The Company’s estimated annual effective tax rate from continuing operations increased from 17.0% for the nine months ended September 30, 2004 to 34.0% for the nine months ended September 30, 2005. This increase is primarily attributable to the write-down of the net deferred tax assets in the U.S. resulting from the Company’s assessment of the realizability of the net deferred tax assets for the period ended September 30, 2005.
As of September 30, 2005 the Company had approximately $900 million of net deferred tax assets in the U.S., prior to the valuation allowance recorded during the quarter ended September 30, 2005. Refer to the discussion of the establishment of the valuation allowance presented above under “Income Tax Provision (Benefit)” for the Third Quarter Results of Operations of Management’s Discussion and Analysis of Financial Condition and Results of Operations.
During the nine months ended September 30, 2005, the Company recorded a tax provision of $734 million representing an income tax rate from losses on continuing operations of 125%. The income tax rate of 125% for the nine months ended September 30, 2005 differs from the estimated annual effective tax rate of 34% due to net discrete period tax provisions of $637 million. The net discrete period tax provisions resulted from the following discrete period charges and credits: tax benefits of $80 million associated with restructuring costs of $843 million; tax benefits of $14 million associated with the charges for in-process research and development of $52 million; tax charges of $2 million associated with gains of $41 million on property sales related to restructuring; tax charges of $6 million due to a change in estimate with respect to a tax benefit recorded in connection with a land donation in a prior period; no tax associated with the Lucky Film invest ment impairment charge of $19 million as a result of the Company’s tax holiday in China; tax charges of $5 million associated with changes in state laws in New York and Ohio; a tax charge of $9 million related to the recording of a valuation allowance against deferred tax assets in Brazil; a $677 million tax charge for a valuation allowance against the U.S. net deferred tax asset balance as of December 31, 2004 (included as part of the $900 million valuation allowance discussed above); a tax charge of $26 million associated with the planned remittance of earnings from subsidiary companies outside of the U.S. in connection with the American Jobs Creation Act of 2004; and a tax charge of $6 million for other tax adjustments.
The loss from continuing operations for the nine months ended September 30, 2005 was $1,321 million, or $4.59 per basic and diluted share, as compared with earnings from continuing operations for the nine months ended September 30, 2004 of $139 million, or $.49 per basic and diluted share, representing a decrease of $1,460 million. This decrease in earnings from continuing operations is attributable to the reasons described above.
PAGE 51
DIGITAL & FILM IMAGING SYSTEMS
Worldwide Revenues
Net worldwide sales for the D&FIS segment were $5,947 million for the nine months ended September 30, 2005 as compared with $6,775 million for the nine months ended September 30, 2004, representing a decrease of $828 million, or 12%. The decrease in net sales was primarily attributable to volume declines in the film capture SPG and the wholesale and retail photofinishing portions of the consumer output SPG, which decreased sales by approximately 9.1 percentage points, and declines related to negative price/mix, driven primarily by the digital capture SPG and the traditional film capture SPG, which reduced net sales by approximately 5.0 percentage points. These decreases were partially offset by favorable exchange, which increased net sales by approximately 1.5 percentage points.
D&FIS segment net sales in the U.S. were $2,436 million for the current year period as compared with $2,695 million for the prior year period, representing a decrease of $259 million, or 10%. D&FIS segment net sales outside the U.S. were $3,511 million for the current year period as compared with $4,080 million for the prior year period, representing a decrease of $569 million, or 14%, which includes a favorable impact from exchange of 2%.
Digital Strategic Product Groups’ Revenues
D&FIS segment digital product sales were $2,035 million for the nine months ended September 30, 2005 as compared with $1,635 million for the nine months ended September 30, 2004, representing an increase of $400 million, or 24%, primarily driven by the consumer digital capture SPG, the kiosks/media portion of the consumer output SPG, and the home printing SPG. Net worldwide sales of consumer digital capture products, which include consumer digital cameras, accessories, memory products, and royalties, increased 23% in the nine months ended September 30, 2005 as compared with the prior year period, primarily reflecting strong volume increases and favorable exchange, partially offset by negative price/mix.
Net worldwide sales of picture maker kiosks/media increased 43% in the nine months ended September 30, 2005 as compared with the nine months ended September 30, 2004, as a result of strong volume increases and favorable exchange. Sales continue to be driven by strong market acceptance of Kodak’s new generation of kiosks and an increase in consumer demand for digital printing at retail.
Net worldwide sales of the home printing solutions SPG, which includes inkjet photo paper and printer docks/media, increased 50% in the nine months ended September 30, 2005 as compared with the nine months ended September 30, 2004 driven by sales of printer docks and associated thermal media. Kodak’s printer dock product continues to maintain leading United Kingdom and Australia market share positions through August. For the nine months ended September 30, 2005, inkjet paper sales declined year over year, as volume growth was more than offset by lower pricing. Industry growth for inkjet paper continues to slow as a result of improving retail printing solutions, and alternative home printing solutions.
Traditional Strategic Product Groups’ Revenues
Segment traditional product sales were $3,912 million for the current year period as compared with $5,140 million for the prior year period, representing a decrease of $1,228 million or 24%, primarily driven by declines in the film capture SPG and the consumer output SPG. Net worldwide sales of the film capture SPG, including consumer roll film (35mm and APS film), one-time-use cameras (OTUC), professional films, reloadable traditional film cameras and batteries/videotape, decreased 30% in the nine months ended September 30, 2005 as compared with the nine months ended September 30, 2004, primarily reflecting volume declines and negative price/mix, partially offset by favorable exchange.
PAGE 52
U.S. consumer film industry sell-through volumes decreased approximately 24% in the nine months ended September 30, 2005 as compared with the prior year period. Kodak’s sell-in consumer film volumes declined approximately 34% in the current year period as compared with the prior year period, reflecting a continuing reduction in U.S. retailer inventories as well as a decline in market share. Kodak continues to project full year 2005 consumer film industry volumes to decline as much as 30% in the U.S., and its worldwide industry volume to decline to a range of 23% to 27%.
Net worldwide sales for the retail photofinishing SPG, which includes color negative paper, minilab equipment and services, chemistry, and photofinishing services at retail, decreased 24% in the nine months ended September 30, 2005 as compared with the nine months ended September 30, 2004, primarily reflecting volume declines and negative price/mix partially offset by favorable exchange. Kodak has changed its participation model for minilab equipment in the U.S. eliminating direct sales involvement in favor of a referral model.
Net worldwide sales for the wholesale photofinishing SPG, which includes color negative paper, equipment, chemistry, and photofinishing services at Qualex in the U.S. and CIS (Consumer Imaging Services) outside the U.S., decreased 45% in the nine months ended September 30, 2005 as compared with the nine months ended September 30, 2004, reflecting continuing volume declines partially offset by favorable exchange.
Net worldwide sales for the entertainment film SPGs, including origination and print films for the entertainment industry increased 2%, primarily reflecting volume increases, favorable exchange, and overall positive price/mix.
Gross Profit
Gross profit for the D&FIS segment was $1,670 million for the nine months ended September 30, 2005 as compared with $1,996 million for the prior year period, representing a decrease of $326 million or 16%. The gross profit margin was 28.1% in the current year period as compared with 29.5% in the prior year period. The 1.4 percentage point decrease was primarily attributable to negative price/mix, primarily driven by the film capture SPG and the digital capture SPG, which reduced gross profit margins by approximately 3.5 percentage points. Declines in price/mix were partially offset by positive results from initiatives to reduce manufacturing costs, which improved gross profit margins by approximately 1.5 percentage points, and foreign exchange, which favorably impacted gross profit margins by approximately 0.7 percentage points.
Selling, General and Administrative Expenses
SG&A expenses for the D&FIS segment decreased $73 million, or 6%, from $1,226 million in the nine months ended September 30, 2004 to $1,153 million in the current year period, and increased as a percentage of sales from 18% for the nine months ended September 30, 2004 to 19% for the current year period. The dollar decrease is primarily attributable to cost reduction actions. These cost reduction actions are being outpaced by the decline of traditional product sales, which resulted in the year-over-year increase of SG&A as a percentage of sales.
Research and Development Costs
R&D costs for the D&FIS segment decreased $74 million, or 26%, from $286 million in the nine months ended September 30, 2004 to $212 million in the current year period and remained constant as a percentage of sales at 4%. The absolute dollar decrease in R&D was primarily attributable to spending reductions related to traditional products and services.
Earnings From Continuing Operations Before Interest, Other Income (Charges), Net and Income Taxes
Earnings from continuing operations before interest, other income (charges), net and income taxes for the D&FIS segment were $305 million in the nine months ended September 30, 2005 compared with $484 million in the nine months ended September 30, 2004, representing a decrease of $179 million or 37%, as a result of the factors described above.
PAGE 53
HEALTH
Worldwide Revenues
Net worldwide sales for the Health segment were $1,955 million for the nine months ended September 30, 2005 as compared with $1,945 million for the prior year period, representing an increase of $10 million, or 1%. The increase in sales was primarily attributable to increases in volume, primarily driven by the digital capture SPG and the services SPG, which contributed approximately 1.6 percentage points to the increase in sales. Sales were also favorably impacted by favorable exchange of approximately 1.4 percentage points. These increases were partially offset by decreases in price/mix of approximately 2.4 percentage points, primarily driven by the digital capture SPG, digital output SPG, and the traditional medical film portion of the film capture and output SPG.
Net sales in the U.S. were $778 million for the current year period as compared with $811 million for the nine months ended September 30, 2004, representing a decrease of $33 million, or 4%. Net sales outside the U.S. were $1,177 million for the nine months ended September 30, 2005 as compared with $1,134 million for the prior year period, representing an increase of $43 million, or 4%, which includes a favorable impact from exchange of 2%.
Digital Strategic Product Groups’ Revenues
Health segment digital sales, which include digital products (DryView laser imagers/media and wet laser printers/media), digital capture equipment (computed radiography capture equipment and digital radiography equipment), services, dental systems (practice management software and digital radiography capture equipment) and healthcare information systems (Picture Archiving and Communications Systems (PACS)), were $1,271 million for the nine months ended September 30, 2005 as compared with $1,242 million for the nine months ended September 30, 2004, representing an increase of $29 million, or 2%. The increase in digital product sales was primarily attributable to volume increases and favorable exchange, partially offset by negative price/mix.
Traditional Strategic Product Groups’ Revenues
Segment traditional product sales, including analog film, equipment, chemistry and services, were $684 million for the nine months ended September 30, 2005 as compared with $703 million for the nine months ended September 30, 2004, representing a decrease of $19 million, or 3%. The primary drivers were lower volumes and unfavorable price/mix for the film capture and output SPG, partially offset by favorable exchange.
Gross Profit
Gross profit for the Health segment was $770 million for the nine months ended September 30, 2005 as compared with $823 million in the prior year period, representing a decrease of $53 million, or 6%. The gross profit margin was 39.4% in the current year period as compared with 42.3% in the nine months ended September 30, 2004. The decrease in the gross profit margin of 2.9 percentage points was principally attributable to: (1) price/mix, which negatively impacted gross profit margins by 2.5 percentage points driven by the digital capture SPG, digital output SPG and the traditional medical film portion of the film capture and output SPG, and (2) an increase in manufacturing cost, which decreased gross profit margins by approximately 1.1 percentage points due to an increase in silver and raw material costs as well as the amortization of unfavorable 2004 manufacturing variances during the nine months ended September 30, 2005. These decreases were partially offset by favorable exchange, which contributed approximately 0.6 percentage points to the gross profit margins.
PAGE 54
Selling, General and Administrative Expenses
SG&A expenses for the Health segment increased $15 million, or 4%, from $350 million in the nine months ended September 30, 2004 to $365 million for the current year period and increased as a percentage of sales from 18% in the prior year period to 19% in the current year period. The increase in SG&A expenses is primarily attributable to a change in allocation of certain corporate overhead costs between costs of goods sold and SG&A. SG&A was also negatively impacted by unfavorable foreign exchange of approximately $4 million, and SG&A costs associated with the Orex acquisition of approximately $4 million.
Research and Development Costs
Current period R&D costs were $141 million as compared with the prior year period of $148 million, representing a decrease of $7 million or 5%, and decreased as a percentage of sales from 8% to 7%. This decrease is a result of reduced R&D spending related to traditional products, as well as a decline in corporate allocated R&D costs.
Earnings From Continuing Operations Before Interest, Other Income (Charges), Net and Income Taxes
Earnings from continuing operations before interest, other income (charges), net and income taxes for the Health segment decreased $61 million, or 19%, from $325 million for the prior year period to $264 million for the nine months ended September 30, 2005 due to the reasons described above.
GRAPHIC COMMUNICATIONS
The Graphic Communications segment serves a variety of customers in the in-plant, data center, commercial printing, packaging, newspaper and digital service bureau markets with a range of software and hardware products that provide customers with a range of solutions for prepress, traditional and digital printing, and document scanning and multi-vendor IT services.
On May 1, 2004, Kodak completed the acquisition of the NexPress-related entities, which included the following:
- | Heidelberger Druckmaschinen’s (Heidelberg’s) 50% interest in NexPress Solutions LLC (Kodak and Heidelberg formed the NexPress 50/50 JV in 1997 to develop high quality, on-demand, digital color printing systems) |
| |
- | 100% of the stock of Heidelberg Digital LLC (Hdi), a manufacturer of digital black & white printing systems |
| |
- | 100% of the stock of NexPress GMBH – a R&D center located in Kiel, Germany |
| |
- | Certain sales and service people, inventory and related assets and liabilities of Heidelberg’s sales and service units located throughout the world. |
There was no consideration paid to Heidelberg at closing. Under the terms of the acquisition, Kodak and Heidelberg agreed to use a performance-based earn-out formula whereby Kodak will make periodic payments to Heidelberg over a two-year period, if certain sales goals are met. If all sales goals are met during the two calendar years ending December 31, 2005, the Company will pay a maximum of $150 million in cash. For the first calendar year (2004), no amounts were paid, and for the second calendar year (2005), the Company does not expect to make any payments to Heidelberg. Additional payments may also be made relating to the incremental sales of certain products in excess of a stated minimum number of units sold during a five-year period following the closing of the transaction. The acquisition is expected to become accretive by 2007. During the nine months ended September 30, 2005, the NexPress-related entities contributed $241 million in sales to the Graphic Communications segment.
PAGE 55
On April 1, 2005, the Company became the sole owner of KPG through the redemption of Sun Chemical Corporation’s 50 percent interest in the KPG joint venture. This transaction further established the Company as a leader in the graphic communications industry and complements the Company’s existing business in this market. Under the terms of the transaction, the Company redeemed all of Sun Chemical’s shares in KPG by providing $317 million in cash at closing and by entering into two notes payable arrangements, one that will be payable within the U.S. (the U.S. note) and one that will be payable outside of the U.S. (the non-U.S. note), that will require principal and interest payments of $200 million in the third quarter of 2006, and $50 million annually from 2008 through 2013. The total payments due under the U.S. note and the non-U.S. note are $100 million and $400 million, respectively. The aggregate fair value of these notes payable arrangements of approximately $395 million as of the acquisition date was recorded as long-term debt in the Company’s Consolidated Statement of Financial Position.
On June 15, 2005, the Company completed the acquisition of Creo Inc. (Creo), a premier supplier of prepress and workflow systems used by commercial printers around the world. The acquisition of Creo uniquely positions the Company to be the preferred partner for its customers, helping them improve efficiency, expand their offerings and grow their businesses. The Company paid $954 million (excluding approximately $11 million in transaction related costs), or $16.50 per share, for all of the outstanding shares of Creo. The Company used its bank lines to initially fund the acquisition, which has been refinanced through the Company’s new credit facilities. Creo’s extensive solutions portfolio is now part of the Company’s Graphic Communications segment.
Worldwide Revenues
Net worldwide sales for the Graphic Communications segment were $2,048 million for the nine months ended September 30, 2005 as compared with $952 million for the prior year period, representing an increase of $1,096 million, or 115%, which includes a favorable impact from exchange of approximately 1%. The increase in net sales was primarily due to the KPG, Creo, and NexPress acquisitions, which contributed $1,032 million in sales.
Net sales in the U.S. were $738 million for the current year period as compared with $415 million for the prior year period, representing an increase of $323 million, or 78%. Net sales outside the U.S. were $1,310 million in the nine months ended September 30, 2005 as compared with $537 million for the prior year period, representing an increase of $773 million, or 144% as reported, which includes a favorable impact from exchange of approximately 3%.
Digital Strategic Product Groups’ Revenues
The Graphic Communications segment digital product sales are comprised of KPG digital revenues; NexPress Solutions, a producer of digital color and black and white printing solutions; Creo, a supplier of prepress systems; Kodak Versamark, a leader in continuous inkjet technology; document scanners; Encad, Inc., a maker of wide-format inkjet printers; and service and support.
Digital product sales for the Graphic Communications segment were $1,671 million for the nine months ended September 30, 2005 as compared with $741 million for the prior year period, representing an increase of $930 million, or 126%. The increase in digital product sales was primarily attributable to the KPG, Creo, and NexPress acquisitions.
Traditional Strategic Product Groups’ Revenues
Segment traditional product sales are primarily comprised of sales of traditional graphics products, KPG’s analog plates and other films, and microfilm products. These sales were $377 million for the current year period compared with $211 million for the prior year period, representing an increase of $166 million, or 79%. This increase is primarily attributable to the acquisition of KPG.
PAGE 56
Gross Profit
Gross profit for the Graphic Communications segment was $537 million for the nine months ended September 30, 2005 as compared with $243 million in the prior year period, representing an increase of $294 million, or 121%. The gross profit margin was 26.2% in the current year period as compared with 25.5% in the prior year period. The increase in the gross profit margin of 0.7 percentage points was primarily attributable to: (1) the acquisitions of KPG, Creo and Nexpress, which positively impacted gross profit margins by approximately 2.1 percentage points, (2) positive exchange, which increased gross profit margins by approximately 0.6 percentage points, and (3) volume increases related to Versamark and NexPress products and services of approximately 0.3 percentage points. These positive impacts on gross profit margin were partially offset by negative price/mix of approximately 0.5 percentage points and an increase in manufacturing costs of approximately 1.9 percentage points.
Selling, General and Administrative Expenses
SG&A expenses for the Graphic Communications segment were $370 million for the nine months ended September 30, 2005 as compared with $185 million in the prior year period, representing an increase of $185 million, or 100%, and decreased as a percentage of sales from 19% in the prior year period to 18% in the current year period. The dollar increase in SG&A dollars is primarily attributable to the acquisitions of NexPress, KPG and Creo, while the decrease in SG&A as a percentage of sales is primarily attributable to the increase in sales as a result of the acquisitions, as well as the fact that the acquired businesses generally have lower SG&A as a percentage of sales.
Research and Development Costs
Current period R&D costs for the Graphic Communications segment increased $123 million, or 148%, from $83 million for the nine months ended September 30, 2004 to $206 million for the current year period, and increased as a percentage of sales from 9% in the prior year period to 10% in the current year period. The increase was primarily attributable to the write-off of in-process R&D associated with the KPG and Creo acquisitions of $52 million, as well as increased levels of R&D spending associated with the acquired companies of $62 million.
Earnings (Loss) From Continuing Operations Before Interest, Other Income (Charges), Net and Income Taxes
The loss from continuing operations before interest, other income (charges), net and income taxes for the Graphic Communications segment was $38 million in the nine months ended September 30, 2005 compared with a loss of $24 million in the first three quarters of 2004. This decrease in earnings of $14 million is attributable to the reasons described above.
ALL OTHER
Worldwide Revenues
Net worldwide sales for All Other were $121 million for the nine months ended September 30, 2005 as compared with $86 million for the nine months ended September 30, 2004, representing an increase of $35 million, or 41%. Net sales in the U.S. were $51 million for the current year period as compared with $43 million for the prior year period, representing an increase of $8 million, or 19%. Net sales outside the U.S. were $70 million in the nine months ended September 30, 2005 as compared with $43 million in the prior year period, representing an increase of $27 million, or 63%.
Loss From Continuing Operations Before Interest, Other Income (Charges), Net and Income Taxes
The loss from continuing operations before interest, other income (charges), net and income taxes for All Other was $140 million in the current year period as compared with a loss of $126 million in the nine months ended September 30, 2004, representing a decrease in earnings of $14 million or 11%.
PAGE 57
RESULTS OF OPERATIONS - DISCONTINUED OPERATIONS
Earnings from discontinued operations for the nine months ended September 30, 2005 were $2 million, or $.01 per basic and diluted share. Earnings from discontinued operations for the nine months ended September 30, 2004 were $476 million or $1.66 per basic and $1.56 per diluted share and were primarily related to the gain on the sale of the Company’s Remote Sensing Systems business to ITT Industries, Inc. in August 2004.
NET (LOSS) EARNINGS
The net loss for the nine months ended September 30, 2005 was $1,319 million, or a loss of $4.58 per basic and diluted share, as compared with net earnings for the nine months ended September 30, 2004 of $615 million, or $2.15 per basic and $2.05 per diluted share, representing a decrease of $1,934 million, or 314%. This decrease is attributable to the reasons outlined above.
RESTRUCTURING COSTS AND OTHER
Currently, the Company is being adversely impacted by the progressing digital substitution. As the Company continues to adjust its operating model in light of changing business conditions, it is probable that ongoing focused cost reduction activities will be required.
In accordance with this, the Company periodically announces planned restructuring programs (Programs), which often consist of a number of restructuring initiatives. These Program announcements provide estimated ranges relating to the number of positions to be eliminated and the total restructuring charges to be incurred. The actual charges for initiatives under a Program are recorded in the period in which the Company commits to formalized restructuring plans or executes the specific actions contemplated by the Program and all criteria for restructuring charge recognition under the applicable accounting guidance have been met.
PAGE 58
Restructuring Programs Summary
The activity in the accrued restructuring balances and the non-cash charges incurred in relation to all of the restructuring programs described below were as follows for the third quarter of 2005:
(in millions) | | Balance
June 30, 2005
(Restated) | | Costs
Incurred | | Reversals | | Cash
Payments | | Non-cash
Settlements | | Other
Adjustments
and
Reclasses(1) | | Balance
Sept. 30,
2005 | |
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2004-2007 Program: | | | | | | | | | | | | | | | | | | | | | | |
Severance reserve | | $ | 246 | | $ | 132 | | $ | (3 | ) | $ | (91 | ) | $ | — | | $ | 10 | | $ | 294 | |
Exit costs reserve | | | 36 | | | 15 | | | — | | | (25 | ) | | — | | | 5 | | | 31 | |
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Total reserve | | $ | 282 | | $ | 147 | | $ | (3 | ) | $ | (116 | ) | $ | — | | $ | 15 | | $ | 325 | |
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Long-lived asset impairments and inventory write-downs | | $ | — | | $ | 32 | | $ | — | | $ | — | | $ | (32 | ) | $ | — | | $ | — | |
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Accelerated depreciation | | $ | — | | $ | 105 | | $ | — | | $ | — | | $ | (105 | ) | $ | — | | $ | — | |
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Pre-2004 Programs: | | | | | | | | | | | | | | | | | | | | | | |
Severance reserve | | $ | 16 | | $ | — | | $ | (2 | ) | $ | (5 | ) | $ | — | | $ | (2 | ) | $ | 7 | |
Exit costs reserve | | | 17 | | | — | | | (1 | ) | | (2 | ) | | — | | | — | | | 14 | |
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Total reserve | | $ | 33 | | $ | — | | $ | (3 | ) | $ | (7 | ) | $ | — | | $ | (2 | ) | $ | 21 | |
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Total of all restructuring programs | | $ | 315 | | $ | 284 | | $ | (6 | ) | $ | (123 | ) | $ | (137 | ) | $ | 13 | | $ | 346 | |
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| (1) | The Other Adjustments and Reclasses column of the table above includes reclassifications from (to) Other long-term assets, Pension and other postretirement liabilities (for amounts relating to restructuring actions that impacted the Company’s retirement and postretirement plans) in the Consolidated Statement of Financial Position. |
The costs incurred, net of reversals, which total $278 million for the three months ended September 30, 2005, include $105 million and $10 million of charges related to accelerated depreciation and inventory write-downs that were reported in cost of goods sold in the accompanying Consolidated Statement of Operations for the three months ended September 30, 2005. The remaining costs incurred, net of reversals, of $163 million were reported as restructuring costs and other in the accompanying Consolidated Statement of Operations for the three months ended September 30, 2005. The severance costs and exit costs require the outlay of cash, while long-lived asset impairments, accelerated depreciation and inventory write-downs represent non-cash items.
2004-2007 Restructuring Program
The Company announced on January 22, 2004 that it planned to develop and execute a comprehensive cost reduction program throughout the 2004 to 2006 timeframe. The objective of these actions is to achieve a business model appropriate for the Company’s traditional businesses, and to sharpen the Company’s competitiveness in digital markets.
PAGE 59
The Program was expected to result in total charges of $1.3 billion to $1.7 billion over the three-year period, of which $700 million to $900 million are related to severance, with the remainder relating to the disposal of buildings and equipment. Overall, Kodak’s worldwide facility square footage was expected to be reduced by approximately one-third. Approximately 12,000 to 15,000 positions worldwide were expected to be eliminated through these actions primarily in global manufacturing, selected traditional businesses and corporate administration.
On July 20, 2005, the Company announced that it would extend the restructuring activity, originally announced in January 2004, as part of its efforts to accelerate its digital transformation and to respond to a faster-than-expected decline in consumer film sales. The Company now plans to increase the total employment reduction to a range of 22,500 to 25,000 positions, and to reduce its traditional manufacturing infrastructure to approximately $1 billion, compared with $2.9 billion as of December 31, 2004. When largely completed by the middle of 2007, these activities will result in a business model consistent with what is necessary to compete profitably in digital markets. As a result of this announcement, this program has been renamed the “2004-2007 Restructuring Program.”
Due to the faster-than-expected decline, the Company revised the useful lives of its manufacturing assets during the third quarter resulting in increased depreciation charges of $66 million. These changes will also result in increased depreciation charges in future periods. The Company also expects traditional manufacturing asset impairment and write-off charges to be recognized when the Company commits to specific restructuring actions under the extended program.
The Company implemented certain actions under the Program during the third quarter of 2005. As a result of these actions, the Company recorded charges of $179 million in the third quarter of 2005, which were composed of severance, long-lived asset impairments, exit costs and inventory write-downs of $132 million, $22 million, $15 million and $10 million, respectively. The severance costs related to the elimination of approximately 2,075 positions, including approximately 75 photofinishing, 1,200 manufacturing, 50 research and development and 750 administrative positions. The geographic composition of the positions to be eliminated includes approximately 1,550 in the United States and Canada and 525 throughout the rest of the world. Included in the 2,075 positions are approximately 75 positions related to the recently acquired Creo business. The severance related to these positions is included in goodwill as part of the purchase accounting related to the acquisition. The reduction of the 2,075 positions and the $147 million charges for severance and exit costs are reflected in the 2004-2007 Restructuring Program table below. The $22 million charge in the third quarter and the $104 million year-to-date charge for long-lived asset impairments were included in restructuring costs and other in the accompanying Consolidated Statement of Operations for the three and nine months ended September 30, 2005, respectively. The charges taken for inventory write-downs of $10 million and $31 million were reported in cost of goods sold in the accompanying Consolidated Statement of Operations for the three and nine months ended September 30, 2005, respectively.
Under this Program, on a life-to-date basis as of September 30, 2005, the Company has recorded charges of $1,245 million, which was composed of severance, long-lived asset impairments, exit costs and inventory write-downs of $788 million, $242 million, $165 million and $50 million, respectively. The severance costs related to the elimination of approximately 15,550 positions, including approximately 5,350 photofinishing, 6,725 manufacturing, 825 research and development and 2,650 administrative positions.
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The following table summarizes the activity with respect to the charges recorded in connection with the focused cost reduction actions that the Company has committed to under the 2004-2007 Restructuring Program and the remaining balances in the related reserves at September 30, 2005:
(dollars in millions) | | Number of
Employees | | Severance
Reserve | | Exit
Costs
Reserve | | Total | | Long-lived Asset
Impairments
and Inventory
Write downs | | Accelerated
Depreciation | |
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| |
Q1, 2004 charges | | | — | | $ | — | | $ | — | | $ | — | | $ | 1 | | $ | 2 | |
Q1, 2004 utilization | | | — | | | — | | | — | | | — | | | (1 | ) | | (2 | ) |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
Balance at 3/31/04 | | | — | | | — | | | — | | | — | | | — | | | — | |
Q2, 2004 charges | | | 2,700 | | | 98 | | | 17 | | | 115 | | | 28 | | | 23 | |
Q2, 2004 utilization | | | (800 | ) | | (12 | ) | | (11 | ) | | (23 | ) | | (28 | ) | | (23 | ) |
Q2, 2004 other adj. & reclasses | | | — | | | (2 | ) | | — | | | (2 | ) | | — | | | — | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
Balance at 6/30/04 | | | 1,900 | | | 84 | | | 6 | | | 90 | | | — | | | — | |
Q3, 2004 charges | | | 3,200 | | | 186 | | | 20 | | | 206 | | | 27 | | | 31 | |
Q3, 2004 reversal | | | — | | | — | | | (1 | ) | | (1 | ) | | — | | | — | |
Q3, 2004 utilization | | | (2,075 | ) | | (32 | ) | | (14 | ) | | (46 | ) | | (27 | ) | | (31 | ) |
Q3, 2004 other adj. & reclasses | | | — | | | — | | | (5 | ) | | (5 | ) | | — | | | — | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
Balance at 9/30/04 | | | 3,025 | | | 238 | | | 6 | | | 244 | | | — | | | — | |
Q4, 2004 charges | | | 3,725 | | | 134 | | | 62 | | | 196 | | | 101 | | | 96 | |
Q4, 2004 reversal | | | — | | | (6 | ) | | — | | | (6 | ) | | — | | | — | |
Q4, 2004 utilization | | | (2,300 | ) | | (125 | ) | | (22 | ) | | (147 | ) | | (101 | ) | | (96 | ) |
Q4, 2004 other adj. & reclasses | | | — | | | 26 | | | (10 | ) | | 16 | | | — | | | — | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
Balance at 12/31/04 | | | 4,450 | | | 267 | | | 36 | | | 303 | | | — | | | — | |
Q1, 2005 charges, as restated | | | 1,650 | | | 70 | | | 23 | | | 93 | | | 34 | | | 81 | |
Q1, 2005 utilization | | | (2,000 | ) | | (72 | ) | | (18 | ) | | (90 | ) | | (34 | ) | | (81 | ) |
Q1, 2005 other adj. & reclasses, as restated | | | — | | | (43 | ) | | — | | | (43 | ) | | — | | | — | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
Balance at 3/31/05 | | | 4,100 | | | 222 | | | 41 | | | 263 | | | — | | | — | |
Q2, 2005 charges, as restated | | | 2,200 | | | 168 | | | 28 | | | 196 | | | 69 | | | 75 | |
Q2, 2005 reversal | | | — | | | — | | | (1 | ) | | (1 | ) | | — | | | — | |
Q2, 2005 utilization | | | (2,725 | ) | | (91 | ) | | (30 | ) | | (121 | ) | | (69 | ) | | (75 | ) |
Q2, 2005 other adj. & reclasses, as restated | | | — | | | (53 | ) | | (2 | ) | | (55 | ) | | — | | | — | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
Balance at 6/30/05, as restated | | | 3,575 | | | 246 | | | 36 | | | 282 | | | — | | | — | |
Q3, 2005 charges | | | 2,075 | | | 132 | | | 15 | | | 147 | | | 32 | | | 105 | |
Q3, 2005 reversal | | | — | | | (3 | ) | | — | | | (3 | ) | | — | | | — | |
Q3, 2005 utilization | | | (2,050 | ) | | (91 | ) | | (25 | ) | | (116 | ) | | (32 | ) | | (105 | ) |
Q3, 2005 other adj. & reclasses | | | — | | | 10 | | | 5 | | | 15 | | | — | | | — | |
| |
|
| |
|
| |
|
| |
|
| |
|
| |
|
| |
Balance at 9/30/05 | | | 3,600 | | $ | 294 | | $ | 31 | | $ | 325 | | $ | — | | $ | — | |
| |
|
| |
|
| |
|
| |
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PAGE 61
The severance charges of $132 million for the third quarter and $370 million year to date were reported in restructuring costs and other in the accompanying Consolidated Statement of Operations for the three and nine months ended September 30, 2005, respectively. Included in the $132 million third quarter charge taken for severance was a net curtailment loss of $4 million. The liability related to this charge is reported in pension and other postretirement benefits on the Company’s Consolidated Statement of Financial Position as of September 30, 2005, and is disclosed in Note 9, “Retirement Plans and Other Postretirement Benefits.” The exit costs of $15 million and $66 million were reported in restructuring costs and other in the accompanying Consolidated Statement of Operations for the three and nine months ended September 30, 2005, respectively. Included in the $15 million third quarter charge was a $1 million charge for environmental remediation associated with the closure of manufacturing facilities in Coburg, Australia. The liability related to this charge is disclosed in Note 6, “Commitments and Contingencies” under “Environmental.” In addition, $2 million and $6 million were added to the reserve for severance and exit costs, respectively, associated with third quarter restructuring actions within the recently acquired Creo business. The offset associated with the reserve was recorded in goodwill in the accompanying Consolidated Statement of Financial Position. The severance costs and exit costs require the outlay of cash, while the long-lived asset impairments and inventory write-downs represent non-cash items. During the third quarter of 2005, the Company made $91 million of severance payments and $25 million of exit costs payments related to the 2004-2007 Restructuring Program. In addition, the Company reversed $3 million of severance reserves during the third quarter, as severance payments to employees whose positions were eliminated were less than originally estimated. As a result of the initiatives already implemented under the 2004-2007 Restructuring Program, severance payments will be paid during periods through 2007 since, in many instances, the employees whose positions were eliminated can elect or are required to receive their payments over an extended period of time. In addition, certain exit costs, such as long-term lease payments, will be paid through 2007 and subsequent periods.
As a result of initiatives implemented under the 2004-2007 Restructuring Program, the Company recorded $105 million and $261 million of accelerated depreciation on long-lived assets in cost of goods sold in the accompanying Consolidated Statement of Operations for the three and nine months ended September 30, 2005, respectively. The accelerated depreciation relates to long-lived assets accounted for under the held and used model of SFAS No. 144. Accelerated depreciation represents a non-cash item. The third quarter amount of $105 million relates to $10 million of photofinishing facilities and equipment and $95 million of manufacturing facilities and equipment that will be used until their abandonment. The year-to-date amount of $261 million relates to $34 million of photofinishing facilities and equipment, $222 million of manufacturing facilities and equipment, and $5 million of administrative facilities and equipment. The Company will incur accelerated depreciation charges of approximately $52 million in the fourth quarter of 2005 as a result of the initiatives already implemented under the 2004-2007 Restructuring Program.
The charges of $284 million, excluding reversals, recorded in the third quarter included $64 million applicable to the D&FIS segment, $8 million applicable to the Health segment and $6 million applicable to the Graphic Communications segment. The balance of $206 million was applicable to manufacturing, research and development, and administrative functions, which are shared across all segments.
The restructuring actions implemented this quarter under the 2004-2007 Restructuring Program are expected to generate future annual cost savings of approximately $139 million and future annual cash savings of approximately $135 million. These cost savings began to be realized by the Company beginning in the third quarter of 2005, and are expected to be fully realized by the end of 2006 as the actions and severance payouts are completed. These total cost savings are expected to reduce future cost of goods sold, SG&A, and R&D expenses by approximately $77 million, $61 million, and $1 million, respectively.
Based on all of the actions taken to date under the 2004-2007 Restructuring Program, the Program is expected to generate annual cost savings of approximately $866 million, including annual cash savings of $835 million, as compared with pre-program levels. The Company began realizing these savings in the second quarter of 2004, and expects the savings to be fully realized by the end of 2006 as actions and severance payouts are completed. These total costs savings are expected to reduce cost of goods sold, SG&A, and R&D expenses by approximately $605 million, $201 million, and $60 million, respectively.
PAGE 62
The above savings estimates are based primarily on objective data related to the Company’s severance actions. Savings resulting from facility closures and other non-severance actions that are more difficult to quantify are not included. The Company reaffirms its estimate of total annual cost savings under the extended 2004-2007 Restructuring Program of $1.6 billion to $1.8 billion, as announced in July 2005, and does not expect the final annual cost savings to differ materially from this estimate.
Pre-2004 Restructuring Programs
At September 30, 2005, the Company had remaining severance and exit costs reserves of $7 million and $14 million, respectively, relating to restructuring plans committed to or executed prior to 2004. Included in the severance reserve balance was a reversal of $2 million made during the third quarter, as severance payments to employees whose positions were eliminated were less than originally estimated. In addition, a reclassification of $2 million was made to other postretirement benefits on the Company’s Consolidated Statement of Financial Position as of September 30, 2005.
Included in the exit reserve balance was a reversal of $1 million made during the third quarter, as the Company was able to settle a lease obligation for less than originally anticipated.
The remaining severance payments relate to initiatives already implemented under the Pre-2004 Restructuring Programs and will be paid out during 2005 since, in many instances, the employees whose positions were eliminated can elect or are required to receive their severance payments over an extended period of time. Most of the remaining exit costs reserves represent long-term lease payments, which will continue to be paid over periods throughout and after 2005.
LIQUIDITY AND CAPITAL RESOURCES
The Company’s cash and cash equivalents decreased $645 million to $610 million at September 30, 2005 from $1,255 million at December 31, 2004. The decrease resulted primarily from $60 million of net cash used in operating activities and $1,203 million of net cash used in investing activities, offset by $639 million of net cash provided by financing activities.
The net cash used in operating activities of $60 million was primarily attributable to a decrease in liabilities excluding borrowings of $728 million of which $406 million was due to a decrease in accounts payable, excluding the impacts of acquisitions, as the Company’s accounts payable and other current liabilities balance is historically the highest at year end. In addition, the Company reported a net loss of $1,319 million, which, when adjusted for the earnings from discontinued operations, equity in earnings from unconsolidated affiliates, depreciation and amortization, purchased research and development, the gain on sales of businesses/assets, restructuring costs, asset impairments and other non-cash charges, and provision for deferred taxes, provided $712 million of operating cash.
The net cash used in investing activities of $1,203 million was utilized primarily for capital expenditures of $332 million and business acquisitions of $987 million. These uses of cash were partially offset by a distribution from Express Stop Financing, a joint venture partnership between the Company’s Qualex subsidiary and a subsidiary of Dana Credit Corporation, in the amount of $63 million and $62 million for the sale of assets and investments. The net cash provided by financing activities of $639 million was primarily the result of a net increase in borrowings of $699 million due to the funding of the acquisition of Creo during the second quarter.
The Company’s primary uses of cash include debt payments, acquisitions, capital additions, restructuring payments, dividend payments, employee benefit plan payments/contributions, and temporary working capital needs.
PAGE 63
The Company has a dividend policy whereby it makes semi-annual payments which, when declared, will be paid on the Company’s 10th business day each July and December to shareholders of record on the close of the first business day of the preceding month. On May 11, 2005, the Board of Directors declared a semi-annual cash dividend of $.25 per share payable to shareholders of record at the close of business on June 1, 2005. This dividend was paid on July 15, 2005. On October 18, 2005, the Board of Directors declared a semi-annual cash dividend of $.25 per share payable to shareholders of record at the close of business on November 1, 2005. This dividend will be paid on December 14, 2005.
Capital additions were $332 million in the nine months ended September 30, 2005, with the majority of the spending supporting new products, manufacturing productivity and quality improvements, infrastructure improvements, and ongoing environmental and safety initiatives. For the full year 2005, the Company expects its capital spending, excluding acquisitions, to be in the range of $400 million to $450 million.
During the nine months ended September 30, 2005, the Company expended $358 million against the related restructuring reserves, primarily for the payment of severance benefits. Employees whose positions were eliminated could elect to receive severance payments for up to two years following their date of termination.
As a result of the cumulative impact of the ongoing position eliminations under its Pre-2004 and 2004-2007 Restructuring Programs as disclosed in Note 8 and above as part of Management’s Discussion and Analysis of Financial Condition and Results of Operations, the Company incurred curtailment gains and losses with respect to certain of its retirement plans in 2005. These curtailment events resulted in the remeasurement of the respective plans’ obligations, which impacted the accounting for the additional minimum pension liabilities. As a result of these remeasurements, the Company was required to decrease its additional minimum pension liabilities by $46 million during 2005. This decrease is reflected in the postretirement liabilities component within the accompanying Consolidated Statement of Financial Position as of September 30, 2005. The net-of-tax amount of $33 million relating to the decrease of the additional minimum pension liabilities is reflected in the accumulated other comprehensive loss component within the accompanying Consolidated Statement of Financial Position as of September 30, 2005. The related decrease in the long-term deferred tax asset of $13 million was reflected in the other long-term assets component within the accompanying Consolidated Statement of Financial Position as of September 30, 2005.
The Company made contributions (funded plans) or paid benefits (unfunded plans) totaling approximately $163 million relating to its major U.S. and non-U.S. defined benefit pension plans in the first three quarters of 2005. The Company expects its contribution (funded plans) and benefit payment (unfunded plans) requirements for its major U.S. and non-U.S. defined benefit pension plans for the balance of 2005 to be approximately $36 million.
The Company paid benefits totaling approximately $184 million relating to its U.S., United Kingdom and Canada postretirement benefit plans, which represent the Company’s major postretirement plans, in the first three quarters of 2005. The Company expects to pay benefits of $62 million for its U.S., United Kingdom and Canada postretirement plans for the balance of 2005. Payments relating to the Company’s other postretirement plans were not, and are not expected to be, material.
The Company believes that its cash flow from operations will be sufficient to cover its working capital and capital investment needs and the funds required for future debt reduction, restructuring payments, dividend payments, and modest acquisitions. The Company’s cash balances and financing arrangements will be used to bridge timing differences between expenditures and cash generated from operations.
As of September 30, 2005, the Company and its subsidiaries, on a consolidated basis, maintained $1,523 million in committed bank lines of credit and $900 million in uncommitted bank lines of credit to ensure continued access to short-term borrowing capacity.
PAGE 64
As of September 30, 2005, the Company had a 5-year committed revolving credit facility of $1,225 million expiring in July 2006 (5-Year Facility), which was available for general corporate purposes. There is a quarterly financial covenant that requires the Company to maintain a debt to earnings before interest, income taxes, depreciation and amortization (EBITDA) ratio, on a rolling four-quarter basis, of not greater than 3 to 1. In the event of violation of the covenant, the facility would not be available for borrowing until the covenant provisions were waived, amended or satisfied. The Company was in compliance with this covenant at September 30, 2005. As of September 30, 2005, the outstanding usage under the 5-Year Facility was $1,101 million primarily in connection with the acquisition of Creo. This amount includes $101 million in outstanding letters of credit. The available balance for additional usage was $124 million.
At September 30, 2005, the Company had an accounts receivable securitization program at a maximum borrowing level of $200 million. At September 30, 2005 the Company had no amounts outstanding under this program. This program held the same debt to EBITDA financial covenant as the 5-Year Facility. The Company was in compliance with this covenant at September 30, 2005.
The Company has other committed and uncommitted lines of credit at September 30, 2005 totaling $298 million and $900 million, respectively. These lines primarily support borrowing needs of the Company’s subsidiaries, which include term loans, overdraft coverage, letters of credit and revolving credit lines. Interest rates and other terms of borrowing under these lines of credit vary from country to country, depending on local market conditions. Total outstanding borrowings against these other committed and uncommitted lines of credit at September 30, 2005 were $91 million and $95 million, respectively. These outstanding borrowings are reflected in the short-term borrowings in the accompanying Consolidated Statement of Financial Position at September 30, 2005.
On October 18, 2005 the Company closed on $2,700 million of Senior Secured Credit Facilities (Secured Credit Facilities) under a new Secured Credit Agreement (Secured Credit Agreement) and associated Security Agreement and Canadian Security Agreement. The Secured Credit Facilities are comprised of a $1,000 million 5-year Committed Revolving Credit Facility (5-Year Revolving Credit Facility) expiring October 18, 2010 and $1,700 million of Term Loan Facilities (Term Facilities) expiring October 18, 2012.
The 5-Year Revolving Credit Facility can be used by Eastman Kodak Company (U.S. Borrower) for general corporate purposes including the issuance of letters of credit. Amounts available under the facility can be borrowed, repaid and re-borrowed throughout the term of the facility provided the Company remains in compliance with covenants contained in the Secured Credit Agreement. At closing, there was no debt outstanding and approximately $75 million of letters of credit issued under this facility.
The Term Facilities allow for borrowing of up to $1,700 million. At closing, $1,200 million was borrowed primarily to refinance debt originally issued under the Company’s previous $1,225 million 5-Year Facility to finance the acquisition of Creo Inc. on June 15, 2005. The $1,200 million is comprised of a $920 million 7-year term loan to the U.S. Borrower and $280 million 7-year term loan to Kodak Graphic Communications Canada Company (KGCCC or, the Canadian Borrower). The remaining $500 million is committed by the Lenders and available to the U.S. Borrower, through June 15, 2006. For this $500 million commitment, a 1.50% annual fee is paid on the unused amount to the Lenders.
In addition to the $2,700 million of Secured Credit Facilities, the Secured Credit Agreement contemplates up to an additional $500 million for a new secured credit loan based on terms and pricing available and agreed to at the time the new credit loan would be established. There are no fees for this incremental uncommitted $500 million credit line.
Pursuant to the Secured Credit Agreement and associated Security Agreement, each subsidiary organized in the U.S. jointly and severally guarantees the obligations under the Secured Credit Agreement and all other obligations of the Company and its subsidiaries to the Lenders. The guaranty is supported by the pledge of U.S. assets of the U.S. Borrower and the Company’s U.S. subsidiaries. Assets pledged include, but are not limited to, receivables, inventory, equipment, deposit accounts, investments, intellectual property, including patents, trademarks and copyrights, and the capital stock of Material Subsidiaries. Excluded from pledged assets are real property, “Principal Properties” and equity interests in “Restricted Subsidiaries”, as defined in the Company’s 1988 Indenture.
PAGE 65
Pursuant to the Secured Credit Agreement and associated Canadian Security Agreement, Eastman Kodak Company and Creo Americas, Inc., jointly and severally guarantee the obligations of the Canadian Borrower, to the Lenders. The assets of the Canadian Borrower in Canada were also pledged in support of its obligations. Assets pledged include, but are not limited to, receivables, inventory, equipment, deposit accounts, investments, intellectual property, including patents, trademarks and copyrights, and the capital stock of the Canadian Borrower’s Material Subsidiaries.
Material Subsidiaries are defined as those subsidiaries with revenues or assets constituting 5 percent or more of the consolidated revenues or assets of the corresponding borrower. Material Subsidiaries will be determined on an annual basis under the Secured Credit Agreement.
Interest rates for borrowing under the Secured Credit Agreement are dependent on the Company’s Long Term Senior Secured Credit Rating. The Secured Credit Agreement contains various affirmative and negative covenants customary in a facility of this type, including two quarterly financial covenants: (1) an earnings before interest, taxes, depreciation and amortization (EBITDA) to interest expense ratio, on a rolling four-quarter basis, of no less than 3 to 1, and (2) a debt for borrowed money to EBITDA ratio of not greater than: 4.75 to 1 as of December 31, 2005; 4.50 to 1 as of March 31, 2006; 4.25 to 1 as of June 30, 2006; 4.00 to 1 as of September 30, 2006; and 3.50 to 1 as of December 31, 2006 and thereafter. In addition, subject to various conditions and exceptions in the Secured Credit Agreement, in the event the Company sells assets for net proceeds of $75 million in any year, except for proceeds used within 12 months for reinvestments in the business of up to $300 million, proceeds of sales of assets used in the non-digital business of the Company to prepay or repay debt or pay cash restructuring charges within 12 months from the date of sale of the assets, or proceeds from the sale of inventory in the ordinary course of business, the excess amount over the $75 million must be applied to prepay loans under the Secured Credit Agreement.
If unused, the 5-Year Revolving Credit Facility has a commitment fee of $5.0 million per year at the Company’s current credit rating of Ba2 and B+ from Moody’s Investor Services, Inc. (Moody’s) and Standard & Poor’s Rating Services (S&P), respectively.
At closing, the Company terminated its previous $1,225 million 5-Year Facility, a $160 million revolving credit facility established by KPG, and the Company’s $200 million Accounts Receivable Securitization Program.
The Company has $575 million aggregate principal amount of Convertible Senior Notes due 2033 (the Convertible Securities) on which interest accrues at the rate of 3.375% per annum and is payable semiannually. The Convertible Securities are unsecured and rank equally with all of the Company’s other unsecured and unsubordinated indebtedness. The Convertible Securities may be converted, at the option of the holders, to shares of the Company’s common stock if the Company’s credit rating assigned to the Notes by either Moody’s or S&P is lower than Ba2 or BB, respectively.
Moody’s and S&P’s ratings for the Company, including their outlooks, as of the filing date of this Form 10-Q are as follows:
| | Senior
Secured | | Corporate
Rating | | Senior
Unsecured
Rating | | Outlook | |
| |
|
| |
|
| |
|
| |
|
| |
Moody’s | | | Ba2 | | | Ba3 | | | B1 | | | Negative | |
S&P | | | B+ | | | B+ | | | B | | | Negative | |
On September 21, 2005, Moody’s downgraded the Company’s corporate family debt rating (Corporate Rating) to Ba3 from Ba2 and its senior unsecured notes rating to B1 from Ba3, concluding a review for possible downgrade initiated on July 21, 2005. Concurrently, Moody’s assigned a Ba2 rating to the Company’s $2.7 billion Senior Secured Credit Facility. The rating outlook is negative.
PAGE 66
Moody’s downgrades reflect their views regarding Kodak’s: (i) ongoing exposure to the accelerating secular decline of its consumer film business and potential decline of its entertainment imaging film business, (ii) variability in the utilization of its traditional manufacturing assets and potential for incremental restructuring costs, and (iii) ongoing execution risks related to the digital migration of its consumer and health businesses and integration of its commercial graphics imaging businesses.
Moody’s Ba2 rating assigned to the Senior Secured Credit Facility reflects the above factors as well as the security collateral and the secured cross guarantee afforded to the Senior Secured Credit Facility.
The negative rating outlook reflects Moody’s belief that Kodak may be further impacted by execution risks related to the digital migration of its consumer and health businesses and integration of its commercial graphics imaging businesses and may be subject to further incremental restructuring cash outflows related to its traditional franchise.
During the third quarter, S&P lowered its various ratings on Eastman Kodak Company numerous times. On July 21, 2005, S&P lowered its senior unsecured debt and corporate credit ratings on the Company to BB from BB+ and placed the ratings on CreditWatch with negative implications. On August 15, 2005, S&P lowered its senior unsecured debt rating on the Company from BB to BB- with the ratings remaining on CreditWatch. On September 16, 2005, S&P assigned a BB rating to the Company’s $2.7 billion Senior Secured Credit Facility. On September 30, 2005, S&P lowered its ratings on the Company’s senior secured and corporate credit rating from BB to BB-, and the Company’s senior unsecured debt from BB- to B+. On October 20, 2005, S&P further lowered its ratings on the Company’s corporate credit rating and the Company’s Senior Secured Credit Facility from BB- to B+, and the Company’s senior unsecured debt from B+ to B. S&P also removed the Company’s ratings from CreditWatch, where they were placed on July 21, 2005. The outlook is negative.
The August 15, 2005 downgrade was driven by S&P’s concern about the likely reduction of recovery prospects for senior unsecured creditors as a result of the pending addition of a large layer of secured debt (the Senior Secured Credit Facility) and the (at the time) unknown nature and extent of the collateral pledged for that secured debt. The later downgrades on September 30, 2005 and October 20, 2005, as well as the basis for the initial rating of the Senior Secured Credit Facility on September 16, 2005, was the result of S&P’s increased concern and reduced confidence in the Company’s profitability and cash flow prospects in light of the ongoing and rapid deterioration of the traditional imaging business and transition to digital imaging business, uncertain digital profitability potential, high cash restructuring costs, and overall economic uncertainty.
The October 20, 2005 negative outlook reflects, in S&P’s view, the potential for S&P’s ratings on the Company to be lowered if the Company’s cushion of compliance with its bank financial covenants contracts as covenants tighten, if negative discretionary cash flow worsens, if digital profitability does not improve steadily and meaningfully, and if debt leverage does not improve.
On September 5, 2003, the Company filed a shelf registration statement on Form S-3 (the primary debt shelf registration) for the issuance of up to $2,000 million of new debt securities. Pursuant to Rule 429 under the Securities Act of 1933, $650 million of remaining unsold debt securities under a prior shelf registration statement were included in the primary debt shelf registration, thus giving the Company the ability to issue up to $2,650 million in public debt. After issuance of $500 million in notes in October 2003, the remaining availability under the primary debt shelf registration is currently at $2,150 million. The Company filed its 2004 Form 10-K on April 6, 2005, which was late relative to the SEC required filing date (including extension) of March 31, 2005. The Company also completed the filing of a Form 8-K/A related to the acquisition of KPG on July 1, 2005, which was late in relation to the SEC required filing date of June 17, 2005. As a result of these late filings, the Company’s primary debt shelf registration statement on Form S-3 will not be available until the third quarter of 2006. In addition to the credit facilities described above, the Company could use Form S-1 or a Rule 144A transaction to issue securities in the capital markets. However, the success of future debt issuances will be dependent on market conditions at the time of such an offering. The recently completed $2.7 billion Senior Secured Credit Facilities, along with other committed and uncommitted credit lines provide the Company with sufficient flexibility and liquidity to meet its working capital and investing needs.
PAGE 67
The Company is in compliance with all covenants or other requirements set forth in its credit agreements and indentures. Further, the Company does not have any rating downgrade triggers that would accelerate the maturity dates of its debt. However, the Company could be required to increase the dollar amount of its letters of credit or other financial support up to an additional $89 million at the current credit ratings. As of the filing date of this Form 10-Q, the Company has not been requested to materially increase its letters of credit or other financial support. However, as discussed above, at the current rating of B1 by Moody’s and B by S&P, Convertible Securities holders may, at their option, convert their Notes to common stock. Further downgrades in the Company’s credit rating or disruptions in the capital markets could impact borrowing costs and the nature of its funding alternatives. However, further downgrades will not impact borrowing costs under the Company’s $2.7 billion Senior Secured Credit Facilities.
At September 30, 2005, the Company had outstanding letters of credit totaling $114 million and surety bonds in the amount of $91 million primarily to ensure the completion of environmental remediations, the payment of casualty and workers’ compensation claims, and to meet various customs and tax obligations.
OFF-BALANCE SHEET ARRANGEMENTS
The Company guarantees debt and other obligations under agreements with certain affiliated companies and customers to ensure that financing is obtained to facilitate ongoing business operations and selling activities, respectively. At September 30, 2005, these guarantees totaled a maximum of $223 million, with outstanding guaranteed amounts of $124 million. The maximum guarantee amount includes guarantees of up to: $218 million of customer amounts due to banks in connection with various banks’ financing of customers’ purchase of products and equipment from Kodak ($121 million outstanding); and $5 million for other unconsolidated affiliates and third parties ($3 million outstanding).
The guarantees for the other unconsolidated affiliates and third party debt mature between 2005 and 2011. The customer financing agreements and related guarantees typically have a term of 90 days for product and short-term equipment financing arrangements, and up to five years for long-term equipment financing arrangements. These guarantees would require payment from Kodak only in the event of default on payment by the respective debtor. In some cases, particularly for guarantees related to equipment financing, the Company has collateral or recourse provisions to recover and sell the equipment to reduce any losses that might be incurred in connection with the guarantees.
Management believes the likelihood is remote that material payments will be required under any of the guarantees disclosed above. With respect to the guarantees that the Company issued in the quarter ended September 30, 2005, the Company assessed the fair value of its obligation to stand ready to perform under these guarantees by considering the likelihood of occurrence of the specified triggering events or conditions requiring performance as well as other assumptions and factors. The Company has determined that the fair value of the guarantees was not material to the Company’s financial position, results of operations or cash flows.
The Company also guarantees debt owed to banks for some of its consolidated subsidiaries. The maximum amount guaranteed is $361 million, and the outstanding debt under those guarantees, which is recorded within the short-term borrowings and long-term debt, net of current portion components in the accompanying Consolidated Statement of Financial Position, is $123 million. These guarantees expire in 2005 through 2006. As of the closing of the $2.7 billion Senior Secured Credit facilities on October 18, 2005, a $160 million KPG credit facility was closed. Debt outstanding under the KPG credit facility of $57 million was repaid and the guarantees of $160 million were terminated. This reduces the amount of guarantees of debt owed by subsidiaries.
The Company and its U.S. subsidiaries guarantee debt and other payment obligations owed to lenders and their affiliates under the $2.7 billion Secured Credit Agreement dated October 18, 2005. Essentially these obligations are included in the Company’s Consolidated Statement of Financial Position. Due to the nature of this guarantee it is not practicable to determine the exact amount of obligations guaranteed to the specific lenders and their affiliates.
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The Company may provide up to $100 million in loan guarantees to support funding needs for SK Display Corporation, an unconsolidated affiliate in which the Company has a 34% ownership interest. As of September 30, 2005, the Company has not been required to guarantee any of the SK Display Corporation’s outstanding debt.
The Company issues indemnifications in certain instances when it sells businesses and real estate, and in the ordinary course of business with its customers, suppliers, service providers and business partners. Further, the Company indemnifies its directors and officers who are, or were, serving at Kodak’s request in such capacities. Historically, costs incurred to settle claims related to these indemnifications have not been material to the Company’s financial position, results of operations or cash flows. Additionally, the fair value of the indemnifications that the Company issued during the quarter ended September 30, 2005 was not material to the Company’s financial position, results of operations or cash flows.
OTHER
Refer to Note 6: Commitments and Contingencies to the Notes to Financial Statements for discussion regarding the Company’s undiscounted accrued liabilities for environmental remediation costs relative to September 30, 2005.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 2005, the Financial Accounting Standards Board (FASB) issued Staff Position No. 143-1, “Accounting for Electronic Equipment Waste Obligations” (FSP 143-1). FSP 143-1 addresses the accounting for obligations associated with Directive 2002/96/EC on Waste Electrical and Electronic Equipment adopted by the European Union, and requires application of the provisions of SFAS No. 143 and FIN 47 as those standards relate to the Directive. This FSP is effective the later of the first reporting period ending after June 8, 2005, or the date of adoption of the Directive by the individual EU-member countries. There have been no material impacts on the Company’s consolidated financial statements resulting from the adoption of this FSP in those countries for which the Directive has been adopted, and there are no material impacts expected in the future from the adoption of the Directive in the remaining EU-member countries.
In March 2005, the FASB issued FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (FIN 47). FIN 47 clarifies that the term “conditional asset retirement obligation” as used in FASB No. 143, “Accounting for Asset Retirement Obligations,” refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the Company. In addition, FIN 47 clarifies when a company would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effective no later than the end of the fiscal year ending after December 15, 2005. Retrospective application of interim financial information is permitted but not required. The Company is currently evaluating the impact of FIN 47 on its consolidated financial statements and will implement the provisions of FIN 47 during the fourth quarter of 2005.
In December 2004, the FASB issued Statement No. 123R, “Share-Based Payment,” a revision to SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123R eliminates the alternative to record compensation expense using the intrinsic value method of accounting under Accounting Principles Board Opinion 25 (Opinion 25) that was provided in SFAS No. 123 as originally issued.
Under Opinion 25, issuing stock options to employees generally resulted in the recognition of no compensation cost if the options were granted with an exercise price equal to their fair value at the date of grant. SFAS No. 123R requires companies to measure and record the cost of employee services received in exchange for an award of equity instruments based on the fair value of the award at the date of grant (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award (usually the vesting period). No compensation cost is recognized for equity instruments for which employees do not render the requisite service.
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In April 2005, the Securities and Exchange Commission voted to change the effective date of SFAS No. 123R to fiscal years starting after June 15, 2005; however, early application is encouraged. The Company adopted the modified version of the prospective application of SFAS No. 123R as of January 1, 2005 under which the Company is required to recognize compensation expense, over the applicable vesting period, based on the fair value of (1) any unvested awards subject to SFAS No. 123R existing as of January 1, 2005, and (2) any new awards granted subsequent to the adoption date. Refer to Note 11, “Shareholders’ Equity” for the effect of adoption on the Company’s consolidated financial statements.
In December 2004, the FASB issued SFAS No. 151, “Inventory Costs” that amends the guidance in Accounting Research Bulletin No. 43, Chapter 4, “Inventory Pricing,” (ARB No. 43) to clarify the accounting for abnormal idle facility expense, freight, handling costs, and wasted material (spoilage). In addition, this Statement requires that an allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 is effective for inventory costs incurred for fiscal years beginning after June 15, 2005 (year ending December 31, 2006 for the Company). The Company does not expect the implementation of SFAS No. 151 to have a material impact on its financial statements.
In December 2004, FASB issued FSP No. 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 (the “Act”).” The Act, which was signed into law on October 22, 2004, provides for a special one-time tax deduction of 85 percent of certain foreign earnings that are repatriated (as defined in the Act) in either a company’s last tax year that began before the enactment date, or the first tax year that begins during the one-year period beginning on the date of enactment. Accordingly, the FSP provides guidance on accounting for income taxes that relate to the accounting treatment for unremitted earnings in a foreign investment (a consolidated subsidiary or corporate joint venture that is essentially permanent in nature). Further, the FSP permits a company time beyond the financial reporting period of enactment to evaluate the effect of the Act on its plan for reinvestment or repatriation of foreign earnings for purposes of applying FASB Statement No. 109, “Accounting for Income Taxes.” Accordingly, an enterprise that has not yet completed its evaluation of the repatriation provision for purposes of applying Statement 109 is required to disclose certain information, for each period for which financial statements covering periods affected by the Act are presented. Subsequently, the total effect on income tax expense (or benefit) for amounts that have been recognized under the repatriation provision must be provided in a company’s financial statements for the period in which it completes its evaluation of the repatriation provision. The provisions of FSP 109-2 were effective in the fourth quarter of 2004.
In the third quarter of 2005, the Company completed its evaluation of the repatriation provision. The Company has determined that it is eligible and intends to repatriate approximately $500 million in dividends subject to the 85% dividends received deduction. Accordingly, the Company recorded a corresponding tax provision of approximately $20 million in the third quarter of 2005 with respect to such dividends. See Note 5, “Income Taxes,” for further disclosure.
CAUTIONARY STATEMENT PURSUANT TO SAFE HARBOR PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Certain statements in this report may be forward-looking in nature, or “forward-looking statements” as defined in the United States Private Securities Litigation Reform Act of 1995. For example, references to expectations for the Company’s cash, cost savings, capital spending and inventories, and for the consumer film industry’s volumes are forward-looking statements.
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Actual results may differ from those expressed or implied in forward-looking statements. In addition, any forward-looking statements represent the Company’s estimates only as of the date they are made, and should not be relied upon as representing the Company’s estimates as of any subsequent date. While the Company may elect to update forward-looking statements at some point in the future, the Company specifically disclaims any obligation to do so, even if its estimates change. The forward-looking statements contained in this report are subject to a number of factors and uncertainties, including the successful: implementation of the digital growth strategy and business model; implementation of a changed segment structure; implementation of the cost reduction program, including asset rationalization, reduction in general and administrative costs and personnel reductions; implementation of, and performance under, the debt management program; implementation of product strategies (including category expansion, digitization, organic light emitting diode (OLED) displays, and digital products); implementation of intellectual property licensing and other strategies; development and implementation of e-commerce strategies; completion of information systems upgrades, including SAP, our enterprise system software; completion of various portfolio actions; reduction of inventories; integration of newly acquired businesses; improvement in manufacturing productivity and techniques; improvement in receivables performance; reduction of capital expenditures; improvement in supply chain efficiency; implementation of the strategies designed to address the decline in the Company’s analog businesses; and the performance of the Company’s business in emerging markets like China, India, Brazil, Mexico, and Russia. The forward-looking statements contained in this report are subject to the following additional risk factors: inherent unpredictability of currency fluctuations and raw material costs; competitive actions, including pricing; changes in the Company’s debt credit ratings and its ability to access capital markets; the nature and pace of technology evolution, including the analog-to-digital transition; continuing customer consolidation and buying power; current and future proposed changes to tax laws, as well as other factors which could adversely impact the Company’s effective tax rate in the future; general economic, business, geo-political, regulatory and public health conditions; predictions of market growth and market decline; and other factors and uncertainties disclosed from time to time in the Company’s filings with the Securities and Exchange Commission.
Any forward-looking statements in this report should be evaluated in light of these important factors and uncertainties.
Item 3. Quantitative And Qualitative Disclosures About Market Risk
The Company, as a result of its global operating and financing activities, is exposed to changes in foreign currency exchange rates, commodity prices, and interest rates, which may adversely affect its results of operations and financial position. In seeking to minimize the risks associated with such activities, the Company may enter into derivative contracts.
Foreign currency forward contracts are used to hedge existing foreign currency denominated assets and liabilities, especially those of the Company’s International Treasury Center, as well as forecasted foreign currency denominated intercompany sales. Silver forward contracts are used to mitigate the Company’s risk to fluctuating silver prices. The Company’s exposure to changes in interest rates results from its investing and borrowing activities used to meet its liquidity needs. Long-term debt is generally used to finance long-term investments, while short-term debt is used to meet working capital requirements. The Company does not utilize financial instruments for trading or other speculative purposes.
Using a sensitivity analysis based on estimated fair value of open forward contracts using available forward rates, if the U.S. dollar had been 10% weaker at September 30, 2005 and 2004, the fair value of open forward contracts would have decreased $5 million and increased $45 million, respectively. Such gains or losses would be substantially offset by losses or gains from the revaluation or settlement of the underlying positions hedged.
Using a sensitivity analysis based on estimated fair value of open forward contracts using available forward prices, if available forward silver prices had been 10% lower at September 30, 2005 and 2004, the fair value of open forward contracts would have decreased $2 million and $1 million, respectively. Such losses in fair value, if realized, would be offset by lower costs of manufacturing silver-containing products.
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The Company is exposed to interest rate risk primarily through its borrowing activities and, to a lesser extent, through investments in marketable securities. The Company may utilize borrowings to fund its working capital and investment needs. The majority of short-term and long-term borrowings are in fixed-rate instruments. There is inherent roll-over risk for borrowings and marketable securities as they mature and are renewed at current market rates. The extent of this risk is not predictable because of the variability of future interest rates and business financing requirements.
Using a sensitivity analysis based on estimated fair value of short-term and long-term borrowings, if available market interest rates had been 10% higher (about 52 basis points) at September 30, 2005, the fair value of short-term and long-term borrowings would have decreased $4 million and $64 million, respectively. Using a sensitivity analysis based on estimated fair value of short-term and long-term borrowings, if available market interest rates had been 10% higher (about 35 basis points) at September 30, 2004, the fair value of short-term and long-term borrowings would have decreased $1 million and $58 million, respectively.
The Company’s financial instrument counterparties are high-quality investment or commercial banks with significant experience with such instruments. The Company manages exposure to counterparty credit risk by requiring specific minimum credit standards and diversification of counterparties. The Company has procedures to monitor the credit exposure amounts. The maximum credit exposure at September 30, 2005 was not significant to the Company.
Item 4. Controls and Procedures
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities and Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures.
As of the end of the period covered by this Quarterly Report on Form 10-Q, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to the Securities and Exchange Act Rule 13a-15. Based upon this evaluation as of September 30, 2005, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were not effective for the reasons more fully described below related to: (1) the unremediated material weaknesses in the Company’s internal control over financial reporting identified during the Company’s evaluation pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 as of the year ended December 31, 2004, and (2) the material weakness that was identified during the third quarter of 2005, as described below under “Changes in Internal Control over Financial Reporting.” A material weakness is a control deficiency, or combination of control deficiencies, that result in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.
To address these control weaknesses, the Company performed additional analysis and performed other procedures in order to prepare the unaudited quarterly consolidated financial statements in accordance with generally accepted accounting principles in the United States of America. Accordingly, management believes that the consolidated financial statements included in this Quarterly Report on Form 10-Q fairly present, in all material respects, our financial condition, results of operations and cash flows for the periods presented.
Management’s assessment identified the following material weaknesses in the Company’s internal control over financial reporting as of December 31, 2004 and September 30, 2005 that are in the process of being remediated as of September 30, 2005: material weaknesses relating to (a) internal controls surrounding the accounting for income taxes; (b) internal controls to validate the accuracy of participant census data and the monitoring of benefit payments for pension and other postretirement benefit plans and (c) internal controls surrounding the preparation and review of spreadsheets that include new or changed formulas, as described below. Accordingly, this section of Item 4, “Controls and Procedures,” should be read in conjunction with Item 9A, “Controls and Procedures,” included in the Company’s Form 10-K for the year ended December 31, 2004 and the section “Changes in Internal Control over Financial Reporting” included below within this Item 4 disclosure.
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Internal Controls Surrounding the Accounting for Income Taxes:
The principal factors contributing to the material weakness in accounting for income taxes were as follows:
| • | Lack of local tax law expertise or failure to engage local tax law expertise resulting in the incorrect assumption of reduced tax expense associated with restructuring charges in various foreign locations in 2004 and 2003; |
| • | Inadequate knowledge and application of the provisions of SFAS No. 109 by tax personnel resulting in errors in the accounting for income taxes; |
| • | Lack of clarity in roles and responsibilities within the global tax organization related to income tax accounting; |
| • | Insufficient or ineffective review and approval practices within the global tax and finance organizations resulting in the errors not being prevented or detected in a timely manner; and |
| • | Lack of processes to effectively reconcile the income tax general ledger accounts to supporting detail and adequate verification of data used in computations. |
This material weakness contributed to the restatement of the Company’s consolidated financial statements for 2003, for each of the quarters in the year ended December 31, 2003 and for the first, second and third quarters for 2004, and in the Company’s recording audit adjustments to the fourth quarter 2004 financial statements. Additionally, if this material weakness is not corrected, it could result in a material misstatement of the income tax accounts that would result in a material misstatement to annual or interim financial statements that might not be prevented or detected.
Internal Controls Surrounding the Accounting for Pension and Other Postretirement Benefit Plans:
The principal factors contributing to the material weakness in the internal controls to validate the accuracy of participant census data and the monitoring of benefit payments for pension and other postretirement benefit plans included the following control deficiencies as discovered by management during the year end 2004 closing procedures and in conjunction with testing of controls during management’s assessment of internal control over financial reporting:
| • | A deficiency in the design of controls to validate actual versus estimated benefit payments in the accounting for other postretirement benefits. The design deficiency was an erroneous belief that actual payment data could not be captured at the required level of detail to enable adjustment of actuarial estimates on a quarterly basis. |
| | |
| • | A failure to demonstrate operating effectiveness in controls surrounding reconciliation of participant census data between source systems and the plan actuary models for various domestic and international pension and other postretirement benefit plans. While analytical procedures to validate the reasonableness of census data extracts were employed, they were not sufficiently robust to prevent or detect errors in census data which could result in more than a remote possibility of a material misstatement of the Company’s financial statements. |
This material weakness resulted in adjustments that were included in the restatement of the Company’s consolidated financial statements for 2003, for each of the quarters in the year ended December 31, 2003 and for the first, second and third quarters for 2004, and in the Company’s recording adjustments to the fourth quarter 2004 financial statements. Additionally, if this material weakness is not corrected, it could result in a material misstatement of the pension and postretirement accounts that would result in a material misstatement to annual or interim financial statements that might not be prevented or detected.
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The Company identified these material weaknesses in its internal control over financial reporting during its evaluation pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 as of December 31, 2004; accordingly, these material weaknesses are in the process of being remediated as of September 30, 2005. The findings outlined above were classified as material weaknesses in accordance with the standards of the Public Company Accounting Oversight Board, as a more than remote likelihood that a material misstatement of the Company’s interim or annual financial statements would not be prevented or detected. Refer to the specific remediation steps identified below.
Remediation Plans for Material Weaknesses in Internal Control over Financial Reporting
During the three months ended September 30, 2005, the Company has made significant progress in executing the remediation plans as outlined above. This resulted in material improvements in the Company’s internal control over financial reporting, specifically surrounding 1) the accounting for income taxes, and 2) the accounting for pension and other postretirement benefit plans. With the help of external advisors (other than our registered independent accounting firm), the following remedial actions have been undertaken:
Accounting for Income Taxes
| • | Effective July 11, 2005 and August 1, 2005, the Company hired a new Chief Tax Officer and Tax Accounting Controller, respectively. |
| | |
| • | A root cause analysis was performed on all control deficiencies. Using the results of this analysis, new processes and procedures, with appropriate controls, were developed, documented and implemented in the third quarter of 2005 for the majority of the processes that are critical to the Company’s income tax provision calculations reflected in its periodic financial reporting. |
| | |
| • | In the third quarter of 2005, the Company developed and rolled out clearly defined and enhanced roles and responsibilities across the worldwide income tax organization. |
| | |
| • | A detailed, quarterly income tax reporting package, which collects tax-sensitive data and information at the jurisdictional level, was developed and rolled-out in the third quarter of 2005. |
| | |
| • | In August and September 2005, the Company held training sessions for the worldwide income tax organization, as well as certain Controller’s personnel. Topics covered in the sessions included accounting for income taxes, training on the newly developed processes, procedures, internals controls and the income tax reporting package, and Sections 302 and 404 of the Sarbanes-Oxley Act of 2002. |
| | |
| • | Effective October 24, 2005, the Company has hired an Audit Manager with a strong income tax background who, in conjunction with co-source resources from an external consultant, will enhance our audit procedures surrounding accounting for income taxes. |
In addition to the above, the Company continues to investigate the implementation of an IT solution to enhance controls with respect to the collection, tracking and bookkeeping of detailed tax information on a global basis. Further, the Company will continue its efforts with respect to 1) enhancing the overall design of the worldwide income tax organization, 2) evaluating the need to further upgrade its tax personnel, and 3) developing an effective and efficient forecasting process for purposes of determining its effective tax rate.
Although substantial progress has been made, the Company’s remediation efforts are not complete and the Company does not yet have sufficient evidence of the operational effectiveness of the controls undergoing remediation to conclude that such actions have been successful in remediating the material weakness in internal control addressed above.
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Accounting for Pension and Other Postretirement Benefit Plans
| • | A root cause analysis was performed on all control deficiencies. Using the results of this analysis, new processes and procedures, with appropriate controls, were developed, documented and implemented in the third quarter of 2005 for all of the relevant processes that are critical to the Company’s quarterly and annual reporting requirements, as well as the annual actuarial valuations for the Company’s pension and other postretirement benefit plans. |
| | |
| • | In the third quarter of 2005, the Company developed and rolled-out clearly defined and enhanced roles and responsibilities across the Finance, Human Resource, Information Technology, and Global Shared Services functions, for those individuals with responsibilities in this area. |
| | |
| • | The Company completed its implementation and roll-out of a global IT system which will enable the control environment with respect to the tracking of benefit arrangements, collection of census and funding data, assumption-setting and journal entries that are critical to the actuarial valuation and accounting for pension and other postretirement benefit plans. |
| | |
| • | The Company developed a detailed training protocol, which is currently being implemented to the appropriate personnel in the respective functions. Topics covered in the sessions include accounting for pension and other postretirement benefit plans, training on the newly developed processes, procedures, controls and the global IT system, and Sections 302 and 404 of the Sarbanes-Oxley Act of 2002. |
| | |
| • | Existing regional resources that have consistently demonstrated strong benefits valuation and reporting knowledge have been identified to provide first-level support to their regional colleagues. |
| | |
| • | In preparation for the upcoming annual actuarial valuations, an extensive review of census data quality is being undertaken for all material pension and other postretirement benefit plans. |
Although substantial progress has been made, the Company’s remediation efforts are not complete and the Company does not yet have sufficient evidence of the operational effectiveness of the controls undergoing remediation to conclude that such actions have been successful in remediating the material weakness in internal control addressed above.
Changes in Internal Control over Financial Reporting
In connection with the Company’s closing process for the quarter ended September 30, 2005, the Company identified errors in the accounting for restructuring accruals associated with severance and special pension-related termination benefits of $11 million (net of tax) and $4 million (net of tax), respectively. As indicated in Note 1, “Basis of Presentation,” of the consolidated financial statements for the third quarter of 2005, the Company will restate the previously issued financial statements for the first and second quarters of 2005 as a result of these errors. In performing the Company’s quarterly evaluation of the effectiveness and of the design and operation of its disclosure controls and procedures as of September 30, 2005, including its assessment as to whether or not these two items constitute changes during the third quarter of 2005 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting, the Company considered the following in making its conclusions:
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Special Pension-Related Termination Benefits
In reconciling the general ledger balance sheet account for one of the Company’s international pension plans as of September 30, 2005 in accordance with the implementation and reinforcement of controls being undertaken in connection with the Company’s material weakness remediation efforts relating to the pension and postretirement benefit plan area, the Company discovered it had overaccrued the special termination benefits for the quarters ended March 31, 2005 and June 30, 2005 by $2 million (net of tax) and $2 million (net of tax), respectively. The Company performed a root cause analysis to understand the control deficiency, which revealed that the error was the result of a failure in the operation of the existing preventive and detective controls that were appropriately designed to ensure the timely reconciliation of the related general ledger balance sheet account. The Company is in the process of remediating this control deficiency in connection with its ongoing efforts to remediate the material weakness in its internal controls surrounding the accounting for pension and other postretirement benefit plans as discussed above.
Severance
In reconciling the general ledger balance sheet account for severance as of September 30, 2005 relating to one of the Company’s plant closings in the United Kingdom under its ongoing restructuring program, the Company discovered that a spreadsheet error caused it to overstate a severance accrual as of and for the quarter ended June 30, 2005 by $11 million (net of tax). The Company performed a root cause analysis to understand the control deficiencies, which revealed that the error was primarily the result of a failure in the operation of, not the design of, the existing preventive and detective controls surrounding the preparation and review of spreadsheets that include new or changed formulas. This deficiency resulted from a failure to follow established policies and procedures partially due to changes in personnel.
The Company has concluded that this deficiency constitutes a “material weakness” as defined by the Public Company Accounting Oversight Board’s Auditing Standard No. 2. This material weakness resulted in an adjustment that will be included in the restatement of the Company’s consolidated financial statements as of and for the quarter ended June 30, 2005. Additionally, if the material weakness is not corrected, it could result in a material misstatement of other financial statement accounts that utilize spreadsheets that would result in a material misstatement to annual or interim financial statements that might not be prevented or detected.
The Company believes that this material weakness will be remediated by December 31, 2005. As this deficiency resulted from the failure to follow established policies and procedures partially due to changes in personnel, the remediation will primarily constitute the reinforcement, through communication with the appropriate individuals, of the importance of adherence to the internal control structure that is in place.
Except for the matters discussed above and the continuing integration of the second quarter 2005 acquisitions of KPG and Creo Inc., there have been no changes in the Company’s internal control over financial reporting during the most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. As of and for the year ended December 31, 2004, KPG net sales and total assets were $1,715 million and $1,310 million, respectively. As of and for the year ended September 30, 2004, Creo Inc. net sales and total assets were $636 million and $579 million, respectively.
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Part II. OTHER INFORMATION
Item 1. Legal Proceedings
During March 2005, the Company was contacted by members of the Division of Enforcement of the Securities and Exchange Commission (the “SEC”) concerning the announced restatement of the Company’s Financial Statements for the full year and quarters of 2003 and the first three unaudited quarters of 2004. An informal inquiry by the staff of the SEC into the substance of that restatement is continuing. The Company has fully cooperated with this inquiry, and the staff has indicated that the inquiry should not be construed as an indication by the SEC or its staff that any violations of law have occurred.
On June 13, 2005, a purported shareholder class action lawsuit was filed against the Company and two of its current executives in the United States District Court for the Southern District of New York. On June 20, 2005 and August 10, 2005, similar lawsuits were filed against the same defendants in the United States District Court for the Western District of New York. The complaints filed in each of these actions (collectively, the “Complaints”) seek to allege claims under the Securities Exchange Act on behalf of a proposed class of persons who purchased securities of the Company between April 23, 2003 and September 25, 2003, inclusive. The substance of the Complaints is that various press releases and other public statements made by the Company during the proposed class period allegedly misrepresented the Company’s financial condition and omitted material information regarding, among other things, the state of the Company’s film and paper business. The cases have been consolidated in the Western District of New York and the lead plaintiffs are John Dudek and the Alaska Electrical Pension Fund. Defendants’ initial responses to the Complaints are not yet due. The Company intends to defend these lawsuits vigorously but is unable currently to predict the outcome of the litigation or to estimate the range of potential loss, if any.
Item 6. Exhibits
(a) Exhibits required as part of this report are listed in the index appearing on page 77.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | | EASTMAN KODAK COMPANY |
| | | (Registrant) |
| | |
Date: November 9, 2005 | | /s/ Richard G. Brown |
| |
|
| | Richard G. Brown |
| | Controller |
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Eastman Kodak Company
Index to Exhibits
Exhibit
Number | | |
| | |
(3) A. | | Certificate of Incorporation, as amended and restated May 11, 2005. |
| | (Incorporated by reference to the Eastman Kodak Company Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2005, Exhibit 3.) |
| | |
(3) B. | | By-laws, as amended and restated May 11, 2005. |
| | (Incorporated by reference to the Eastman Kodak Company Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2005, Exhibit 3.) |
| | |
(4) K. | | Secured Credit Agreement, dated as of October 18, 2005, among Eastman Kodak Company and Kodak Graphic Communications Canada Company, the banks named therein, Citigroup Global Markets Inc., as lead arranger and bookrunner, Lloyds TSB Bank PLC, as syndication agent, Credit Suisse, Cayman Islands Branch, Bank of America, N. A. and The CIT Group/Business Credit, Inc., as co-documentation agents, and Citicorp USA, Inc., as agent for the lenders. |
| | (Incorporated by reference to the Eastman Kodak Company Form 8-K, filed on October 24, 2005, Exhibit 4.1.) |
| | |
(4) L. | | Security Agreement, dated as of October 18, 2005, among Eastman Kodak Company, the subsidiary grantors identified therein and Citicorp USA, Inc., as agent, relating to the Secured Credit Agreement. |
| | (Incorporated by reference to the Eastman Kodak Company Form 8-K, filed on October 24, 2005, Exhibit 4.2.) |
| | |
(4) M. | | Canadian Security Agreement, dated as of October 18, 2005, among Kodak Graphic Communications Canada Company and Citicorp USA, Inc., as agent, relating to the Secured Credit Agreement. |
| | (Incorporated by reference to the Eastman Kodak Company Form 8-K, filed on October 24, 2005, Exhibit 4.3.) |
| | |
(10) F. | | Letter dated May 10, 2005, from the Chair, Executive Compensation and Development Committee, to Daniel A. Carp. |
| | (Incorporated by reference to the Eastman Kodak Company Form 8-K, filed on May 11, 2005.) |
| | |
(10) P. | | Amendment to Letter Agreement, effective May 5, 2005, between Eastman Kodak Company and Bernard Masson. |
| | (Incorporated by reference to the Eastman Kodak Company Form 8-K, filed on May 6, 2005.) |
| | |
| | Letter Agreement, dated September 30, 2005, between Eastman Kodak Company and |
| | Bernard Masson. |
| | (Incorporated by reference to the Eastman Kodak Company Form 8-K, filed on October 6, 2005.) |
| | |
(10) S. | | Eastman Kodak Company Executive Compensation for Excellence and Leadership Plan, as amended May 11, 2005. |
| | (Incorporated by reference to the Eastman Kodak Company Form 8-K, filed on May 11, 2005.) |
| | |
(10) BB. | | Form of Notice of Award of Restricted Stock with a Deferral Feature, pursuant to the 2005 Omnibus Long-Term Compensation Plan. |
| | (Incorporated by reference to the Eastman Kodak Company Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2005, Exhibit 10.) |
| | |
(10) CC. | | Notice of Award of Restricted Stock with a Deferral Feature Granted to Antonio M. Perez, Effective June 1, 2005, pursuant to the 2005 Omnibus Long-Term Compensation Plan. |
| | (Incorporated by reference to the Eastman Kodak Company Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2005, Exhibit 10.) |
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Eastman Kodak Company
Index to Exhibits (continued)
Exhibit
Number | | |
| | |
(10) DD. | | Letter dated May 10, 2005, from the Chair, Executive Compensation Development Committee, to Antonio M. Perez. |
| | (Incorporated by reference to the Eastman Kodak Company Form 8-K, filed on May 11, 2005.) |
| | |
(10) EE. | | Eastman Kodak Company 2005 Omnibus Long-Term Compensation Plan, effective January 1, 2005. |
| | (Incorporated by reference to the Eastman Kodak Company Form 8-K, filed on May 11, 2005.) |
| | |
(10) FF. | | Form of Notice of Award of Non-Qualified Stock Options pursuant to the 2005 Omnibus Long-Term Compensation Plan. |
| | (Incorporated by reference to the Eastman Kodak Company Form 8-K, filed on May 11, 2005.) |
| | |
(10) GG. | | Form of Notice of Award of Restricted Stock, pursuant to the 2005 Omnibus Long-Term Compensation Plan. |
| | (Incorporated by reference to the Eastman Kodak Company Form 8-K, filed on May 11, 2005.) |
| | |
(10) HH. | | Form of Administrative Guide for Annual Officer Stock Options Grant under 2005 Omnibus Plan. |
| | |
(10) II. | | Form of Award Notice for Annual Director Stock Option Grant under 2005 Omnibus Plan. |
| | |
(10) JJ. | | Form of Award Notice for Annual Director Restricted Stock Grant under 2005 Omnibus Plan |
| | |
(12) | | Statement Re Computation of Ratio of Earnings to Fixed Charges. |
| | |
(31.1) | | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | |
(31.2) | | Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | |
(32.1) | | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| | |
(32.2) | | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
