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Introduction

Eastman Kodak’s (EK) business has been in decline for a long time. Share prices peaked in the mid ‘90s and have generally been in decline since. The consumer transition away from traditional film to digital products was too overwhelming for management to deal with effectively, and probably would have been even if they read the tea leaves perfectly.

However, it is no secret today that film has been in a long and permanent decline, to the market or to management. And management has been taking steps for the last decade to right-size and reorient the company, resulting in employment decline from 74,000 in 2001 to 20,400 employees today. This has been accompanied by sustained restructuring charges in the range of $600-700 million every year.

If Kodak continues restructuring at this rate, they will have no employees left in three years, creating a fundamental catalyst for restructuring charges to end or at least be greatly diminished in the future.

If we try to think about Kodak moving forward, we can finally bring into focus the effects of the changes made over the past decade.

By excluding the restructuring, impairment, and excessive depreciation charges that absolutely cannot continue (assets have been almost fully depreciated as well), and making some conservative estimates for the cost reduction benefits of recent restructuring efforts, we find that Kodak presents an attractive investment opportunity despite a continuing decline in demand for traditional film products.

Background

Everyone is aware of the Kodak brand name and most associate it with quality. However, declines in the market for consumer film have left Kodak questioning its purpose in the 21st century. Kodak has answered that question by separating its business into three distinct operating segments.

  1. The graphic communications group produces both hardware and software for the commercial printing industry, ranging from high-speed continuous-stream digital print-heads for use on web presses to basic consumables such as ink and plates. In 2008 this segment generated more revenue than the others for the first time in Kodak history despite the fact that revenue has slightly declined since 2006. More importantly, margins have been consistently growing as well, also surpassing the other segments for the first time if we exclude R&D spend. The margin expansion has outweighed the slight revenue decline resulting in higher earnings. GCG represents a line of business that the ordinary consumer (and investors who haven’t taken a look) wouldn’t be aware of. The growth of this segment relative to the others provides some degree of stability against permanently declining film sales and a weak consumer market, although capital expenditure in the printing business will likely be down until the market recovers as well. The printing industry is mature and highly fragmented, and one of the biggest changes is the switch to digital technology for more customizable end products. For Kodak, this switch to digital benefits sales. The software and technology Kodak has been producing targets this segment.
  2. The consumer digital imaging group manufactures digital cameras, printers, retail picture developing and printing solutions, and it licenses imaging sensor technology. Revenue has grown, but in a chaotic and unpredictable manner. Margins had also been growing nicely until the economic downturn in 2008. As described in my model below, I assume that margins, even excluding R&D spend, remain negative going forward. Given the segment’s historic performance, permanently negative margins might not seem fair. However, after reading online reviews of the printers and cameras, I’m concerned that Kodak has been releasing consumer products prematurely. Cameras seem to get below average reviews, and the printers have serious problems, particularly with the software, printheads, and customer service. In short, I believe permanently negative margins are the only expectation I feel comfortable basing an investment decision off of. I don’t think this segment will remain unprofitable, but I’m not going to rely on expected improvements.
  3. The film, photofinishing, and entertainment group is the remaining traditional film business, which Kodak expects to continue to decline at a somewhat unpredictable rate. Unpredictability is a function of both consumer transition to digital, as well as transitions in the cinema market. The transition to digital projection in the cinema market is slowed by an unusual cost structure that makes digital projectors less desirable for theater operators despite overall efficiency gains to the industry. The good news is that the FPEG is now responsible for generating less revenue than either of the other segments. As this business continues to decline, it will have less of an impact on total performance.

Model

My model for Kodak is very simple. I assume that revenue from the GCG and CDG segments are flat going forward despite the fact they’ve been growing for the past few years, and the FPEG segment continues to decline at a rate of 20% per year as it has done since 2004.

2004 is my benchmark year because that is when EK provides data under the current segmentation. I maintained COGS margins from the last twelve months which I believe to be conservative because it includes a piece of our current recession. SG&A is locked in at 18% of revenue for all segments, which also seems to be historically consistent. R&D is 5% of revenue for the GCG and CDG segments and 0% for FPEG, which is slightly below historic averages, but more than a fair assumption since I’m trying to capture the no-growth piece. This R&D is simply meant to maintain current levels of revenue and profitability, and not contribute to growth.

The net effect of all this is an operating margin for the consumer goods segment that is a negative 0.4% indefinitely before the 5% R&D expense. I don’t think this is necessarily fair given a history of profitability for the segment, but it is a conservative estimate and that’s what I’m aiming for at the moment. The graphic communications segment does better, pulling in 11% EBIT margins ex-R&D, and the film business pulls in 3.5% with no R&D, for a weighted average of 5.2%.

Management estimated an additional benefit from restructuring of between $300-$350 million per year from restructuring efforts in 2009 and late 2008 which will cost $265 million cash. Given management’s estimate for headcount reduction, $300 million seems consistent with average salary data from 2008, so I add a $300 million benefit back in for all years minus $265 in 2008.

The net effect of this is an EBIT margin expansion without which EK might barely be profitable. It’s hard to pinpoint the exact meaning of a $300-350 million cost savings.

How much revenue could Kodak bring in at current employment levels? If the answer is in the range of $8.5 billion (long-term) than the model works. If not, than Kodak will continue to undergo changes. If 20,000 employees is only enough to sustain $7 billion in revenue, then Kodak will need to hire more employees and squeeze margins. If 20k employees could bring in $10 billion, than Kodak will either incur another year of restructuring charges in the hopes of expanding future margins, or hang onto valuable employees in the hopes that business might improve.

However, given current employment levels, it’s impossible for Kodak to maintain historic restructuring charges. There would be no employees left in 3 years.

One other source of earnings is a reduction in depreciation. This doesn’t affect cash flow, but it will work to bring earnings more in-line with cash flow measures. With a PP&E book value of about $1.3 billion, Kodak’s assets would be completely wiped out with another year or two of historic depreciation expenses. So I model depreciation expenses as 1/3 of PP&E and CapEx as an increasing percent of depreciation, rising from 50% in 2009 to 90% in 2013.

This seems to be somewhat consistent with the trend I’ve observed over the past decade. Because depreciation isn’t broken out on the income statement for us, I simply add back in the difference between 2008 depreciation and the depreciation I expect to see for each year going forward. This results in a benefit of $83 million in 2009 rising to $196 in 2013.

Continuing down the income statement, my assumptions yield earnings of $104 million in 2009 rising to $388 in 2013 despite a 20% annual decline in the film business and otherwise flat revenue. FCF (CFO-CapEx) is negative $199 million in 2008 as a result of short-term liability liquidations, rising to $474 in 2010, and then continuing to decline towards $418 in 2013 as CapEx approaches depreciation and the gap between earnings and cash flow narrows.

These levels of cash flow would allow Kodak to continue paying the 15%+ dividend and allow them to repay all debt as it comes due, including the puttable converts in 2010, reducing debt outstanding from $1.3 billion today to only $16 million in 2013, and the cash balance from $1.3 billion today to $917 million in 2013.

Fortunately or unfortunately, Kodak has cancelled dividend payments, so it’s not something for us to worry about. But I modeled it anyway.

Discussion

Using the simple model described above, we have a basis for evaluating what risks investors should be aware of and what reasonable expectations for return might be. For starters, we have an earnings forecast and a FCF forecast that are significantly different.

However, the earnings forecast is growing and the free cash flow forecast is shrinking forcing the two to converge. Therefore it’s reasonable to assume (including the negative 2009 FCF forecast) that the present-value of both streams of cash are somewhat equivalent.

An important factor to consider is how sensitive this analysis is to the assumptions made for margins. It is very sensitive. One reason why I took the shortcut of assuming that all SG&A expenses are 18% of revenue (although the average since 2004 was about 17.5%) was to make it easy to demonstrate this point. Starting from a baseline of 18%, Kodak earns an EBIT of $239 million in 2009 and over $500 moving forward.

But if we ratchet SG&A expenses up only 2%, our EBIT drops to $16 million in 2009 and about $400 after that. Of course, the upside potential is equivalent. An unexpected expansion of margins by 2% would result in $415 million of EBIT in 2009 and about $700 moving forward.

Clearly the differences, especially in the short-term, are extremely sensitive to our assumptions. This is why I chose to create an unusually simple model that relies on only the most basic and transparent assumptions.

Given the pessimistic assumptions I’ve made for margins, I would expect to see expansion over the next 3 years, although the tail end of a recession could cause continued short-term contraction.

Earnings and cash flow are equally sensitive to the assumption I made for restructuring and depreciation benefits. As described above, restructuring benefits are not a static benefit of layoffs.

Worst-case scenario, Kodak has to continue restructuring, although at a significantly reduced rate. If Kodak shrinks too much, they might waste severance costs and have to rehire employees as soon as their investments in R&D start bearing fruit.

On the other hand, it’s unreasonable to ignore the benefit of restructuring, and I chose the low end of management guidance to build my model. The same is true of the relationship between earnings, depreciation, and PP&E.

Kodak is quickly running out of assets to depreciate, and with CapEx consistently and significantly below depreciation, it seems unreasonable to ignore the fact that depreciation in future years will be significantly reduced as it approaches CapEx.

By taking the NPV of these scenarios with a terminal value equal to the average of FCF and earnings in perpetuity, discounted all the way through at 15%, we find that EK is worth $2.7 billion with SG&A at 16%, $2.1 billion with SG&A at 18%, and $1.4 billion at 20%, compared to a market cap today of $700 million.

An investor can expect a long-term earnings and FCF yield of somewhere between 40-70%, and the dividend payment of 18% at today’s share price could easily be reinstituted with no threat to the cash balance. I expect that some of the sensitivity of this analysis will be compensated for by the most conservatively conservative estimates I could offer within reason.

Film continues to decline, the other segments remain flat, and the consumer digital group isn’t even profitable before R&D expenses are factored in. Net income is only 1.2% of revenue in 2009, rising to 5.2% in 2013.

Prolonged Recession

Of course a major concern for investors is that Kodak’s business is heavily tied to consumer spending. Even the commercial printing business relies on a strong business outlook. The Camera & Imaging Products Association (CIPA) releases monthly data on digital camera and printer sales.

Data for April was recently released with some indications of a market recovery. Global digital camera production was up 25% in April compared to March. YoY production was down 31.4% in March, compared to 28.1% for April, indicating an improvement. Production is down 29.8% YTD compared to last year.

The data for printers didn’t show a similar rebound. Excluding Japan, printer shipments were up 6.9% in April over March. However, including Japan, sales were down 35% over the last month, down 70% YoY, and down 50% YTD vs. the same time period last year. So we could potentially be seeing the first signs of a recovery in the camera market, not so much for printers. We’ll have to stay tuned for updates on these numbers as they’re published.

Further Restructuring

It’s difficult to model the effects of continued layoffs and restructuring charges. It is possible that the Film segment is actually a liability rather than an asset if layoffs will cost Kodak more than they can expect to recoup through the normal course of business.

In keeping with the worst-case-scenario line of thinking, let’s see how the immediate loss of the entire film business would impact Kodak’s present valuation.

Above I estimated that Kodak is worth between $1.4 and $2.7 billion compared to a market cap of $700 million today. Now, if we closed down the film segment, we would loose after tax earnings of $86 million in 2009, falling to $36 in 2013, the PV of which is $208 million (at our 15% discount rate).

If we divide the restructuring fees since 2001 by the number of employees laid off, we find Kodak has paid $76k per employee. If a third of remaining employees were in the film business earning average wages, the restructuring charge would be ~$620 million.

If we take these two estimates and apply them to the pessimistic scenario above, we reach an enterprise value of $572k. Using the middle scenario, we still get a market cap or EV of $1.272 billion.

Just to summarize, to justify a value of $572 million, we need to immediately wipeout the film business absorbing the full cost of restructuring, assume that the consumer products division will loose money forever, assume that the GCG segment will never grow, and assume that margins across the board are materially worse than they have been in the recent past. Then we need to discount future cash flow and earnings at 15% which assumes a high likelihood of default.

You can compare 15% to average stock market returns over any time period here. It seems to me like only a highly pessimistic scenario could resulting in a market cap of $700 million.

Bankruptcy

Kodak is a member of Moody’s “Bottom Rung”, a list of companies believed likely to default within the year. I believe concerns are exaggerated given Kodak’s debt maturity timetable, cash, ability to generate cash flow, and other liabilities or off-balance-sheet debt.

At the end of the first quarter, Kodak had cash equal to long and short-term debt. $51 million is due within the year, and then a large issue of puttable bonds will have to be repaid in ’10 plus some other bonds, for a total of $620 million. These bonds are trading in the mid 80s yielding 18% till put, giving Kodak management an opportunity to make valuable changes to capital structure.

Based on my expectations for future cash flow generation, Kodak could have maintained their historic dividend of 18% at today’s share price, and still generated enough cash to repay all debt as it comes due.

This doesn’t take into account the recent renegotiation of Kodak’s credit agreement that extended borrowing terms until 2012 for about $375 million. For a little historic reference, this news report compared Kodak to Polaroid in 2003 when Kodak had twice as much debt as they have today. Kodak has less earning and cash flow generating power than it had then, but we have a lower downside risk of losses today with a clear end to restructuring charges in sight, and more cash saved to cover short-term expenses.

Credit rating aside, I looked for other evidence indicating EK might default. Before 2008 the pension plan was over funded by over $1 billion. As a result of market losses, the pension plan is now under-funded.

There is also an unfunded benefit plan that includes healthcare, dental, and other benefits to employees and their families. The present value of expected payments was recorded on the balance sheet as a liability of approximately $1.5 billion, requiring a payment of $175 in 2009. The net benefit obligation (retirement and medical) was a liability of $1,631 and $984 in ’08 and ’07 respectively.

Kodak also has $66 million in off balance sheet guarantees made on loans for customer purchases, but Kodak isn’t responsible for interest payments, and in the event of customer default, Kodak should be able to recoup at least a portion of the losses from collateral.

And finally there is also a normal amount of guaranteed purchase agreements of about $500 million in 2009, rapidly decreasing into the future. I don’t believe any of these factors are a serious concern for investors, but with the credit rating so low, it’s important to be aware.

Conclusion

Investors have been talking about a turnaround for a long time. The reporters at Business Week have done a good job of documenting investor, management, and consumer sentiment in the process (1, 2, 3, 4, 5, 6). It seems as though the investment community has generally been willing to accept the Kodak turnaround story; that restructuring charges are almost at and end and investors will be left with a profitable company. Now the market has spun 180 degrees with investors expecting the worst.

However, Kodak is approaching the point where they have no employees left to lay off, and the traditional film business is now responsible for less revenue than either of the other segments. Even if the film business was wiped out tomorrow, if Kodak was able to bring costs down within a reasonable time frame, EK would still generate attractive returns. Even if the consumer digital business continues to have negative margins before R&D expenses forever, the commercial group would still be able to pull the weight.

Constructing a scenario where investors lose money at this point would have to involve bankruptcy, but with enough cash to cover all outstanding debt, the odds seem unlikely unless Kodak can’t maintain a non-negative cash flow for an extended period of time.

And with industry reports showing signs of improvement in Kodak’s markets, sustained negative cash flow seems unlikely as well. And obviously the potential upside is barely worth mentioning. Anyone with an imagination could picture this company growing market share and expanding margins in the process as Kodak differentiates itself with new technology and builds upon an already strong brand name.

Given the risk/return profile, the current stock price seems silly.

Download my Excel Model EKv2 here.

Disclosure: I have some call options on EK expiring 2011, I plan on holding them until they expire.

Source: Bringing Kodak into Focus