Industry Analysis & Kodak Strategic Logic Quiz

Industry Analysis on Housing

This a report on the US housing market. Whether you agree with the author’s assumptions or not, he carefully lays out his thesis. Also, his research shows the difficulty in investing in cyclical industries. The future is unknown, but if you can find a skewed risk reward opportunity then pursue it.

Kodak Case Study in Strategic Logic

Value-Line on Kodak: Note the high returns on capital pre-2000.

50-Yr. Chart: Note how the stock price of Kodak (EK) begins to underperform the stock market back in 1973/74. Back then (1972) the digital camera was invented. Coincidence or every picture tells a story doesn’t it? (Rod Stewart).

The history of the digital camera:

Digital imaging also had another government use at the time that being spy satellites. Government use of digital technology helped advance the science of digital imaging, however, the private sector also made significant contributions. Texas Instruments patented a film-less electronic camera in 1972, the first to do so. In August, 1981, Sony released the Sony Mavica electronic still camera, the camera which was the first commercial electronic camera. Images were recorded onto a mini disc and then put into a video reader that was connected to a television monitor or color printer. However, the early Mavica cannot be considered a true digital camera even though it started the digital camera revolution. It was a video camera that took video freeze-frames.

Bill Miller Loses on Kodak

Bill Miller bought Kodak near $60 and then many years later sold at $1.  He said to a reporter that Kodak was his biggest mistake. He underestimated the need for a cultural change to turn the company around.  Do YOU agree with his assessment of his mistake?  Not to pick on Mr. Miller, but using strategic logic what questions would you ask if Kodak was transitioning from film photography to Digital?  What might you do if you were the CEO?

In 2002, Fortune described the quandry Kodak faced in this article:

Kodak: In The Noose

Andy Serwer                                                                                                             February 4, 2002

(FORTUNE Magazine) – When I was a boy, my grandfather gave me a few shares of Eastman Kodak. I never got a chance to talk to him about it, but I’m sure his thinking was, “Taking pictures is a great business. People will always take pictures, and Kodak is the big fish in that pond.” Well, for years my grandfather was right, and Kodak was a fair, though by no means stellar, stock. Now, however, it seems that only the first part of Grandpa’s axiom holds true. Everyone still takes pictures, but increasingly Kodak isn’t the big fish in the photography business.

Despite all of Kodak’s best efforts, this grand old American brand could very well go the way of Wang and Xerox. Which is to say the company may be hanging around for years, but for all intents and purposes, it’ll just be twisting slowly in the wind.

EK is under siege. On one side, Fuji and others are chipping away at Kodak’s very profitable consumer film business. On the other, the digital image revolution (i.e. digital photography) is hitting critical mass. Yes, Kodak is a big player in that arena, but even if it succeeds there–which is far from clear–that’s a much less profitable business than those little yellow boxes.

Take a look at the numbers. In 1991, Kodak had $19.4 billion in sales. Last year, it’s expected to have done just a bit over $13 billion. And while net income hit close to $1.4 billion in 2000, that’s about what it earned in 1988. The company has recorded “nonrecurring” losses in ten of the past 12 years. Kodak’s dividend is now $1.80 per share, but some analysts don’t think the company will earn that this year. The stock, which hit $94 in 1997, now trades for $27. (How long, you might ask, before the good people at Dow Jones do what they did to Woolworth, Bethlehem Steel, and Union Carbide, and throw EK off the DJIA?)

But there is an even more disturbing figure for EK shareholders: Sales of digital cameras climbed an estimated 30% last year, to 5.5 million units. Now, Kodak makes digital cameras–in fact, it recently became the market share leader. But (1) Kodak’s digital camera business isn’t profitable, (2) every time someone buys a digital camera he is no longer a customer of the company’s high-margin film business, and (3) to succeed, Kodak must compete with the likes of Sony and Canon.

Kodak says it’s hurting because of the recession and the slump in travel since Sept. 11. (“Why then,” asks one short-seller, “is its medical imaging business also slumping?”) As for digital photography, the company says that it’s not only selling cameras but also high-quality paper and other digital photo-finishing services. Again, though, margins there are nothing like those in film. The other problem with digital photography is that consumers seem to print far fewer images. Why bother? You just store ’em on a disk or PC and print out the few you want when you want ’em.

Management at Kodak has long been considered–to quote one knowledgeable Wall Street source–“entrenched, inbred, and unresponsive.” (And one key outsider, COO Patricia Russo, just left to head up Lucent.) I doubt, however, that any manager could “turn around” Kodak. What’s happening doesn’t lend itself to a restructuring. To exaggerate only slightly, we are talking buggy whips here. Film for Kodak is somewhat like long distance for AT&T: a mature, still profitable business that’s very much in decline. One thing to do would be to take Kodak’s film operation and turn it into some sort of master trust that pays out cash to shareholders. But that would probably require a level of fortitude that only an outside-raider type like Carl Icahn possesses.

Sure, film will be around for years, but let’s be real: Digital cameras are totally changing how we take pictures. Here’s a story: Friend of mine told me about a woman who mostly uses a digital camera. One day she had her old SLR instead. Her daughter looked in the back of the camera after a shot and asked Mommy where the picture was. “This camera doesn’t let you see the picture,” Mom said. “Then why are we using it?” the kid asked. Get the picture?

You answer should be no more than a few sentences.  Bill Miller is an intelligent, well-read investor but he failed to think strategically (yes, easy to point fingers with hindsight bias).  But you can take the same analysis of entering the digital photography market and apply it to investing in Salesforce, Inc. (CRM) today. If you were to invest in CRM, what questions must you ask?

If you have trouble with this case, I have started a training camp to teach strategic logic. Watch a clip of a recent training day:

5 responses to “Industry Analysis & Kodak Strategic Logic Quiz

  1. Well, I’m probably going to get this all wrong … but here goes …

    I do not agree with Miller’s assessment of his mistake. The problem was simply that the company’s main product was facing technological obsolescence. The need for “cultural change” is too vague a term. His problem was that he took a contrarian stance against a consensus view that happened to be right.

    This is perhaps the nub of the real problem that a value investor must face at every buy decision. You have to try to distinguish between whether something is in a cyclic or secular decline. From your article, it appears that the market was aware of the secular decline even as far back as a decade.

    It’s interesting seeing the difference: housing is of course a very cyclic industry. Although housing construction “technology” changes, it does so slowly, and not to the detriment of the housebuilder. It seems inconceivable that housebuilding could ever experience a secular decline, because people will always need houses.

    I think a key question to ask oneself is this: does the company operate in a a rapidly-evolving industry, and/or is it a “big-ticket” item?

    For big-ticket items, I would expect economic sensitivity – so you’re probably looking at cyclic companies. So you’d be asking yourself the question “am I buying at the right time”, and “does the company have a good enough balance sheet to survive the rough patch?” If a company operates in a rapidly-evolving market, then that obviously represents a great deal of risk. It’s possible that you can’t even decide who’s going to win. it’s too hard.

    And I think this is the big problem. You can apply a lot of intelligence to questions that are “too hard”, and even genius wont get it right.

    I think there’s two very interesting contemporary examples. One is in mobile phones, and the other is GMG (Game), the UK equivalent of GME (Gamestop).

    I’ve read very enthusiastic reports about what a great company Nokia is (or more to the point, /was/). You also have other companies like RIM (Research In Motion) which makes the Blackberry. The bulls on RIM claim that blackberry have a niche market in business. The bears just say that Apple is an unstoppable machine that is eating everyone’s lunch.

    Who’s right? How do you decide such a thing? RIM is either a screaming buy, or a value trap, depending on if you can answer that question correctly. You will either make, or lose, a great deal of money. I’ve seen very intelligent debate on both sides of the fence. But who’s right, and how do you tell?

    GME is also a very very interesting case study. At the recent Value Investors Conference, Greenblatt has pronounced it a “good and cheap” company, whilst Chanos has pronounced it “a value trap that going to look cheap all the way down”. Again, I’ve heard very intelligent people argue about it being in a temporary cyclical decline whose fortunes are tied to the timing of console releases. I even know of an investor who is better than me buy into GMG on the basis that it is too cheap on standard valuation metrics.

    For my money, I consider GMG a value trap – it’s more of a Kodak than a housebuilder. Why? I don’t think the second-hand game market idea of theirs makes much sense. Not really. Supermarkets are able to cut into their sales on the short tail, and places like Amazon will kill them on the long tail (AND the short tail). Plus, new tech like Steam is a game publisher’s dream, as it should enable them to knock out a fair chunk of the middlemen.

    • Dear Mark:

      Don’t get discouraged. This isn’t about intelligence, but a WAY OF THINKING or training your mind to look at problems.

      Well, you are on the mark (target). Sorry, I can’t help myself. His analysis was too vague and not on point. Yes, technological change obliterated Kodak’s dominance (along with Fuji’s Film) in film. The key issue is whether Kodak could have a competitive advantage with barriers to entry in digital images. But see the flaw. If Kodak could enter the digital imaging market, then there probably were no barriers to entry, thus no competitive advantages. Kodak–at best–if efficiently managed, could only earn a market rate (cost of capital) on its investment into a new market. And if there already were imcumbents with lower costs of production due to their market share, then Kodak might not even earn its cost of capital.

      So if you take the concepts of what create and sustain competitive advantages then apply them to specific investments and industries you will have a starting point for your valuations/risk management. I will post on this.

      Housing is a business with no barriers to entry, so it is like a commodity cyclical business. When demand rises ahead of supply, then profits rise and vice versa. Technology can be used by any competitor and brands have limited (no) customer captivity. So you know not to pay over replacement value. If you pay below replacement value for LPX or a TOL or MDC you will lose if demand continues to be below supply (the future is unknown) but the odds are on your side that over time, management (people matter) will right-size their business to current conditions. This is what sets in motion regression to the mean in a competitive (relatively) market. Austrians say the bust is what is good while the boom is bad because the bust creates the conditions for profitability. If the future were clear then prices should remain forever within a tight band for no chance of profit. What a grey world (like CUBA, N. Korea) that would be.

      Even knowing about competitive advantage won’t stop you from investing in Nokia. I did–losing 28% of my investment as its competitive advantages declined as the market shifted rapidly. But if I lost 25% to 50% on some while making 35% to 100% on others in a diversified portfolio then I will do so. No question that NOKIA is in a different type of business in terms of risk than Clorox. I made a mistake on Nokia’s business but I knew the risk going in, but I can place more precision on my mistake (I believe)–the trick will be applying this lesson to the future.

  2. I don’t know if Mr. Miller made these mistakes but if I were in his position I would be tempted to make the following mistakes. First I may incorrectly assume Kodak’s pricing power from its share of mind in film would transfer to digital photography. Then after I bought majority ownership of the company I may very likely suffer from commitment bias and thus hold on as the stock tanked.

    If I were Kodak’s management and I would try to license Kodak’s brand to the tech firms coming out with digital photography rather than trying to compete against them. I will also focus more on the products that are more sticky (e.g. medical and dental film) and ensure the best quality and service for those products.

    In terms of CRM, I would want to know the stickiness of their product, switching costs, and their rationale for spending so many ad dollars. It seems they have been desperately trying to obtain a share of mind in their customers without much success in the past few years.

    • Dear IImarsii:

      See above comment. I will post in more detail about Kodak.

      Nice idea about licensing Kodak’s technology/brand name. Why fight a losing battle, seek to milk your name/assets for the greatest possible advantage. If only you had been the CEO of Kodak the story might have been different. The problem is that strategy would have meant a massive and sudden shrinking of KODAK–better for shareholders but difficult for management and employees. Name one CEO who likes a shrinking empire.

      If you invest in CRM without CRM having a strong competitive advantage then you are in for a world of hurt. Sales growth is meaningless without profits in e3xcess of the investments made to generate that growth. If CRM can’t keep entrants out (How?) then paying a premium to asset values will be lethal.

  3. FYI, Slashdot and its nerdy readers are discussing Kodak:

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