lessons from the Eastman Kodak bankruptcy

A bankruptcy is never fun.  But studying what happens as a company approaches a financial crisis is an important and useful exercise in securities analysis.  Eastman Kodak’s Chapter 11 filing illustrates many general characteristics, as well as one or two novel twists.  Here’s what I see:

a close-in look

–bankruptcy fears feed on themselves.  One day a senior analyst at my first job told me about a research report he wrote on a small magazine publishing company.  He pointed out gently deteriorating subscriber trends and opined that–unless they were reversed within a year or eighteen months–the company could be out of business.  He called the publisher two months later and found out the company was closing its doors for good.  Why?  The CEO told my colleague that advertisers had read his report, concluded it made no sense doing business with a dying firm and stopped placing ads.  Cash flows dried up, the company began to bleed red ink and was forced to cease publication.

Maybe my former colleague’s report was that influential, maybe not.  But something did happen to accelerate the magazine company’s decline–a loss of market confidence.

On paper, a firm might appear to have plenty of time to fix current financial problems, but the situation can change dramatically and very quickly if business partners decide to defend themselves against a possible Chapter 11 filing.

What can happen?

working capital issues 

End users will likely worry that bankruptcy will mean the end to a product line, or at least a cessation of operating supplies, repair parts and service.  Warranties, too.  So they’ll hesitate to buy.  Anticipating a falloff in demand, wholesalers and retailers may no longer want to carry the products.  And they certainly won’t be in any rush to pay the manufacturers for units they have in stock–no matter what terms they’ve agreed to.

Suppliers, knowing that trade creditors have little clout in bankruptcy proceedings, may ask for payment in advance before they’ll ship raw materials.

In theory, these supplier and customer actions should show up on the balance sheet in expanding receivables and shrinking payables, or maybe a buildup in finished goods inventory.  In practice, however, my experience is that they’re almost impossible to detect.

drawing down a bank credit line.  Contrary to what people commonly believe, a bank’s commitment to offer long-term finance can be very fragile thing.  For money already borrowed, restrictive clauses (covenants) in the loan agreements can easily mandate that if the borrower’s financial condition falls below specified levels, bad stuff will happen–say, the entire principal becomes due immediately, or the borrower has to devote all of its cash flow to repayment.

The same thing applies to unborrowed money, except that the line can be reduced or cancelled outright if the bank sees deterioration in the financials a company periodically submits as a condition of keeping the credit line open.  When Kodak suddenly borrowed its entire $160 million credit line (see my post), it signaled to Wall Street that it was worried about this possibility.

–fraudulent conveyance.  This is a new one for me.  Kodak had been supporting its turnaround efforts in recent years despite by selling patents.  According to newspaper reports, lawyers for potential buyers warned of a legal risk were Kodak to enter Chapter 11 soon after a purchase.  In that event, lawyers for the creditors could sue to reclaim the patents, arguing the sales price was too low (the fraudulent conveyance).  If this tactic were successful, the pre-bankruptcy buyer would have to give up the patents.   But it wouldn’t get its money back.  It would become an unsecured creditor of Kodak–at the end of the line of those hoping to be paid by the bankruptcy court.  If bankruptcy is imminent, why take the risk?

–foot-dragging in litigation.  Kodak has also been suing tech companies for violating its intellectual property rights.  After its Chapter 11 filing, Kodak complained that the other parties had been dragging out settlement talks, ostensibly in hopes of getting better terms from the bankruptcy court.   Maybe so, but what’s so surprising about that?

–resigning directors.  Shortly before Kodak’s bankruptcy filing, three independent (that is, not company employees) directors resigned.  This isn’t an everyday occurrence.  It’s almost never a good sign.  In this case, it signaled to me that Kodak had made a very important decision that these directors not only disagreed with but wanted to forcefully distance themselves from.

stepping back a bit

From the Kodak case, I think an analyst can develop a useful checklist of possible bankruptcy symptoms.  I have one further, Kodak-specific comment though:

why printers?

I’ve followed printer companies in the US and Asia off and on for the better part of twenty years.  My take is that printers, both corporate and personal, are a very mature, brutally competitive, commodity business, whose heyday was three decades ago.  Corporate customers play one supplier off against another to get discount services.  Retail customers buy machines for well below the cost of making them, while the printer companies hope to eventually earn a profit through ink sales (I understand this may not exactly be the Kodak model, but that in itself is another potential worry).

In my view, this is an industry to get out of, not get into.  My questions about Kodak’s strategic direction would make me less willing to back the company, not more–and I suspect I’m not alone in this view.  That alone would make business partners quicker to adopt defensive measures than they ordinarily would.

why Kodak using its bank credit line is spooking investors

Eastman Kodak

Decades ago, when cameras used physical film, Eastman Kodak (EK) was among the bluest of blue chips.  The company has been unable to adjust to the end of that era, however.  Although still listed on the New York Stock Exchange, EK was trading at a stock price below $3 a share in mid-September, giving the company a market capitalization of below $750 million.

the 8-K

On Friday September 23rd, EK filed an 8-K with the Securities and Exchange Commission, in which it revealed it had borrowed $160 million from its banks under a credit agreement negotiated earlier in the year (summary on p. 12 of the 2Q11 10-Q).

Since the 8-K, EK shares have dropped from $2.38 each to $.78–a loss of 67% of the company’s value.

Why this reaction?

details of the situation

The corporate balance sheet from the June 10-Q shows EK to have $957 million in cash.  Working capital is $842 million.  On the surface, then, there seems to be no pressing need to use the credit line.

The credit line has a maximum borrowing amount, subject to the availability of adequate collateral (like receivables, inventory, etc.–as defined in the credit agreement), of $400 million.  According to the June 10-Q, $235 million of that was available to EK then.

Therefore, EK borrowed most, if not all (maybe the amount of EK’s specified collateral has shrunk since the end of June) of the credit line, suddenly and without further clarification–and at a time when it didn’t appear to need the money.

what Wall Street fears

Bank credit lines aren’t set in stone, even after an agreement is signed.  In this case, I see two possibilities that would diminish or eliminate EK’s ability to borrow from the credit line it just used.

1.  The line is asset-based, meaning the amount lent depends on EK’s ability to furnish acceptable collateral, like receivables.  If that shrinks, so too does the available credit.

2.  Also, the banks’ credit committee can meet at any time and decide to withdraw part or all of the line right away, if it determines that EK’s financial condition has deteriorated.

Wall Street is reading the suddenness of EK’s borrowing action and the large amount as signs that EK borrowed the maximum amount it could because it feared one of the two might happen.

last Friday

Last Friday, the New York Times reported that EK has hired a law firm that specializes in corporate restructurings, including bankruptcies.  After the market close that day, EK issued a press release stating it has “no intention” of filing for bankruptcy.  That caused EK shares to rebound to $1 each in aftermarket trading.

what’s next

EK’s fate may not be entirely in its hands, however.  The credit line EK has just borrowed under (and probably all its debt, for that matter) has a set of stipulations, called covenants, that specify financial tests EK must continue to meet, as well as things the company may/may not do, in order to keep the loan in good standing.  Since this credit line is EK’s most recent borrowing, it presumably has the most restrictive covenants.

(To be clear:  I have no position in EK and I have no intention of buying or selling it.  I just think the current situation is worth writing about.  As a result, I’ve only read the summary of the credit line terms that is contained in the company’s latest 10-Q–not the full document, which is also available on the Edgar website.  I haven’t gone through the company’s other borrowings or done a credit analysis, either.)

Anyway, if EK violates these covenants in a serious enough way, the company’s banks can declare it in default of the loan agreement.  They can then demand immediate repayment of the entire outstanding amount. The banks aren’t compelled to declare a default in this situation, but they are able to.

If they do, however, EK’s response may be to seek court protection under Chapter 11 bankruptcy.

Only time will tell.