A Big Chill For Kraft?

If Altria spins off the rest of it, the reception could be cool

Five years ago investors were crazy for Kraft Foods Inc. (KFT ) It had been off the market since 1988, when tobacco giant Philip Morris Cos., now Altria Group Inc. (MO ), acquired it. By 2001 tobacco litigation was in full swing, and Kraft's double-digit growth prospects made it too valuable for Altria to keep to itself. The $8.7 billion initial public offering of roughly 16% of Kraft is still the second-largest U.S. IPO ever. Investors pounced on it, sending the stock up 40% in a 12-month period that saw the Standard & Poor's 500-stock index plunge 17%.

Now, Altria may be offering more shares. Management has indicated that it will spin off the rest of Kraft once the tobacco-litigation environment sufficiently improves. In December the Illinois Supreme Court overturned a class-action ruling against Altria, and Florida is expected to rule on another case in the next few months. A favorable judgment could pave the way for Kraft's split from Altria later this year. "If and when Altria decides [to spin off its stake], we'll be ready," says Kraft CEO Roger K. Deromedi.

But some analysts wonder if the market will welcome another helping of Kraft, whose margins have been shredded of late. Shares are down 12% from their 52-week high and trade 4% below the IPO price. If Altria shareholders decide they don't want Kraft, the subsequent sell-off would put more pressure on an already struggling stock.

Complicating matters, Altria's now 87% stake in Kraft is worth $43.5 billion. The value of large-cap food stocks in the hands of public investors is roughly $100 billion. So post-spin, Kraft would account for one-third of the industry, a huge hunk of cheese for the market to digest.


It's easy to understand why Altria holders might not go for Kraft. For one thing, says David J. Adelman, an analyst at Morgan Stanley (MS ), the tobacco business is more promising right now, with superior pricing power, stronger brand loyalty, and higher gross margins than food. Altria's stock is also cheaper. Kraft sells for 17 times 2005 earnings; back out the food group from Altria's price-to-earnings ratio of 14, and the implied p-e for the tobacco holdings is 13, vs. 17 for the S&P 500.

What went so wrong for Kraft? It has been ravaged by global competition and rising commodity prices. Operating margins fell from 21% in 2002 to 15% in 2005. Sales by volume barely budged last year. And there's concern on the Street that the company's products are not innovative or different enough from generic brands to entice consumers to pay up for them. Analysts estimate that earnings will drop from $1.72 a share in 2005 to $1.49 this year. "It's hard to get your stock up when you don't [improve] your earnings," says UBS (UBS ) analyst David Palmer.

Kraft's Deromedi says investors will recognize the value of the nation's No. 1 food company. He has spent the past couple of years shedding lackluster units, focusing on blockbuster brands such as Oreo and Oscar Mayer, and building new ones like South Beach Diet. In January, Deromedi expanded the company's worldwide restructuring program, announcing plans to shutter up to 20 more plants and trim 8,000 additional jobs through 2008. Kraft expects to realize $1.15 billion in annual cost savings from such moves, money Deromedi is using to invest in product development and marketing. "New products and the value proposition of our brands are going to help our momentum," says Deromedi. "More people are going to want to hold Kraft stock."

He had better hope so. Otherwise, Kraft shares may end up in the bargain aisle.

By Adrienne Carter

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