The Heat in Kraft's Kitchen

Cheap rivals and demands for leaner fare close in

Few things in the food business are as bankable as Kraft Foods (KFT ) Inc.'s extending one of its powerful brands. But when Kraft flooded supermarkets last winter with a microwavable Ooey Gooey Warm 'n Chewy version of Chips Ahoy cookies, shoppers were unimpressed. Worried about microwave safety, Kraft had dialed down the heating instructions. The result was a less than gooey, altogether not ooey-tasting cookie -- and overpriced to boot. Kraft wound up paying $5.5 million in the second quarter to pull unsold cookies off store shelves, enough to shave 1 cents a share off its bottom line.

That's not the only misfire at Kraft. After a two-year honeymoon in which she seemed to have figured out how to wring consistent growth from the $29.7 billion food manufacturer, Kraft co-CEO Betsy D. Holden, 47, is suddenly feeling pressure from all sides. The departure of two top operations executives on the same day, July 9, raised concerns about thinning ranks in Kraft's executive suite, where Holden shares the CEO duties with international chief Roger K. Deromedi, 49. Then, on July 16, Kraft shocked investors by acknowledging that it had failed to meet second-quarter expectations and was lowering earnings forecasts for the rest of 2003.

All Kraft's flagship businesses -- cheese, biscuits, cold cuts, and coffee -- lost market share and sales volumes in the spring. The announcement drove the stock down by $2 in one day. Today it trades around $29, off 26% since Jan. 1. An overreaction to one bad quarter? Not exactly. What's spooking investors is Kraft's sluggish response to a pair of threats that have been building for the past year: an attack on its core brands by cheap private-label goods, and a rising demand for less fattening, more healthful food. "Kraft's bulletproof reputation as a steady grower was shattered," says Daniel Peris of Federated Investors Inc., which owns 286,000 Kraft shares. "Everyone suddenly realized that it's just a regular packaged-food company, not a superior one."

What had placed Kraft a cut above and warranted its long-term 3%-to-4% volume growth target was its reputation as an innovator. Indeed, Holden, an ex-teacher with an MBA from Northwestern University's J.L. Kellogg (K ) Graduate School of Management, sped through the ranks as a marketing whiz by pulling off such tricks as converting the DiGiorno pasta brand into a powerhouse that captured 19% of the frozen pizza business. Lunchables, a combo of meat, crackers, cheese, drinks, or candy, exploded from scratch in 1988 to a $676 million business today. Sales of Oreo, the No. 1 cookie in the world, leaped 9% after two chocolate creme variations were introduced in 2001.

Lately, however, new products have sputtered. Besides the Ooey Gooey flop, a squeezable pouch of cream cheese -- Philadelphia To Go! -- has generated less than $500,000 in sales per month since its launch late last year. And several companies were faster off the mark with offerings that respond to rising concerns about fatty foods. Last September, PepsiCo (PEP ) Inc. began to remove trans fatty acids, which boost levels of harmful cholesterol, from its three popular snack brands. Doritos, Tostitos, and Cheetos are 99% free of trans fat, and Pepsi's "better for you" snacks grew 28% by volume in the second quarter. General Mills (GIS ) Inc. and Kellogg Co. have greatly enhanced their cereal lines with health-oriented extensions such as adding soluble fiber to Honey Nut Cheerios. Meanwhile, some critics say Kraft let its Post cereals wilt. "Cereal is all about new flavors and new items that are good for health, and Kraft hasn't kept up," says Jennifer McCaffrey of McCaffrey's, a small grocery chain in Langhorne, Pa.

Some of the same lawyers who pressed cigarette suits against Kraft's 84% parent Altria Group (MO ) Inc. -- formerly Philip Morris -- are now queuing up to target Kraft's fat-rich lineup. That's not surprising: After all, a deep-dish pizza lunchable, with cola and peanut-butter cup, packs 760 calories and 28 grams of fat. Fat will become even more of an issue when the Food & Drug Administration begins requiring that food labels disclose levels of trans fat on Jan. 1, 2006.

Kraft's response? It has promised to explore cutting trans fats out of regular Oreos. And on July 1, Kraft said it would cut some portion sizes. Of course, that could raise profit margins, if unit prices don't come down by a proportionate amount. Kraft also said that it would eliminate in-school marketing such as ads on classroom Channel 1 and product sampling, although for now it will still stock school vending machines. Holden vowed to review all of Kraft's products to see where it could provide reduced-fat alternatives. "The only way we're going to make progress against obesity is if all sectors of society do their part -- and that includes the food industry," Holden said in an e-mail interview.

Analysts, several of whom have downgraded Kraft in the past month, worry even more about a price squeeze on such core brands as Kraft Singles, Maxwell House, Oscar Meyer, and Ritz. They say that starting last year, Holden should have been more aggressive in meeting the threat from private-label products. Grocery chains, trying to stave off discounters such as Wal-Mart Stores (WMT ) Inc. and Costco Wholesale (COST ) Corp., have loaded up on those goods, which deliver fatter margins at lower prices: a 12-count package of American cheese singles from Kraft sells for $2.99, vs. $1.99 for Albertson's (ABS ) Inc.'s version.

Holden was determined not to get into a pricing war. In fact, she increased prices on cold cuts and coffee as commodity costs climbed. But when the competition balked and Kraft didn't respond quickly enough with promotions, it paid the price. Kraft's sales of natural cheese in the past five months rose just 1%, while private-label cheese jumped 13%, according to Merrill Lynch (MER ) & Co.

Now Holden is upping the ante. Kraft will boost its multibillion-dollar marketing budget in the second half by a further $200 million, much of it to bolster core brands. And price cuts are coming in selected areas. That combination might get sales growing again, but it is also a big reason why Kraft will miss its earnings targets.

Amid all these challenges, Holden is also fighting off criticism that she has found it hard to hold on to key talent. That started with the 2001 departure of Ann Fudge, a rival for the top Kraft job who is now CEO of Young & Rubicam. It continued with the July departures of Irene B. Rosenfeld, Holden's No. 2 as president of Kraft North America, and Michael B. Polk, who left as president of the biscuits and snacks division to become chief operating officer of Unilever Bestfoods North America. Holden counters that Kraft has had relatively little turnover at the top, adding: "Because we have such a depth of talent, there sometimes are people who want certain jobs, including CEO, faster than is possible here."

For most of her tenure, Holden had little trouble hitting her targets. That's thanks in no small part to a masterly integration of Nabisco Group Holdings (MO ) Corp., which Philip Morris bought in 2000 for $19 billion. But some worry the resulting portfolio of products is unwieldy. Clearly, Holden disagrees. But she'll have to show some deft kitchen management in order to hold off the competition and wring the fat out of Kraft's lineup.

By Pallavi Gogoi in Chicago

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