In Sharp Focus: Red Flags at Eastman Kodak

Mar.22.11 | About: Eastman Kodak (KODK)

East­man Kodak Com­pany (EK) is not exactly a high-flying stock over the last few years. The aver­age sell-side rat­ing is ‘hold,’ which is not sur­pris­ing given the stock is down about 40% in the last 12 months while the S&P (NYSEARCA:SPY) is up around 10% over the same time. As soci­ety has embraced the dig­i­tal age, EK’s busi­ness model has fallen out of favor. None of this infor­ma­tion should be new to any­one who fol­lows EK.

What I bet very few peo­ple, out­side the com­pany itself, know is that EK’s pen­sion lia­bil­i­ties could tor­pedo the com­pany into bank­ruptcy and send the stock to sig­nif­i­cantly lower lev­els. In the Foot­notes of the company’s recently published 10-K, we found that EK’s pen­sion oblig­a­tions are under­funded by $2.6 bil­lion, about 3 times the company’s mar­ket value. That’s right, the com­pany is on the hook for $2.6 bil­lion in oblig­a­tions to its employ­ees that, right now, it has no way to pay. Notably, this sit­u­a­tion reminds me of analy­sis we did on Gen­eral Motors (NYSE:GM) for the Forbes’s arti­cle “Pay­checks on Steroids” in spring 2005. We pointed out to Forbes that GM’s under­funded pen­sion lia­bil­i­ties, about $70 bil­lion, were nearly 5 times the company’s mar­ket value, about $15 bil­lion, at that time. Mys­te­ri­ously, Forbes chose not to include our analy­sis of those facts on GM in the arti­cle, but we all know what hap­pened to GM a few years later: a declin­ing busi­ness sad­dled with pen­sion oblig­a­tions it could not pay was forced into bank­ruptcy. I do not have a crys­tal ball, but EK’s cur­rent sit­u­a­tion looks fairly sim­i­lar to GM’s before it went bankrupt.

One could argue that EK’s under-funded pen­sion lia­bil­ity is not an urgent issue because the com­pany has lots of time to pay off that lia­bil­ity. That argu­ment sim­ply does not hold water as the under-funded amount, $2.6 bil­lion, rep­re­sents the present value of all future oblig­a­tions less the value of the assets EK’s ded­i­cates to the pen­sion oblig­a­tions. And EK is already stretch­ing the lim­its on how it val­ues its pen­sion assets by assum­ing the long-term return on plan assets will be 8.73% for the life of the plan. That assump­tion is among the very high­est of all 3000+ com­pa­nies we cover. It also rep­re­sents a siz­able increase (over 20 basis points) from the prior year. Click here (png) to see the page in EK’s 10-K that shows the pen­sion plan assump­tions. In fact, the company’s assumed return on plan assets is so high that it allowed EK to book income from its pen­sion plan equal to 2.2% of its rev­enue last year. Book­ing any income from a pen­sion plan that is $2.6 bil­lion under water seems a bit fishy.

For argument’s sake, let’s take a look at what kind of future profit growth is required for EK to meet its pen­sion (and debt) oblig­a­tions and jus­tify the cur­rent stock price of $3.27 as of close on 3/21/11. The answer is: prof­its have to grow 10% com­pounded annu­ally for at least 11 years to jus­tify the cur­rent price. The com­pany must grow prof­its at about 10.5% com­pounded annu­ally for at least 5 years before share­hold­ers will ever see a dime because that is what is required to sat­isfy pen­sion and debt oblig­a­tions alone. These growth expec­ta­tions do not com­pare well to his­tor­i­cal results, which show the aver­age rev­enue growth rate over the past 5 years is –14%.

A declin­ing busi­ness with mount­ing pen­sion lia­bil­i­ties, EK is a stock with a lot more down­side risk than upside poten­tial. Look­ing beyond the reported account­ing results reveals that EK is not quite as prof­itable a com­pany as it seems, and its val­u­a­tion has out-grown its prof­its by a wide margin.

In a busi­ness where investors make money by buy­ing stocks with low expec­ta­tions rel­a­tive to their future poten­tial, EK fits the pro­file of a great stock to short or sell.

For sam­ples of more Red Flags like what we revealed for EK, click here (pdf).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.