Beware Declining Margins: Bill Miller and Kodak

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Jun 29, 2011
Value investors don’t sell out of a great stock due to the ups and downs of the stock market, and look at numerous financial factors when making a decision on whether a stock is cheap compared to its market price. Many times, however, investors analyzing a company may conclude that they have found a value stock paragon, but miss one telling metric that indicates the stock is actually a value trap: declining profit and operating margins.


Bill Miller, the manager of the Legg Mason Value Fund who became famous for beating the S&P for 15 consecutive years, might have made this mistake with Kodak (EK, Financial).


Kodak (EK)


Bill Miller finally sold his shares of Kodak, which he has held for over a decade, in late 2010 and early 2011. He sold for about $3 per share, realizing a $551 million loss.


Miller began buying Kodak shares in 2000 and acquired 25% of the company by 2005. With its world-recognized brand, increasing film market share and production of a product everyone used – cameras and film – Kodak looked like a stalwart. The company was also generating over $1 billion in free cash flow from 2001-2003.


But in 2003, digital camera sales exceeded film camera sales for the first time. Kodak was such an innovative company that it actually invented the first useful camera for general sale (which retailed at $20,000) in 1991, and retained the No. 1 US marketing position in digital cameras in 2005. Kodak conceded defeat to the digital camera in 2004 when it ceased production of its film cameras.


Kodak made big promises to investors that as it phased out one segment of its business, it would aggressively innovate in other areas that would compensate. In its 2005 annual report, Chairman and CEO Antonio M. Perez wrote:


“Starting in 2006, we have split our consumer business into two groups — the Consumer Digital Imaging Group and the Film and Photofinishing Systems Group — which will allow us to effectively address differences in how you manage a growing and a declining business….


Staying true to our strategy, by 2008 we expect all of Kodak’s businesses to be leaders in their industry segments — achieving attractive margins and generating substantial cash.”


The company’s top 2 and 3 goals were to grow revenue from digital products and services and expand profit margins on products and services. Growth into the digital world seemed to be a lucrative replacement stream of revenue for the company.


The stock was already falling from the $90 range at which it traded in 1997, and by 2005 – the year after the company stopped selling cameras – it fell to the $20s.


At this point Miller might have seen the dip as a temporary setback. The company still generated $736 million in free cash flow that year, although it had a net loss of $1.4 billion and a negative 69.2% return on equity. Miller continued holding on to the stock until the end of 2010, when the stock had not generated cash flow in three years.


"We expect the company to generate free cash equal to almost half of its current market capitalization over the next five years,” Miller said in his 2000 shareholder letter.


Well before Kodak stopped making money and it became fairly clear that it would not for some time, its declining profit margin was a red flag for investors. A glimpse at GuruFocus’ gross margin graph shows that Kodak’s gross margin had been declining drastically since 2002.





Furthermore, its operating margin fell rapidly beginning in 2002, falling negative in 2008, when the recession hit the already struggling company.





While sales in its consumer digital imaging group segment actually increased in 2010, its film segment sales have declined almost $1 billion from 2008 to 2010, and it is now the No. 5 producer of digital cameras.


A closer look at Kodak’s business shows that its film segment is dragging down not just revenue but margins as well. Kodak operates in three segments: Consumer Digital Imagining, Graphic Communications, and Film, Photofinishing and Entertainment. The gross operating margin for Kodak’s Consumer Digital segment (its largest) was 1.3% in 2009, compared to 12.1% in 2010. Its 2009 gross margin for its Film, Photofinishing and Entertainment segment in 2009 was 7%, compared to 3.6% in 2010.


Conclusion


Kodak has existed since 1901, maintained a dominant market position for years and has worldwide marketing operations. But its profit margin has been falling for years, and investors had plenty of time to get out before the stock hit almost rock bottom.


Even if it wasn’t a bargain when Bill Miller bought it, a good question today is, is it a value play at its current price of around $3? Or is it down for good?