Dueling Fools

Dueling Fools
A Kodak Moment
April 7, 1999

Kodak Bull's Pen
by Paul Larson (tmfparlay@aol.com)

Picture this. Imagine being able to buy one of America's premier companies at half the valuation of the rest of the market. This company has a long history of innovation and one of the most recognized brand names on the planet. Plus, the stock would pay you triple the dividend of the S&P 500. You don't have to stretch your imagination too far since that is the situation today with Kodak.

Let's first talk about two Foolish strategies that both show Kodak popping up on the radar. While not exactly a strategy many analysts and investors use to weigh the investment potential of a company, the Foolish Four (and its numerous variations) has shown extremely impressive returns in the past. I only mention this because Eastman Kodak is, as of this writing, one of the stocks one would purchase if starting the Foolish Four method today. This is because Kodak pays a generous dividend, now approaching 3% annually. I have little doubt that most reading this would prefer oversized capital gains to the income dividends bring, but the dividend is still difficult to ignore as an overall bullish signal.

Let's move on to some more fundamental analysis. As I was preparing to write this, I couldn't help but notice that Kodak has many of the attributes of a Rule Maker. Below are the Rule Maker criteria and how Kodak stacks up against them:

1) Repeat Purchase Business -- I can think of few businesses other than the camera and film business that better exemplify the repeat purchase model. Gillette (NYSE: G) has razors and blades; Kodak has cameras and film.

2) Global Consumer Brand -- Who here has not heard of Kodak? Plus, more than half of the company's sales come from outside the United States.

3) Sporting Strong Historical Performance -- Recent history hasn't been too kind, but there are many mitigating factors. Additionally, the fact the company has survived over a hundred years should speak loudly about its staying power.

4) Super-size the Company! -- Being on the Dow and having global revenue north of $13 billion, its size is undeniable.

5) A Direction That Exceeds Location -- I'm sure my associate Bill will elaborate on how digital technologies will kill the traditional film business, but I beg to differ. Plus, Kodak has an impressive share of the digital-imaging market, too.

6) Gross Margins of At Least 50% -- Check. Gross margins were 51.2% last year, up from 45.1% in 1997.

7) Net Margins of At Least 7% -- Check. Net margins were 10.4%, up from 9.2% in 1997 if you ignore one-time charges.

8) Cash No Less Than 1.5x Long-Term Debt -- The most recent results show the company has $457 million in cash and long-term debt of $504 million. While shy of the 1.5x mark, there is Kodak's ongoing share buyback to consider. Plus, let's not forget that dividend!

9) Efficient Use of Cash -- Current assets sans cash is less than the company's current liabilities, giving the company a Flow Ratio of less than one. This is an attribute those with a Rule-Maker bent consider good.

While not a perfect fit for all the Rule Maker criteria, the company resembles one enough to warrant further consideration. Having the Foolish Four flashing "buy" and being a potential Rule Maker means that two of the premier Foolish investment strategies are pointing toward Kodak as an interesting company to own.

Suppose you don't subscribe to the Rule Maker or the Foolish Four strategies; there are still some compelling reasons why Kodak looks attractive at these levels. Probably the most obvious reason is the rather low P/E multiple. At roughly 15x trailing profits and 12x forward estimates, the company is trading at approximately half the average earnings multiple of its peers in the S&P 500. The company has also been holding the analysts' hands when giving forecasts, so the profit estimates for a strong year are relatively solid. Plus, should the pricing battles with Fuji ease a bit or the international economies rebound, there is clearly room for even further improved results down the road.

Looking at some other numbers, the company's trailing return on equity is more than double that of the averages. Furthermore, the price-to-sales and price-to-cash-flow ratios are roughly half the average market multiple. Any way you slice it, Kodak is trading on the cheap.

Behind the increased profitability seen at Kodak is the diet the company has been on to get its focus back. The company has been shedding its peripheral businesses while cropping overhead costs at an astonishing rate. The company's administrative costs decreased 15% last year, and the slimming down is continuing. While still a conglomerate with literally dozens of businesses of varying profitability, Kodak is getting leaner and meaner by the day.

To make a long story short, Kodak has gotten the picture that it must reduce costs. The restructuring charges the company took to downsize in 1997 was some mighty icky tasting medicine, but the profits over the past year seem to indicate that its diet has worked.

There may be companies out there with higher growth, and there are others out there that have had more success over the past decade. Nevertheless, Kodak is a newly focused and solid company that is trading at an inexpensive valuation. In a nutshell, I think that the future will give Kodak shareholders plenty to smile about.

Next: The Bear Argument