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Subject: Eastman Kodak--EK Date: 3/22/2004 6:10 PM
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In August of 2003, Kodak announced plans to accelerate growth in the commercial and consumer digital imaging markets. They maintain a presence in film, but are restructuring and decreasing this part of the business. They may be about a decade late, but they are making an attempt at the transition to digital technology. Besides consumer digital markets, they are also attempting to penetrate the digital medical imaging sector. Hospitals have a need to make the switch to digital radiology and much of the new spending by hospitals will be in this area. In both the consumer market and the medical applications market, Kodak faces heavy competition.

The digital and film imaging systems segment combines digital and traditional photography and photographic services in all its forms, including consumer, advanced amateur, professional and motion picture. Kodak manufactures and markets films, photographic papers, processing services, photofinishing equipment, photographic chemicals, and cameras (including one-time-use, traditional and digital).

Ofoto has accelerated Kodak's growth in the online photography market and helped to drive more rapid adoption of digital and online services. Ofoto offers digital processing of digital images and traditional film, top- quality prints, private online image storage, sharing, editing and creative tools, frames, cards, photo calendars and other merchandise.

The health imaging segment supplies the healthcare industry with traditional and digital image capture and output products and services. Products of the health imaging segment include traditional analog medical films, chemicals, and processing equipment. Kodak's history in traditional analog imaging has served as the foundation for building its important digital imaging business. The segment provides digital medical imaging and information products, systems and solutions, which are key components of future sales and earnings growth. These include digital print films, laser imagers, computed and digital radiography systems, and healthcare information systems (HCIS). Business in digital radiology equipment is expected to increase as hospitals begin to invest in the new technology.

In November 2003, the company completed the acquisition of Algotec Systems a leading developer of advanced picture-archiving-and- communications systems (PACS), which is part of HCIS, in a move that improves Kodak's competitive position in the growing market for PACS, which enable radiology departments worldwide to digitally manage and store medical images and information.

The commercial imaging segment is composed of document imaging products and services, commercial and government systems products and services, and optics. The commercial printing segment is composed of equity investments in NexPress Solutions LLC (Kodak's 50/50 joint venture with Heidelberger Druckmaschinen AG (Heidelberg)) and Kodak Polychrome Graphics (Kodak's 50/50 joint venture with Sun Chemical), and the graphics and wide-format inkjet businesses.

All other is composed of Kodak's display and components business for organic light emitting diode (OLED) displays, sensors and other small, miscellaneous businesses. These businesses offer state-of- the-art OLED displays. These are screens a few milimeters thick that may eventually find their way to flat panel display home entertainment centers.They are only suitable for small screens at present.

A link to OLED information follows:
http://www.kodak.com/US/en/corp/display/index.jhtml

Kodak recently announced a new strategy that will be implemented over the next three years to complete its transition to the emerging digital imaging markets. They plan to stick with film but at reduced levels; grow the digital segment by acquisition and organic growth; and diversify into printing and electronic displays.

By the end of 2006, Kodak expects to have achieved a balanced digital and traditional imaging products and services portfolio.

Revenue recognition

Kodak recognizes revenue when it is realized or realizable and earned.
For full service solutions sales there are two acceptable methods of accounting: percentage of completion accounting and completed contract accounting. The completed contract method of accounting is being followed by the company. It is a more conservative method, less prone to manipulation.
Kodak offers customer financing to assist customers in their acquisition of Kodak's products, primarily in the area of on-site photofinishing equipment. This is done through a wholly owned subsidiary that sells the contract to a partner.

Income statement in millions

2003 2002 2001

Net sales $13,317 $12,835 $13,229
Cost of goods sold 9,033 8,225 8,661
------- ------- -------
Gross profit 4,284 4,610 4,568

Selling, general and
administrative expenses 2,648 2,530 2,625
Research and development costs 781 762 779
Goodwill amortization - - 153
Restructuring costs and other 484 98 659

Interest expense 148 173 219

Earnings from continuing operations
before income taxes 172 946 115
(Benefit) provision for income
taxes (66) 153 34
------- ------- -------
Earnings from continuing operations $ 238 $ 793 $ 81

Net income $ 265 $ 770 $ 76
======= ======= =======

Basic and diluted net earnings
(loss) per share:
Continuing operations $ .83 $ 2.72 $ .28
Discontinued operations .09 (.08) (.02)
------- ------- -------
Total $ .92 $ 2.64 $ .26

======= ======= =======

Ratios for the income statement
 
2003 2002 2001 2000 1999
Gross Profit 32% 42% 40% 49% 50%
Operating Margin 12% 17% 15% 22% 21%
Net Margin 2% 6% 1% 10% 10%
Growth in Revenue 4% -3% -5% -1% --
Growth in Net Income -66% 913% -95% 1% --
Growth in COGS 22% -6% 11% 1% --
Change in
Marketing Costs -0.20 -0.03 -0.09 -0.09 --



**Margins are decreasing and revenue is growing slightly in the face of a serious decline in net income. The costs of restructuring are doing damage to the bottom line. The question is, can Kodak survive until their anticipated revival in 2006? They recorded charges of $381 million, which was composed of severance ( $23l million), long-lived asset impairments($109 million), exit costs($40 million) and inventory write- downs($1 million).

**Net worldwide revenue was $13,317 million for 2003 as compared with $12,835 million for 2002. The increase in net sales was primarily due to increased volumes and favorable exchange, which increased sales for 2003 by 2.4 and 5.3 percentage points, respectively.

**The increase in volumes was primarily driven by consumer digital cameras, Printer Dock products, inkjet media and entertainment print films in the photography segment, digital products in the Health Imaging segment, and imaging services and document scanners in the commercial imaging segment. We begin to see the importance of the shift in strategy.

**Traditional film products are in decline with decreased volumes for traditional consumer film products. This is no surprise and has been a trend that forced the company to reevaluate their business model.

**Earnings from continuing operations were $371 million as compared with $1,220 million for 2002, representing a decrease of $849 million, or 70%. The decrease is primarily the result of (1) the decline in gross profit margin and an increase in SG&A, and (2) net focused cost reduction charges of $484 million incurred during 2003 as compared with $98 million for 2002, an increase of $386 million which was primarily
due to the costs for restructuring.

**Photography segment net sales in the U.S. were $3,812 million for the current year as compared with $4,034 million for the prior year, representing a decrease of $222 million, or 6%. The lower film product sales are attributable to a declining industry demand driven primarily by the impact of digital substitution and retailer inventory reductions.

**Net sales from the Company's consumer digital products and services, which include picture maker kiosks/media and retail consumer digital services revenue primarily from Picture CD and Retail.com, increased 6% in 2003 as compared with 2002, driven primarily by an increase in sales of kiosks and consumer digital services.

**Net worldwide sales of consumer digital cameras increased 79% in 2003 as compared with 2002, driven almost entirely by strong increases in volume, which were partially offset by declines in price/mix. Sales continue to be driven by strong consumer acceptance of the EasyShare digital camera system, as reflected in increased market share in a rapidly growing market. Kodak believes they can compete with companies like Canon and Sony.

**Kodak continues to hold one of the top U.S. digital camera market share positions in channels reporting share data, attaining the number three share position for the full year, after attaining the top spot for the fourth quarter alone.

**The movie and entertainment industry continues to use traditional print film for the most part. There is not a big switch to digital yet. Net worldwide sales of origination and print film to the entertainment industry increased 11% in 2003 as compared with 2002, primarily reflecting higher print film volumes.

**Net worldwide sales of digital products, which include laser printers digital media, digital capture equipment (computed radiography capture equipment and digital radiography equipment), services, dental practice management software, and Healthcare Information Systems (HCIS) including Picture Archiving and Communications Systems (PACS), increased 14% in 2003 as compared with 2002.


Balance sheet in millions


2003 2002
ASSETS

CURRENT ASSETS
Cash and cash equivalents $ 1,250 $ 569
Receivables, net 2,389 2,234
Inventories, net 1,075 1,062

Total current assets 5,455 4,534
------- -------

Property, plant and equipment, net 5,094 5,420

TOTAL ASSETS $14,818 $13,494


Accounts payable and other current
liabilities $ 3,707 $ 3,351
Short-term borrowings 946 1,442

Total current liabilities 5,307 5,502

Long-term debt, net of current portion 2,302 1,164
Postretirement liabilities 3,344 3,412
------- -------
Total liabilities 11,554 10,717
------- -------

Additional paid in capital 850 849
Retained earnings 7,527 7,611
Accumulated other comprehensive loss (231) (771)
Unearned restricted stock (8) -
------- -------
9,116 8,667
Treasury stock, at cost
104,712,089 shares in 2003 and
105,359,581 shares in 2002 5,852 5,890
------- -------
Total shareholders' equity 3,264 2,777
------- -------
TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY $14,818 $13,494
======= =======

Ratios for the balance sheet

2003 2002 2001 2000 1999

Current ratio 1.03 0.84 0.87 0.88 0.94
Quick Ratio 0.24 0.11 0.08 0.04 0.06
Accounts receivable growth 6.94% -4.41% -11.91% 4.57% ---
DSO 65.48 80.65 138.01 336.02 36.74
Days Inventory on hand 43.44 52.33 52.50 87.95 78.43
Day Payable Outstanding 149.70 165.10 151.30 167.60 197.90
ROA 1.79% 5.76% 0.57% 9.90% --
ROE 8.12% 27.73% 2.63% 41.04% 35.58%
ROIC 1.72% 11.42% 1.23% 2.05% 1.22%
Fixed asset turnover 2.61 2.37 2.34 2.36 --
Debt to equity 99.51% 93.84% 110.57% 98.37% 53.66%
Debt to capitalization 49.88% 48.41% 52.51% 49.59% 34.92%
Book value 11.39 9.71 9.95 11.80 12.60
Cash per share 4.36 1.99 1.54 0.85 1.20
Working capital 148 -843 -671 -724 -325
Non Cash Working Capital -156 30 415 1236 465
Cash Conversion Cycle -40.78 -32.12 39.21 256.37 -82.73

**WACC is 7.8 and with a ROIC at 1.72 they are not generating much in the way of returns on capital.
**Moderate amounts of debt. Poor credit rating creates higher risk and higher interest rates.
**Good job managing receivables, inventory and payables. This gives them a good cash conversion cycle, which they need.
**Returns on equity and assets poor. Net income suffering from restructuring costs
**High cash per share
**Working capital increasing. Higher levels of debt


Cash flow statement in millions

2003 2002 2001

Net earnings $ 265 $ 770 $ 76
(Earnings) loss from discontinued
operations (27) 23 5
Depreciation and goodwill amortization 830 818 917
Gain on sales of businesses/assets (11) (24) -
Purchased research and development 32 - -
Restructuring costs, asset impairments
and other charges 156 85 415

Net cash provided by continuing
operations 1,626 2,218 2,213
------ ------ ------
Net cash provided by (used in)
discontinued operations 19 (14) (7)
------ ------ ------
Net cash provided by operating
activities 1,645 2,204 2,206
------ ------ ------
Cash flows from investing activities:
Additions to properties (506) (577) (743)
Net proceeds from sales of
businesses/assets 26 27 -
Acquisitions, net of cash acquired (697) (72) (306)
Net cash used in investing
activities (1,267) (758) (1,188)
------ ------ ------
Cash flows from financing activities:
Net decrease in borrowings with
maturities of 90 days or less (574) (210) (695)
Proceeds from other borrowings 1,693 759 1,907
Repayment of other borrowings (531) (1,146) (1,355)
Dividends to shareholders (330) (525) (643)
Exercise of employee stock options 12 51 22
Stock repurchase programs - (260) (44)

------ ------ ------

Ratios for the cash flow statement

2003 2002 2001 2000 1999
Total shares 286.6 285.9 290.9 290.5 310.4
Growth in Capex -22.03% -38.13% -2.42% -4.87% --
Capex/operating cash flow 31.12% 29.26% 50.80% 109.47% 58.46%
Free cash flow 1120 1569 1016 -93 240
Free cash flow per share 3.91 5.49 3.49 -0.32 0.77
Operating cash/Revenue 0.12 0.17 0.16 0.07 0.14
Growth in Cash Flow 28.62% 54.43% 1192.47% 138.75% --

**Free cash flow positive
**Declining capex possibly the result of restructuring? Acquisitions are not included.
**operating cash to revenue stays at fairly consistent ratios.

Options
By 2005, Kodak will begin to expense options. This is a positive for shareholders. Exercise has declined dramatically over the past two years most likely due to the decline in stock price. On February 18, 2004, they announced that it will begin expensing stock options starting January 1, 2005 using the fair value recognition provisions of SFAS No. 123.

The weighted-average fair value of options granted in 2003 was $7.70.

Outstanding on December 31, 2002 42,277 $25.92 - $92.31 $48.52
Granted 1,595 $22.58 - $38.85 $28.45
Exercised 392 $29.31 - $32.50 $31.28
Terminated, Canceled or
Surrendered 3,931 $26.82 - $86.94 $44.49
------
Outstanding on December 31, 2003 39,549 $22.58 - $92.31 $48.30

Dilution is 13.6%
Value is $304 M
Per share $1.06
Dilution is high for a company of this size. However, not many are being exercised and if prices stay flat, its likely 2004 won't see much activity. Then in 2005, they will be expensed.

Pension fund
                                 2003                  2002 
Non- Non-
U.S. U.S. U.S. U.S.
Change in Benefit Obligation

Projected benefit obligation
at January 1 $ 6,213 $2,594 $ 5,939 $2,099
Projected benefit obligation
at December 31 $ 6,559 $3,131 $ 6,213 $2,594
======= ====== ======= ======

Fair value of plan assets
at December 31 $ 6,503 $2,432 $ 5,790 $1,805

The pension fund is in good shape compared to other big corporations I have looked at like Sara Lee and BUD. One small problem that may be worth noting is the very low discount rate of 6% the company uses for estimation of plan assets. It works like this:
When interest rates drop, so do discount rates, which are often based on the yield on investment-grade corporate bonds. At the end of 2002, the yield was about 6.75 percent. Now it's around 6 percent. Discount rates are used to estimate how fast money already in the pension plan will grow, and how much more money is required to meet the pension obligations over an employee's lifetime. The lower the discount rate, the more money the company needs to contribute to its pension fund.

Debt

The Company's debt ratings were downgraded during 2003 by each of the three major rating agencies. Moody's, Standard & Poors (S&P) and Fitch ratings for long-term debt (L/T) and short-term debt (S/T), including their outlook, at the beginning and end of 2003 were as follows:
 

December 31, 2002 December 31, 2003
--------------------- ---------------------
L/T S/T Outlook L/T S/T Outlook
---- --- ------- ---- --- --------
Moody's Baa1 P-2 Stable Baa3 P-3 Negative
S&P BBB+ A-2 Stable BBB- A-3 Negative
Fitch A- F2 Negative BBB- F3 Negative

BBB
An obligation rated 'BBB' exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation. Obligations rated 'BB', 'B', 'CCC', 'CC' and 'C' are regarded as having
significant speculative characteristics. 'BB' indicates the least degree of speculation and 'C' the highest. While such obligations will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposures to adverse conditions.

The long-term and short-term debt rating downgrades and negative
outlooks reflect the rating agencies' concerns about:

(1) the Company's weakened sales and profitability in the core photographic businesses due to continuing pricing pressure from competitors
(2) continued digital substitution, including doubts about the profit potential of digital imaging relative to conventional photography
(3) unfavorable economic factors, including reduced leisure travel
(4) potential future restructuring actions that may restrict cash flow, slowing efforts to reduce debt
(5) the likelihood that debt reduction will be slowed in the short to medium term due to the company's rising business risk, investment strategies, and the rapid pace at which it has made its recent acquisitions
(6) the financial burden of its significant unfunded postretirement benefit liabilities.

These credit rating actions have limited the Company's access to commercial paper borrowings. In response, Kodak has been forced to issue notes. They issued $1,075 million of long-term debt through an offering and sale of $500 million of Senior Notes due 2013 and a concurrent private placement of $575 million of Convertible Senior Notes due 2033. For 2004, the company expects interest expense to increase relative to 2003 as a result of the replacement of outstanding commercial paper with new long-term debt.

Acquisitions

Kodak has had to accelerate the pace of acquisitions in an attempt to rapidly catch up in the field of digital photography. This is a gamble and the cost of these acquisitions has lowered the company's debt rating and made it difficult for them to get commercial loans. If they do not begin to contribute quickly to revenues, Kodak may sink. The film segment is not guaranteed to keep them afloat while they make the transition. Again, they were very late to the digital party.

Note the number of acquisitions just in the last year!

During the second quarter, they purchased Applied Science Fiction's proprietary rapid film processing technology and other assets for approximately $32 million in cash.

On October 7, 2003, Kodak acquired all of the outstanding shares of PracticeWorks, Inc. (PracticeWorks), a leading provider of dental practice management software (DPMS) and digital radiographic imaging systems, for approximately $475 million in cash, inclusive of transaction costs.

On October 31, 2003, the Company announced that it had completed the acquisition of Laser-Pacific Media Corporation (Laser-Pacific), a leading Hollywood-based post-production company for approximately $31 million or $4.22 per share. At the time of the closing, Laser-Pacific had approximately $6 million of net debt. The acquisition will allow the Company to establish a major presence in television post-production and further extends Kodak's current digital services capabilities in the feature film market.

On November 26, 2003, the Company announced that it had completed the acquisition of Algotec Systems Ltd. (Algotec), a leading developer of advanced picture-archiving-and-communications systems (PACS) in Raanana, Israel, for approximately $43 million in cash. The acquisition improves the Company's position in the growing market for
Healthcare Information Systems (HCIS), which enable radiology departments worldwide to digitally manage and store medical images and information.

On November 25, 2003, the Company announced that it had entered an agreement to acquire the assets of Scitex Digital Printing (SDP) from its parent for $250 million. SDP is the leading supplier of high-speed, continuous inkjet printing systems, primarily serving the commercial and transactional printing sectors. Customers use SDP's products to print utility bills, banking and credit card statements, direct mail materials, as well as invoices, financial statements and other transactional documents. The acquisition was completed on January 5, 2004.

Possible competitor for TACT?
http://moneycentral.msn.com/investor/research/profile.asp?Symbol=tact

On December 4, 2001, the company and SANYO Electric Co.announced the formation of a global business venture, the SK Display Corporation, to manufacture organic light emitting diode (OLED) displays for consumer devices such as cameras, personal data assistants (PDAs), and portable entertainment machines.

On June 4, 2001, Kodak completed its acquisition of Ofoto. The purchase price of this stock acquisition was approximately $58 million in cash. Ofoto has accelerated Kodak's growth in the online photography market and has helped drive more rapid adoption of digital and online services. Ofoto offers digital processing of digital images and traditional film, top-quality prints, private online image storage, sharing, editing and creative tools, frames, cards and other merchandise.

On February 7, 2001, they completed its acquisition of substantially all of the imaging services operations of Bell & Howell Company. The purchase price of this stock and asset acquisition was $141 million in cash.

On October 22, 2003, the Company announced that it signed a 20-year agreement with China Lucky Film Corp.


Discussion

The switch to digital technology has has had an impact primarily on the Kodak's film and paper sales, and processing services in the U.S., Japan and Western Europe. The strategy is to offset this by providing digital products, digitization services and output services. Despite the digital substitution that is occurring in the Japan, U.S. and Western Europe markets,their is still a potential for significant growth in the sale of sensitized products outside the U.S., particularly in emerging markets including Russia, India and China, where they have expanded the number of outlets for Kodak products. To further accelerate the market for photography in China, the company entered into an agreement with China Lucky Film Corporation in 2003 to work together in this regard. They will try to balance growth into the digital market with the ability to pay for it by maintaining a presence in traditional film. Luckily, there is a market for film in China.

They are also making heroic attempts to restructure by cutting costs and severing workers and consolidating and closing property. Its property portfolio will be reduced significantly over the next few years as a result of the new cost reduction program that will be executed throughout the 2004 to 2006 timeframe. Under this new program, the company plans to reduce its worldwide facility square footage by approximately one-third. As a result of the actions, the Company expects cost savings in the range of $800 million to $1,000 million for full year 2007. The restructuring is expected to result in total charges of $1.3 billion to $1.7 billion over the three-year period, of which $700 million to $900 million are related to severance, with the remainder relating to the disposal of buildings and equipment. That is $566 million per year to be spent on restructuring alone per year until the end of 2006. Restructuring costs in 2003 were $484 million. If they don't start experiencing some cost savings in 2004, they may have some difficulty in finding an extra $80 million to fund the restructuring planned. Net income is already suffering. They will also have difficulty borrowing with their low credit rating and negative outlook. The next year or two will be difficult. Will they cut dividends again? I can't imagine they will be able to pay off debt or fund more acquisitions without some very creative financing or a miraculous increase in revenue.

The Company's primary estimated future uses of cash for 2004 include the following: dividend payments, debt reductions, and acquisitions.

On September 24, 2003, the Company's Board of Directors approved the reduction of the amount of the annual dividend to $.50 per share.

A DCF gives a value of $36.25. The inputs were a little unusual. I gave them only a 1% growth rate for 5 years to reflect the uncertainty of any growth at all while they restructure. That changes to 3% stable growth. The risk is 9.7%. The beta was 1. Even with the massive changes surrounding the present and future, they still generate a lot of revenue currently and with careful management they may survive. The current price is around $26. Because the dividend may be a candidate for further reduction if they fall short of cash, I wouldn't count on the $0.50 per share to pay off while waiting for the share price to go up. They are not worth buying for the dividend yield. Even the credit rating reflects the tenuous nature of their finances and has been downgraded and the outlook categorized as negative. Investment in a distressed company like Kodak requires faith in their direction and ability to carry through and a huge discount. A 40% to 60% margin of safety might make a good buy.

At present EK is a company in transition, not returning anything to investors except the dividend. They have fairly manageable levels of debt, but a rather less than stellar rating. They still reap huge amounts of revenue. The pension fund won't drain them in the foreseeable future. They know where they need to go and are attempting to get there. Unfortunately they are late to the digital party. One can only wonder what management was thinking--the digital thing was just a fad? They are headed in the right direction now.

>^..^<
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