Eastman Kodak enters the picture

Like Sony Corporation and a few other erstwhile heavyweights, Eastman Kodak has been a company in transition for several years. Thanks largely to the arrival of new digital-content technologies, Kodak has seen a relatively high-margin business, one that used to account for nearly a fifth of the company’s revenues as late as four years ago, disappear virtually overnight. The market for consumer film has deteriorated, to be sure, but unlike its former archrival Polaroid, Kodak has at least shown a modicum of forward-thinking in adapting to the new dispensation, and after a painful restructuring, the first quarter of 2007 probably marks the most important in the company’s history.

In January, Kodak made a key strategic decision in dumping its medical imaging business, selling it to Canadian conglomerate Onex Corporation for around $2.55 billion. In exiting medical imaging—a business it had been engaged in since the 19th century and helped to pioneer—Kodak will use the proceeds to pay down its secured term debt and help finance its new strategic direction.

According to the company’s 2006 Annual Report, medical imaging represented 18.6% of the company’s sales in 2005, a 1% decline over 2004 numbers. The division’s profits suffered as well in 2005, losing 10% over 2004’s numbers. Profit margins were down from 42% to 39%. Based on the numbers of the last few years, which manifest declining margins and declining R&D by the company, the decision to ditch medical imaging appears to be one that needed to be made sooner rather than later. The division is still strong, and while its overall profitability seems to be declining, it is still throwing off a good deal of cash—over a solid billion dollars a year. But each year that Kodak held on to it, the division’s value in the marketplace would decline absent a reversal of fortune on the pricing front, which does not look likely.

If there are solid reasons for getting out of medical imaging for Kodak, the more pressing question might then be how to proceed in the future. This week, Kodak answered the question somewhat, announcing its decision to enter the printer market currently dominated by Hewlett Packard. The market for printers (and replacement ink cartridges) is around $45 billion a year, so obviously, even a marginal market presence could see significant revenues; however, Kodak’s attempt to replace the high margins of consumer film with those of ink cartridges could hit some bumps in the road.

For one, profit margins on the printers themselves are tight and getting tighter (however, margins for ink-cartridge replacements are quite high). In fact, many models of printer are basically used by their manufacturers as loss-leaders, with the idea being that it is more profitable to soak consumers down the road by way of expensively priced printer cartridges. Obviously, the snazzier, up-market printers probably do turn a profit, but by and large, the current strategy adopted most broadly by printer manufacturers revolves around the lucrative cartridge segment of the marketplace, and because each brand of printer uses its own proprietary cartridge technology, consumers are forced into long-term relationships with the printer manufacturer. This explains in large part why printer-makers were so aggressive in the past few years in their litigation strategies against so-called copy-cat cartridges. There are companies that specialize in refilling ink cartridges—and they account for about 30% of the industry, according to the Wall Street Journal—but the market for copy-cat cartridges has pretty much been nixed by patent lawyers. At any rate, it’s easy to see how, minus the exclusivity of intellectual property, the whole business model potentially tilts into loss.

In rolling out its new printers, Kodak’s marketing strategy is centered upon (a) its outstanding brand-name recognition and (b) its decision to undercut the market leaders concerning the price of replacement cartridges. It’s a nifty way to build market share quickly, that is, if the marketing strategy works, but over the long term, could spark a price war. Kodak’s strategy will put enormous pricing pressure on all manufacturers, something the Wall Street Journal noted today, quoting one industry analyst who ominously said that “this will be the year the razor-and-blade model breaks.”

It will be extremely interesting to see how Kodak’s strategy pans out long term. There are a lot of things that could go wrong. For instance, the strategy to price the printer at or above comparable models—despite less functionality—could backfire. Just anecdotally, I remember my recent purchase of a printer; had the salesman not pointed out to me the cost of replacement cartridges, I would have ended up buying a more cheaply priced model with higher costs for cartridges down the road. Point being that many consumers don’t even think of the ink-cartridge problem until the ink runs out. So at the heart of Kodak’s long-term success must be a marketing- and PR-driven push to raise consumer consciousness of ink-cartridge cost at the time of printer purchase.

Another possible problem area is the R&D needed to sustain market share. In responding to Kodak’s announcement, Hewlett Packard reminded folks that it spends over $1 billion a year in R&D on its ink-jet printers. That’s an enormous amount of money for a mature and relatively static technology. By comparison, Kodak spent around $170 million in 2005 for research and development for its now-divested medical imaging business. Having said that, Kodak will introduce some innovations with its ink-jet printers, but most of the innovation was aimed at reducing unit costs (thus enabling the lower-cost model). The company’s entry into printer-making does not reduce the huge advantage H-P currently enjoys, and if profits don’t materialize quickly enough, finding funds for ongoing R&D might be difficult.

In this vein, one might ask how quickly can Kodak expect to take market share. Philip J. Faraci, head of Kodak’s digital imaging consumer group, has said that 1% share in 2007 would be ‘wildly successful,’ and he’s probably right. Dell, which started making printers a few years back, took market share at a pretty swift clip for a while (largely on the back of its unique direct-to-consumer PC sales model) and now has about 6%, showing that gaining market share can be done, but Dell’s experience also shows that newcomers can hit the wall pretty quickly. After a hot start, Dell’s printers have cooled off a bit.

At any rate, it will be an interesting 12 to 18 months for ink-jet printers, and perhaps more importantly, for Eastman Kodak.