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The Deal Pipeline
January 17, 2012

Kodak's moves leave much to decipher
By Paula Schaap

When is inventory not inventory? When it's being moved around to make things look better for company profits or for a potential asset bidder.

That could be what's happening at Rochester, N.Y.-based Eastman Kodak Co., where people familiar with the company say that its once-storied film division is moving its motion picture stock around possibly to make the struggling company's finances look, if not greatly improved, then somewhat less dire than they actually are.

The moves add a level of intrigue to an otherwise pedestrian story of a company struggling to stay afloat. Although Kodak regularly insists that it isn't going to file for bankruptcy, the signs have been unmistakable.

It hired Jones Day for restructuring advice in September, then moved the firm aside in favor of Sullivan & Cromwell LLP last month. Because Jones Day defends Kodak in patent litigation and the patent portfolio is likely to be the crown jewel in a bankruptcy estate estimates of the portfolio value range from $1 billion to $2 billion the Sullivan hire is another indication that bankruptcy may be imminent.

Media outlets have reported that Kodak was in talks to arrange about $1 billion in debtor-in-possession financing with Citigroup Inc. Although a spokesman for Citi refused to comment, the bank is the lead arranger on Kodak's $2.7 billion secured credit facility which matures in October 2012.

A spokesman for Kodak said the company would not comment on rumors or market speculation.

Kodak on Jan. 10 also announced a restructuring into two divisions from three one division to handle consumer products and the other commercial products and services. The consumer division is led by corporate counsel Laura Quatela, who was recently elevated to the president's role. Presumably, her legal expertise may be useful when the company tries to sell off its remaining consumer services, which will be likely to generate little more than walking-around money.

Or, in the alternative, as the company files for bankruptcy.

Kodak CEO Antonio Perez had bet the farm on the company's printer and ink consumer business, despite the presence of entrenched competitors, as well as a high-end commercial printer business that has already run into higher-than-expected startup costs. Of course, high-end printing, like film photography, is a less-than-robust industry.

Then there are the approximately 1,100 patents that, while certainly valuable, are still held by a company that could go bankrupt any day and subject buyers to fraudulent transfer claims.

The company hasn't been standing pat on asset sales. Toward the end of last year it sold its gelatin products-making division to Vion Food Group's Rousselot and its Image Sensor Solutions business to Platinum Equity LLC. The company refused to disclose details for both deals.

Although the motion picture business remained with those units that Kodak is focusing on, as it becomes the "digital company" of Perez's dreams, a sale could still be in the cards.

For one thing, the motion picture business has proved remarkably steady as Kodak's overall losses mounted. While the company's quarterly losses have registered in the triple millions for all of 2011, the film business has come in at a net positive for two out of the three reported quarters in 2011.

Additionally, the film division's net sales haven't varied from about one-quarter of the overall net sales for the company, while overall earnings slid, then fell off a cliff in 2011. The company's net loss from continuing operations quintupled in the third quarter of last year: $222 million in Q3 2011 as compared to a loss of $43 million the same time the year before, according to Kodak's financial statements.

If Perez & Co. can't get top dollar for the film division, then it not only means a waste of some very good technology, but also a black eye for the CEO's legacy. Film, after all, made the company what it once was.

So when about five tractor-trailers filled with film products are moved to storage facilities that Kodak doesn't own, and then moved back into Kodak facilities, and not because the company doesn't have room for them, according to sources, then questions naturally arise.

While moving inventory off-site could have legitimate business explanations, sources said that the practice started only in the past year and a half, at the same time that Kodak's earnings started to slide along with its share price. Kodak shares have lost almost 90% of their value since the middle of 2010; they are now trading at penny stock values and the company has been threatened with delisting.

People familiar with the company also said that the film moves happened within a week or two of the close of each fiscal quarter during at least the first three earnings quarters last year.

Terry Collister, operations vice president at Allied Frozen Storage Inc., which is in nearby Brockport, N.Y., confirmed that Kodak stored product in the company's facility, although he refused to comment further on Allied's business dealings with the company.

A Kodak spokesman said that reports of motion picture film inventory being moved from one storage facility to another was not the company's normal way of doing business. "Typically, we ship film directly to customers and not much is inventoried because it's sold in such large quantities," he said. "There is usually no middle man."

The Kodak scenario is not unlike the one sketched out by hedge fund manager David Einhorn about Green Mountain Coffee Roasters Inc., which Einhorn is shorting, partly because he said the company is boosting its numbers by needlessly rotating inventory among its distributors.

In the case of Green Mountain, the question wasn't whether the company was a going concern, the question was whether it deserved its premium stock price that shot up almost 3-1/2 times over the past year to its 52-week high of $115.98 per share, before settling down recently to the mid-$40s.

But for Kodak, where Perez tried to assure nervous investors that the company had enough money to last at least another year, this could have been one of many last-ditch tricks up his sleeve to keep the iconic manufacturer staggering on toward the promised patent sales.

Forensic accountant Michael Kessler said that, although he doesn't know the specifics in this case, reports like the one coming out of the Kodak situation would raise an immediate red flag.

"If we heard that, we'd be all over it," Kessler said, "in order to find out if there's something that's not kosher."

Kessler also characterized as unusual a note in Kodak's 2011 regulatory filings that it had extended the depreciation time frame for the film division's specialized equipment.

"When you're expensing less for depreciation," Kessler said, "it can be to try to make an unprofitable operation look more profitable, or at least less unprofitable."

A source confirmed that Walt Disney Co. was one of the companies that considered buying the film division. But there are other potential buyers that might not be immediately apparent to those not versed in the underlying technology.

Kodak owns the patent for Estar, a film base product that is also used to make the thin film for the touch screen technology that makes smartphones and iPads the big consumer sellers that they are.

Whether the Estar technology would walk with a sale of the film division, or whether it's part of the 1,110 patent portfolio isn't clear.

The company has done little to clarify what exactly is in that portfolio, or as Perez said in an earnings conference call in response to an analyst's question: "This is a very vast I mean, the patents are public. You can go read them. There are only 1,100, so good luck." But the value of those patents, as well as the film division and other assets owned by what was once one of America's great innovators, may no longer be up to management; it might be up to a bankruptcy court judge.

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