Description
I wanted to throw this out there because I think this is a tremendous short at current prices and i don't understand the bull case for the stock at this price. would be great to get the insights of other thoughtful investors
i believe the company makes more than 100% of its profits in 3 categories, all which are currently in decline or will decline in the next 3-4 years: 1)consumer film; 2) analog health imaging; 3) entertainment (cinema) film.
Here is my take on the stock:
Q4 2004 – Beat on low quality earnings
--- The market was expecting 0.66, EK printed an EPS number of 0.78 based largely on a $58m tax benefit; excluding this benefit, at the tax rate EK has guided investor to for 2005 (14%), earnings would have been 0.51
--- Earnings from Operations (EFO), or a proxy for EBIT, was $186m for the quarter, a 32% decline from Q4 of last year
--- Revenues were essentially flat on an organic bases, boosted 3% by a combination of FX and acquisitions
--- Cash flow (as defined by EK – basically FCF after dividends) – came in at $536m for 2004 vs. $675 for 2003, a 21% decline (meanwhile, headline EPS has gone from $2.31 to $2.62, an increase of 13.4%)
--- They have guided to Cash Flow in 2005 of $400-600 (their guidance for 2004 was $650m, they came in at $536m). Again, cash flow would decline at the midpoint of the range, but EPS guidance calls for a 5% increase at the middle of the range. At the midpoint of next year’s guidance, they would generate $645, or $2.25/share of FCF before dividends. However, I believe their assumptions on profitability of digital products are overly aggressive.
2005 – Several things working in our direction
1. organic revenues will be flat/down. EK ended 04 w/ revenues of $13.5b. They have guided to organic growth of $1.2b to $1.4b in their digital segment, and a revenue decline of $1.8b to $1.4b in traditional revenues. This would represent a 2% decline in organic revenues, offset by several acquisitions to show 6% growth. They recently acquired a business called KPG at 17x earnings that grows at 3%. They paid $300m up front and it added $500m of debt as the purchase price included future payments in 2005 and beyond ($400m of the debt represents notes payable for the FV of the purchase price). I believe this will prove to be a low quality acquisition. Furthermore, I believe the purchase price was structured in such a fashion because the $1.1b of cash on EK’s balance sheet is necessary to run the business as opposed to excess cash (mgmt said today they need $750m on the b/s because they have no access to commercial paper).
2. margins will continue to decline. A 1-for-1 replacement of traditional revenues for digital revenues has led to a decrease in gross margins from 35.0% to 29.5% in the past 2 years. A decreasing tax rate, massive restructurings, and lower R&D and selling expenses have increased EPS. These cost cuts (or at least their pace) are not sustainable, particularly the tax rate. EK has structured their business to be unprofitable in the US (high tax jurisdiction) and paid 9% taxes this year.
3. FCF decline. FCF after dividends was $536 in 2004 (vs. management guidance of $585-715) and next year’s guidance was $400-600m. This would represent a decline at the midpoint, but I believe they are too aggressive.
4. Overly-aggressive profit assumptions in Digital. Current digital revenues are approx. $5.8 billion. Mgmt. expects this to rise by 36% in 2006. Current EFO is approximately $50m and management expects to get to $300m next year to offset declines in the traditional business. This would represent profitability of approximately 12% on incremental revenues vs. less than 1% margins currently. Considering a large portion of these revenues are digital camera revenues where ASPs for similar models are down 30% YOY, I find this difficult to believe.
5. Pace of restructuring and working capital improvements will slow. EK has done a good job of rapidly cutting costs in their traditional business to maintain EFO. Consumer film volumes continue to decline at an accelerating pace 25-30% in the US in the last quarter (vs. low -20’s earlier in the year). Mgmt. acknowledges that traditional EFO will decline between $125-225m next year. They have traditionally had to revise downwards their projections for traditional revenues and profitability
Though somewhat difficult to pinpoint, I believe the cash earnings power of this business will approximate $2.00-2.25 next year, with risk to the downside. Furthermore, I believe as traditional film revenues decline and are replaced by digital, margins will continue to deteriorate and earnings will generally be flat or most likely down looking out into 06 and beyond absent a very attractive acquisition. However, given their track record and an increasing thought that the balance sheet can not bear a large acquisition, I believe earnings even including acquisitions should not be materially greater than $2.00-2.25. I believe management’s guidance of $2.60-$2.90 in “operational EPS” in 2005 was necessary to appease longs who are focused on the company’s $3.00/share guidance for 2006, which appears to be unachievable on a cash basis.
Catalyst
-- continued deterioration in cash flow and margins