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Will Two Heads Be Better Than One at Kraft?

Rosenfeld, Vernon gear up for life after split

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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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