Antonio M. Perez
Chairman and Chief Executive Officer, Eastman Kodak Company

Thank you very much for inviting me here. You have heard two people talking about disruptive innovation. Michael Mauboussin spoke from the investor's point of view, and Clay Christensen spoke from the academic's point of view. I will talk to you about disruptive innovation from a very different point of view. I will speak to you from Kodak's current circumstances and from the ecosystem in which we want to coexist. I will give you a brief historical tour to give you the context for the things we are doing today.

I had a love affair with Kodak starting in 1996. I was working for Hewlett-Packard [HP] at the time. In my career, I have always kept a focus on Intellectual Property [IP] filings. In the industrial economy, capital, trade secrets and know-how acted as barriers to entry. In the digital space, if there is any barrier to entry, it will be IP. Brand functions as less and less of a barrier to entry these days. Therefore I have always stayed very aware of what our competitors were doing with IP.

By looking at the IP filings and portfolios in the digital space in 1996, I realized that Kodak had an exceptionally wide range of IP, and they were filing an enormous amount of patents. These included thin-film technology, pixel technology, sensor technology, software for color management, software for digital filters, software for workflow, marking technologies, inkjet technologies, electrophotography, thermal, not to mention the very large portfolio that they had in materials sciences related to inks, media, nanoparticles, pigments and almost anything else you can think of. They had been doing this for a hundred years. I decided at that time that it would be better to be friends with Kodak than enemies. At the time Kodak was not doing anything with their IP, and I was not sure if they would, but I didn't know. So I went to visit.

I didn't know much about the company other than the IP study that I did. I did not know much about Rochester, either. In fact, I chose the middle of January as the first time to go visit! Sure enough, there was a snow storm. I was living in La Jolla, California at the time. You don't talk about the weather there - there's nothing to talk about. I said to the limo driver, "So this is Rochester, eh?" I remember the look on his face when he turned back to me and said, "The actual name is 'Rotten-chester', sir." Little did I know that I would be living there with my family a few years later!

We were able to create a relationship between HP and Kodak, and we engineered a series of inkjet printers using their digital imaging software and their paper. We created a joint venture called Photogenics that was successful but later closed down.

So the world revolved a few more times, and I was no longer with HP. I was in La Jolla trying to write a book. I got a call from George Fisher, a former CEO. Don Carp was the new CEO. George said that he had noticed my interest in Kodak a few years before and asked if I would be interested in taking over the company. I had a very good memory of all of the powerful IP Kodak had accumulated and which was not yet in use. So I took the job in April 2003.

The first three months were fascinating for me. They were wow months for me! I would go to the lab and see polymer and thin-film technologies that made me think we could build a better ink jet head than existed in the market. I would visit the ink labs, and I would see the holy grail of inkjet printing - we could do pigment basings that would not clog the nozzles. I would go to the sensor labs and see so much more technology than any other company out there in CMOS and filters. I could go on and on. I would go to the digital capture group and realize that most of the fundamental patents in digital capture belong to Kodak.

When you think about it, it makes a lot of sense. This was the only company fully dedicated to imaging before anyone else. Their life was imaging. They had a lot of money, they hired very good people, they gave them the right tools, and they built a phenomenal IP portfolio. I felt like a boy in a toy store. Which ones of these many opportunities will deliver the most value to us?

The problem with going to a toy store is that eventually you have to go to the cash register. I went to the Kodak cash register, which was the film business. In 2003, the plans for the company predicted a very good life for film. The company was not very concerned about the decline of film. I don't want to be negative about the past, but I want to talk about this so that you understand why this decision was so difficult.

Kodak was one of the best companies in the world in materials science. Without any doubt, they were also one of the top companies in the world in digital imaging in terms of IP, know-how and trade secrets. Whatever we did next had to be at the intersection of those two sciences. We have a lot of tools to play in that area, and we still have to pick the right way to apply those tools to create the most value.

Then I went to the cash register. We had a great group of people, but we had a very tough transformation to make. Three or four months into my tenure at Kodak, we formally and publicly acknowledged that the film business was quickly becoming obsolete, and that we were going to deal with it. The company had talked about it for twenty years, but not until that moment did they begin to do anything about it. When you don't have a plan for anything else, it is very hard to acknowledge such a thing. If the plan is not good enough, why would you accelerate the demise of the best thing that you have in your hand? And to be fair, up until the year 2000, the film business had been pretty flat. It was not decaying very badly.

This was bad news for several reasons. Film represented a high-revenue business with very high margins. It never feels good to lose margins like that. We had about $3 billion of assets associated with film. On our books, these assets had a useful life of, say, 20 years. Once we made this decision, the useful life of those assets would be cut to five or seven years. We had to accelerate our depreciation which would kill our GAAP earnings. More important than that was that we had fourteen sites with people dedicated to creating film. We knew that we had to cut that number to two or three in just a few years. It was going to cost us a lot of money to make that transition - and that was part of the same money that we were going to use to launch the digital company.

Having said all of that, we confronted the fact that we were going to have four years in which we would spend a lot of money. We have spent over $1.2 billion per year to restructure the film business to make it what it is now. About half of that money was cash that we would have otherwise put into the digital business.

We still had a lot of tools to work with. Our challenge was finding those areas to work on and deciding how we would make those choices.

In simple terms, we had a lot of IP and trade secrets, we had a powerful brand, and we had a significant amount of cash from the film business. We also had a few challenges. We were late getting into the market by about twenty years. Our competitors were strong, cash-rich companies - they represented a typical fortified hill. We also had a culture better suited to managing something already growing than to building something new. We had a functional organization. Not only did we have to lay off a lot of people, but we also had to reshuffle a large percentage of the teams. We needed to create a streamlined structure with small teams of people with full authority over a customer segment, a business model, and a value proposition. These groups needed to be free to make the everyday decisions to move fast. This is the culture that you need when you are creating something new. This did not exist at Kodak.

We catalogued all of the IP that we had in the company. We identified the core patents that we needed to leverage and defend. We eliminated those patents that didn't offer a lot of value. We concluded that we have about 10,000 "fundamental" patents. A patent lasts about twenty years, so you will lose about 5% each year. So if we wanted simply to maintain our number of patents, then we needed to file at least 500 new patents each year. We wanted to file a lot more than 500, so we created a whole department to pursue that effort. We are filing a lot more than 500 patents per year, sometimes double that number. We are trying to make our competitive advantages sustainable.

We have to leverage our core competencies at the intersection of digital imaging and materials science. In that area, we have IP, know-how, trade secrets and a strong brand. We have people who understand this space. But we were also late to the game, so we needed to bring breakthroughs.

Breakthroughs come in three areas - technology breakthroughs, supply chain breakthroughs, and business model breakthroughs. In my experience, if you can create significant and meaningful breakthroughs in each of those three areas, your probability of success is very high. If you have a breakthrough in only one area, your chance of success is a little lower.

So how should we choose which area to focus on to extract a lot of value?

Let me talk first about the CMOS technology. When I first arrived, we had a digital camera business of significant size, but it was losing a lot of money. It was not clear how this business would ever make money or how it would be sustainable. The breakthrough for us was in identifying the business in which our core competencies would help us the most. Are we in the digital camera business, or in the digital capture business? There is a huge difference for us between these businesses. We chose to become a leading company by supplying the world with digital capture technology. We put all of our efforts into the CMOS technology.

CMOS is a piece of semiconductor that captures light. There are three key elements of a camera - a lens, a shutter, and something that captures the light. In the past, that thing was the film. Now it is a piece of semiconductor. The advantage of CMOS technology is that the semiconductor not only captures the light, but you can also imbed a lot of software in there. This raises the value of the component, and makes it arguably the most important part of the camera. The opportunity for us was to make that integration happen and then sell it to the world. We shifted our business model to become much more horizontal. The margins were high because we were differentiated, and profits were higher because this is a very large market. This is sustainable as long as you maintain your differentiation, and this is possible because of our IP and know-how. This represents a large opportunity for differentiation.

The second example is inkjet. It was obvious from my very early tours of the labs that we could make an inkjet printer, but the market was already full of too many competitors. Why would we go this route? We argued this for a very long time. It is important to ask yourself what an inkjet print really is. Leavitt said that people want to buy a quarter-inch hole, not a quarter-inch drill. Clay Christensen asks what job your customers are hiring your products to do. Why do people buy an inkjet printer? You buy a printer because you want to obtain a printed page - that is the quarter-inch hole in this example.

The disruption in the inkjet printer market will come about by our applying our technology to create a better printed page, a more desirable printed page, and maybe a lower-cost printed page. How much better does it have to be to create a disruption? What are the attributes of "better"? And how can this be sustainable given the strength of the four major competitors - HP, Canon, Epson and IBM/Lexmark? These are fabulous companies full of brilliant people. Our challenge was to create not only a better printed page, but also a printed page that others would have difficulty replicating. This is the only way to extract value over a very large market. HP alone probably makes over $3.5 billion in operating profits in their printing business. This is a very good business, even if you get only a little piece of it.

As teams went to work, all of the technology that they used had to improve the quality of the printed page. First, we created the first permanent print head for this market at this price point. The breakthrough with the permanent print head is that you can now sell your customers only the ink in the cartridges. You don't have to sell them a piece of silicon every time that you sell the ink. This is what you have to do if you have replaceable print heads. This technological breakthrough was made possible by our proprietary ability to work with polymers and other technologies such that that print head will be able to last for a very long time. That is not a minor task.

Because of the technology that we had within the company, we were able to create a permanent print head. This allowed us to do two things. First, it makes the replacement ink cartridges much cheaper than those of our competitors. More importantly, this allowed us to create a high-quality printed page for much less than our competitors because we do not have to sell a new piece of silicon every time we sell the ink.

The second innovation was in the supply chain. In some ways, being late to enter this market was a wonderful advantage. The manufacturing of ink cartridges is very similar to the production of semiconductors. This involves a lot of clean rooms with very expensive robotics to do all sorts of maneuvers to create the cartridges. The four companies who started early in the inkjet market were dealing with the semiconductor industry 15-20 years ago. That industry was very different then. The robotics that they bought twenty years ago was custom-made robotics for this purpose. Custom-made robotics is much more expensive, and the lead time for ordering new robotics is eighteen to twenty-four months.

The problem with this is that you would need to create a purchase order for $40 or $100 million twenty-four months before you are actually going to get the robotics, and the purchase decision will be based on the analysis of some 25-year-old MBA whose analysis will tell you that that particular cartridge will sell in a certain amount two years from now. If you think it's a joke that human beings sweat blood, I can tell you that it's actually true. You can actually sweat blood!

We designed our print head using the state-of-the-art, most modern tools that exist today. These tools did not exist when our competitors got started. Because we were coming late, we were able to buy state-of-the-art robotics off the shelf. These robotics are cheaper and much faster to deliver. We only need to forecast our cartridge sales for the next six months. The forecast will still be wrong, but it will just be in the rough - not in the woods or in the water.

We have created a number of other supply chain innovations as well. ASICs [Application-Specific Integrated Circuits] are required to run an inkjet printer. Twenty years ago, we had to employ 200 highly-paid engineers to create this for us. Today, we can buy this off-the-shelf. We look for every advantage that you can have when you already have established markets, and this has helped us create a very sustainable business. We have been able to create capabilities that our competitors already have with less risk and fewer assets. For our competitors to replicate what we have done, they will have to do to their business what Kodak did to its film business. They will have to accelerate the depreciation on their $100 million custom robotics from twenty years to three because they will have to be replaced. When you look at the infrastructure of our competitors, they have infrastructure that is still useful, but not up-to-date. They could do this, but the cost for them is so high that the probability of them replicating our work is very low. Even if they did it, they would have to pay a very high price so we will still have an advantage.

The technology innovations and the supply chain innovations have allowed us to do something very powerful for the printed page. For the last fifteen years, the biggest dissatisfaction in this market is the cost of the ink. A distant second complaint is the quality of the print. The one factor that is by far most likely to encourage you to consider changing your printer is the cost of the ink. This is the key for the value creation - the more you print, the more that you will like this business model. Value creation is key - how can we make a lot of money with a printer? Like any industry, we make 80% of our profits with 20% of our customers. Those 20% of our customers are the people who print a lot. They are the people who might also listen to a value proposition that includes both a higher-quality printed page (that will last 100 years, that won't fade in UV light, that won't smudge, etc.) and at half the cost of our competitors. That is value creation.

Can our competitors do that? Of course they could, but it is very unlikely that they will. If the management team for our competitors decides to follow our business model, they will be fired from the company because they would have just eliminated $2 billion of operating margins. It is far more logical for our competitors to continue to do what they are doing, and this is what I would do if I were in their place.

Our sustainability is based on the fact that they cannot easily replicate what we are doing. Why won't they follow us? What they are doing is the logical thing to do. They are not feeling much pain from what we are doing because our market share is still quite small. They will continue to leverage their tools - more promotions, more discounts, more selection and more specialization of printers. They will bundle their printers with their PCs. These are the right things for them to do in their circumstances.

At the end of the day, however, we firmly believe that they are fighting gravity. The company that offers the best printed page at the lowest cost is going to gain substantial market share. That is the kind of share you want to have. We don't really want customers who don't print because we lose money on the printer.

We look for disruptions that lead to the highest value creation in the areas that we think we could sustain.

We get a lot of emails from our customers. One customer likes the printer because the quality is good and the cost is low. Another customer loves the ink cartridges. We also get some very emotional emails from customers - they feel very strongly about the price of ink. Let me say right here that there is no cartel in this industry. Those four companies compete ferociously against each other. But it is also true that even though the volumes of printers and ink have grown substantially over the last 20 years, the price of ink has never gone down. This is kind of interesting. This has built up a level of pent-up emotion in the printing customers that we think we can use to our advantage.

As a company, Kodak tries to focus on areas where we have an advantage - the intersection of materials science and digital imaging. We are trying to pick a few businesses in which we can make a difference. And we are looking for the disruption that leads to value generation. Even with all of those things, we know that this is not going to be easy. We are competing against very strong companies and strong people. But I believe that if you find the better whole, you will end up selling a lot and winning.

Thank you very much!

Michael Mauboussin: Clay, I would like to start with you. I know that you've worked with Kodak for a long time. What are your general impressions? Could you also talk about vertical versus horizontal outsourcing?

Clay Christensen: I would like to give you my impressions of the digital side of Kodak's business. They started to invest in digital imaging way back in the early 1990s, long before the disruption was a commercial reality. I had a chance to interact with George Fisher and that generation of leaders. One of my inputs was that they were trying to cram digital imaging in to the blue space of their market. They were using charged coupled devices (CCDs) to try to make digital cameras so capable of generating high-quality images that they could compete head-on with film. That drove the price of digital cameras so high that the only people who could afford them were already using film. So when they succeeded in the digital market, they cannibalized the film market.

They introduced a camera called the Kodak EasyShare. This grew to be a very large business. When Antonio took the job, he got out of that business. I was very angry. They had done everything that I thought they should do up until that point. But it turns out that Antonio understood the theory better than I did. While digital cameras were disrupting the film industry, camera phones were already beginning to disrupt the stand-alone digital camera business. Those cameras are crummy, but they are getting better at a frightening pace. Nokia's most advanced cameras are pretty good machines and much more convenient to use. Antonio was right to sell that business off, and I was wrong.

On the sustaining trajectory, the original architecture of the products is often interdependent, proprietary and optimized. Apple computers have that kind of optimized, proprietary character, as does the Apple iPod. You have to have control of all of the pieces of the system in order to play in any piece of the system. There is a big advantage to being integrated. In the early years of telecommunications, automobiles and investment banking, integrated companies with proprietary architectures tend to dominate their industries.

When disruption happens, there is almost always a parallel shift to open, modular architectures. In computers, the Apple gave way to the open architecture of the IBM PC. When the architecture opens up, the industry disintegrates. In a Dell PC, a different company makes the OS and the logic circuitry and the disk drives and the display system and the DRAM. They are all independent companies, and Dell just assembles them. When an industry moves to an open architecture, the place in the value chain where attractive profits can be made migrates.

The article that we wrote about this was called "Skate to Where the Money Will Be" in honor of Wayne Gretzky. Someone once asked him why he was so good, and he said that he never skates to where the puck is but rather to where the puck is going to be. As disruption happens in the value chain, the place where attractive profits can be made migrates to a different spot. In an Apple computer, the performance of the machine is determined at the system's architecture - Apple makes the money, and its suppliers do not. In a General Motors automobile of the 1950s and 1960s, its performance was determined by the system's architecture, and none of its 10,000 components really drove the car's performance. In this model, General Motors made all of the profits in the industry, and its suppliers lived a miserable, profit-free existence.

When disruption happens, the ability to make money tends to migrate down to the subsystems or the component suppliers. These components now drive the performance of the disruptive product. Back in the years of a mainframe or minicomputer, you created a new architecture in order to create a better computer. The components didn't drive performance. If you worked for Compaq, however, and your boss told you to design a better computer than Dell, how would you do it? The only way to make a better computer is to put in a better processor, the latest version of Windows, more gigabytes from Seagate, more megapixels on the screen, and so on. In a disintegrated world, all of your competitors are outsourcing the components from a common supplier base. It is the components inside that drive the performance of the product, not the product's architecture. The ability to make attractive profits flips from what's outside to what's inside.

You see this happening in the automobile industry as the automobile at the low end develops a more open, modular architecture, the ability to drive the performance of the car is embedded in the tier-one suppliers. The supplier commoditized the assembler.

As I watched what Antonio did, I think it's brilliant in retrospect. As the digital camera is disrupted by the cell phone camera, you want to position yourself as the "Intel Inside" of the imaging capability in the cell phone camera. You don't want to make the camera. You want to be the brains inside of it. Kodak's CMOS technology allows you to have on the same chip both the image capturing mechanism and the intelligence that puts it all together. In fact that is what my theory said that you ought to do, but I had never thought about it before. I think it is a really brilliant way to play. If I were in Antonio's shoes, I would really push the technology to make the cell phone cameras better and better. This would make Kodak the engine of the disruption for the digital camera business.

Q: [off-microphone]
Antonio: Let me tell you a story that explains why we have to be in that business. If you ever visit Kodak Park (and I wish you could), you will see a machine tool as wide as this room. There will be a piece of plastic between six and eight feet wide that is moving so fast that you can hardly see it. The machine will deposit eighteen different coatings at specific locations in specific thicknesses to create extremely good film. To make things more interesting, you have to do this in the dark because the film is photo-sensitive. If we decided to shift the plastic to paper, the eighteen coatings to four or five inks, and reduce the speed to 2,000 sheets per minute, we would become the best printer in the entire world. The technology was there, and the people were there. The company had tried some other businesses before, but with film being such a large market with such great margins, the other opportunities always seemed trivial in comparison. If the film business was not in danger, then anything else in the company was probably seen as a distraction.

Q: What finally convinced Kodak to bring in someone like you who would force them to make this kind of business-changing decision?
Antonio: I was not there, of course, so I can only speculate. Of course, the company has a very good board. (Of course, what else am I going to say about them?) I have an enormous amount of respect for the previous management team. I think it was hard to let go of film. Film was not declining rapidly, and the cash it was generating was unbelievable. I think it is a normal, human reaction not to shout "Fire!" in a theater until you see a fire. Unfortunately, if you wait until you see the fire, it is already too late - you're going to be dead. By the time we at Kodak called "Fire", we were already burning. The lack of another powerful vision limits your ability to make this step. This is always a leap of faith, no matter what. If you tried to make this decision with good data, you can never make this decision. It happens to all of us.

Q: You mentioned a number of challenges to change. What role did culture play?
Antonio: In my experience, culture is the last thing to change. You change people. You change plants. You change the technology. You change the methodology. You change the rewards. You can change everything, and the culture will still lag. In my view, the only way to change the culture is by replacing people. When I came to the company, we had 75,000 people. We are going to finish this year with 35,000. We bought a few companies along the way who could contribute pieces to our puzzle. This added another 15,000 people. Out of the 35,000 in the company this year, only 20,000 of them were with the company when I arrived. I don't know what culture we have now, but it is certainly different than the culture that we had before. We are building a new company and a new culture. We have the same values as the old Kodak company, but the behaviors are so different. The only way to change behaviors is by changing the people. Gorbachev tried to change the Politburo by replacing some of its leaders. He thought that by changing the leaders, he would change the organization. He did not recognize that the entrenched bureaucracy would not change so easily. The people who stayed with Kodak were the people who really wanted to do this long before I arrived. The ones who left are the ones who didn't want to stay.

Thank you all very much!

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