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Special Report

Our Take on Kraft Foods

Kraft may take a while to live up to its full potential.

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Kraft Food's (KFT) $8.4 billion IPO has received quite a bit of attention, and with good reason. For the first time in more than a decade, investors are able to buy a piece of America's largest food company without all the legal and moral baggage that comes with tobacco giant (and Kraft parent) Philip Morris (MO)--or, at least, with less baggage than before. Once all the hype is stripped away, Kraft looks to us like a solid and attractive company, but one with some shadows over it that potential investors should be aware of.

On the plus side, the size and breadth of Kraft's product lines give it a definite advantage in the rapidly consolidating food industry. It makes everything from Oscar Mayer hot dogs to Jell-O to Maxwell House coffee--last year it had 61 different brands that brought in at least $100 million in revenue apiece, and its products are used in more than 99% of U.S. households. Such scale has allowed Kraft to generate healthy profits, as its operating margin grew from 11.7% in 1996 to 15.1% in 2000. Such fellow food giants as Nestle (NSRGY) and Sara Lee (SLE) have operating margins in the 11% to 12% range, indicating that Kraft has done a better job than its peers of wringing efficiency out of each dollar of revenue.

The downside of being a giant is that it's tough to grow very fast, and slow growth has been one of Kraft's main problems. Its overall revenue has actually declined in each of the past five years, and the mature North American food market, where Kraft gets 73% of its revenue, offers limited growth opportunities. Most of Kraft's overseas business comes from the similarly mature West European market, and in faster-growing emerging markets, it's far behind such European competitors as Nestle and Danone (DA). The much-vaunted purchase of Nabisco isn't much immediate help, since that company was also growing sluggishly. Kraft is hoping that synergies from the merger will boost the top line, but we'll believe that when we see it.

Tobacco taint is another factor to consider. Philip Morris still owns 98% of the voting rights in Kraft, and it will continue to control Kraft's board. Furthermore, while Kraft has downplayed the possibility that it would be materially affected by any court judgements against its nicotine-stained parent, it's impossible to rule out that possibility as long as Philip Morris still owns a majority of the company. We don't see much immediate risk for Kraft, but that could change if the legal environment for tobacco becomes significantly worse.

All in all, we think Kraft looks like a solid long-term holding, but investors should be wary of paying too much for it. Based on the IPO offering price of around $30 a share and its 2000 pro forma earnings, Kraft has a trailing P/E of 37--high for a food company, but not excessive for a quality one like Kraft. However, we'd be hesitant to pay too much more than that, given the concerns outlined above. If the hype surrounding the offering drives the share price much above $30, investors may want to wait for it to settle back to a more reasonable level before taking the plunge.

David Kathman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.