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Kodak's Rally: Rebound or Illusion?

Eastman Kodak investors and analysts debate whether its surprisingly strong fourth quarter is a mirage or a sign of a fledgling rebound. Rob Holmes explores the world of under-$5 stocks in The Dollar Store.



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Eastman Kodak


shares have been on a rollercoaster ride in 2010, as investors and analysts debate whether the troubled digital imaging company's surprisingly strong fourth quarter is a mirage or a sign of a fledgling rebound.

Eastman Kodak

, the one-time film giant whose fortunes soured with the rise of digital photography, saw a surge in share price on Jan. 28 after the reporting a fourth-quarter profit, which broke a string of four straight quarterly losses. The stronger-than-expected earnings, which came thanks to lower costs, licensing gains and consumer and commercial printer sales, pushed the stock more than 30% higher to its best level in more than a year.

"We're very pleased about how we had a very strong close to the year and a fourth quarter that demonstrated some momentum," Eastman Kodak CFO Frank Sklarsky said in an interview with



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Eastman Kodak CFO Frank Sklarsky

Sklarsky adds that the company saw a return in demand and revenue in some key businesses, including the digital capture arm, and the company built "a very strong cash balance" of $2 billion and boosted profits by reducing its workforce and containing costs. The structure Kodak has in place on the debt and equity side should help the company weather any storm, he argues.

Kodak shares took a sharp turn lower, though, after the company hosted its annual investor day on Feb. 4. There, Kodak said 2010 sales should fall between $7.5 billion to $7.7 billion, vs. $7.6 billion in 2009 and the Thomson Reuters average estimate of $7.66 billion.

Doubters argue Kodak's outlook for 2010 fails to show growth that can sustain a rally. The biggest criticism levied against the company is that its core businesses will remain soft and that strong fourth-quarter earnings were largely the result of unsustainable one-time payments related to its intellectual property portfolio.

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In the fourth quarter, Kodak settled disputes with




, which resulted in new royalty deals based on Kodak's digital technology that boosted fourth-quarter results.

The Samsung deal generated a $100 million payment in the fourth quarter with an additional $450 million in payments due in 2010. The agreement with LG was good for $414 million in revenue, and Kodak's sale of its OLED business to LG generated another $100 million.

Brean Murray analyst Ananda Baruah argued that the $450 million in payments from the Samsung settlement due in 2010 could provide a cushion to softer businesses. But Baruah argues that less soft isn't necessarily great.

"To make the business model really 'work,' we believe Kodak needs to see relative stabilization in its core traditional businesses, see profitable growth in 'core' digital imaging, and see either stable to growing annual IP income," Baruah said in a research note.

Deutsche Bank analyst Chris Whitmore takes a more pessimistic stance, arguing that when the income from the $550 million Samsung settlement is stripped out, Eastman Kodak should continue to lose money on its core operating businesses in 2010.

"In other words, the rest of Eastman Kodak will continue posting substantial losses despite expectations of further macro improvement," Whitmore wrote in a research report.

Citigroup analyst Richard Gardner piles on, arguing that investors are failing to recognize the one-time nature of the IP revenue payments. In addition, the settlements may create tough year-over-year comparisons in 2011.

Kodak's Sklarsky asserts that Eastman Kodak's reversal is based on a wide variety of factors and its performance. For one, Sklarsky says that Kodak has made "significant progress" in revenue, earnings and cash as it was prepared for the difficult recession earlier than most.

"Because of the economy, we demonstrated that we got after things very early and set up the structure of the company in a way that would allow us to have significant operating leverage once a recovery took place," Sklarsky said. "We've done very well so far through the recession so far. We've exited it with a very strong cash position. As things recover, we'll do well in the months and years to come."

Eastman Kodak is also quick to reinforce the point that if non-recurring intellectual property royalties are excluded from both 2008 and 2009 results, gross margins improved by six percentage points year-over-year, while profitability improved by more than $100 million.

While the focus is on growing its consumer divisions, there is the potential the Eastman Kodak could see more one-time payments on its intellectual property, as it has taken cases against


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to the International Trade Commission. What's unclear is if investors have factored this into Kodak's share price.

"We're confident with our position with RIM and Apple, and we're very confident with our intellectual property portfolio," Sklarsky said. "We have demonstrated a long record of success over the last several years in prevailing in a number of cases and negotiations. I'm sure that at an appropriate time we'll reach a satisfactory resolution as it relates to RIM and Apple."

Receiving fair compensation for the billions spent on research and development and patents is important to the company, but Sklarsky says Kodak's greater focus is on offering a set of unique value propositions that are superior in the marketplace.

"Our legacy of innovation has continued and will continue, we're starting to be recognized for that," Sklarsky said. "We've gotten a lot of good reviews from professional media and from consumers. That's what's going to help us ramp up our gross margins over our planning period and will hopefully be very accretive to both our customers and our shareholders."

Eastman Kodak isn't alone in its upbeat view. Standard & Poor's analyst Erik Kolb recently turned bullish on Kodak, citing a number of improving trends, with the biggest being consumer digital.

"Kodak has undergone multi-year, multi-billion dollar restructuring efforts and it's starting to bear fruit," Kolb said during a recent interview with


. "It's an attractive company and it's very cheaply valued based on our forward estimates."

As for the volatility in Kodak's share price, Sklarsky says that the swings in recent trading activity is understandable given the difficulty in forecasting when a recovery will take hold.

"It's important to recognize that most of us in the corporate world are seeing limited visibility to the pace and the slope of an economic recovery," he said. "The risk now is from things that are externally driven. So we're going to focus very strongly over what we can control. We're going to maintain a tight discipline over our own execution."

For Kodak, Sklarsky says, that means the company won't necessarily chase every opportunity. Instead, Eastman Kodak is going to manage for profitability and cash flow.

"That's what our shareholders expect us to do," he adds. "And we're going to focus on satisfying our customers and creating new customers. If we do that, we're going to weather this just fine."

-- Written by Robert Holmes in Boston


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