having said that, what is very important to know, this is, this is factual data is that in North America, the assistance have grown 2% to 3% this year, the number of people going to see movies have gone up.

Q - Laura Starr

The box office is up too this year.

A - Antonio Perez

Yes and their revenues about 5% up.

Q - Laura Starr

Right.

A - Antonio Perez

This is before Memorial Day weekend, which is normally the time when all this blockbusters that you mentioned and they're all ready to come out, are coming into play. So, I don't know how those are going to be received. But we are -- we're optimistic but we keep saying the same thing we said before. We expect this business to be flattish. We don't expect this business to grow significantly, or go down significantly. On the other hand of the equation, we have seen as well a shortage in what is called the theatrical window, which is the time from a movie is going to the theaters and then coming into DVDs. It doesn't seem to affect the attendance to the theaters, though, which is an interesting thing. And so -- and then, we are doing well with our digital -- with our digital program. Our pre-show digital, we are actually the largest shareholder of independent theaters as far as pre-show digital projection. We have 2,000, I believe, or a little more, I don't know, about 2,000 installations already in place. We have a system they can actually perform through HDs, so we are ready for whatever happens, although it is going to happen slowly, and we know this is going to -- there are going to be some pilots this year and next year and the year after and this is going to be in our view a long process, and a hybrid industry, and we're working through it.

Q - Laura Starr

Okay. Thank you very much.

Operator

And we will take our next question from Jack Kelly with Goldman Sachs.

Q - Jack Kelly

Good morning. Antonio, can you just go back to maybe consumer digital, and talk about the first quarter. You mentioned inventory back up at retail, and maybe talk about take-away. I mean could we be seeing at least in terms of consumer digital cameras, the beginning of the flattening or decline, because it sounded like camera sales went down, so have we reached penetration maybe sooner rather than later?

A - Antonio Perez

Let me take a little perspective to give you the best answer that I know. We did very well in the fourth quarter, and in fact, I can tell you that we are doing very well in sell-through in the first quarter. Sell to is a different story. Obviously, we, the inventory in the channel has to clear up in the first quarter. We expect that it will be, clear up by the second quarter. Our pricing points are moving up. We are moving a lot more the V series -- our V series has been incredibly successful. We're very proud of it, and is a much higher price that, the original cameras, the collect use itself, so we are happy with that too. As you probably noticed, we have introduced new models starting with the second quarter, because we know that what happens in the first quarter is a clean up of the old models. And then on top of that, we have been careful as far as taking what market share we want to gain and which one we don't want to gain. So during the first quarter, where you have all this pricing deals, we only decided to participate in the ones that we thought were appropriate for us following this strategy of margin expansion. Now, overall, the market is flattening. And we knew that when that, I mean there is going to be some growth, but nothing compared to the last three years. So that's -- so that's the story. We are on track. We are making more money than last year, and I feel optimistic for the year.

Q - Jack Kelly

So versus a decline in your shipments of digital cameras, you're saying the sale of Kodak cameras at retail was up?

A - Antonio Perez

No, the sell-through. The sell-through, not the sell-to. The sell-to was lower. That's why in our numbers it shows –

Q - Jack Kelly

Yeah, that's what I'm saying. We're down 10% plus in selling to retailers but you're saying retail sales of cameras to consumers was up for Kodak?

A - Antonio Perez

That's right, very strong, and that's really what counts. When do you sell these things to the retailers is relative, what matters at the end of the day is when the retailer finally sells these products to a final consumer.

Q - Jack Kelly

Okay. This is a question maybe for Bob. On the potential divestiture or partial sale or whatever you might do on health care, I thought there was a provision in the -- I guess the new bank loan deal that you negotiated last year that up to 1.1 billion of asset sales would be required to pay down debt. Is that just triggered Bob, by an outright sale, so if you did something less than that, that provision wouldn't be triggered?

A - Robert Brust

An outright sale would require payment of the coveted debt, which is about 1.1 billion to 1.2 billion. Any other options we would choose, we would have to deal with at that time. But we're talking about reviewing alternatives here. We have not made a decision nor has a decision been made. So if we did outright sell, we'd pay the debt.

Q - Jack Kelly

Okay, and just finally, Bob, on the restructuring, you mentioned or was it Antonio described it was mentioned as being kind of already in the plan. I guess this year we're going to have restructuring charges of 1.1 billion and then maybe another 500 next year, and so maybe you could just talk about those numbers and what the cash implications of those two -- those numbers would be?

A - Robert Brust

Jack, the cash this year, we've been talking about is around $650 million, and we are tightly controlling ourselves at that rate, and it was close to 138 million in the first quarter. It tends to be built up toward the third quarter and then diminish a little bit in the fourth. Next year, there will be a fairly sharp reduction in restructuring. There will still be some significant charges but cash will probably be -- we've got it before down around 200 million to 300 million, so it will be probably half or less than half of this year's. So once we get through this year, we're really through the lion share of it.

Q - Jack Kelly

Okay. So the 650 in cash this year would be equivalent to the expense, the charges of 1.1 or so, and then next year –

A - Robert Brust

1.1 billion to 1.3 billion, yes, depending on how, -- We estimate this and we start the year and we actually get to the actual assets, you have to write them down. So, I would say 1.1 billion to 1.3 billion would be the financial charge.

Q - Jack Kelly

And the 2 to 3 next year might gross up to 5? The 200 million to 300 million --

A - Robert Brust

Yes, somewhere around there. I don't know yet. We will have to give you some more guidance on that in September. You have to wait and see how fast we can get everything done this year and then what is left over, but it will be materially lower next year, and it will be early in the year. As we come out of '07, we should be having this pretty well cleaned up.

Q - Jack Kelly

And just on the silver price increases which were implemented May 1, excuse me, price increases, because of silver, implemented May 1. Did you see any build-up or any acceleration in shipments in April or in the first quarter, as people try to anticipate those price increases?

A - Antonio Perez

No. We didn't see that. That market is kind of a -- this is not a growing market where those things tend to happen. This was a market -- now, we don't know what the rest of the industry will do but material costs goes high significantly, we feel this is the right thing to do.

Q - Jack Kelly

Okay. Good. Thank you.

Operator

We will take our next question from Chris Whitmore with Deutsche Bank. Mr. Whitmore, your line is open. Please go ahead with your question.

And we will go ahead and move on to our next question with Ulysses Yannas with Buckman, Buckman and Reid.

Q - Ulysses Yannas

Hi, Antonio. You're talking about price declines of 38% to 50% in kiosk media. You had the decline of 9% in overall revenue. That means that your burn through rate was what, over 50%?

A - Antonio Perez

Yes, to say again –

Q - Ulysses Yannas

I was trying to come down to this burn rate at kiosks.

A - Antonio Perez

The burn rate continues to be very good. It is excellent. We haven't seen any reduction in burn rate or anything. Actually, it is going up. Burn rate is going up. We put the price at that point because the environment, because the ecosystem, because of the other systems that come into play. We have to put a price that is competitive to the one arm lab, to the home printing, and to the other kiosks that come around, so we did an analysis, we model these things, looking for the impact on our customers and market shares, what's the best economic solution for that. And that's how we put the price. But we feel -- we are very -- we feel very strong about our kiosks and the burn rate. The burn rate is going up. We don't have a problem there.

Q - Ulysses Yannas

How about the package things you are doing, cameras and the printer docks?

A - Antonio Perez

You're going to be seeing less than that. Normally when you do this, obviously you make a very attractive price for both, and that plays a role when you're trying to build your install base, one or the other or both, and reinforce the value of the connection, and everything else. But obviously, it is not as attractive financially as when you -- for us, as when you sell them separately. So, you are going to see less this year of those than we did last year.

Q - Ulysses Yannas

You were talking last year about the Versamark doing extremely well. Is that continuing to be strong besides an express?

A - Antonio Perez

Yes, Versamark, we have a very good profit for the year. They tend to be very large orders. This first quarter, they were -- they were weak compared to last year. They don't have a true competitor, if you ask me. I mean, they have a very specific technology.

Q - Ulysses Yannas

-- Products new Vera, a competitor.

A - Antonio Perez

Which one?

Q - Ulysses Yannas

I'm sorry, Xerox’s new Vera.

A - Antonio Perez

I don't consider that a competitor. It’s a different technology. Continuous injet is a very specific characteristics and for the jobs that that has been designed, I think is -- there is the best alternative. But as when the deals are coming, we have very good prospects for Versamark for the year. It is just this first quarter, compared to the year ago first quarter was weaker than last first quarter, but it doesn't have any sign of, any negative signs for the year.

Q - Ulysses Yannas

How about the cost reduction out of the KPG and Creo acquisitions? Where do you stand there? You were talking about $150 million.

A - Antonio Perez

Yes, cumulative over two years. They're on track, maybe slightly better. The bulk of those are going to come later this year. But they're on track. That organization is executing beautifully. I have full confidence that they will get those numbers.

Q - Ulysses Yannas

You haven't started yet on Creo, have you?

A - Antonio Perez

Well, yes, we have started on Creo. Actually those cost reductions have a lot to do within those two organizations working together to eliminate dualities and improve productivity. Those numbers are around -- is the whole GCG but a lot has to do with the two organizations working together to improve productivity. So, those numbers are applied both to KPG and Creo. Some, the rest of GCG, but by and large it is about KPG and Creo.

Q - Ulysses Yannas

Great. Thanks a lot.

A - Antonio Perez

Thank you.

Operator

We will take our next question from Carol Sabbagha with Lehman Brothers.

Q - Carol Sabbagha

Thanks. Just a couple of follow-ups on the consumer digital businesses. You kept your digital profits I mean your digital revenue growth for the year the same, although it looks like consumer digital may come in lower than expected for the year. Is something else going -- is something else within that going to do better as the year progresses to make up for, I'm guessing some more muted expectations around consumer digital?

A - Antonio Perez

I don't know that we count the expectations on anything yet, Carol. What are you referring to?

Q - Carol Sabbagha

Well, it’s just given how you talked about digital revenues, consumer digital revenues as the year progresses, doesn't sound like you're looking for significant growth coming from that business as a whole.

A - Antonio Perez

Oh, I see. Well, what I tried to say, what I tried to say is that the primary, the most important objective for that organization for this year is margin expansion. If we have to sacrifice growth to get the margin expansion that we want, we will do so.

Q - Carol Sabbagha

Okay, let me –

A - Antonio Perez

Hopefully we won't have to sacrifice a lot of growth to do that, but if that will be the case, we think it is the right thing to do because there are a lot of deals out there, there are, that could be questionable.

Q - Carol Sabbagha

So on consumer digital cameras, you mentioned that the retailer sell-through to the customer was up in the quarter. Can you give us kind of a feel what that was?

A - Antonio Perez

It is a little too early; it is a little too early. We have, we have this daily and weekly, some information of what is going on in some of the key retailers. We don't get every single retailer in the world. So, I don't want to give you a number. I will -- this takes a little longer. We take -- we have a sample of key retailers. It is a very good sample. It gives you an idea what the world is doing. But I wouldn't -- I wouldn't put that number, I wouldn't put -- I wouldn't make that number public. I just know that our sell-through this quarter is fine, and is doing fine. Even though our sell-to is, is lower than last year.

Q - Carol Sabbagha

Okay. And then in the kiosk business, just so we're not surprised for the year, it seems like you said your media unit sales were strong but there was pricing. Was your hardware sales down, or is it mostly pricing, and therefore it could take another couple of quarters to anniversary out of the numbers?

A - Antonio Perez

I basically think is the price of the media, and the fact that we created large packages that were sold in the third and the fourth quarter, and some of those, they haven't gone through yet. There was an expectation of certain amount of printing by our retailers, and every company came with large packages, moving from 40 to 160 pages in the printer dock, and I believe that some of those packages, they still haven't been used. So some of that in the price and it is not a real usage. The real usage is going up but maybe not as fast as the industry predicted.

Q - Carol Sabbagha

Do you think the kiosk business for the year will be up in revenues?

A - Antonio Perez

Yes. That's the plan we have today, yes.

Q - Carol Sabbagha

Okay. And then I think you mentioned, continuing on consumer digital, I think you mentioned that digital -- that digital capture profits improved, or losses improved year-over-year, while the total segments losses widened.

A - Antonio Perez

Yes.

Q - Carol Sabbagha

What was the main factor there? And then Bob, in his comments, mentioned kind of a major overhaul of the consumer digital businesses to get to profitability. What are the key points in that overhaul? Is it simply just walking away from bad business?

A - Antonio Perez

No, it was a combination of things. Digital capture did better than last year, as far as the year goes. Kiosks, Printer Dock and Kodak Gallery did worse than last year. Hard to -- it doesn't mean much for us in the first quarter. I mean obviously we would like it better, but the first quarter is very small in this, and because of the changes we made to the, to the thermal media, this is understandable and is predictable. The other element that Bob was referring to, we have -- we have been investing in SG&A in the Consumer Digital Group, although by the end of the year, it will be reduced. But compared to the -- to last year, we have more SG&A in CDG than last year. This is because during this fleet of DFIS, it is a pretty complicated thing, and we don't want to lose sales dramatically, so we had the tendency of make sure that we get ourselves right before we start to reduce SG&A, which we will -- it will happen, it will happen during the second and the third and the fourth quarter. I described the plan of moving from basically 61 countries, where we directly sell, with our own, our own office and our own people, into 20. This is not that we're going to abandon the other markets. It is just much more efficient to pick those 20 where there is sufficient size, thereby ourselves, but the rest is going to use, we're going to use distributors, which is a very typical thing to do. We are in the process of doing this, and by and large, it will be done by the end of the year. So the SG&A will go down, but in the first quarter, it is up. Because of the split that was done of DFIS between the digital and the non-digital.

Q - Carol Sabbagha

One last question, and thank you for taking so many. On the price increases that you instated across the board around your film products, it might be too early to say, but if you could walk through the major segments and tell me if any are sticking, and how the feeling is around customer acceptance and whether they will be able to go through?

A - Antonio Perez

I think they're going to stick because we're not going to move them down. I don't know how the world is going to react. This is the right thing to do. It doesn't make any sense. It doesn't make any sense in any way, shape, or form to absorb this enormous cost. It doesn't make any sense. So I don't know what our competitors are going to do but we are going to stick with those.

Q - Carol Sabbagha

Thank you very much.

Operator

And we will take our next question from Sam Doctor with J.P. Morgan.

Q - Sam Doctor

Thank you. I have a couple of questions. Most of them have been answered. But can you give us a sense of overall advertising? Was it up year-on-year this year? You said it was up in CDG. Was that an absolute increase or was it a reallocation of advertising expense?

A - Antonio Perez

The advertising was higher in CDG, yeah.

Q - Sam Doctor

But in aggregate for the fourth quarter, was it -- ?

A - Antonio Perez

I don't know that, Sam. We are looking at it. We will tell you in a second. Right now, I just -- I'm starting to look like I expect you guys to look at this, by segment. It was up slightly, like 4%.

Q - Sam Doctor

Okay.

A - Antonio Perez

Oh, no. 4 million.

Q - Sam Doctor

4 million.

A - Antonio Perez

It was up 4 million, sorry.

Q - Sam Doctor

Okay.

A - Antonio Perez

That's practically nothing.

Q - Sam Doctor

Great. On the GCG plan, you said you’re raising the target from 5% to 8% operating margin. What is the new target?

A - Antonio Perez

What is that?

Q - Sam Doctor

The new target for earnings from operations from GCG?

A - Antonio Perez

Oh, we are going to raise the target, and I'm still negotiating with my team. They're over-performing. It's very clear that they're over-performing, and it is very clear that the opportunity is better than what we had in the plan. We don't have a number yet.

Q - Sam Doctor

Okay. And final question from me is, what is the philosophy on the cash balance? I know that you’ve said that at the moment you're looking at $1 billion minimum, but if you're looking at reducing debt by what 800 million, are you looking at that contingent on asset sales, or is your target you will be looking at exclusive of what you might do with the cash?

A - Robert Brust

It’s the exact story we gave in the January meeting. We started the year with about $1.7 billion of cash. We anticipate generating about 500 million. Included in that 500 million will be asset sales, as we -- as they become available through the restructuring. So that would be 5 plus 1.7 billion is 2.2, and plan on paying down about $800 million of the debt so I envision ending the year at about 1.3 billion or 1.4 billion, so no change at all.

Q - Sam Doctor

Okay, great thanks.

Operator

And management, at this time, I would like to turn the call back over to you for any additional remarks or closing comments.

Antonio Perez, Chairman, Chief Executive Officer

Well, thank you very much. I really appreciate the time that you take to listen to the call. Again, I want to reiterate that this is a very typical first quarter. There are lots of strategic wins for us. There are some clear issues that we have to work on, specifically inventory buildup; we're going to deal with that in the second quarter. Otherwise, I see the year, the way we planned it at the beginning, we have the same goals, and we are ready to execute. Thank you very much.

Operator

And ladies and gentlemen, this does conclude today's teleconference. You may now disconnect, and have a great day.

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Source: Eastman Kodak Company Q1 2006 Earnings Conference Call Transcript (EK)
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