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Kraft Keeps Right on Cookin'

By Eric Wahlgren Everyone knows of a merger that sounded good at the time but turned into a trying challenge. The AOL Time Warner marriage is one that comes to mind. But one deal appears to be working out rather nicely: Kraft Foods' $19.2 billion takeover of rival Nabisco Holdings in December, 2000.

The combined Kraft Foods (KFT) was spun off from tobacco giant Philip Morris (MO), which remains the majority owner, in a June, 2001, initial public offering. Today, it's the biggest food company in North America, with some of the country's most familiar brands, including Kraft cheese, Maxwell House coffee, and Oscar Mayer meats. Cost savings resulting from the Nabisco integration are expected to reach $300 million this year, climbing to $600 million in 2004.

The savings generated by mergers of the two outfits' distribution and marketing operations represent one reason why analysts are bullish on Northfield (Ill.)-based Kraft. "The cost savings has a lot to do with the company's ability to keep hitting earnings targets," says Richard Joy, senior investment officer at Standard & Poor's equity research in New York. "A much stronger and better company is being built."

HEALTHY RISE. Joy argues that Kraft's profit picture and industry dominance warrant a premium price for the stock relative to other large-cap food companies. (Kraft's Web site boasts that its products are found in more than 99% of U.S. households.) Kraft trades at about 16 times 2003 earnings, which is slightly above the S&P 500-stock index price-earnings multiple of about 14. But Kraft's valuation is right in line with that of its peers, Joy says. "The price is not reflecting the fact that they are the top food company in most of the categories that they compete in, and that they are also the most profitable," he adds.

Investors have already taken note of the success behind products such as Cheese Whiz, Oreo cookies, Milk-Bone dog biscuits, and A.1. Steak Sauce. In a terrible market, the stock has risen more than 8% over the first nine months of 2002, to close just shy of $37 as of Oct. 2 -- about 19% higher than its IPO price of $31 a share. That compares to the 26% percent drop in the benchmark S&P 500 index over the same period.

Kraft shares are 16% off the closing highs reached in mid-June, 2002, as the overall market has steadily fallen on concerns about the economy, corporate earnings, and mounting troubles abroad. But some Wall Streeters say the recent pullback represents a buying opportunity. "Now is a good entry point" for investors, says Ann Gurkin, a food analyst at independent brokerage Davenport & Co. in Richmond, Va. Kraft stock could appreciate as much as 30%, to $48 a share, in the next 12 months, she says. (Although Davenport has no investment-banking relationship with Kraft, Gurkin says she owns some shares of the company in a family account.)

PUMP UP THE VOLUME. Besides the rising cost savings, Gurkin likes Kraft's market position, management team, strong cash flow, and profit margins that are the envy of the industry. Kraft products generate EBIT (earnings before interest and taxes) margins of about 21%, vs. an industry average of about 15%, says Joy, who adds: "This is really everything you would want in a company."

Joy rates Kraft a buy -- S&P's highest rating. He says the stock is worth at least $44, or 20% more than its current price, based on intrinsic value, an S&P valuation model based on future cash-flow estimates and other factors. (Like BusinessWeek Online, S&P is a unit of The McGraw-Hill Companies and has no investment-banking relationship with the companies it rates.)

In 2002, Kraft is looking to build its volume, or total units shipped, by 3% (the low end of its 3% to 4% long-term goal) as it rolls out new products and expands into new markets, analysts say. As a result, Joy expects 2002 profits to rise about 15%, to $2.04 a share -- or net income of around $3.5 billion on about 2.5% higher revenues, estimated at $30.2 billion. (The figures are adjusted to account for a change in how the Nabisco acquisition is reflected on Kraft's books.) In the longer term, Joy expects Kraft to deliver annual earnings-per-share growth increases of 13% to 14%.

CRACKER SYNERGY. Despite a tough global economy, Kraft's future looks promising. Acquiring Nabisco has given it the ability to "dual brand" -- come up with new products that leverage the strengths of both names, Gurkin says. One dual-brand creation is Kraft Cheese Nips: Nabsico crackers made with Kraft cheese. "There will be great opportunity to do this kind of dual branding," says Gurkin.

Analysts say Kraft is ramping up marketing and product introductions to continue to build market share, thanks in part to cash available by cost savings from the Nabisco integration. Some new products are already showing promise, said Andrew Lazar, a Lehman Brothers analyst in New York, in a recent research note to investors. Chocolate Creme Oreos grew to a $70 million brand in only seven months since its launch, Lazar pointed out. "It has been years since we have seen such a significant number of new products in the pipeline at Nabisco," he wrote.

Overseas, which accounted for about 20.5% of Kraft's revenue in 2001, should be another source of future growth. Expansion will likely be most dramatic in the developing world, where volume grew 11% in 2001, exceeding Kraft's overall volume growth for the year. The latest move? The acquisition of Turkish snack-food company Kar Gida on Sept. 20 "is part of Kraft's strategy to rapidly expand our food portfolio in high-growth developing markets," Maurizio Calenti, a Kraft division president, said in a statement at the time.

CHEESE PRESS. Yet another reason why analysts are upbeat about Kraft: It recently hiked its quarterly dividend to 15 cents from 13 cents, a 15% increase. The move bucks a recent trend of companies reducing or abandoning dividends to cope with rough times. "It suggests that Kraft feels good enough about their business to raise their dividend and increase their return to their shareholders," Gurkin says.

Investing in Kraft is not without risks, however. For starters, it may be challenging for Kraft to meet its 2002 volume growth target of 3%, Lazar noted in his research. Kraft's cheese unit, which represented 18.4% of revenue in 2002, faces stiff competition. Also, weak demand in Germany, a large overseas market for Kraft, could weigh on results, Lazar added. A spokeswoman says Kraft can't comment since it's in a quiet period ahead of releasing third-quarter results on Oct. 16.

What's more, Lazar believes Kraft's longer-term EPS growth will be more in the 7% to 8% range than in the midteen area some have predicted. That's more than respectable in this shaky economy, when stocks like Kraft have defensive appeal. But if the economy picks up, investors may again become enamored with higher-growth names.

TOP DOG. Despite his caveats, Lazar still rates Kraft a stock a strong buy because he sees its position in the food industry as unique. "This dominance, we believe, will continue to provide Kraft with better opportunities to outperform its peers in relatively mature categories," Lazar wrote in his report.

Indeed, in a time when investors continue to lose money in the broader stock market, a name like Kraft with dependable earnings and rock-solid brands could provide some nourishment for starving portfolios. Wahlgren covers financial markets for BusinessWeek Online in New York

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