Eastman Kodak Co (KODK) 2005 Q3 法說會逐字稿

Good day, everyone, and welcome to the Eastman Kodak third-quarter sales and earnings conference call.

Today's conference is being recorded.

At this time, for opening remarks and introductions I would like to turn the conference over to the Director and Vice President of Investor Relations, Mr. Don Flick.

Please go ahead, sir.

Good morning and welcome to our conference call this morning.

I am here with Antonio Perez, Kodak's Chief Executive Officer; and Bob Brust, our Chief Financial Officer.

Bob will be reviewing our financial performance in the third quarter followed by Antonio who will provide an operating perspective on that period.

Before we begin, I have the usual housekeeping activities to complete.

First, certain statements during this conference call may be forward-looking in nature or forward-looking statements as defined in the United States Private Securities and Litigation Reform Act of 1995.

For example, references to expectations for the Company's earnings, revenue, and cash are such forward-looking statements.

Actual results may differ from those expressed or implied in forward-looking statements.

These forward-looking statements are subject to a number of important risk factors and uncertainties, which are fully enumerated in our press release this morning.

Listeners are advised to review this statement.

Lastly, Kodak has largely stopped disclosing non-GAAP measures with this quarter, except in the areas of digital revenue, digital earnings and investable cash as we have metrics in these areas that predate that decision.

Therefore, we feel it is helpful to investors to continue the same basis of comparison.

As we go forward, we will continue to move in the direction of GAAP-only disclosure, but we will continue the use of these measures for the balance of the year.

Where we do use non-GAAP measures today, they are reconciled in our release this morning to the nearest GAAP equivalent.

And now I would like to introduce Bob Brust.

Thanks, Don, and good morning, everyone.

I would like to spend the next few minutes discussing our third-quarter financial results and our plans for cash.

Then Antonio will provide you with comments from an operating and strategic perspective.

I need to remind you of a number of changes we announced at our September 28, meeting.

These include the adoption of shorter useful life assumptions for our traditional and digital assets.

Resulting in accelerated depreciation costs.

And the reallocation of legacy costs associated with our traditional businesses.

Both of these have an impact on third-quarter results and reflect our ongoing efforts to refine our metrics.

I would like to point out that at our September investor meeting, we estimated that the reallocation of our legacy costs would result in a favorable impact on digital earnings of $120 million this year.

As we close the quarter and finalize the calculation methodology for this change, we revised that impact to $68 million for the full-year 2005.

The quarter was in line with the goals and expectations we outlined at our September investor meeting.

Digital revenue growth was 47% year-over-year, driven primarily by the recent acquisitions within the Graphic Communications Group.

DFIS also had a strong digital quarter with digital capture growing 20%, home printing up 45%, and kiosks up 48%.

Traditional products revenue declined 20%, which is essentially on our expectations.

Consolidated revenue growth for the Company was 5%.

We concluded a favorable exchange impact of $22 million or a 1% increment to sales.

In the quarter, digital revenues totaled 1.89 billion, and traditional revenues totaled 1.66 billion.

Gross profit margin was 26.3% versus 32% last year.

Gross profit includes the following items.

Additional year-over-year restructuring costs of 78 million, additional write-off of physical assets of approximately 30 million, and higher depreciation costs of 66 million due to use -- asset useful life changes.

Excluding these items, gross profit was around 31.3%.

In the quarter, SG&A increased 44 million or 7%, and as a percentage of sales from 18.6 to 18.9%.

This increase was driven by acquisition-related SG&A costs of $94 million, which was partially offset by cost reduction activities during the quarter.

Excluding the acquisitions, SG&A actually declined by 8%.

R&D declined $2 million or 1% despite the infusion of net acquisition-related R&D costs of $10 million.

As part of our expanded cost reduction program, the Company recorded third-quarter pretax charges totaling 261 million or $0.71 per share which included severance associated with the elimination of approximately 2,000 positions during the quarter.

These charges also included acceleration -- accelerated depreciation, exit costs, and asset and inventory writedowns.

Third-quarter digital earnings were $10 million, which includes a favorable impact of 18 million in the current quarter for legacy cost allocation changes and a charge of approximately $5 million for reducing the useful lives of certain digital assets.

To calculate a common basis of comparison with our digital earnings projection as adjusted for the two accounting changes cited requires the exclusion of $44 million of costs associated with purchase accounting and Creo operating results and the exclusion of in process R&D credits of $12 million which net to $32 million.

On this basis, digital earnings were $42 million in the current quarter.

The earnings trend gained momentum as the quarter progressed with significant digital earnings improvement recorded for the month of September alone.

The trend is in line with our seasonal digital expectations, as more than 40% of the Company's total digital revenues are expected to occur in the last four months of the year.

This high percentage of revenue late in the year will favorably -- will favorably leverage our cost structure.

As you know, the year is especially back-end loaded due to the April 1, acquisition of KPG and the June 15, acquisition of Creo.

The other income and charges category had a negative year-over-year swing of $39 million.

The biggest contributor to the year-over-year change is the elimination of KPG equity income.

KPG results are now recorded in the Graphic Communications Group segment as a result of Kodak's purchase of this business in April.

Interest expense was 57 million in the current quarter, an increase of 14 million from the third quarter of last year, as a result of increased levels of debt associated with our acquisitions.

Quarterly results also include the recording of a valuation allowance of $900 million to writedown the net deferred tax assets in the U.S.

This valuation allowance results from a number of factors including the continuing losses in the U.S. created by our accelerated and extensive restructuring access.

The past losses and expected future losses in the U.S. in the near term, while we restructure during the next five quarters or so requires the Company to establish this valuation allowance in accordance with GAAP.

This, of course, has no cash impact, and the net deferred tax assets may still be realizable in the future when we return to profitability in the U.S.

As a result of these factors Kodak posted a $3.59 loss per share for the third quarter on a continuing operations basis.

Turning now to cash and liquidity.

This week the final agreement was signed covering our $2.7 billion credit secured facilities which provides us with permanent financing for our recently completed acquisition -- acquisitions and renews our line of credit.

The credit facilities include a five-year $1 billion revolving credit line which is expected to be used for general corporate purposes and replaces our existing $1.225 billion line of credit.

In addition, we have a $1.7 billion term loan of which 1.2 billion was drawn at closing, largely to repay debt for the Creo acquisition.

The remaining 500 million is available for future use through June of 2006.

This puts us in a good liquidity position.

I would now like to discuss our cash plans for the balance of the year.

To remain consistent with our previous discussion -- discussion basis, I will be using our concept of investable cash flow.

To get there, I start with net cash from operating activities in the quarter of 370 million, add 40 million of asset sales in the quarter and subtract 122 million of capital expenditures and $72 million of dividends.

That gets me to the third-quarter investable cash flow of positive 216 million, in line with our expectations.

Our cash balance at the end of the quarter was $610 million, an increase of $57 million quarter sequentially.

We also paid down approximately $160 million of debt during the third quarter.

Remember investable cash either goes in the bank, pays down debt or is used for acquisition.

We will either bank the cash or pay down debt for the foreseeable future.

Our new targeted cash balance at the end of the year 2005 is now expected to be approximately 1.3 billion reflecting the additional 200 million of debt from our recently concluded deal.

We will also pay down some debt during the fourth quarter, and so our estimated data year end will be approximately 3.5 billion, essentially flat with third-quarter levels.

The $1.3 billion cash balance along with our recently signed credit agreement provides adequate liquidity to the Company for the foreseeable future.

We intend to pay down debt for the next few years and fund the transformation of the Company.

To reach that cash balance at year end, means we need to generate 400 to 500 million of investable cash flow for the year which is in line with our discussion from our September investor meeting.

Because we have used 339 million of investable cash through three quarters, we will have to generate approximately 790 million during the fourth quarter, at a midpoint -- to get to a midpoint of approximately 450 million for the year.

That would put our cash balance in the 1.3 billion range after we pay down the debt in the fourth quarter.

Here's the basics of that plan.

We often generate 400 to $450 million of investable cash in the fourth quarter. 400 to 500 million of investable cash in the fourth quarter.

Let's use 450 for this exercise.

This assumes good cash earnings performance in the the fourth quarter and the strong digital revenue with good cost leverage should ensure the cash from earnings..

Our inventory plans include an approximate $300 million reduction in digital inventories and approximate $200 million reduction in traditional inventories.

Achievement of these targets would generate 250 to 300 million, above what has happened in the recent performance.

We are also planning asset sales of between 100 and 200 million during the fourth quarter and this would all be incremental to the recent performance of the past few years.

We will hold capital expenditures to less than 450 million for the year, or around 100 million for the fourth quarter and pay out approximately $625 million of cash restructuring payments this year, which is around 180 million to be paid in the fourth quarter.

Adding the incremental 250 from inventory and 150 million from asset sales to the 450 million of normal cash yields just more than 800 million, which achieves our objectives.

This is a big number for the fourth quarter, but we have plans and actions in place to execute.

All in all, our three critical measures for success, digital revenue growth, digital earnings growth, and cash flow were in line with expectations we outlined at our recent investor meeting.

We will begin reporting digital earnings by business segment with the first quarter of 2006.

Now I would like to turn the call over to Antonio.

Thank you, Bob, and good morning to everyone.

I am pleased with how this quarter came out.

Again, the three key metrics that will define the future of Kodak.

Which were strong digital revenues, good year-over-year growth in digital earnings, and our cash performance is moving upwards as per plan.

I am especially pleased with the strong uptick we experienced in September which is very encouraging news getting to the very important Q4.

In other words, in line with the view we presented to the investment community in our meeting on September 28, we continue to push hard to remove costs from the firm, complete the restructuring of our traditional assets, drive digital revenues and earnings, and pursue our cash goals.

Digital revenues were up 47% in the quarter and 38% year to date.

It is also important to note that this is the first quarter where the Company had greater revenues from digital sources than from traditional sources.

This is an important milestone in our transformation journey.

I will also remind you of our new seasonality, where a disproportionate amount of our revenue occurs in our fourth quarter.

As we indicated in our recent meeting, we expect more than 50% of our full-year consumer digital revenues to occur in the last four months of this year.

This situation is further exaggerated this year due to mid-year acquisitions of our Graphic Communications Group that add to the year-over-year comparisons for the whole company.

As a result, we are looking for more than 40% of total company digital revenues to be booked in the September through December time frame.

Driving expected strong digital earnings in the fourth quarter.

As Bob mentioned in his remarks, we saw the expected from a strong uptick in additional revenues and earnings in the month of September.

Putting us on the right track to achieve our fourth-quarter goals.

A side look at our third-quarter results, I would like to emphasize the following points -- to begin, our consumer digital products were essentially on plan with revenues up 22% year-over-year, individual capture area we used the first two months of the third quarter to complete the rollover to new models in our digital camera line-up.

This process always results in a time period with lower prices in margins as we work to sell through stocks of existing models.

This was completed by the first of September, and we are now well-positioned with new products for the important fourth quarter.

As I mentioned our September results reflected this improvement as digital capture revenue was up 41% in September, an increase 20% for the quarter.

Operating experienced year-over-year revenue growth of 45%.

During the quarter we also completed the refresh of our home printing dock line-up.

In preparation for the year-end season.

Most importantly, the revenues from our printer docks and associated thermal media were up 78% with increase in margins as we work on improving the media-to-hardware mix.

Our kiosk and media revenues grew 48% with 4 by 6 media volumes up approximately 140%.

We are well positioned in this growing attractively margined business with last year's supply constraints on media resolved, and we are moving forward with our plans for remote monitoring.

Before I leave the consumer digital products, I wanted to provide an update on our view of the industry for the balance of the year.

At our September 28, meeting, I indicated that we had reduced relative to plan our digital camera and printer dock production quantities, a move to prudently acknowledge some of the uncertainty in the economy this fourth quarter; however, we left some flexibility in our supply chain to move up or down depending on November owing of sales numbers for the industry.

And that's what we will do.

We have been speaking directly with our retail partners over the past several weeks, and we are monitoring the POS results weekly to ensure we are aligned in our view of the upcoming season.

We have a strong line-up full of new products and we have a comprehensive sell program in place working with the channel.

As a result, I feel very good about our prospects for the upcoming sales season for these important consumer products.

The Health Group performed on plan with a 14.2% operating margin on essentially flat sales.

Strong sales of computer radiography equipment and healthcare information systems were largely offset by expected declines in the digital output and in traditional X-ray businesses.

You may recall that we encountered some computer radiography product problems in the first quarter of this year.

The 27% year-over-year CR growth in the third quarter and the 34% growth in the second quarter indicates that we have effectively put these issues behind us.

As I said at our September 28, meeting we look for steadily improving performance from the digital products portfolio in health.

Our Graphic Communications segment performance was consistent with our very high expectations.

We now have had a full quarter of experience with the portfolio we have assembled, and we remain very happy with what we have seen.

As we discussed previously, the recent Print '05 trade show provided the first public forum for this integrated product line.

The results from this show were well above our expectations, and provided us with a strong customer endorsement of the direction we have set for this business.

In the quarter, I was especially pleased by the continued upward momentum in our NexPress portfolio, the digital scanner business, as well as continued growth in our computer to play portfolio.

Our integration program continues to go very well.

We have the most talented management team in the industry, and we have a unique and differentiated value proposition.

This is a great opportunity for the Company which we fully expect to be a significant source of earnings as we go forward.

In summary, This will be a big year for Kodak, including the first-year digital revenues will exceed traditional revenues.

Digital earnings improving more than 300%.

Acceleration of our traditional restructuring program which will be largely complete within five quarters.

Graphic communications will end up the year with a $4 billion run rate revenues with great earnings upside.

Steady earnings improvements in Heath Group digital earnings while maintaining the mid-teen margins overall.

Cash flow and liquidity more than sufficient to fund the transition.

Overall, we are expecting a good -- a good year of progress in a historic transition.

We are building a strong digital company for the future that starting 2006 will be divided into four independent segments as we announced in September 28, DCG, health, consumer digital, and film products.

We will now be happy to take your questions.

Thank you, sir. [OPERATOR INSTRUCTIONS] We go first to Jack Kelly with Goldman Sachs.

Go ahead, sir.

Good morning.

Hey, Jack.

Antonio, can you just give us a little bit of a feel on the digital camera side, just how much you cut back in September?

It sounds now maybe you are leaning towards flexing the other way.

No, we haven't changed the plan, Jack.

We actually kept 1.6 million cameras, and we cut down about 400,000.

But we left -- we left the flexibility in our supply chain to -- when we look at the results of November, mid-November which is a key indicator for the year to come back and get some -- we won't be able to get all of those back, but we can get a good number back if we were to need them.

We don't -- we are not planning to lose share for the quarter.

We are just planning not to have inventory that we don't need.

That is what we are trying to do.

We are -- we are watching the POS sell-through every week.

We have a full team dedicated to this.

This is something that has been done for many years.

We are talking to our retailers.

We understand the sentiment.

Remember the fourth quarter has the tendency to move volumes more and more to the mass market.

We're very strong in the mass markets, and then this year particularly, we put -- we change -- we did the rollover to the new products late in the year.

This has put us in a very strong position for the fourth quarter.

We have new products with new prices and new marketing programs right in place.

As you know the deals, they're already made.

It is just -- we have all the marketing programs in place, it is just a matter of how the sell-through goes, September is a very important indicator, and it was very good as we said.

So -- we feel -- we feel well for the fourth quarter.

Okay.

Bob, just two questions on your walk through of the cash flow.

You had mentioned I thought $300 million reduction in digital inventories s, 200 in traditional, then I thought I heard you say 250 from total inventory reduction.

It sounded like it should have been 500.

So if you could just clarify that maybe.

What I was trying to do there, Jack, is in the last five years I said we had a base -- in the last five years, I said we had a base, in the last five years we've had an average generation of cash of about $450 million of investable cash, and in that was about $200 million or so of inventory reduction.

This year we are going for $500 million which would add another 2 to 250 to 300 to that total.

Got it.

So I didn't want to double count it.

But we normally get a couple hundred million out of the fall, now we're going for 500 million so that's why I added half of it in.

Okay.

Just last question.

In terms of the EFO associated with new technologies, that was a loss of 50 million this quarter versus 34 last year.

Can you just give us a sense of if that is going to build over the next couple of quarters as maybe you get more into -- closer to the introduction of your printer products and then mid to late '06 time frame?

No, it's not going to move substantially off that number, Jack.

It should be around that number for the next few quarters.

Okay then, thank you.

We go next to Matt Troy with Citigroup.

Go ahead, sir.

Good morning.

Antonio, I was wondering if you could give us an update tactically with the integration of the Graphics Communication Group.

I think you were looking to more fully rationalize the product base by the end of October and have all the account captains designated by year end.

Are we on track?

And could you just help us with the learning curve there?

What may be different?

We are on track, Matt.

Matt, we are on track.

The -- we actually put -- you know Print '05 was a key day for us to consolidate our -- a lot of the key go-to-market presentation to customers, and the group worked very hard to be ready to present a unified form there.

I believe that you were there.

You saw where we are.

We have the key people in place all over the world.

We -- as we announced -- I think Jim announced this if I can remember well and the 28, of September that we were aiming at getting about $30 million this year for -- from synergies.

We are on track for that.

And then we have a big number for next year, and we are on track.

I mean if you ask me three times the same question, the third time I might say that we are actually a little ahead of -- but we feel very well with that group.

Okay.

If I think about the kiosk and printer dock business, could you just help me get a sense of the mix?

Obviously the numbers there remain strong, but what is hardware versus the consumables pull through?

Well, in one month nothing much has changed from the data that I shared with you in September.

I mean, it obviously gets a little better every month.

Normally.

But what happens -- it depends -- there are quarters in which you sell -- a lot of hardware those quarters.

They rate from -- media revenue and merchant hardware changes get lower and then it starts to go up again because you have -- you have the big install base.

Basically, the numbers that I shared with you in September are where we are.

They won't change much this year.

They will move up next year significantly, but not much this year.

This year, the end of the year, we have a lot of hardware sales in -- in home printers and that doesn't help with that ratio that you are looking at obviously is the right thing to do for next year and the year after.

But -- so the ratios that I gave you were the -- the revenue for -- from media, from kiosk is about three times the revenue from hardware -- I think I said for the year, and the -- and in the home printing, we are still -- we almost the other way around, it's only about one-third and you can't expect that to change much in one month especially because the next quarter is going to be a lot of hardware sales.

But that's the only way you can build your install base.

You will see the benefits coming into next year when more prints and more media gets sold.

Okay.

Last question.

If things are trending on spend the die sub capacity in Rochester.

When is that scheduled to come on line?

I didn't get the question.

I think this first quarter of next year, yes.

But we have -- that's why I made the point during my presentation we are fully prepared to take care of what we think is going to be a very good season.

All right.

Thanks, guys.

We have enough capacity.

Thank you.

Thanks, Matt.

We go next to Jay Vleeschhouwer with Merrill Lynch.

Go ahead, sir.

Thanks.

Good morning.

Bob, I appreciated the walk-through on the Q4 cash flow outlook.

I was wondering if you could talk about how repeatable those metrics might be next year, particularly how much similar leverage you will be able to get out of working capital improvement in the traditional business in terms of turns and DSOs, and then second question regards the health profitability.

It was better as a percentage of revenue in Q3 than it was in Q1, but the overall level has been basically trending lower from where it was a couple of years back.

The question for you there is, what would you describe as the most material risk to being able to sustain mid-teens profitability in the health business?

Okay, Jay, let me hit your first question.

Antonio will answer your second question.

The repeatability of the actions we are taking.

The seasonality of our consumer digital business is always going to present this opportunity because as Antonio said it is very heavily back-end loaded to the end of the year as you have sell into the holiday season.

So you will see us on digital products, printers, cameras, stuff like that, building high inventories in the third quarter and liquidating them in the fourth quarter.

The traditional inventories.

The percentage reduction's a little ahead of the sales reduction this year and we certainly will have that opportunity next year because we still have -- are facing a similar type revenue reduction next year and traditionals we saw this year so that opportunity will avail itself next year but with diminishing returns as the starting balance gets lower every year.

We, on capital, we are watching that very carefully.

The digital environment will have a lower capital intensity than a traditional environment, so we will certainly watch that very carefully.

So it looks to me like the cash flow in the fourth quarter is going to continue to be the big quarter for the year.

I would hope we can spread it out but that doesn't look like it is going to happen.

So I -- a long-winded answer to your question, yes, this is repeatable but it gets a little smaller next year because the traditional inventories will be lower.

Antonio.

Yes, I will take the health question.

So what is going down -- to keep the -- to keep the neat things, we have to balance out these two things.

DO is going to continue to go down in revenue, and, therefore, the amount of profit that we get from it.

And film will continue to go down at the respective rates.

So those are the negatives.

Those are the ones that will be pulling those mid-teens -- those mid-teens now, down.

The ones that are moving it up is CR which is very profitable and is growing very well.

DR that was not profitable up until now but with the new -- the new introduction of the 7500 systems that we've been introduced this month we have seen a huge increase in gross margin.

We have more work to do, but that is going to contribute positively to compensate for the negative that I just mentioned before.

The other one is Dental.

Dental is very profitable and has the possibility as well to continue to grow the profitability, and then the last one is HCIS, where right now as you all know we lose money, but we are making steady improvements.

So you have Dental, CR, DR, and HCIS pulling up and you have DO and film pulling down.

That is the balancing act that we have to -- that we have to play.

But we are still -- we still believe that it is going to be in the mid-teens for the foreseeable future.

Future with this combination.

Those four going up and the other two going down.

Okay.

One last one on the graphics business.

The Company has been talking about the importance to the strategy's success of blended or hybrid sales, and you had some examples of that at Print '05.

I was wondering if you could be a little bit more specific and talk about the proportion of the business that you are in fact seeing from these multiproduct hybrid-type sales, and if you expect that proportion to grow through next year and beyond?

I think that's a [Inaudible - highly accented language] question and it's certainly too early to have a number.

But by the fact you are going to talk -- you are going to talk to your customers and you try to solve their problems with the biggest issue they have which is work flow today.

I would even argue that even if you don't sell the work flow, your chances of selling some of the other pieces of equipment becomes a lot higher.

So -- you will have to consider that into your equation as well.

It is not only that a lot of people are going to buy work flow and printers and CTP and everything else, which some, they will, it's as well, that the ability to engage in a full conversation with a business manager that is trying to solve a serious problem, and you become a good consultant for him is going to help us in many ways, okay.

So we -- and we've seen that too.

Now we don't have a number to give you.

I don't think we will ever give you a number, but that is the philosophy, and the facts behind what we said.

Thank you.

We go next to Carol Sabbagha with Lehman Brothers.

Go ahead please.

Good morning, thanks.

Couple of questions.

First on graphics, sequentially -- you talk about the integration efforts being on track.

Can you help me better understand why the EBIT margin -- why the absolute EBIT levels were down sequentially.

I don't know if that's because you have a full quarter of Creo and Creo is losing money but I didn't think it was on an EBIT basis.

Can you just put a little bit more color around that?

Yes, hi, Carol, it's Bob.

We -- Creo was acquired on June 15, and we did some initial estimates of purchase accounting and write-off of in process R&D and that was largely done during the third quarter, and that was about I think 20 or $30 million.

Creo is a stand-alone business, was very close to -- was very close to profitability but we had write-off of purchase accounting as we still have some in KPM&G during the quarter.

So the fourth quarter will be the first quarter that we get a more clear indication of what this is, although there still will be some activities but I think the heaviest of it will happen in the third quarter.

Bob, that 20 to 30 million in purchase accounting.

Obviously that is not part of that restructuring charge, that 260 something -- the 261, call it?

That was restructuring under the old restructuring.

This is purchase accounting.

Right.

When we did the digital earnings reconciliation for the third quarter we added back in, I believe $22 million for the purchase accounting and the digital earnings, which I've captured most of.

There was a little bit of that would be applied to the traditional business in there, but it was in the 20s.

Okay.

And then -- I know you are not going to give any sort of guidance looking out several quarters, but I think you have talked about it for health, but maybe for the other two businesses or two big businesses in terms of trends how we should expect those businesses to trend over the next several quarters.

I guess on -- more specifically on DFIS as it stands today, you have been taking a lot of restructuring in that, and I thought it would hold up margins a little bit better.

And maybe you need even faster restructuring charges.

And on the graphics business, once the purchase accounting is gone, how should we look at that business over the next several quarters?

Carol, in general as you stated in the September meeting, we will be doing a lot of this restructuring during the next at that time six quarters, now five quarters and try to get a lot of this behind us by early 2007.

And this includes a very heavy accelerated depreciation because much shorter useful lives, demolitions, and reductions of people.

So I think it's going to be very hard for you to get definite trends on a GAAP basis as we go through this.

After that, you should -- there should be a marked improvement in all of these measurements when this heavy restructuring is done.

As you know we are only going to report GAAP basis on the total four businesses, and we we'll have a lot of the traditional in the one business that Antonio outlined.

So I think in the next four or five quarters, you won't see huge improvements.

If you look at gross profit this quarter, it was down -- as I mentioned in the little talk I had, it was 32% this year.

It was down 5.7 points.

But if you take out the useful lives and all of the restructuring charges it was almost flat with last year.

So I think that's just going to be the nature of what we are doing in the next four or five quarters.

It is very hard for us.

The reason why we move out of giving these projections is the complexity of the transformation.

We will give you all the data that we have every quarter, and in fact, we are moving next year to the four segments.

Which will give you a lot more visibility.

The accounting of all the transformation is really complicated and so I think the best thing for us is to stay away from giving those numbers.

Antonio, I was just more specifically kind of business trends more than anything rather than kind of a hard number, but--.

Okay, no, business trends I can tell you.

I think Graphic Communications is -- it's a growing business that is going to continue to improve the contribution of its bottom line.

I don't have any doubts about that.

The consumer digital part is going to continue slowly improving performance because this is a business in which we getting small improvement with cameras.

We build an install base with our -- with our printers and with our -- and with our kiosks, and we are trying to build a system business -- a system business which is -- is still not making money worldwide.

So this is a small improvement, but an improvement, moving from wherever we are today.

And then we, as you know, we have added, the CMOS part of the business into the consumer digital because we think as well when it gets to volume that for that business, time to volume is time to profit.

And I think that will be an important contribution to that business.

So I see it moving up.

But I am not giving you much.

I am not giving you any rate, but I see moving -- moving up with all those things that I just mentioned.

A healthy objective is to remain within this mid-teens while we deal with this balancing act that I describe before.

There are two businesses, they are very good businesses that they are going down, and they are going down at a -- at an understandable pace and then we have the other four.

You know that we continue to improve.

So our goal is to stay around the number that we have today.

Thank you very much.

Our next question is from Sam Doctor with JP Morgan.

Go ahead, sir.

Hello.

Hi, Sam.

Actually, this is Adam Poulin with Excalibur Research.

A couple of questions.

Right now how are you guys looking to cut costs as you are transitioning from one business to another?

Well, we announced in July -- we've had two series of major cost reductions in our traditional business.

In 2004, we announced a large reduction of our footprint which was about a third of it, and then we updated that in July of this year and announced we had would write down that whole traditional business to less than $1 billion by '07 and would reduce roughly 25,000 people in that program.

We are also looking hard at our corporate staffs and are working diligently to reduce those.

I think we announced that was roughly 2000 and 2300 people, and all that has been well published and documented in the last couple of years.

So our cost reductions are both in -- heavily in the traditional businesses and then streamlining our corporate staffs and our go-to-market overhead structures.

All of this is taking place essentially in the next five or six quarters where we will see heavy restructuring costs which are both reductions and positions and write-offs of depreciation and increased depreciation.

Most importantly on your hardware side with cameras and printers, how are you guys working with your supplier base to keep raw material costs as low as possible and overall improve your supply chain efficiency and compete in this very challenging economy?

We have a lot of plans for that.

I don't know that I can answer that in three -- in three seconds.

This is all--.

Just give me an overview for the call.

Well, normally in a digital business like this you have to reduce your hardware costs at about 15% every year for starters.

And then you have to build -- you have to build a go-to-market structure that is extremely thin that looks for large deals.

This is going to take half an hour to answer that question, by the way, but I will do my best.

Okay.

So we are working in every area.

We are working in the whole supply chain.

By the way we design these products we don't design products any more which we used to do.

What we do now is we design platforms, platforms add a wage.

You can create you can churn seven or eight products out of the same platform.

That reduces your cost of the long lead time products and the inspection products because you don't have a lot of rollover costs.

As well, a larger inventory cost and it helps with your supply chain.

At the same time, we -- by changing the system to a pure digital organization which up until now we had it together with the analog for good reasons we had it because we needed to grow fast, and then we needed to use the organization and the infrastructure we had in the analog part to get the coverage that we need which with we grew more than 110% of revenue in the last two years.

Now we are going -- we are going to focus in the business model goals that we have published many times about what the business model is for that business, and it has an SG&A of 6% and then it has an advertising of about 5 or so, with a gross margin with -- runs around 25 and it will give you an earful of around 6, 7, or 8%.

That's -- we are working in every part of the value chain.

We have a lot of expertise in this company to do that.

We have a team of people that have done this before successfully and we are going to do it again.

That's great to hear.

One thing I have noticed over the last couple of years while you guys are still able to have a good brand-name recognition is quality has always been a key driver with your organization.

How are you making sure that your suppliers are still meeting your strict quality standards?

Are you scorecarding them on a quality basis or meeting with them through a supplier forum?

What are you doing to make sure they are meeting your top supplier metrics and also are you looking to consolidate your supplier base as well?

We have consolidated our supplier base to very few and they have a incredibly stringent -- they hate us -- they love us and they hate us for what we are demanding.

In fact, as well as I know, we haven't declared any issue with our quality for the fourth quarter like I hear that some of the people did.

We don't have any problems.

We are very serious about quality.

The whole brand name is based on our quality.

We are absolutely determined to -- and -- in fact -- in the last two years, we got year after year two of the awards of JD Power which is an award that is given by our own customers, not a third party or a bunch of people that sit in a room, but actually the customers that use the cameras they gave us the award in two of the four categories of camera.

That is because we pay attention to the quality and we pay attention to the user views, and we have a valued proposition that asks the customer for a price that is fair compared to the quality they get.

You are meeting with your suppliers regularly through forums or scorecarding to make sure each metric is met?

More than regularly.

This is Don, could I ask to make this the last question so we can move on?

Sure.

Okay.

Thank you, sir.

We will go next to Philip Olesen with UBS.

Yes, hi, thank you.

Two questions actually.

First, in terms of the fourth-quarter cash flow walk through that you gave, it would still imply a fairly dramatic acceleration versus the trends that we've seen this year and versus historic levels at least over the past couple of years of fourth-quarter cash generation.

Just wondering what is your confidence level that -- away from the active sales and the working capital improvement that the core business will actually be able to generate the type of increase that you will need in order to hit the midpoint of the guidance?

Yes, I am very confident in that.

We -- as I said earlier, the last four years, if you add up the cash flow in the fourth quarter and divide by 4, it comes out to about 450 to $500 million.

And we've put in some constraints to ensure that we will do at least that by controlling our CapEx very tightly and CapEx should be a smaller number than is normally incurred in the fourth quarter.

The big variable this year that's new , that has caused the trends to be different is the heavy restructuring cash outflows which I said would be about 625 million.

And that will be a number I think I said about $180 million for the fourth quarter and that will get us to 625.

The earnings in the fourth quarter are normally good.

We've talked all morning about how strong we think this fourth quarter is going to be in revenue, which will leverage our fixed cost position and give us a good cash outflow on cash earnings.

So I am very confident of that.

And we are doing some unusual inventory reductions.

One, because we should in traditional, and the second because we are being very prudent in digital.

And we are going to do some asset sales which we said early in the year to help offset the increased cash outflows and restructuring this year.

So I walked you through that, and took you through the various pieces of it because we have I think very solid plans in place to achieve all these and be very close to that $800 million in the fourth quarter.

All right, great.

Just one quick follow-up.

From a valuation perspective, the stock is down more than 30% so far this year.

From a sum of the parts perspective, it would seem that the drag coming from the traditional film business is depressing the valuation that otherwise would be warranted by both your graphics and likely healthcare businesses.

What is the overall strategy over the next couple of quarters to narrow that gap of what the valuation should be for those businesses that have more robust profiles than the traditional, particularly in the film side?

And is the strategy more one of just waiting for the traditional business to continue to strength so it becomes less of an issue?

Or can you maybe outline some proactive steps you can take structurally that would help to drive that value?

The question is long and I guess it has a couple of answers.

But the best answer that I have for you is we did announce that in order to get the highest possible value from the sum of the parts is starting next year we will put the Company in four different segments well identifiable everything included in those segments that would allow any investor to know what is the relative value compared to true competitors of those four segments that I announced before.

One would be GCE, the other one is health, the other one is the consumer digital, and the last one is the film business.

I think -- I believe -- I agree with you that the sum of the parts it is larger than the -- than this conglomerate look at the Company, which is very complex with all the allocations that we are trying to get away from that.

We have been working very hard and a lot of the restructuring that you see this year and all these accounting issues that happens is because we are trying to clean that up and put this company into the four natural businesses that we have that you will have access to that data starting next year.

That -- that's what we're doing in structuring.

But -- just providing the data may not give you the valuation lift unless from an investor perspective, we believe there is the ability to direct or to invest directly in those four segments.

As part of the strategy, would you be willing to look at opportunities to monetize one of the four businesses if you view that it would be a driver of valuation overall?

We are a public company.

We have a Board that is very aware of the value of the Company, and we will always do what is best for the shareholder value.

Thanks.

We go next to Shannon Cross with Cross Research.

Hi.

Hi, Shannon.

Hi.

Let's see here, most of my questions have been answer but I did have one question.

If we could just get a little more detail on the traditional film inventory side.

I think we are all beating this to death, but just to get comfortable with the cash flow.

Any specifics you can give on how you can see that trend off -- what you're -- not on the supply chain, but from your retailer standpoint, anything you can give us that's a little bit more granular that we can feel comfortable knowing that will go down maybe, I think you said an incremental 200 million this year?

Yes, I'll give you two things, Shannon.

One, is the number of SKUs that are being reduced constantly.

That takes a lot of inventory out, and it actually doesn't change much the revenue.

And then our go-to-market strategy that is consolidating more.

We have less people and less third parties working with higher numbers that helps as well with the inventory reduction.

At the same time, we are being very disciplined with the idea that if this business is going down 20%, inventory should be going down at least 20%, more than 20%.

Those are the three elements.

Within that, there are a lot of activities.

There is -- there are activities as well, and how many factories we have, how that affects the supply chain, this -- it is a complex equation, but those three are the elements that are going to help us to get those numbers.

Okay.

And then I guess sort of back to the last question.

I mean on the asset sales side of things, and more substantial.

I mean if you -- if you don't get these level of cash flows that you are anticipating, I would assume you guys have been looking at plan B scenarios.

You don't have to give those to us today, but just can you give us some confidence that you do have some of those and ways you might monetize assets if you need to.

Actually, we don't have plan B, we have plan B, plan C, and plan D. Of course, Shannon.

That we looked at all the possible scenarios as you can imagine.

And we used third parties to analyze everything that you can think they issued in our lives in the Company and we have that very present in our minds and we will do what we think with the Board approval what is absolutely the best thing for the shareholder value.

Okay, Antonio with regard to some of the new initiatives you're looking at in CapEx expectations for 2006, I think Bob had said you will keep it down to about 400 million this year.

Are you still on track with the idea that you outsource basically all manufacturing of any new initiatives, therefore you keep your CapEx down?

We have been doing that, and we -- we actually -- we will be outsourcing even more.

Digital, by and large -- we should be doing only those parts of the value chain where we are really the best in the world, anything else should be farm out.

And this is what we will -- this is what we are doing already.

We are continuing to do -- you will see us doing more of these things.

We don't publish a lot of those because of -- for competitive reasons you don't want to know who your partner is -- or at least you don't want to be the first to announce who your partner is for this and for that.

But, yes, the answer is yes, we will continue to do that.

And remember the more factories we close in the traditional business, the less keep-up capital is needed.

And those machines, they take a lot of capital to keep running.

So when we consolidate into less units, into less factories, we save a lot of capital, for the Company.

Okay.

All I was trying to confirm was that you aren't going to go out and build factories to make ink cartridges, so it sounds like that is the case.

And then the last question I had for Bob.

Just in terms of the interest, can you give us -- or interest expense, can you give us the terms that the deal was done at.

I apologize if I missed it, and what we should assume for sort of interest cost going forward?

Yes, the all-in interest costs over time were around 6.5% on this.

Okay.

Or so.

And you drew down an incremental 200 million, right?

We drew down an incremental 200 million because it was just convenient to do so.

It went in the bank.

We have a $200 million note due in November.

So, yes, we did, and we will keep that at about the same level we have it now.

So we took 200 more and we're paying 200 debt so the debt levels will stay the same.

And then next year we will be net repayers of debt again.

Okay, great, thank you.

Ge next to Jamelah Leddy with McAdams Wright Ragen.

Go ahead.

Thank you.

I was wondering if you could just discuss a little bit more the decline in the gross margin primarily as a result of the price-to-mix issues and I think Antonio that you mentioned that new product introductions accounted for part of it and I am wondering if that accounted for all three percentage points?

Let me start.

When I was talking I went through the -- we have moved from operational the GAAP numbers now and we only talked about GAAP.

Our gross margin last year was 32%.

Additional -- because of the restructuring and going to GAAP basis, this year we had an additional restructuring cost of $78 million hitting gross profit.

We had additional write-offs of physical assets of 30 million, and we had higher depreciation costs of 66 million under the asset useful life changes.

If you grind all that through and you took it -- took it back out, that will give you a gross profit of approximately 31.3 versus the 32 last year.

So while it was down, it was down -- it was down only slightly.

We have had a mix down impact of digital from traditional.

Our digital gross profits are lower than our film gross profits so this has been a process that's been going on for several years.

During the third quarter as Antonio mentioned we did, and he may want to talk about this a little bit more, we did roll over our hardware offerings in digital products both in our printer docks and in our cameras and in the first two months of the quarter we liquidated a large position in those order products and brought out new products in September, and in September we had a sharp uptick in our digital sales.

So that's kind of -- the financial financial view of the thing.

Antonio, do you want to say anything on that?

Yes, I think she is referring to the DFIS number, right?

You weren't talking about the whole company.

I was -- yes, I am interested in the DFIS as well.

Not the whole company.

The three points have to do with the DFIS and the MD&A is very well described, but a lot of it has to do with the this particular quarter with the rollover.

When you do -- I mean there's -- one of the -- one of the characteristics of a great digital company and that -- a great digital company is able to do a rollover with a minimum, minimum cost.

There's always some costs involved but a minimum cost.

I don't proclaim that we have the best digital company in the world but we are getting better and better all the time and we did have -- we did have a price to pay by rolling over the new products that we needed to roll over for the fourth quarter, and, therefore, we needed to clean up the shelves from the old products, and that whole process -- you have to pay for that.

The rest of the stuff is pretty well defined in the MD&A.

Right.

If you happen to go through it, but that's the only element that I will mention that is different from any other quarter

Okay.

That's helpful.

Just one other quick question with respect to the International growth.

It looked like it was pretty strong with the exception of China, India, and Russia.

Is there anything that you can comment in, in those emerging markets because I have been under the impression that particularly China and India would be large growth markets going forward and I know that there is a transition, but are there other issues or other -- more color that you can add to this?

No, I think it is just a transition.

We called in September -- I think it was September when we said that we have reached the peak.

July.

July, sorry, July.

We said that we felt that -- then that China had reached the peak of sales in film and has been going down since, and the -- and digital is coming up.

But at this point of time, although we are doing well we are number three provider of digital cameras in China and coming up, we are not there yet, and we haven't been able to compensate for that loss.

That's basically what it is in China.

The analog at this point is going down more than we are growing in digital.

We don't have the full portfolio of our digital products in China too either for a variety of reasons, in the -- in DFIS.

We will with time, but we don't have them yet.

And this is -- we are trying to be practical and prepare the market for those new products, and find the business model and so -- so we are kind of behind in digital in China versus where we are in Europe or in the U.S.

And, therefore, because we are behind, we can catch up with the decline overall.

Yet, yet.

That is yet.

Remember the yet.

Okay.

Do you have any type of time frame or goals tha you can share with us as to the crossover point in China?

No, I don't -- I don't have one now.

But I -- I'll be thinking hard and see if I can give you guys one when we have one that we can trust.

Okay.

Thank you very much.

And our final question today comes from Ildiko Hilldress with Waterstone Capital.

Please go ahead.

Yes, I just had two questions.

When you reconciled from the GAAP to the non-GAAP, the digital income, you took out or you showed what the digital income was before Creo operating earnings.

And my question is, why do we not back out KPG operating earnings because those are in '04 -- or, excuse me '05 numbers but they were equity earnings in '04.

And I don't know what that looked like in '04.

Well, the reason we did that -- we are trying to reconcile back to a goal we gave in January 22, analyst meeting when we said the Company target for the year was digital earnings on an operating basis of between 275 and 325 million.

At that time Creo was not envisioned, was not in any -- we didn't purchase it at that time and we had not announced that we were even looking at it at that time.

So Creo was not in the base number so we take all the Creo, the purchase accounting, the operating earnings, and everything out.

KPG at that time which was acquired April 1, we had at that time told the world we were going to acquire Creo -- no, KPG and KPG was in the target so we don't make that -- we don't make that change because we had put it in that target of 275 to 325.

If you were not at that meeting and didn't hear this, just that we are trying to bridge that gap between GAAP earnings and operational earnings to that original target.

So correct me if my understanding is wrong, the 42 million includes KPG earnings but the 12 million does not?

No, they both include KPG because we did restate -- recast last year for that.

Okay.

It should be apples and apples.

Okay.

And then my second question was in some kind of agreement with Heidelberg you may have to pay out cash earn-out payments regarding NexPress in the fourth quarter.

Any estimate on what type of a number that is going to be?

For the fourth quarter of this year?

Yes.

There's no -- there is -- the estimate is zero.

Okay, thank you.

That does conclude today's question-and-answer session.

I will turn the conference back over to Mr. Perez for any closing comments.

Well, thank you very much for your attendance.

We really appreciate that.

Again, I am going to repeat how I feel.

I think this is a very good quarter.

Very important quarter for us, because, I said the writedown for the fourth quarter, we know that the results of the Company for the year will be based on how well we perform in the last four months of the year.

One is out and so far so good and we feel strong for the rest.

Thank you very much.

That does conclude today's conference call.

We appreciate your participation.

You may now disconnect.