Spinoff Could Put the Crunch Back Into Kraft - TheStreet

Editor's Note: Jon D. Markman writes a weekly column for CNBC on MSN Money that is republished here on

TheStreet.com.

The fate of

Kraft Foods

( KFT), the world's premier maker of cookies, crackers and cheese, hangs in the balance now that its majority owner has decided to sell its 89% of Kraft to the public in the form of a corporate spinoff.

At stake is not just who gets to market Oreos, Velveeta, Lunchables and Jell-O to a snack-craving public, but the very nature of what it means to be a junk-food king in the age of an increasing focus on nutrition and health. The spinoff, Kraft-parent

Altria

(MO) - Get Report

said Wednesday, will happen on March 30 and give Altria shareholders seven-tenths of a Kraft share for each Altria share they own.

Wall Street has so far appeared lukewarm to the prospect of the transaction because Kraft has done a lousy job in recent years of streamlining its product lines for maximum profitability. During the 20 years it has been a reluctant part of Altria, which is best known for its Marlboro cigarettes, Kraft has fallen badly behind competitors such as

Kellogg

(K) - Get Report

in the quest to turn flour, milk and sugar into gold.

Just to give you an idea, Kraft's gross profit margins are just 36%, compared with 44% at Kellogg and 42% at

Campbell Soup

(CPB) - Get Report

. That means its competitors spend much less on expenses such as wheat, labor and marketing, or find ways to charge much more at the register, or both.

On the surface, in other words, it may seem as if Kraft has built a brilliant shelf lineup that includes perennial kid favorites such as Oscar Mayer wieners, Crystal Light and American cheese singles, but its executives actually deserve a big fat frowny face on their report card for the way those brands have been managed.

Free the Oreo!

The depth of Kraft's misfortune can be viewed better in the stock market than in the supermarket. In the past five years, shares of Kraft, which have traded separately from Altria since 2002, are basically flat, while shares of Kellogg are up 85%, Campbell Soup is up 50%, and the broad market is up 30%. Yecch! No wonder Altria wants to give this biz the old heave-ho.

Should you be a buyer? Well, when the fundamental results of a famous business become so bad that its parent decides to kick it out of the house, the contrarian in you should smell opportunity. And in this case, you should pay heed, because when those new Kraft shares come on the market in the spring, they're almost certainly going to start life by crumbling like a stale biscuit. But be ready to pounce, perhaps a few weeks later around the $31 level, because they should then recover and begin a binge of appreciation.

The reason: Liberty has its advantages. The slogan "Free the Oreo!" might not have the same ring to it as "Free Tibet!" but the concept is the same. A company like Kraft should do much better as an independent entity than as a cog in a giant machine.

To understand why, let's rewind a moment. Twenty years ago, investors applauded diversity in companies. When the cigarette maker then known as Philip Morris purchased Kraft for $12.9 billion in what was then the largest transaction in history, the market gave the deal a big thumbs-up. It seemed like a good idea to become less reliant on making products that killed your customers, and the processed food business was considered a star performer.

Now a different theory has swept Wall Street. Investors currently prefer companies that do one or two things really well, and urge them to shed operations that divert top managers' attention from core strengths. This is one reason you are seeing so much merger-and-acquisition activity, as business units are being swapped around left and right, and then repackaged and resold to investors as shiny, new, refocused entities.

The person charged with unlocking the hidden value of the Kraft brand will be Irene Rosenfeld, who took over as chief executive of the company eight months ago. Many investors expect her to announce, at a meeting with analysts in New York in late February, a series of sweeping changes, including the sale of many noncore food and beverage lines.

She may also announce that the company, which has very little debt, will sell a ton of bonds and use the proceeds to buy back as much as 8% of the shares outstanding -- a transaction that has the effect of dramatically increasing a company's earnings per share, a key measure of value.

Cheez-It Innovation

Rosenfeld has a daunting task, to be sure, as the packaged-food industry faces formidable hurdles: The price of commodities such as corn has skyrocketed because of global demand for food, cattle feed and ethanol; supermarkets are aggressively marketing high-quality store brands to enhance their own profitability; and regulators are on the warpath against ingredients linked to the obesity epidemic, such as trans fats and high-fructose corn syrup.

But Wall Street loves a new hero and is likely to give Rosenfeld a break as she figures out how to decentralize decision-making in Kraft's notoriously top-heavy bureaucracy, change middle managers' compensation to encourage market-share growth over stability, spend more on marketing, improve profitability and invest in some clever, tuck-in acquisitions.

One area in which the new CEO must lavish attention: innovation. Although the cookie division has done a great job of making a dozen new varieties of Oreos -- including the Uh-Oh! Oreo, which swaps chocolate cream for vanilla, orange Oreos for Halloween and mint Oreos just for fun -- other divisions are snoozing. While Kellogg has done great work by innovating numerous varieties of its Cheez-It brand, for instance, Kraft has failed to energize its own Cheese Nips entry in the category. Laugh if you will, but packaged food wars are won and lost in the shelf-by-shelf battle for snackers' fast-changing tastes.

The bottom line is that Kraft is not a dormant brand; it is only playing dead. Investors would normally kill to acquire shares of a company that generates three-quarters of its $30 billion in annual sales from products in which it has a No. 1 market-share position, as such dominance normally leads to enhanced clout with stores, manufacturing efficiencies and higher profit margins. If Rosenfeld can find a way to improve margins at least to the level of competitors by paring head count and slashing oddball divisions such as the beverage Capri Sun, then she's going to have a real winner on her hands.

Be a savvy shopper. Try to buy Kraft shares around $31 and look for prices to trek toward $40 by the middle of 2008.

At the time of publication, Jon Markman did not own or control shares of companies mentioned in this column.

Jon D. Markman is editor of the independent investment newsletter The Daily Advantage. While Markman cannot provide personalized investment advice or recommendations, he appreciates your feedback;

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