We closed this position on January 19, 2012. A copy of the associated Position Update report is here.
Eastman Kodak Company (EK) is not exactly a high-flying stock over the last few years. The average sell-side rating is ‘hold’, which is not surprising given the stock is down about 40% in the last 12 months while the S&P is up around 10% over the same time. As society has embraced the digital age, EK’s business model has fallen out of favor. None of this information should be new to anyone who follows EK.
What I bet very few people, outside the company itself, know is that EK’s pension liabilities could torpedo the company into bankruptcy and send the stock to significantly lower levels. In the Footnotes of the company’s recently-published 10-K, we found that EK’s pension obligations are underfunded by $2.6 billion, about 3 times the company’s market value. That’s right, the company is on the hook for $2.6 billion in obligations to its employees that, right now, it has no way to pay. Notably, this situation reminds me of analysis we did on General Motors (GM) for the Forbes’s article “Paychecks on Steroids” in spring 2005. We pointed out to Forbes that GM’s underfunded pension liabilities, about $70 billion, were nearly 5 times the company’s market value, about $15 billion, at that time. Click here to see the details on the “funded status” of GM’s pension obligations for the 2004 fiscal year. Mysteriously, Forbes chose not to include our analysis of those facts on GM in the article, but we all know what happened to GM a few years later: a declining business saddled with pension obligations it could not pay was forced into bankruptcy. I do not have a crystal ball, but EK’s current situation looks fairly similar to GM’s before it went bankrupt.
One could argue that EK’s under-funded pension liability is not an urgent issue because the company has lots of time to pay off that liability. That argument simply does not hold water as the under-funded amount, $2.6 billion, represents the present value of all future obligations less the value of the assets EK’s dedicates to the pension obligations. And EK is already stretching the limits on how it values its pension assets by assuming the long-term return on plan assets will be 8.73% for the life of the plan. That assumption is among the very highest of all 3000+ companies we cover. It also represents a sizable increase (over 20 basis points) from the prior year. Click here to see the page in EK’s 10-K that shows the pension plan assumptions. In fact, the company’s assumed return on plan assets is so high that it allowed EK to book income from its pension plan equal to 2.2% of its revenue last year. Booking any income from a pension plan that is $2.6 billion under water seems a bit fishy.
For argument’s sake, let’s take a look at what kind of future profit growth is required for EK to meet its pension (and debt) obligations and justify the current stock price of $3.27 as of close on 3/21/11. The answer is: profits have to grow 10% compounded annually for at least 11 years to justify the current price. The company must grow profits at about 10.5% compounded annually for at least 5 years before shareholders will ever see a dime because that is what is required to satisfy pension and debt obligations alone. These growth expectations do not compare well to historical results, which show the average revenue growth rate over the past 5 years is -14%.
A declining business with mounting pension liabilities, EK is a stock with a lot more downside risk than upside potential. Looking beyond the reported accounting results reveals that EK is not quite as profitable a company as it seems, and its valuation has out-grown its profits by a wide margin.
In a business where investors make money by buying stocks with low expectations relative to their future potential, EK fits the profile of a great stock to short or sell.
For samples of more Red Flags like what we revealed for EK, click here.
Note: Stock pick of the week is updated every Tuesday.