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Kodak Ready to Bridge Film and Digital?

For the past few years, the rising tide of digital photography has seemingly threatened to turn the traditional photography world upside down, marginalizing venerable giants like Eastman Kodak in favor of device manufacturers, software vendors and printer OEMs as digital technology cannibalizes the film base.

Analysts and investors have spent the past year turning away from Kodak due to assumptions about digital cannibalization and price pressure from film rival Fuji.

But with the 2003 International Consumer Electronics Show (CES) approaching next week, Deutsche Bank Securities analyst Peter Ausnit called those assumptions into question, noting that new technology from Kodak is finally lining up to allow the company to link film and digital strategies with powerful synergies.

The technology has nothing to do with digital cameras, which Ausnit considers a losing proposition for the company. Instead, he said the great hope for the company is its new Perfect Touch (PT) processing software, which can correct common problems like weak flash, opaque shadows, washed out highlights and inaccurate film tones by scanning film negatives and then digitally correcting and laser printing on traditional photo paper.

This process, according to Ausnit, "has the effect of vastly increasing the dynamic range of the film and paper, allowing images hidden in deep shadows that typically appear black in photographs to print as they appear in life. Other benefits include greater detail and greater range using flashes. Pictures that are extremely difficult to print using conventional processes, such as faces backlit by a sunset, now can be printed. With PT, the number of photos that are useless and discarded because of poor exposure should be sharply reduced. This may increase satisfaction with photography and burnish Kodak's brand, not only for film and paper, but also for advanced technologies."

PT can similarly improve photos taken with a digital camera.

"Previously, we had little faith in Kodak's digital camera-centric strategy for digital photo customer acquisition," Ausnit said. "Kodak has tried to attach software to loss making digital cameras to drive output to Kodak online services. This is very difficult as Kodak needs to win market share in digital cameras, drive higher software attach rates, and then induce consumers to upload large photo files over slow modems. This process seems unlikely. Now it appears that Kodak is developing other options."

"We believe that Perfect Touch processing may provide a link bringing digital services to traditional photographers," Ausnit continued. "By tying PT processing to Kodak's online ofoto service, Kodak can automate the creation of digital photographs by scanning traditional film negatives. Further those digital photos are then in Kodak's possession, potentially on ofoto, where they can be edited, shared, stored and reprinted."

Such a move means consumers can enjoy many of the benefits of digital photography without a digital camera. This is an important point, Ausnit said, because while the number of consumers switching to digital continues to accelerate, Deutsche Bank believes the digital cut of the 2002 U.S. consumer film market was about 4.5 percent, with Kodak holding 65 percent share over the entire market.

"If cannibalization increases 50 percent next year to 7 percent, then we would expect an EPS hit of about 11 cents, and an incremental hit of just 4 cents," Ausnit said. "This suggests that the headwinds from digital cannibalization are increasing, but at a moderate and manageable pace."

Meanwhile, Kodak -- which already dominates conventional photo channels -- can play PT as a trump card, using it drive share on the conventional front, take a strong position in the digital file processing market, and drive business to its online services.

The pieces are there, but Ausnit said Kodak has not yet played them to its greatest advantage, due largely to the company's seeming reluctance to bundle ofoto with PT processing.

"Instead it is encouraging customers to order a Picture CD, which does not store the photos at Kodak," he said. "This foregoes the opportunity for Kodak to hold consumers' photos and act as the de facto scrapbook to the world."

Photo files tend to be large, and are difficult to move over the narrow-band connections which dominate currently, meaning that by encouraging customers to build digital scrap books at ofoto, the company will create incentives to return to Kodak and generate long term loyalty to the brand.