Description

Kodak Warrants (KODK/WS & KODK/WSA)

Kodak Common Stock Price:  $15.28                

Kodak Warrant $16.12 Strike Price (9/2018 exp):  ~$2.30

Kodak Warrant $14.92 Strike Price (9/2018 exp):  ~$3.50

Shares Outstanding:  42m                                      

Market Cap:  $642m

Gross Cash:  $609m

LT Debt:  $671m

EV:  $704m

*2015(e) EBITDA:  $100-$120m                             EV/EBITDA:  ~6.4x (mid-pt)

*2016(e) EBITDA:  $175m                                      EV/EBITDA:  ~4x

*Both figures guided by management.  We believe both of these guidance/goal figures are conservative.

We recognize the warrants may only be liquid enough for PAs and small funds.  It took us a few weeks to accumulate a reasonable quantity but this is as much a pitch for the common as it is the warrants, so keep that in mind.  

Summary of Thesis

Kodak is a misunderstood hodgepodge of businesses and assets.  The income statement is muddy, as are certain aspects of the balance sheet.  Kodak offers income statement optionality, balance sheet optionality, & strategic optionality.  Kodak warrants are a cheap option on those options.  If the company is managed in a competent manner, we believe value should be unlocked over the coming quarters/years.  

What do they actually do?

This is the first question we normally get when we talk about Kodak.  Post-bankruptcy they are focused on commercial printing, imaging, and packaging, they also have a nascent functional (3d) printing business for touchscreen sensors that should start to generate revenue late 2015/early 2016.  Kodak also has a patent portfolio with over 7500 patents that it is mining for licensing & partnership opportunities.  Their business park is one of the larger ones in North America.  There is also a legacy film/consumer inkjet business that is declining (10% of 2015 pre-corp overhead EBITDA forecast).  

What makes Kodak so interesting?

Since bankruptcy, the legacy businesses have declined and functional printing has been delayed.  Declines in some legacy businesses and currency headwinds are masking the growth & quality of their strategic businesses.  Furthermore, the growth itself masks the profitability on the recurring revenue streams for the strategic businesses as systems are sold at cost and installed at a loss.  Margins in those businesses should improve over time as they shift to harvest mode.  The legacy businesses should decline to about 10% of the revenue over the next year or two and should wind up being a smaller and smaller percentage as the other businesses grow.  

Though it is not obvious, the company is asset rich.  There is a ~$5b pension that looks underfunded (a $609m liability) but is much less underfunded (under current assumptions is actually less than $300 underfunded) and under reasonable assumptions is near fully funded and could become overfunded (a strategic asset) over time.  There is also a working capital imbalance, as Kodak gets further away from bankruptcy, it should also be able to free up $50-75m in working capital from securing better terms on receivables/payables.  Kodak also owns its campus (no estimate, but worth something) and a portfolio of 7,500 imaging patents that it is mining for licensing and partnership opportunities (again - no estimate, but worth something).   

The current market cap is ~$640m with an EV of ~$703m, and EV/EBITDA is 6.4x (mid-point of current guide).  They have $671m of debt and $609m of cash.  The business should generate operating cash flow in q3/q4 and be cash flow positive going forward.  Management has stated a “goal” of 2016 EBITDA to $175mm, excluding any one-time IP sales or licensing, which is a 4x multiple.  We have reason to think these numbers will prove to be conservative.  

There was a write-up at the beginning of the year that detailed some of the history, please see that for more background.  Our write-up first focuses on the optionality that exists within Kodak, it will then focus on the guidance for 2015, the goal management set for 2016, and why we think the guide is conservative.  We think the end game is to get the 4 divisions with enterprise value to scale and sell them.  We believe upside potential is most significant in the warrants that were issued out of Kodak’s bankruptcy.  

Income Statement Optionality

1. Mix shift in growth businesses from investing to harvesting

2. SG&A/R&D spend that can come down

3. Debt Refinance/Paydown

Balance Sheet Optionality

1. Pension clarity, looks $600m underfunded

2. Improving working capital (~$50-75m in cash from working capital improvements)

Strategic Optionality

1. Selling businesses, these come significant synergies with competitors, can also bundle the fully funded pension with conservative assumptions to sell to an underfunded plan with more aggressive assumptions

2. Patent Portfolio/R&D licensing opportunities

3. Better utilization of Eastman Business Park

Income Statement Optionality

The opportunity in Kodak exists primarily because until recently the financials were extremely messy, now they are just kind of messy, and as we go into 2016 they should get cleaner.  Specifically, the growth of the new core businesses is being masked by the decline of legacy businesses, as well as currency headwinds and charge-offs.  Legacy inkjet sales should run off and growth in new products divisions should become more obvious over the next 12-18 months.  Below is a brief summary of the new divisions as well as unit economics for each of the major revenue drivers.

Division Breakdown with Ests for 2015:

• Sonora/Print Services ($1.1b revenue, ~$100m EBITDA)

• The major contributor to sales and growth is their SONORA system.  As of year-end 2013, they had 400 SONORA customers and now that number has ballooned to over 2,700 customers.  Plate volume is also growing and pricing is much firmer on Sonora, as it is a closed system.  They expect SONORA to eventually represent 40% of their PSD business, up from low teens today.  It could be larger as they’re working on getting longer run times for the system which would expand the addressable market.

• Sonora is included in the Print System Division (PSD).  PSD is about half of Kodak’s revenue.  While plate volume is growing, and there is a mix shift to higher priced plates helping offset price erosion, there is a 10% currency headwind this year which should leave the division roughly flat, perhaps down 2-3% on a constant currency basis.  

• Flexcel/Functional-Micro 3d Print and Packaging Division ($135m Rev, $14m EBITDA)

• As of Q2 2015, there were 440 Flexel systems sold.  The consumables revenue per system is approximately $150,000 at an EBITDA margin of 35%.  Growth in Flexcel is strong and management expects it can grow to at least 480 systems in 2015 which puts consumables revenue at $67.5mm and EBITDA at $23.625mm.  They’re getting some lift from this now, but not as much as you’d think because of functional.

• MPPD is growing on a constant currency basis but that growth is depressed by the currency headwind, showing 3% growth on a >10% headwind.  

• Functional represents an option for Kodak shareholders, the value of which is debatable.  Kodk's 2015 guidance assumes deminimus revenue from functional printing we expect any revenue that does show up to be in Q4 or 2016.

• It's important to note that Kodak is running $20m in expenses through MPPD related to functional.  The established MPPD business is actually growing and much higher margin than it currently appears (at least high teens Ebitda margin, ex-functional).

• Enterprise Inkjet Services- Prosper ($185m+ revenue, -14m EBITDA)

• As of the Q2 call, 2015 Kodak has 49 Prosper systems sold, up from 39 at year end.  Their guidance is to have 25 systems sold in 2015, for an install base of 64.  This system retails for about $1.5m - $2m per system.  The residual consumables on the system is $1m at a 35% margin.  On the recent call the CEO indicated it was less than this, but that was for current Prosper mix which is about half black/white.  90%+ new sales are in color at this margin profile.  As we leave 2015, Prosper should be >50% of EISD revenue.  

• Post b/k Kodak is able to provide customer financing/leasing of Prosper systems, something they couldn't do in the restructuring, this has and should help the sales ramp.

• Prosper annuities take 6-9 months to appear in the financials.  Our expectation is to see the annuities hitting the income statement in Q3 or Q4 of 2015 with 2016 being an inflection point for the new system.

• EISD should show topline growth in 2015, but that growth is again depressed by currency, in Q2 they showed a ~4% rev decline due to a ~8% headwind.

• Software and Services Division ($113 revenue, $8m EBITDA)

• SSD is growing, it's growth obscured some by the same currency issues as the other divisions.  Last quarter they showed flat YoY revenue on a 6% currency headwind.  Our expectation is that it continue to grow and for incremental sales to have high incremental margins.

• Intellectual Property / Licensing Patent portfolio & Brand (No Revenue, -$25m EBITDA)

• In an effort to manage the street's’ expectations, management has given no value or assumed no additional sales from their IP portfolio.  Clearly value exists here; the question is if, how, and when might it be monetized.  

• Since this is high uncertainty, we’re not assigning a value to the patent portfolio.  

• This is, however, R&D spend that is discretionary and could be cut by an acquirer one day.

• Film / Consumer Film Division (~$260m revenue, 29M EBITDA)

• This division is inkjet refills, which should go to 0 over the next 18 months.  It is also studio film and film for semiconductors.  

• Hollywood studios have contracted with Kodak to provide them with film long term, this business should have enough volume to operate at breakeven.  

• Right now there is about 11-13m in licensing revenue for 2015 that are run through the CFD division.

• For 2015 we anticipate EBITDA of 29M and this should decline to roughly 12m in 2016.

• This is assuming they run CFD at break even before licensing revenue.  

• We estimate revenue declines to $200m, which puts this division at about break even.  

• Since this is largely a melting ice cube, we’re not assigning any value to this division.  Thought the licensing revenue should get some multiple.  

• Eastman Business Park (~$15M in revenue, 2M EBITDA)

• Right now the park is about 50% occupied, about half of that is Kodak.  Each new tenant should provide relatively high incremental EBITDA margins.   Getting the park 75% occupied could double the revenue with a high EBITDA margin.   

• Since this hasn’t happened yet, we’re not assigning a value to the park

Cost cuts:  In 2014 about $100m of R&D expense went through the P&L.  This is expected to decline by at least $20mm in 2015.  In 2014, PROSPER got $40mm of R&D, for 2015 this should decline to $20m.    There is at least 25m of discretionary R&D running through the IP division.  We don't expect this to drop off this year or next, but if the end game is to sell pieces, this is low hanging fruit for an acquirer.

They also plan to reduce SG&A to $95mm for 2015, by shutting down old factories and shrinking headcount, we think they can get it sub-$90m in 2016.  Cost cutting is a continuation of what has been done since bankruptcy when Blackstone/Blue Mountain took control of the business.  For every 1 person hired, 3 people are let go.  

Debt Refi:  Currently there is over $670m of debt on the balance sheet.  This is broken into two term loans.  One is for roughly $400m at a rate of 7.54% and the second tranche is for $270m maturing in 2020 at an 11% rate.  One or both of these tranches could be refinanced to reduce interest expense to Kodak and management is actively looking to get this done.  We believe it likely will get done later this year/early 2016 when additional revenue and growth comes online and the sustainability of the business is more obvious.  Refinancing the debt will be an important step in showing the health of the company and eventually showing positive earnings.  

Balance Sheet Optionality

A cursory look at the balance sheet leaves investors looking at a pension liability of $600m which may not be an accurate representation of economic reality.  For starters the fair value of the pension assets are over $300m higher.  This differential is a function of Kodak using a Calculated Value for Pension Assets (a smoothing mechanism) when it nets out the liability on its balance sheet. The weighted average discount rate between US (discount rate 3.5%) and non-US (discount rate 2.5%) plan assets used for the net benefit obligation is ~3.25% which is significantly below the average pension assumption of most major corporations.  It is also at least 50bps below what an insurance company would assume for a pension risk transfer and what the current discount curve Kodak uses would PV it at.  A 25bps move in discount rate changes the liability by $100m.  So while Kodak’s pension looks underfunded, the economic reality is that it is very nearly fully funded under conservative assumptions today.  

The pension is important for several reasons:

• Kodak doesn't need to contribute any additional cash into the pension despite it looking underfunded.  The anticipation is that in two years, the Calculated Value of plan assets will creep higher and the liability declines the balance sheet.  Over time, it should become an asset and gets further amplified if their discount rate assumption used to calculate the PBO goes back up by 50-75bps, to a market level assumption.  A 25 basis point move in the discount rate assumption equates to about a $100m swing in either direction.  It has already crept up 50bps this year from when the 10k was published.  Below is the Citi Pension Liability Index Kodak is using:

• Investors looking at an EV/EBITDA valuation approach to KODK may be misled by lumping the pension liability onto the EV, making Kodak look more expensive than it really is.

• In theory the pension has value today as Kodak could bundle a division of their business and pension and sell it to a company that would have some synergies and an underfunded pension.  As an example, HPQ has a large underfunded pension and they use a discount rate of 4.9%.  At that rate, and truing up the assets, Kodak’s pension would appear overfunded by nearly $400m.  

The other part of the balance sheet is a working capital imbalance that once corrected could free up $50 to $75m in cash.  

Strategic Optionality

We see three components in the strategic optionality bucket:

1.      Synergies to selling a business division / the entire business

2.      IP Licensing and Sales

3.   Eastman Business Park

#1 Synergies to selling a business division / the entire business

Above and below this section we’ve outlined some potential synergies, specifically via the pension to a strategic buyer.  Recently Kodak adopted a new reporting structure.  We believe the new reporting format was done for two main reasons – one is to highlight the growing business segments and to make the growth visible and easy to understand.  The second reason is to advertise to potential acquirers the segments, their various growth stories, and possible synergies.  Besides the pension, an acquirer could get economies of scale in R&D and SG&A.  It's not hard to imagine $100m+ coming out between the two line items along with any pension funding help an acquirer might get.  While we think it's possible EBITDA is above $200m in 2016, acquirer’s EBITDA is probably north of $300m and a source of greater upside for the stock.  

#2 IP Licensing and Sales

One reason why YOY financials will be muddy for a while is a one-time IP hit in 2014.  Management continues to evaluate opportunities for additional sales and leases, but isnt assume any IP sales or leases are done in 2015 or 2016.

#3 Eastman Business Park

The Eastman Business Park is a 1,200 acre business park in Rochester, New York.  As we mentioned in the EBP section, it is presently 50% occupied (6/30/15).  They continue to shop around for additional external parties to occupy the space.  They seem to be making progress as NY state and the upstate region view the park as vital to an economic renaissance.  Eventually, we believe an outright sale of the property will take place.  One important thing to note is they did have offers for the park but deals fell through because Kodak management was not willing to commit to being there 10 years on a lease, which is somewhat telling.  We think the goal is to get the park to scale with non-Kodak tenants and then sell it.  

Guidance and Goals for 2015 and 2016, Respectively

During the 2014 year-end investor call, Kodak management gave investors EBITDA guidance of 2015 in the amount of $100-$120m, back end loaded for q3/q4.  For 2016, management has the goal of EBITDA of $175m.  They have since reiterated these on subsequent calls.  We believe they were being conservative (for a change) on both of these figures.  Both of these figures were reiterated on the most recent quarterly call.

The 2015 guidance figures include currency headwinds (Euro @ ~ $1.06), increased aluminum costs ($2600/mt, $2100/mt “mostly hedged” 2015 price + $500/mt delivery premium @ >$250m in input cost), very little revenue tied to functional printing, and no IP sales or licenses.  According to the company the $175m goal also just runs these assumptions forward to 2016 with the ending 2015 install base.

For currency we take the guide as is, but aluminum is a different story.  Aluminum is a significant annual cost for Kodak, >$250m last year as they buy over 100k tons annually, it is the biggest COG in the Print Services Division.  Utah's VIC write-up on a short of Century Aluminum (which was a fantastic call) does a wonderful job describing the reasons why one part of this cost had increased and can be expected to stay closer to historical norms.  http://valueinvestorsclub.com/idea/CENTURY_ALUMINUM_CO/136340

For Kodak, Midwest/European premium delivery charges added nearly $500/mt to the price of aluminum (up nearly 5x from a historical average of $100/mt).  While the spot price of aluminum has already come down considerably, to ~$1600, they have hedged “most” of their aluminum for 2015 at higher prices, so we don’t expect declines in the commodity itself to flow through as strongly this year.  It does however appear that we have already seen the delivery premium collapse (as followers of the popular CENX short already know):  

http://www.reuters.com/article/2015/06/02/us-aluminium-premiums-ahome-idUSKBN0OI2JK20150602

http://marketrealist.com/2015/06/europes-aluminum-premiums-recover-hitting-time-low/

Note that Kodak cannot hedge the delivery premium, they are only hedging the price of aluminum and they are doing so on a rolling quarter basis, we expect the delivery premium decline to start to flow through on the back end of this year and the spot declines to flow through in 2016.  Furthermore, they don’t hedge 100% of their input cost.  Since they buy >100k tons, a $100 reduction in delivery premium equates to $10mm in EBITDA.  Conversations with management confirmed this kind of sensitivity.  

We think:

1.      Delivery premiums have already decreased by nearly $350/mt and based on what management has told us, their 2015 guidance and 2016 goal numbers benefit from this tailwind by $26.25m (3/4 of 2015, since 3/4 of business is back end loaded) and $35m for 2016, respectively.  The underlying has also collapsed, which @ $1600/mt is a $50m reduction in cost.

2.  Since these are competitive products we don't expect full flow through, but we do think it adds conservatism to the guidance and goal.

We don't see why the 2015 year end install base should remain the same in 2016, so the baseline goal number may be light on that fact alone.  Management has also commented positively on the status of functional and they have 3 productions lines set up for touch screens that can do $15m in revenue each. We think rather than giving optimistic guidance that they might have to take down, management gave themselves very achievable guidance they have the potential to jump over.

Regardless, if they simply do what they said they'll build trust with investors and the stock should do well.

Management & The Future

The new CEO, Jeff Clarke, was appointed to the position in 2014.  His background includes a prior dealings with Blackstone.  We don’t think it’s a coincidence that Jeff has previous experience with one of the largest holders of Kodak stock, Blackstone.  Two-thirds of the upper management of Kodak were hired within the past 18 months.  

The 2015 proxy is one of our favorite parts of the story.  For year 2014, management did not earn cash bonuses.  Jeff and other management did receive stock options with the strike price struck, most of which were struck on March 12th.  Jeff Clarke was issued the first $1m option grant in March of 2014, the second $1m option grant in March of 2015, and the final grant will be issued in March of 2016.  Currently, the weighted average strike price of all options granted is $22.56.

We think Jeff is there to cut costs, get the nascent businesses to scale, and ultimately sell the divisions.  The fact Jeff commutes from SF to Rochester is also quite telling.  

What’s It All Worth?

We believe 2015 EBITDA will be between $125m and $145m.  For 2015, the guide is for EBITDA to be 75% backloaded to Q3/Q4, we’ve already seen 35m which implies $140m.  Assuming a 8x EV/EBITDA on 125m puts the value of the company at $1B or ~$22/share.  Again, we believe management is giving guidance they believe they can step over and 2016 results could come in better than this.  Based on what we know today, haircutting the impact of AL, we estimate 2016 EBITDA to be closer to $200m (vs. a stated “goal” of $175m).  At an 7x EV/EBITDA multiple we are looking at a share price near $32.

Note these valuations exclude any value to the intellectual property and the value to a strategic acquirer, who could strip out overhead and R&D and perhaps make better use of some of the patents.  There are a lot of levers to pull to improve performance and cut costs. They also exclude the ability to use the pension as an asset in a merger.  As an example, in the recent RKT/MWV merger MWV’s overfunded pension was a significant motivating factor (along with a number of other synergies).  Blackstone, Kodak’s largest shareholder, advised Rock-Tenn on the deal.  

Opportunity in Warrants

Kodak issued two series of warrants coming out of bankruptcy:

1. KODK+ 125% warrants expiring 9/2018, strike = $14.93

2. KODK+A 135% warrants expiring 9/2018, strike = $16.12

Based on our valuation above, we believe the intrinsic value of the KODK+ warrants would have nearly $17 in intrinsic value and the KODK+A over $15 by YE 2016.  Both of these values are significantly more than the prices today, they'll also have some premium on top of intrinsic value as they don’t expire until September of 2018.

Risks

• New systems don’t sell well, though to date they have

• Benefits of lower input costs don’t accrue to Kodak, they won’t get all of it

• Continued dollar strength makes products less competitive abroad (~⅔ revenues)

• Incremental cost cuts don’t take place, but management has found them and seems dedicated to finding more

• Management executes poorly/doesn’t execute

• Functional printing is forever delayed and/or product sales are weak (though revenue isn’t in the guide and continued R&D spend on functional is)

• Longer term low rate environment makes pension less of an asset

Catalyst

• Showing revenue growth in important divisions and improved operating performance in 2015

• Margin expansion as products shift from investment to harvest

• Investor day (Oct 23)

• Asset sales