Wednesday, April 20, 2005

Is Kraft getting healthier or simply getting in shape for sale?

Kraft Foods Inc. has been struggling in the last few years to meet growth expectations. Fiscal Year 2003 was not a good year: although volume was up 0.7%, Kraft lost market share in several other important categories -- cheese, cold cuts, crackers and coffee, and therefore company objectives were not met. Most recently, in 2004, Kraft has still been facing market share loss which analysts believe is due to wide price gaps versus competing products. For the FY ended 12/31/04, revenues increased 5% to $32.17B, but net income from continued operations decreased 21% to $2.67B. These numbers account, however, for some asset impairment and exit cost charges, partly due to divestitures of various business segments and brands. In addition, earnings have been affected by higher marketing and research costs.

In January 2005, Kraft announced its new structure based on a “Sustainable Growth Plan” which intends to reinforce the company’s strategy, focusing primarily on three core issues:
· Building a value brand with consumers and increasing marketing investments in order to improve price gaps.
· Focusing on businesses that have a sustainable competitive advantage or that provide scale benefits regardless of whether these businesses are global, regional or country specific.
· Driving down costs and assets.

As part of the overall strategy, Kraft recently announced several divestitures. This month it reached an agreement to sell its fruit-snack portfolio to Kellogg Co. for about USD 30 million. The sale included brands representing approximately USD 80 million in revenues. This sale is viewed by some analysts more as the result of a poorly managed segment than the divestiture of an unpromising area, yet we believe this sale is part of a bigger strategic decision.

On November 2004 Kraft disposed of its confectionery business with brands as well known as LifeSavers, CremeSavers, Altoids, Trolli and Sugus. The sale took place after a competitive auction won by Wrigley which paid USD1.5 billion for a business with net revenues of USD 477 million (Morgan Keegan, Credit Research Report). Other assets that management seems to have considered non-core and that were divested in the near past are the US Yogurt Business (Breyers, Creme Savers, and Light’n Lively) and certain businesses of Kraft’s UK desserts. Both deals were announced on December 2004.

So why is Kraft getting rid of such well established and successful brands? We believe these strategic changes are not only driven by profit considerations but also by a change in consumer trends leading towards a health and wellness oriented food industry. Statistics show that Americans have become the most overweight population worldwide with an increasing trend. A growing concern, mainly oriented to protect the younger generations, has risen strongly in the last years. An important aspect of the crusade towards a healthier population is that Americans refuse to take the blame alone: corporations in the business of food have increasingly become the target of public boycotts and lawsuits (Wall Street Journal, March 28 & April 12 2005). In our opinion, divestitures such as the sugar confectionary business and more recently the fruit snacks are an early response by Kraft to the consumer driven changes in the food industry as well as to mounting pressure on the nutritious value of the food, especially when marketed to children. Kraft might regard these businesses as providing no sustainable growth in the long term given this rising concern for health.

We believe Kraft intends to focus on healthy foods by gradually eliminating brands that are less aligned with nutrition and health trends from its portfolio. To further support this argument, we looked not only at Kraft’s recent divestitures, but also at its recent acquisitions and development of new brands. In fact, these seem to align with what we consider to be Krafts’s new strategy, such examples are the acquisition of Fruit2O flavored waters, which will compete in the health and fitness water segment, and the launching of the South Beach Diet products. Moreover, on July 2003 Kraft announced an “obesity initiative” (The Economist, July 3rd 2003) with the purpose of revisiting its marketing, labeling and portion size practices. These changes are positive and timely in our view since they respond to consumer demand, and also because they position the company to benefit from “the first mover’s advantage” since Kraft is starting to be recognized as a nutritious focused company.

In addition to becoming more profitable and developing a sustainable competitive advantage, we deem Kraft’s recent actions may have also been triggered by two special factors: first, the fact that Kraft is owned by Altria, which happens to be the parent company of Phillip Morris has placed additional pressure over Kraft to focus on health, given that activists are using the company ties with Phillip Morris (Marlboro) as an argument against the firm to boycott their sales. Second, Altria based on their experience with Philip Morris, might want to avoid confrontation because of the various negative aspects and costs of lawsuits. Thus, Kraft seems to have chosen to adopt a strategy that might appease the public and maintain profitability at the same time.

Altria currently holds an 84% economic interest (97.5% voting interest) in Kraft, and for the last years it has expressed on various occasions that the spin-off of Kraft is by no means out of the question (Citigroup Smith Barney, December 16 2003). Thus we wonder whether Kraft is getting healthier or is it simply getting in shape for sale? In any case, aiming to respond to market trends can only be positive, and if Kraft is looking to increased profitability and growth, doing it the right way will be key for its long term success.

Leccia, Lopez and Villamil

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