Kraft Is Caught in a "Rundown"

In baseball, a "rundown" happens when a player is caught between two bases. You know how it works. The opposing team tosses the ball back and forth, trying to tag the runner out. The unfortunate base runner tries to outwit the defense and get back to a base safely. He rarely makes it.

Kraft Foods (NYSE: KFT  ) has been caught in this type of dilemma for the past year. Rising commodity costs are eating into margins big time. The easy choice would be to pass those higher costs on to consumers in the form of price increases.

But for a branded food company, that's a delicate balancing act -- consumers can trade down to cheaper private-label products if prices for their favorite brands get too expensive. If the U.S. is headed for a recession, customers become much more like to tighten their spending.

The hard choice is to increase prices where possible, rather than jeopardizing the entire top line, and put a major squeeze on expenses. This is the road Kraft appears to be taking, preferring to maintain sales momentum at the cost of significant margin erosion.

We won't dig too deep into the fourth-quarter results; suffice to say, they were a rerun of the three previous quarters. Rising 10.95%, sales growth was encouraging, along with overall with organic sales (excluding acquisitions, divestitures, and currency) up 6.2%.

With commodity cost trends not improving, gross margins sunk to 30.9% compared to 35.3% last year. So despite generating robust sales growth, earnings plunged 18%. However, per-share earnings were reduced to 13.7% with the help of buybacks.

Management expressed optimism that next year, the company will show some modest earnings improvement, expecting 4% organic growth and earnings per share of $1.56, including restructuring costs. This prognosis is based on continued market share growth, somewhat higher pricing, and a favorable mix of sales.

Kraft isn't the only consumer-product company facing input cost issues. Most of the big players -- including Procter & Gamble (NYSE: PG  ) , Unilever plc (NYSE: UL  ) , Kellogg (NYSE: K  ) , and General Mills (NYSE: GIS  ) -- are facing the same issues. Kraft simply appears to have been hit the hardest -- it's not easy to judge the relative effect of cost increases across different companies without actually getting inside them.

In my view, Kraft is making the overall right choices in an unfavorable situation. It could be worse; both sales and margins could be headed south. Commodity costs run in cycles -- they won't stay high forever, although the short-to-intermediate-term outlook for dairy costs is not rosy. At a P/E of 18 times trailing-twelve-month earnings, I'm hard pressed to call Kraft a buy. But the solid top-line momentum at least makes me think that the company could start to show improved earnings results later in 2008. Stay tuned.

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