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Stock Strategist

Kodak's Digital Road to Nowhere

The firm's risky growth plans will destroy capital and hurt investors.

 Eastman Kodak's  announcement last week that it would divert cash from its dividend to digital-related investments and acquisitions is a case study in dumb management decisions. Granted, the firm is in a tough spot, but Kodak would be far better off milking its traditional film-based businesses for cash and returning most of that cash to shareholders than throwing away billions on a digital strategy that has very low odds of success.

Kodak still has a defensible position in the medical, entertainment, and government imaging markets where switching costs for end users are relatively high, and margins are still decent. Moreover, the traditional film business is still growing outside the U.S., Europe, and Japan, and is still very profitable even in the developed economies where consumers are switching to digital. The key word here is profitable: Even if film-based markets are slowly declining in much of the world, Kodak still makes money from them.

But instead of choosing to slowly transition to a smaller but still solidly profitable firm, the gang at Kodak has decided to focus on growth for growth's sake. Just look at the language from the company's press release and investor presentation last week. Early in the presentation was a slide with these two bullet points: "We have a balanced strategy for growth" and "We will finance the strategy for growth." On the next slide appeared a row of smiling portraits of Kodak's senior managers, with the caption, "Digital, output, and growth experts now head all business areas." The chief financial officer was quoted in the press release as saying, "Becoming a growth company demands that we invest money to harness the opportunities provided by digital markets."

Most frightening of all was this bon mot from a Kodak spokesperson, as reported in The New York Times: "We are going to be a bigger, bolder, more diversified Kodak, going for bigger hits, and bigger wins."

Why does Kodak want to become a growth company? Why the focus on being bigger and bolder? Bigger companies aren't necessarily better ones, nor more valuable ones. (They do tend to pay their executives more, but we'll ignore that perverse incentive for the moment.) In the words of Warren Buffett, "Growth benefits investors only when the business in point can invest at incremental returns that are enticing--in other words, only when each dollar used to finance the growth creates more than one dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts investors."

I would submit that in Kodak's case, the planned avenues for growth will, in fact, hurt investors and will destroy economic value. The firm plans to push heavily into low-margin markets with extremely fast product cycles in which even the established participants have had trouble making consistent profits. One of these areas, digital cameras, has not exactly been a cash cow for the likes of Olympus , Canon (CAJ), and Nikon (NINOY), and it's unlikely that it ever will be an attractive market. Consumer electronics has been a cutthroat, take-no-prisoners business for years. Why would industry dynamics suddenly shift to be more attractive with the arrival of a new entrant?

Another market into which Kodak plans to expand is inkjet printers, which to me is the height of folly. At least in digital cameras, Kodak can argue--unsuccessfully, but logically--that it might have some degree of brand advantage. But the inkjet market is already dominated by companies like  Hewlett-Packard (HPQ), Epson, and Canon, all of which make the vast majority of their money from replacement ink cartridges rather than from the printers themselves. And since the only way to make money from ink is to already have a big installed base of printers…well, Kodak's going to have an uphill battle trying to make any money off this part of the business.

Just as worrisome is Kodak's assertion that half of its forecasted growth will come from buying new businesses or technologies. The outlook for this strategy is poor. As a general rule, acquisitions destroy wealth and go awry more often than not. And given that Kodak is a "willing buyer" (i.e. the firm's plan to aggressively push into digital areas is no secret), I'd say the odds that the firm will overpay for some of these planned acquisitions is quite high.

At the end of the day, companies create economic value by allocating capital to projects with returns that are higher than the firm's cost of capital. Growth is not necessarily part of the equation, and if a company has limited internal reinvestment opportunities, it should manage its decline gracefully by returning cash to shareholders through dividends or share buybacks. Frittering away that cash on high-risk, low-return projects is simply a bad idea. It is bold, though, and boldness usually trumps prudence in the executive suite.

Pat Dorsey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.