Dueling Fools

Dueling Fools
A Kodak Moment
April 7, 1999

Kodak Bear's Den
by Bill Barker (tmfmax@aol.com)

Take a company that has been showing a weakening top line for about a decade, has lost pricing power, is bleeding market share, has cut dividends, and has nearly the same price per share that it showed more than a decade ago, and then realize that that is the good part of the story. The real problem with Kodak is that it is in an industry that is completely doomed over the very near future. Why, I ask, would anybody want to invest in that?

Since Kodak is a company that markets its products and brand almost solely on the notion that it's terribly important for everyone to keep lots of pictures of what once was, let's develop a roll of Kodak's past accomplishments. Once upon a time, only six years ago in fact, Kodak did over $20 billion a year in sales. By 1996, Kodak had managed to crop that number down to $16 billion. Not satisfied with that level of editing, Kodak got sales down to $14.5 billion in 1997, and then to $13.4 billion in 1998. Along with that top-line erosion, Kodak's margins have suffered in the last six or seven years, working their way down to a gross margin of 52% from the 56-57% level of 1991-93. Book value is below where it was in the past and dividends were pared in 1993 and again in 1994 and still have not yet come close to returning to where they were in 1991. All of which explains why you can today pick up shares of Kodak for about 20% more than what you could have bought them for in 1987 -- which, had you done so, would qualify as "not a great return on investment."

Anyway, that's all in the past, and the present is a bit more relevant to someone who today holds "Big Yellow." Let's look at the strength of the Kodak brand. What is happening in the traditional silver-halide film market is that Kodak's main competitor, Fuji, is growing its market share at a rapid rate by adopting the terribly novel strategy of selling film at a lower price point than Kodak does. Unprepared for such radical business competition tactics, Kodak has massively slashed its prices, reducing the average price per volume of its film by about 10%. Fuji has countered, also reducing its price, and is thus still a markedly cheaper product than Kodak, which explains why Fuji is increasing its U.S. volume growth in the upper teens while Kodak's volume is basically stagnant.

Kodak management says that it can move top-line growth northwards by 8-12% annually by 2002. To that, I say, "Ha." Kodak is still seeing its revenues dwindle and has just issued yet another earnings warning, which indicated that it could miss Q1 consensus earnings numbers by as much as seven cents per share. A March 23 analyst report from Salomon Smith Barney (a staunch Kodak backer in the past) states: "The latest data seems to carry surprisingly negative implications for Kodak as the company's year-to-year revenues were off by mid-single-digits on a lackluster volume rise of only 2.2%."

Kodak's take? "The company is encouraged by the pricing environment it has experienced so far this year." Hey, with spin talents like that, I'm sure Kodak's management can always find a place in politics if photography doesn't ultimately work out, which is beginning to look kind of likely. That's because the revolution is coming -- and this time the revolution will be digitized.

Digital cameras are expected to be selling at a clip of over 11 million a year by 2002, up from today's fewer than 1 million per annum. Silver-halide cameras are expected to top out in about two years, and then show a slow, steady, and sure diminution ever after. I'd say that's pretty bad news for Kodak. The sale and processing of film has been and continues to be a remarkably high-margin business, which explains Kodak's success these many years and its initial inclusion in the Dow Jones Industrial Average. (Though why Kodak continues to be included in the Dow is beyond me.) With the advent of digital cameras, which will produce no revenue at all to Kodak for film sale or development, margins are sure to contract from now on. That Kodak can sell and develop silver-halide film at much cheaper prices than it chooses to today means that the company can keep silver halide as an economically viable option for the consumer masses for a couple of years, but those days will be over well before the end of the next decade.

For proof of how fast the adoption is going to be, consider the fact that Star Wars creator George Lucas has declared that the second film in his epic series will be shot entirely with digital photography. By the time the third prequel comes out in 2005, theaters will need to be able to handle films beamed directly from satellites, rather than employing today's clunky and uneconomical system of having films manually delivered in heavy canisters. Since Lucas clearly has the clout to make this happen, the motion picture industry is going to change quickly and the huge chunk of Kodak's revenues that comes from motion pictures is also going to evaporate in short order.

Perhaps Kodak can get out in front and secure market leadership in the production and sale of digital cameras, but there's currently little evidence that it will be able, or is particularly eager, to do so. Any success in the digital business will essentially be cannibalizing Kodak's existing high-margin silver-halide business, and it will produce lower profits than Kodak currently enjoys. Given the fact that Kodak has never shown any real success at getting into the camera market, I don't blame Kodak for promoting nostalgia about the past -- it looks a lot better than the future.

Next: The Bull Responds