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Will Two Heads Be Better Than One at Kraft?

Dow LeaderboardAs Kraft Foods (NYSE:KFT) prepares to split into two publicly traded companies later this year, investors will be watching Chairman and CEO Irene Rosenfeld and W. Anthony “Tony” Vernon like hawks. The challenge for both executives — who each will head one of the companies — will be delivering a higher value proposition separately than the combined company can deliver now.

After the split, expected by the end of the year, Rosenfeld will head the Global Snacks business, which generated about $32 billion in 2011. A 30-year food-and-beverage industry veteran who had a successful run as CEO of PepsiCo‘s (NYSE:PEP) Frito-Lay, Rosenfeld has served as Kraft’s CEO since 2006 and chairman since 2007.

On her watch, Kraft managed the Nabisco integration and Altria spinoff, acquired Cadbury and survived a rancorous marketing and distribution divorce from Starbucks (NASDAQ:SBUX) last year. Current Kraft CFO David Brearton will be CFO at the snack foods-company and will assume responsibility for the company’s information systems.

Vernon, who boasts deep consumer product expertise from 23 years leading Johnson & Johnson (NYSE:JNJ) brands such as Tylenol, Motrin and Splenda, takes over as CEO of the $16 billion North American Grocery business, which will keep the Kraft name. He came to Kraft from the private equity firm Ripplewood Holdings in 2009. Ironically, fellow Ripplewood alum John Cahill, a former senior Pepsi Bottling Group executive, steps in this month as executive chairman of Kraft Foods Group. He will team with Vernon to build the grocery business in the U.S. and Canada.

Splitting the world’s second-largest foods conglomerate into two separate companies was not decided on a whim — the focus and goals of the two divisions recently had drifted apart. In fact, the groundwork for the split was laid soon after Kraft’s $19.5 billion acquisition of Cadbury two years ago. The iconic British brand gave Kraft a powerful stronghold outside North America and advanced its emerging markets strategy dramatically. But the corporate cultures and brand positioning were dramatically different.

The split makes sense when you think about it: Snacks — including Trident gum, Ritz Crackers and the Cadbury confectionery line — now comprise half of Kraft’s product portfolio, and more than half of its business is outside North America. The opportunity for investors: better returns from a focused and agile competitor in the high-growth global snack foods arena, while retaining hefty margins in the slow but stable North American grocery business.

The split should allow each separate company to develop an identity best suited to its market and products. The global snack foods company represents the hottest potential opportunity — Kraft’s Developing Markets growth alone was 20% in its last fiscal quarter, led by dramatic growth in China, Russia, India, Brazil and Ukraine. Rosenfeld believes the new company will be able to leverage the strength of Cadbury’s marketing and distribution networks to expand market share and to launch new products. The company was expected to have captured 70% of the cost synergies of the Cadbury acquisition by the end of last year.

While the global snack foods business will be the growth engine, Kraft’s North American grocery operations remain the cash cow. Products like Kraft Macaroni & Cheese, Cool Whip and Oscar Meyer meats are high-margin staples for the average family. But the markets are mature, and it will take aggressive brand management — through marketing innovation and a bold new product pipeline — to keep delivering revenue and profit growth. And as head of Kraft Foods North America, Vernon has spearheaded major new investments in key brands that helped offset the impact of commodity price hikes over the past year.

That’s why on the face of it, the Kraft split is a no-brainer for investors. But whenever you spot a sure thing — whether in Las Vegas or on Wall Street — make sure you’re not seeing an optical illusion. No matter how good a company split looks on paper, the devil is in the details. Kraft has been able to cut costs and boost efficiencies dramatically through adopting Six Sigma business processes and economies of scale. They will lose some of those efficiencies — particularly attractive supplier pricing — by breaking up, though the company also announced it would be cutting 1,600 jobs to make itself “more nimble,” according to Vernon.

A bigger issue is debt: The company ended 2011 with weaker liquidity than it started with — KFT has about $2 billion in cash compared to $29.6 billion in debt. Another issue will be how to divvy up the hefty amount of debt Kraft took on to purchase Cadbury between the two new companies. The Cadbury debt would be a growth-killing millstone around Global Snacks’ neck, and North American Grocery would receive little benefit.

Also earlier this month, Kraft sold $800 million of floating-rate notes it must redeem before the spinoff.

At around $38, Kraft shares aren’t cheap right now — they’re trading 25% above their 52-week low last February. With a market cap of $66.7 billion, it has a price-to-earnings growth ratio of 1.7, indicating that the stock might be overvalued. It has a dividend yield of 3.1%.

Bottom Line: While a split makes sense strategically given the diverging paths of the two lines of business, Rosenfeld and Vernon have their work cut out for them in the short run. The two biggest challenges will be maintaining economies of scale in supply chain and production and boosting liquidity. Without greater clarity on how these two smaller companies will maintain the pricing and operational advantages of a larger one — or how debt will be handled — I think KFT stock is a hold for now.

As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned stocks.

Article printed from InvestorPlace Media,

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