(FORTUNE Magazine) – SO FAR 1986 has brought only embarrassment for Eastman Kodak. On January 9, a federal judge in Washington ordered the company out of the instant-photography business for violating seven Polaroid patents. A week later Kodak dismissed 500 workers in Rochester, New York. On January 21, Kodak announced its return to the 35-mm camera business after a 17-year absence -- with a camera made not in its own exalted plants but in Japan. And in February the company was expected to announce flat sales for the third year running and earnings that, on a per-share basis, are the worst in more than a decade. Those are wrenching events for a company that has prided itself on technical know-how, manufacturing expertise, and unshakable profitability. Such setbacks also are commonplace in the uncongenial new world in which Kodak finds itself. During the late Seventies and early Eighties, a complacent Kodak drifted while others produced the innovations it used to be known for: easy-to-use cameras, better and faster color film, more efficient processing. Even worse, silver halide photography, the technology that Kodak invented 105 years ago, is slowly being eclipsed by electronic images. Kodak's lethargy was partly caused by an insular, tradition-bound management that insisted on doing everything the way George (Eastman) did it. The company was organized along functional lines, so manufacturing and marketing operated as separate fiefdoms and decisions waited until issues percolated to the top. Promotions came through a paramilitary system in which seniority and fealty to Mother Kodak counted nearly as much as ability. The company has had only a handful of senior managers who ever worked anywhere else. Kodak has found an unlikely agent for change in Chairman Colby H. Chandler, 60. An engineer by training -- like every Kodak chief executive since Eastman shot himself to death in 1932 -- the mild, affable Chandler has reorganized the photographic business and embarked pell-mell on diversification and acquisitions. Most of the acquisitions are to fill holes in Kodak's technology as it shifts to an increasingly electronics-based business. Meanwhile the company has begun marketing products made by others to buy time until it develops its own. Chandler has established three primary goals for the revamped Kodak: to be a leader in new ''imaging'' technologies, to keep the $11-billion-a-year company among the 25 largest in the U.S. in terms of profits (it ranked 15th in 1984), and to boost return on shareholders' equity to 20%. Those targets won't be easy to hit. Brenda Lee Landry, a security analyst with Morgan Stanley, estimates that Kodak managed a return on equity of only 9.7% last year. Accustomed to stability (some might say stolidity), managers will find new ways hard to learn. Kodak's changing focus throws it into businesses in which it has little experience and puts it up against formidable rivals. Kodak is fighting RCA and GE in consumer electronics, IBM and Xerox in copiers and electronic office publishing, and Memorex and 3M in floppy disks.

That's just the U.S. competition. In its mainstream photographic lines, Kodak is up against the Japanese giants that have chewed at its earnings for a decade: Fuji and Konica in film; Nikon, Canon, and Minolta in still cameras; and Sony, Matsushita, and Toshiba in video cameras and recorders. Management professor E. Kirby Warren of Columbia's Graduate Business School, who was a consultant to Kodak for seven years, doubts that the company can change quickly enough to keep up with the competition: ''I'd like to see them bring in more outside managers. Psychologically, I don't know whether some of those people in Rochester can get it into their heads that they got whooped by the Japanese, and they have to fight harder, tougher, and meaner.'' Investors are not optimistic. An article of faith in Rochester used to be that there never was a bad time to buy Kodak. The stock might dip briefly, but a shareholder who held on for a couple of years could be sure of selling at a profit. No longer. There hasn't been a good time to buy Kodak in years. The stock is selling for only half its 1973 high (after adjusting for a 3-for-2 split last year). The Polaroid patent suit was a quantum blow to Kodak's self-esteem. Kodak passed up instant photography when Edwin Land offered his process to it in the Forties. Then, as Polaroid's instant pictures moved from being an expensive oddity to a mass consumer product in the Sixties, Kodak set out to develop its own instant system. According to testimony in the patent trial, Kodak spent $94 million perfecting the system, only to scrap it after Polaroid came out with the SX-70 camera in 1972. The SX-70 produced litter-free color prints without the messy layer of paper that shutterbugs had to peel off earlier pictures. Fearing the loss of $6.5 billion of instant camera and film sales over the next decade, Kodak rushed to produce a competing litterless system, telling the several thousand workers on the project not to be ''constrained'' by potential patent problems. Security analysts figure that Kodak's cost for closing its instant- photography operations and carrying out a generous exchange program for its instant cameras (see box) could come to $800 million. Compared with what Kodak got out of instant photography, that's expensive. Sales of instant cameras and film amounted to around $200 million a year and profits were scant. THE TOTAL COSTS of Kodak's foray into instant photography won't be known until a trial is held on damages for Polaroid. Polaroid probably will ask for all Kodak's profits from instant cameras and film, the profits Polaroid would have made on the sales it lost to Kodak, and the profits it lost by competing on price. With interest from the time the suit was filed in 1976, that could come to $1 billion. If Polaroid can prove that Kodak ''willfully and deliberately'' infringed on its patents, it could get triple damages. Whatever the award, it would almost certainly be the largest ever in a patent case, far exceeding the $126.8 million won by Hughes Tool Co. last year for a drill-bit patent infringed by Dresser Industries. Dresser is appealing. With assets of $10.8 billion, Kodak won't be mortally wounded. But it is looking for alternatives to paying up. Polaroid's current market value is about $1.5 billion, so it might be cheaper for Kodak to take over Polaroid. Says Kodak President Kay Whitmore, 53: ''I'm not sure we'd want Polaroid, but we'll have to see what the damages are.'' Kodak is also exploring an out-of- court settlement, so far without success. Says Whitmore: ''The question is: how big is the price? It takes more than one to settle.'' The 35-mm cameras introduced in January will not be much more profitable than the instant cameras, but they put the Kodak name in a market segment that's growing 25% a year. Kodak's primary objective is to sell more film. The company figures that people using its cameras will be more likely to buy its film. The point-and-shoot cameras are a delight for fumble-fingered amateurs, but they are no more advanced than others on the market. Says Herbert Keppler, publisher of Modern Photography magazine: ''In all other unsophisticated cameras -- the Instamatic, the pocket Instamatic, the disk -- Kodak has been a leader. Now it is a follower. The new camera doesn't have the features to propel it to the top of the heap.'' Kodak needs propulsion from somewhere. Sales of photographic products, which account for 80% of revenues and 82% of operating profits, have stalled since 1981. Kodak gets the bulk of its profits from film, an enormously lucrative product that has 55% pretax profit margins, and the company still controls as much as 85% of the U.S. market in color film. But Fuji has captured most of the growth in recent years by keeping prices 10% below Kodak's for film that many photographers believe is just as good as the product in the yellow boxes. With 35% of its sales overseas, Kodak has complained that the rising dollar cut profits by $3 billion from 1980 to 1984. But the company was also hampered by flagging productivity growth. Though the two companies aren't strictly comparable, Fuji got nearly $161,000 in sales per employee in 1984, while Kodak eked out only $85,553. And Fuji's employees are paid less. Chandler is trying to restore the company's flash by reorganizing the photographic division. Last year he broke the division into 17 business units, such as cameras and film, photofinishing, and consumer electronics. Kodak's version of young tigers (average age: 48) leaped over older managers to run 15 of the units. Chandler pushed responsibility for key decisions down from the executive staff to the business unit heads. The aim was to promote innovation, speed reaction time, and establish clear profit goals. The man charged with shaping up the photographic division is J. Phillip Samper, 51. ''There was a feeling that everyone did his own job, and if something went wrong, it was somebody else's problem,'' says Samper, who communicates with the subtlety of a Chicago Bears lineman. ''I've said that if any professional is only working eight to five, he's not doing his job. We haven't been able to show numbers yet but we've cut waste and improved the quality of our production.''

Products are moving to market faster. Upgrading a line of color-print paper, for instance, used to take two years. But with a business-unit manager calling the shots instead of the research department, Kodak took just one year to create a new line of Ektacolor papers announced in January. By breaking Kodak into smaller business units, Chandler hopes to ring in a new age of entrepreneurialism. Says Samper: ''Historically this company has been risk-averse. Today we're saying, 'Making a mistake isn't bad. Just don't make it twice.' '' The new tolerance for risk is making Kodak more nimble. Fuji beat it out for the right to be the official film of the 1984 Olympics Games in Los Angeles. Now Kodak has snapped up the official film rights for the 1988 games in Seoul, South Korea. It paid $10 million, a price that Fuji executives claim was much too high. (Fuji paid $7 million for the Los Angeles rights.) The other big change wrought by Chandler has been to make Kodak more reliant on outside help. The company has been acquiring aggressively to fill gaps in product lines and obtain knowhow. After taking 11 years to make its first four acquisitions, Kodak completed seven in 1985 alone. Among them: Eikonix Corp., a maker of digital image-processing equipment, and Garlic Technology Corp., a developer of advanced digital magnetic recording heads for disk drives. Kodak has formed a ''venture board'' that has helped underwrite seven small projects and also is making conventional venture capital investments, most notably a $20-million stake in Sun Microsystems, a maker of computer work stations. Kodak is using a Sun terminal in a new $60,000 office publishing system called Kodak Ektaprint Electronic Publishing System, or Keeps. The system produces typeset-quality documents with a word processor and a laser printer.

The new acquisitiveness has drawn a stream of entrepreneurs, venture capitalists, and investment bankers to Rochester. The company's ''office of submitted ideas,'' designed to screen outside projects, received more than 3,000 proposals last year. Only 30 or so got through the screen. Kodak executives brag that none of the acquisitions has failed. One has come close: Verbatim Corp., a maker of floppy disk memories for personal computers that Kodak bought for more than $175 million last year, is losing money. Kodak had to shut down two of the company's four plants in Sunnyvale, California, lay off nearly 1,000 workers, and replace the chief executive. Kodak executives explain the setback by saying that Verbatim would not have been for sale if it had not been in trouble. They also predict that floppy disks could someday be as important as color film, though that strains credulity. For many years, whatever Kodak sold Kodak made. It was among the most fully integrated manufacturers in the U.S. The company generated its own electricity at Kodak Park in Rochester, made the plastic for its cameras, and even owned cattle yards to ensure a source of high-quality gelatin for photographic paper. That is all changing. Now the company is willing to leverage its marketing and distribution strengths by selling other companies' wares. Kodak got into video cameras with a product made by Matsushita (see Selling) and markets Kodak videotape made in Japan by TDK Electronics. Chinon Industries, of which Kodak owns 9.5%, makes the new 35-mm cameras bearing the Kodak name. W. Haking Enterprises of Hong Kong supplies cheaper 35-mm cameras sold under Kodak's name in Asia and Latin America; those cameras could wind up in the U.S. by fall. In January, Kodak unveiled two self-contained, one-hour film-processing labs that it buys from Noritsu Koki and Copal in Japan. As with the 35-mm camera, Kodak was late with one-hour film processors. Such minilabs, as they are known, have their own plumbing and can be installed anywhere. Some 8,000 minis in kiosks, camera shops, and big discount stores have taken 20% of the processing market from large central operations, including Kodak's. Wilbur J. Prezzano, group vice president of photographic products, concedes that Kodak ''underestimated the potential'' of minilabs. He now predicts that the number of minis in the U.S. will double within five years. Kodak's diminished role, acting as a mere marketer of other companies' products, leaves it with thinner profit margins than it is accustomed to. Chandler hopes that the shift to Far East suppliers is only temporary. ''A manufacturing company wants to manufacture,'' he says. Taking the long view, Chandler predicts that camera production will eventually return to the U.S.: ! ''I don't see any situation where the process is not reversible. Our manufacturing skills haven't disappeared. If and when it's economically attractive to produce here, we will.'' Kodak's principal business will become increasingly electronic in years to come, with the technology of the computer displacing the chemistry of film. Ultimately, images will be captured on magnetic disks instead of film, and most still pictures will be reproduced on TV screens instead of paper. Scores of companies around the world are at work on the digital technology that will form the foundation of high-quality electronic images, and none is likely to win the commanding lead that Kodak captured in silver halide technology a century ago. The first fully electronic still camera may come to market this year. Sony says it is about to introduce a version of its Mavica camera, which it unveiled four years ago, for use by news agencies. The Mavica captures black- and-white images on a magnetic disk and digitizes them so that they can be transmitted over a telephone line and printed. Sony claims the clarity is better than today's wire photos, but it cannot match conventional cameras in any other use. Kodak is testing a hybrid electronic system that is a kind of high-tech slide projector. A machine transfers conventional negatives to electronic images on magnetic disks. Each disk holds 50 pictures and, when inserted in a player- recorder, produces a broadcast-quality picture on a television screen. For now, however, the machine seems a product in search of a market. Some photography experts estimate that the fancy projector would have to sell for around $2,000. The machine also can freeze an image from a television program or videotape and make a paper copy, but the technology for the copies violates the same Polaroid patents that were involved in the instant-photography suit. Happily for Kodak, an all-electronic system that produces still pictures comparable to today's 35-mm film isn't likely to reach the market until 1990, if then. Electronic images fall short in what are known as pixels (for picture elements), tiny pinpoints of image information. The more pixels in an image, the sharper the picture. Sony's Mavica can handle only 280,000 pixels, compared with 1.5 million for disk film and 18 million for the finest 35-mm Kodacolor film. To repeat a question first asked by former Kodak chairman Walter Fallon, can the Rochester elephant be made to dance? ''I think it is quite a different corporation,'' says William Relyea, an analyst with Eberstadt Fleming, a stock brokerage firm, who has been following Kodak for 15 years. ''It is less paternalistic and less isolated in terms of attitude.'' Analyst Eugene G. Glazer of the Dean Witter brokerage firm is not so optimistic: ''Kodak will end up as a good player, but only one of many. It is not going to dominate.'' Kodak seems to have the right ideas about what it needs to stay at the forefront of its industry. But it was slow to awaken, and its acquisitions don't add up to major new business. Indeed, nothing in Kodak's future has the obvious profit potential of those familiar little yellow boxes. Fortune 3/3 issue BOX: COPING WITH 16.5 MILLION HEADACHES Kodak faced an enormous customer relations problem when a federal judge rendered its instant cameras instantly obsolete in January. Owners of the 16.5 million cameras suddenly found it impossible to get film. Kodak reacted within hours of the ruling with an imaginative solution. It gave owners of the cameras, which originally sold for $26 to $78, the choice of turning them in for a disk camera and film with a retail value of $50, or for coupons for $50 of other Kodak products, or for a share of Kodak stock, then selling for $47.50. Kodak instructed camera owners to call an 800 number in Omaha operated by WATS Marketing of America, a telephone service bureau. WATS operators send names and addresses of owners to Nationwide Fulfillment Systems in Ridgely, Maryland, a mail-order fulfillment house. Nationwide, in turn, mails instructions and a postage-paid envelope to owners so that they can send in their cameras. Then it mails out the merchandise, coupons, or stock certificates. The offer was a public relations triumph but soon became a logistical nightmare. WATS Marketing's 150 operators were overwhelmed by incoming calls the first day. By late January calls were coming in at the rate of 4,000 an hour. WATS had added 450 operators by January 30 and was putting 25 new ones on the Kodak lines daily. It expected to have 1,800 on duty by mid-February. The offer of a share of stock has come under attack from security analysts, who note that the shares are worth twice as much as the wholesale value of the merchandise. Camera owners haven't been wild about the stock offer either. Brokerage fees to sell a single share run as high as $25. Some speculators thought they spied a true bargain when Kodak first announced its plan. A New York man bought 190 instant cameras in the days following the court ruling. Then he discovered that Kodak would accept only three per owner. Kodak suggested he go back to the dealer. Some security analysts expected that Polaroid would offer its cameras for Kodak's, viewing the 16.5 million owners as potential buyers of Polaroid film. No offer materialized. It will be March before customers receive the merchandise, coupons, or stock for their instant cameras. Once the cameras pour in, Kodak will face a massive disposal problem. It is still trying to decide whether to break up the plastic, aluminum, and glass objects for scrap or simply bury them in a landfill.

BOX: INVESTOR'S SNAPSHOT EASTMAN KODAK SALES LATEST FOUR QUARTERS $10.6 BILLION CHANGE FROM YEAR EARLIER UP 1% NET PROFIT $729.2 MILLION CHANGE DOWN 13% RETURN ON COMMON STOCKHOLDERS' EQUITY 11% FIVE-YEAR AVERAGE 15% RECENT SHARE PRICE $48.25 PRICE/EARNINGS MULTIPLE 15 TOTAL RETURN TO INVESTORS (12 MONTHS TO 1/31) 4% PRINCIPAL MARKET NYSE Eplanatory notes: page 120