Today is a day of sorrow. Eastman Kodak, the icon of American invention, filed for bankruptcy protection. And not only that, it has been an incredible waste of shareholders’ cash and resource over the last decade.
One of the first posts on this blog, and one that I am proud of, was a review of the dangers of Eastman Kodak as an investment. You will be able to read it in its entirety after the jump but first some comments.
To start, I am not going to say that I predicted Kodak’s demise because, as you will read, I did not. Instead it was
- an example of the dangers of investing in companies under revenue stress based only on its assets
- a call to avoid investing in turnarounds before they show signs of revenue stabilization.
What happened to those assets that supposedly provided a Margin of Safety? What those assets did provide was time, time to realize that things were not going well and get out! It was one reason I sold Premier Exhibitions: despite the very real possibility that they are going to sell the Titanic assets for a premium: cash and revenues started to decline.
Finally, there are several interesting situations today that fit the mold, priced well below book value but with revenues under stress, like Research in Motion and Sears Holdings. Both have much better chances than Kodak of surviving. Research in Motion revenues are even growing though at a much slower rate. But still be careful, turnarounds are not asset plays. There is no hurry, wait for revenues to stabilize first.
After a while Buffett asked everyone to pick their favourite stock. What about Kodak? Asked Bill Ruane. He looked back at Gates to see what he would say.
“Kodak is toast” said Gates. Nobody else in the Buffett Group knew that the Internet and digital technology would make film cameras toast. In 1991, even Kodak didn’t know that it was toast.
“Bill probably thinks all the television networks are going to be killed” said Larry Tisch, whose company, Loews Corp., owned a stake in the CBS network.
“No, it’s not that simple” said Gates. “The way networks create and expose shows is different than camera film, and nothing is going to come in and fundamentally change that. You’ll see some falloff as people move toward variety, but the networks own the content and they can repurpose it. The networks face an interesting challenge as we move the transport of TV onto the internet. But it’s not like photograph, where you get rid of film so knowing how to make film becomes irrelevant” – The Snowball
Maybe I gave some of you the wrong impression in my previous post. Turnarounds are not the Holy Grail so let’s start by reviewing a dog. Well OK, maybe not a dog dog but a company that I decided not to invest in given the few signs that the turnaround was turning. And that company is Eastman Kodak.
Is Kodak worth analyzing? Well it is a company that symbolizes the best of American innovation and mass marketing in the twentieth century. Kodak is even today one of the most recognized brands in the world with a book of patents that used to be the envy of every business. A great blog Distressed Debt Investing has his sight on this situation as a debt opportunity and irony of ironies, Bill Gates has invested aggressively in it.
Is Kodak toast? The short answer is I don’t know. But it is also the wrong question, we should ask on the probability of Kodak going toast. And the best way to estimate that probability is to hear the story: what management is trying to achieve:
Is your case based on Kodak’s entry into the inkjet-printer business? The new printer business is part of the thesis, which is that Kodak has introduced a technology that has the potential to disrupt the entire industry because it will be able to charge a lot less for ink cartridges — about half the current price.
What’s the rest of the thesis? It’s simple. Throughout this entire transition, during which sales from film have dropped by almost two-thirds, Kodak has continued to generate about $1 billion in free cash flow before restructuring charges. That’s because as film sales have dropped, its graphic-communications and digital businesses have improved. Investors today are valuing $1 billion of free cash flow at $14 billion to $15 billion in the marketplace. But Kodak’s market value is just $6 billion. Why is it so low? Because for each of the past four or five years, Kodak had cash restructuring costs — for environmental-cleanup liabilities, for the costs of closing plants, for severance when there were layoffs — that have totalled roughly $600 million to $700 million per year at the peak. There will be $500 million to $600 million in additional restructuring charges this year related to closing film plants and the sale of Kodak’s health-care business. Next year, there will be no restructuring charges. Unless the business gets a lot worse in the next year or so, Kodak will do $1 billion to $1.2 billion of free cash flow in 2008. And if that happens, the stock should be up 50% to 100% in that period of time. – Bill Miller 2007
So this is a story of new divisions (graphic communications and digital) taking the torch from the traditional film division that is being milked down. These are the divisions
- Film Product Group is the remaining traditional film business, that will continue to decline. The decline rate will depend on the speed of the transition to digital in both the consumer and film markets.
- Consumer Digital Imaging Group includes digital still and video cameras, digital devices such as picture frames, snapshot printers and related media, kiosks and related media, consumer inkjet printing, Kodak Gallery, and imaging sensors. CDG also includes the licensing activities related to intellectual property in digital imaging. Expenditure will likely be down until the recession ends and if past performance indicates future performance it is unlikely to carry the whole group
- Graphic Communications Group serves a variety of business customers in the creative, in-plant, data center, commercial printing, packaging, newspaper and digital service bureau segments. Products and related services include workflow software and digital controllers; digital printing including equipment, consumables and service; prepress consumables; prepress equipment; and document scanners.
Here is a hint, the type of turnaround is critical. A turnaround based on closing or selling cash consuming divisions and cost cutting is usually much simpler than one that is based on new products, debt restructuring or business model innovation. Therefore, this is a difficult turnaround that merits a guilty veredict until proven innocent. What surprises me is that Bill Miller said so himself
There aren’t many companies that have been terribly successful making big technological transitions. How many typewriter businesses moved into computers? - Bill Miller about Kodak 2005
Besides having a credible story, the execution needs to measure up to the story because turnarounds usually do not have lucky breaks. You want to see the wheel turn. So what can we say about the Kodak execution
It seems that all divisions are struggling in the recession. A good point though is that the Film Products Group is not carrying the whole weight. Can the non-film divisions carry Kodak out of this difficult situation?
Well, maybe management was a little overoptimistic on these new businesses. Or maybe the new printers need more time to penetrate against strong competitors like HP and Lexmark. Also digital cameras are commodities with low margins and profitability. So it looks like this is a company carried by three motors, only one is working (traditional film) but it is stuttering and about to shutdown.
Also it seems that those restructuring costs are never ending.
So if we review a checklist summarizing the thesis of investing in Kodak the situation is bleak and deteriorating
- New inkjet-printer business? Not ready for rock and roll
- $1 billion in FCF before restructuring charges? Disappeared
- Graphic-communications improving? Doing just OK
- Digital businesses improving? Bleeding
- No more cash restructuring charges? Continuing and no sign of abating
This is a difficult turnaround, innovation does not work very well under stress, but I would not dismiss it with a hand wave. IBM’s turnaround, one of the most remarkable success stories in the 90s, was the result of the surge of the business service division.
Instead I am waiting, and this is a key difference with the traditional value investor mentality. A traditional value investor when faced with an asset play with a sufficient margin of safety he would make a decision right there: Is it cheap enough? I argue instead for the value of
- Waiting for confirmation instead of just buying
- Adjusting the commitment as the probability and value is discovered instead of just holding
Is it possible to find a margin of safety in turnarounds like Eastman Kodak? Just look at the deterioration of Kodak’s assets the last quarters, and take into account that it had more $4 billion in cash less than two years ago.
|Consumer Digital Imaging Group
|Film Products Group
|Graphic Communications Group
|Cash and Marketeable Securities
|Deferred Income Tax Assets
|Other Corporate Assets / Reserves
|Consolidated Total Assets
It is critically important to avoid investing in turnarounds as if they were asset plays. The key success factors, the dynamics and the character traits needed for both situations are very different. With few chances of liquidation, hope trumping reality and red numbers for years, buying based on asset value is asking for pain. I will argue in future cases that it is possible to have some margin of safety but not in the traditional Graham way.