FOOL ON THE HILL
An Investment Opinion

Kodak: Undervalued or Understood?

By Bill Barker (TMF Max)
December 9, 1999

"Everything interconnects with everything. The beating of a butterfly's wings in China can affect the course of an Atlantic hurricane. If I could interrogate this table-leg in a way that made sense to me, or to the table-leg, then it could provide me with the answer to any question about the universe. I could ask anybody I liked, chosen entirely by chance, any random question I cared to think of, and their answer, or lack of it, would in some way bear upon the problem to which I am seeking a solution."
-- Douglas Adams, The Long Dark Tea Time of the Soul

The problem, of course, is that these days you so rarely find a table-leg that understands conversational English, or, when it does, it's generally incapable of replying in kind. So it looks like I'll have to find somebody or something else to help me with one of the many interesting little mysteries that exists in the investment universe today, namely how to assess the announcement by Kodak today that its stock price is undervalued and plans to repurchase nearly a billion dollars of its shares.

I'm going to confuse the matter somewhat by placing a couple selected Kodak numbers next to some numbers from Akamai Technologies, solely on the basis that the two companies today are "interconnected" by very similar market capitalizations.

                        Akamai Technologies      Eastman Kodak
'99 Sales (through Sept.)      $1.3 million     $10.29 billion
EPS '98                             ($0.05)              $4.24
EPS '99E                            ($0.94)              $5.01
EPS '00E                            ($1.10)              $5.64
EPS '01E                            ($1.05)              $6.00
Sales since 1991 (in billions)       .0013              142.23
Market Capitalization (in billions)   21.2                19.3

As background, and to make a long story extremely short, Akamai Technologies is involved in making the Internet experience faster. (For a more in depth take on what it does, its competitive advantage in algorithms and a general discussion by somebody who, unlike myself, understands something about this company, you might check out a recent Post of the Day from local Chief Techie Geek Dwight Gibbs.) Speeding up the Internet is a pretty necessary little service at the moment -- however this company is far from the only one working toward that end.

You're probably already familiar with Eastman Kodak<% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE:EK)") else Response.Write("(NYSE:EK)") end if %>; it's the world leader in film sales, and also produces and sells other things including cameras and digital imaging products. It is, by some measures, one of the top-rated names in the world, clocking in at #16 on a list of global brands according to one recent ranking. Its products are used and paid for by many millions of people every single day. There are currently more than 150 million cameras in operation in this country alone that use Kodak film. Over the last 12 months the company has had over $1 billion in net income, and that number is currently expected by analysts to grow significantly next year.

The cognitive dissonance created by the comparative valuations of companies such as these two tends to resolve itself along predictable lines -- i.e., the market doesn't understand how to value companies anymore. I could grab any one of a number of commentaries that would conclude that the current market valuations are "absurd" for "new era" companies such as Akamai, and/or that Kodak must be severely undervalued. After all -- "Look at those numbers!" I would rank such analyses as just slightly less helpful than the silence (or noise) of table-legs. Maybe significantly less helpful -- after all, there is almost always method to the market's madness. It is far more likely that the market does understand how to value a company than that it does not.

So, where to turn? In extreme cases such as the Kodak vs. Akamai valuation conundrum, I'm not afraid to admit to the need for a little guidance. After all, I'm going to be a father in a couple of weeks, and my mind -- never a repository for deep thought in the first place -- is even more distracted than usual. Hmmm... assuming the fundamental interconnectedness of all things, shouldn't I be able to ask any randomly selected person to help me with this? And since that's where my mind is at the moment, couldn't I question my daughter-to-be?

In a couple of weeks, when she's actually available for the discussion, what I'll want to know from her is, "Do you think you'll ever buy a single roll of film in your life?" I predict that she'll look at her father, give this question the consideration it deserves, perhaps drool on herself a little and then, hopefully, go to sleep, rather than bursting into tears and cries for her mother, who, I suspect, will not be pleased at my tormenting her child with questions like that.

It looks like I'm going to have to answer my own question here. I'm sure that by the time my not-yet daughter finishes elementary school, film sales essentially will be a thing of the past, at least in this country. The transition to digital cameras is well underway, and it appears inevitable that digicams will erase silver halide film sales the way compact disks ended the sale of records. In brief, the end of the competitive advantage period for Kodak to sell its major product is already visible, and given the fact that Kodak is heavily invested in a dying technology, I'm not sure why anyone would arrive at the conclusion that the shares are undervalued.

It isn't as if the market is having any trouble pricing in the danger to Kodak's business in the very near future. The company's P/E ratio of 12x(!) this year's earnings is telling us a lot -- and the market was not deeply moved by Kodak's announcement today that the company felt the shares are undervalued. Those who would argue that you should look at the numbers of Kodak's business this year and slap a little "growth rate" on top of that and compare the stock price to the market's average P/E multiple are going to find the market turns a deaf ear to analysis like that. Indeed, if you read something like Thoughts on Valuation by Michael J. Mauboussin, you'll see that the market has never valued companies along those lines -- much Wall Street commentary to the contrary.

Compare this situation to the position that Akamai finds itself in, and the relative valuations of the companies begins to come into focus a little better. I'm not here to try to justify Akamai's market cap by the way -- it in fact may be the case that the market really doesn't understand that company. (I don't.) But a terminal point to Akamai's competitive advantage period simply isn't as visible as it is for Kodak's film division. Five years from now Akamai may or may not be integrally involved in delivering content over the Internet at high speeds and may or may not be making significant profits in the process -- but at least somebody is going to be doing that, and the market for that service is still going to be growing. The market understands at least that much.

Perhaps all that is needed is to imagine again what that drooling infant would tell me if I could ask her about the speed of the Internet by the time she is capable of using it. "Dad -- you have no idea what you're in for," I think would be her response. Of course whether that answer would be directed toward my question, or referring to this whole impending parenthood thing generally, I'm really not too sure.

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