Refilling Kraft's Cookie Jar

CEO Irene Rosenfeld is banking on a raft of new products to boost sales. Can she whip them up before investors lose patience?

Oh, the lunchtime dilemma. That turkey-on-whole-wheat sandwich you brown-bagged from home is properly frugal but so boring. That takeout panini with rosemary chicken, sun-dried tomato, and aioli, on the other hand, is tasty but sure takes a bite out of the paycheck.

The chefs at Kraft Foods (KFT) think they've found a middle option: Oscar Mayer Deli Creations. The $2.99 kits, rolled out in grocery stores in August, have the makings of a hot meat-and-cheese sandwich, with bread that even gets toasty in the microwave. The boxed lunch for cubicle dwellers also represents an awakening of sorts at the nation's biggest food producer. "It's not just how we compete in the prepackaged cold-cut case," says Richard Searer, president of Kraft's North American business, "but how we compete in the world of sandwiches."

Under the gun to pick up the pace at the plodding giant, Chief Executive Irene B. Rosenfeld and her newly installed lieutenants have been launching one product after another this year: convenience foods such as salad kits; "good-for-you" snacks that include toasted chips with baked-in fruit or vegetables; indulgences such as soft Oreo Cakesters; and premium-priced entrées such as DiGiorno Ultimate pizza. Kraft's consumer research shows there's a strong market for each one.

Activist Attack

Thanks to these products and more, Rosenfeld says, Kraft's revenues will rise 4% in 2007, and that's excluding acquisitions. Moreover, through a combination of higher-quality food, more advertising and marketing, stock buybacks, and cost cutting, she predicts, Kraft's earnings per share will increase as much as 9% a year from 2009 on. "We're making terrific progress on all of our strategies," Rosenfeld says. Sitting at a conference table in her spacious, well-appointed office at Kraft's headquarters in Northfield, Ill., she adds: "Kraft is a fabulous company."

Kraft is anything but a fabulous investment, however. And that could ultimately be Rosenfeld's undoing. While the Standard & Poor's (MHP) 500-stock index has gained 4.2% over the past 12 months, Kraft shares are down 8.7% , leaving them priced where they were six years ago. Believing that Kraft could be generating better results, activist investor Nelson Peltz took a stake in the company worth upwards of $1 billion. Carl C. Icahn had taken took a smaller stake of $132 million but sold it at the end of September.

Peltz, who has forced changes at other food companies, seems to be getting his way. Kraft agreed in November to expand the board to 11 by adding two outside directors supported by Peltz. After he pressed Rosenfeld to sell Kraft's lackluster Post Cereals and Maxwell House coffee lines, Kraft also said it would merge Post into Ralcorp Holdings in a deal valued at $2.6 billion. In return, Peltz consented to a standstill pact, promising to support the board and to keep his holdings under 10% for the next two years.

But coming only days after Kraft announced weak third-quarter earnings, reports of the Post sale and the truce did little for the stock. Icahn hasn't publicized his agenda. Cliff Remily, an analyst at Thornburg Investment Management, which runs mutual funds in Santa Fe, N.M., and owns 7.7 million Kraft shares, is willing to give Rosenfeld a pass until mid-2008. His reasoning: "You can push for faster growth, but it's a large company, and it won't turn on a dime."

Living in the Past

Kraft is emblematic of what seems almost inevitable at big, old companies with familiar brands. Accustomed to being on top, they cling to the mass market, missing shifts in customer tastes. They become more conservative and often settle for safer bets, such as extending lines with new iterations of the same familiar merchandise. "After the 19th variety of Oreo," notes Neil Stern, senior partner at retail consulting firm McMillan Doolittle in Chicago, "it reaches the point of absurdity."

Kraft's marketplace makes growth all the harder to achieve: Food sales tend to rise no faster than a country's population or economy. And where there have been quicker sales increases—in organic foods, say, or in developing nations, such as India and China—Kraft has little presence. Two-thirds of sales and 80% of profits, in fact, come from the U.S. and Canada.

Rosenfeld herself says she sensed a deepening stodginess when she returned to Kraft in mid-2006 after a two-year stint running PepsiCo's (PEP) Frito-Lay division. "The surprise was how focused the organization had gotten on cost to the exclusion of almost all else, particularly quality," the 54-year-old CEO says. "So every conversation began with how much something cost—how much we could save—rather than what it would take to grow faster."

For a company that boasts at least one product in 199 of every 200 pantries in the U.S., Kraft also can be surprisingly myopic. Although Starbucks (SBUX) arrived on the scene more than 20 years ago and revolutionized the way Americans drink coffee, Kraft's Maxwell House introduced a richer coffee with 100% Arabica beans only this fall. "Our frame of reference was coffee sold in the grocery store," Searer concedes. "We competed with Folgers."

Rosenfeld—a food industry lifer with a direct, no-nonsense style—is no revolutionary, however. She says blockbusters are not necessary and dismisses the notion of significantly shaking up the company's portfolio. She may have surprised investors with her $7.2 billion purchase of Group Danone's cookie and cracker business in July, but she explains that it was only an opportunistic grab; major acquisitions are not part of her strategy.

Indeed, while competitors such as Procter & Gamble (PG) and Sara Lee (SLE) are slimming down, Rosenfeld sees Kraft's "wall-to-wall" presence in grocery stores as a plus. "There is benefit in having a broad portfolio," she says. "Our scale is a competitive advantage."

Instead of dramatic strokes, she is banking on generating a profusion of new products that will each add $50 million or more in annual sales. To that end, she says, she is "rewiring the organization for growth." She has upped spending on marketing and on research and development by a total of $419 million a year, or 8%. She has installed new people in more than half the positions in Kraft's top two tiers of management. And she has pushed responsibility for brand development down the ranks and tied compensation to results. "I set high expectations for my team," she says, but "there's nothing I would ask them to do that they wouldn't ask themselves to do."

Even her modest revenue goals may be a stretch, however. Consider that a solid hit such as Kraft's South Beach Diet line, with $250 million in annual sales, barely registers at the $34.4 billion company. Kraft would need to create from scratch at least five lines as popular as the South Beach Diet foods each and every year to achieve Rosenfeld's revenue target. How hard is that? Of the 35,000 products introduced at supermarkets each year, fewer than 3% ever reach $50 million in revenues, says Thomas Kuczmarski, president of the Chicago product development firm Kuczmarski & Associates.

Sluggish Sales

Kraft has long been a laggard. Under Altria Group (MO), the packaged-food company was considered little more than a utility, churning out a steady flow of cash that could mitigate the risks of the company's Philip Morris tobacco unit. After its partial spin-off in 2001, Kraft was saddled with a co-CEO structure, which predictably blurred authority. A five-year restructuring that will eliminate 14,000 jobs and cost $3 billion in charges has demoralized employees.

Revenues increased an average of 5% a year from 2002 to 2005, but more than half came from acquisitions; so-called organic growth amounted to 2.25% annually. Last year, sales inched up just 0.7%. Earnings, hurt by a $157 million writedown, after taxes, on its disappointing Tassimo single-cup coffee products, nevertheless rose 16.3% in 2006, to almost $3.1 billion. Still, that trailed its $3.5 billion profit in 2003.

By many measures, this year's performance is worse. Through the third quarter, sales were up 7.4%, but Kraft's organic growth rate of 4.6% so far in 2007 is no better than world economic expansion. Nine-month profits, meantime, fell 17.7%, to $2 billion, and its operating margin shrank by 190 basis points, to 12.3%. In the third quarter, more than half of Kraft's products lost market share or were flat in North America, with its supermarket share of natural cheeses, for example, slipping 0.59 points, to 26%, for the 52 weeks ended Oct. 7, according to market trackers Information Resources Inc. (IRI). Rosenfeld says earnings have been hurt by the bump in spending for marketing and higher ingredient costs. By her own projections, though, Kraft will log its poorest year since 2001, with $2.45 billion in net income.

Rosenfeld is a marketing veteran. Hired as a market researcher at General Foods in 1981 after earning a PhD in marketing and statistics at Cornell University, she spent the next 22 years working her way up by analyzing and reframing food brands. "She was very articulate and focused on the facts," recalls James M. Kilts, a former CEO of Gillette who promoted Rosenfeld into product management when he was a group product manager in the beverage division at General Foods, which was merged into Kraft in 1989. Rosenfeld relishes her reputation as a boss who doesn't mince words. "Tough," she describes herself. "Tough, but fair."

Cooking Up a Storm

Her reputation now depends on how quickly Kraft can come up with products that please today's time-pinched consumers, who increasingly shun packaged foods in favor of ready-to-eat dishes from restaurants or grocery stores. "It is critically important that our innovations be bigger and more distinctive to our consumers," Rosenfeld says.

Employees are hard at it in Kraft's four North American test kitchens, including the one at Glenview. The company unveiled 70 new products in North America in advance of the supermarket industry's trade show at McCormick Place last May. That's up from 60 products introduced a year earlier, but the same as in 2005.

The lineup included adult versions of macaroni and cheese, with portobello mushrooms or sun-dried tomatoes; resealable packages for Oreo cookies and Oscar Mayer bacon; vitamin-enhanced Crystal Light powdered drinks; probiotic Kraft cheeses that are supposed to aid digestion; and organic Yuban coffee.

Kraft's R&D starts with dispatching ethnographers to consumers' homes, where they watch folks cook and eat and check out their cupboards and refrigerators, says Robert Becker, senior vice-president for new product development in North America. Researchers then explore what they believe are unmet needs and gaps in the market based on their in-home observations. Next, they ask consumers for input on specific products and packaging. Finally, they use focus groups and surveys to measure everything from product quality to pricing and advertising before releasing new items into test markets.

In Kraft's quest to cut costs, Rosenfeld says, this process had been compromised. The hefty increase in her R&D and marketing budget is aimed at improving consumer research and increasing the company's success rate. She says spending will be kept at this new higher percentage of sales in years to come, too.

Cheese-AND-Meat Combos

Kraft says one of its best hopes is the relaunch of its Tassimo coffee line. Though its four-step research process had shown great potential for machines that made individual cups of espresso or cappuccino at home, the single-serve coffee pods bombed when mass-marketed in the U.S. Kraft has since repositioned the espresso coffees to appeal to connoisseurs.

In a move to elevate commodity meats and cheeses into higher-priced convenience products—in much the same way Kraft combined meat and cheese into Lunchables in 1989—the company is also field-testing single-serve Fresh Creations salads in produce aisles in Boston and Denver. "They're moving up the value chain a bit," says Robert Goldin, executive vice-president at food consultants Technomic.

Kraft executives say the company's most-promising new product, though, may be its sandwich kit for keyboard-bound workers. Sales of Kraft cheese and Oscar Mayer meats had been essentially flat for several years as Americans made fewer sandwiches at home, preferring to pick them up at such places as Subway. Still, Kraft researchers believe there's an unmet need: Fully 70% of consumers work through lunch or take less than 10 minutes to eat. "Many consumers don't want to go out but still would like to eat a hot lunch," says Jean E. Spence, executive vice-president of global technology and quality.

Deli Creations was pulled together in less than a year by a team of managers with expertise in manufacturing, marketing, and market research. A technical breakthrough came with the bread. Normally, a roll tossed in the microwave turns hard. Borrowing from Kraft's experience with DiGiorno pizza crusts, the team came up with a product that avoids this fate. A special dough allows the rolls to stay soft while an insert on the bottom of the paper baking basket slightly toasts the bread, making it smell freshly baked.

At $2.99 apiece, Deli Creations are more expensive than a do-it-yourself sandwich from home but cheaper than a $5.99 sub from Quiznos. Kraft says the kits are selling well, with repeat sales above projections. The company sold about 8.9 million units at supermarkets, generating $23 million in revenues through Oct. 7, according to IRI.

Yet even if the microwavable sandwiches do well, the question remains: Will they generate enough sales to transform Kraft from tortoise to hare? Some investors are heartened that the company is taking calculated risks on new products rather than continuing to play defense. "They need innovation in areas that consumers care about, such as organic, ethnic, and convenience," says Eric R. Katzman, a food analyst at Deutsche Bank Securities (DB) in New York. "They need a multicategory offense with enough differentiated products to start taking back market share. And they need to make themselves relevant in categories that are meaningful to retailers and consumers."

Rosenfeld says this year's results show her strategy is working. She asks not to be judged until 2009, however. "This is a very large ship," she says. "We're only months into a three-year plan. This is a work in progress."

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