Higher prices for raw materials frustrate the turnaround efforts of this maker of iconic American foodstuffs. By Ilana Polyak, Contributing Writer August 8, 2008 It's best to avoid being cheesy when delivering jokes or pickup lines. But how Kraft Foods handles its cheeses as costs soar and consumers reel from the effects of inflation will determine whether the stock is an inspiring turnaround story or a disappointment.Since its spinoff from Phillip Morris (now Altria) in 2007, Kraft, maker of such iconic American foodstuffs as Oreos, Cheez Whiz and Oscar Mayer hot dogs, has been on a restructuring tear. Leading the charge is the newly installed chief executive, Irene Rosenfeld, who returned to Kraft in 2006 after a two-year stint with PepsiCo's FritoLay division. Sponsored Content Since taking the helm, she has revamped the marketing effort, something that stagnated under Altria's thumb. "Coming out of Altria, the problem was an under-investment in the brand," says Cliff Remily, associate portfolio manager of Thornburg Investment Income Builder fund. "Rosenfeld said that in order to realize value, you have to reinvest in marketing and improve brand equity." Despite these valiant efforts, Kraft isn't immune from higher costs for dairy, grain and meat products that are plaguing all food companies. "Every food company is being pushed down from a valuation perspective due to commodity price inflation," says Gregg Warren, an analyst with Morningstar. "A lot of these companies are trading at levels that we haven't seen in seven or eight years." Advertisement Yet fans of the new Kraft say there's a lot to like, such as the stock's recent performance. Over the past 12 months through August 7, the stock (symbol KFT) returned 1.5%, according to Morningstar. That's not much of a gain, but it beat Standard & Poor's 500-stock index by 14 percentage points. One apparent fan of Kraft is Warren Buffett. At last report, his Berkshire Hathaway owned 132.4 million shares, or about 8.6%, of Kraft's stock. Another plus is a sales strategy called "Wall-to-Wall," in which a single sales rep is responsible for almost the entire Kraft product line in one store, allowing each rep to spend more time with retailers and build relationships. Early results suggest that the program is working. Stores with Wall-to-Wall increased sales one percentage point more in the year ended April 30 than stores without. Observers were also impressed by the company's spinoff of the Post cereal brand shortly after acquiring Danone's biscuit business. "Getting rid of Post got them to be a much more narrowly focused firm," says Warren. The Danone purchase, meanwhile, allows Kraft to build on that brand's existing international relationships in developing markets. In the most recent quarter, 42% of sales were overseas. "It's adding a lot of growth on the margins," says Remily. Then there's the cheese. That's the segment most sensitive to higher raw-material costs because it's not easy to hedge dairy prices. Yet Kraft was able to pass on to consumers price increases of 6% to 33% on 90% of its cheese products. Though it sold less cheese as a result, it managed to draw in higher operating profits in that segment. Advertisement And with $708 million in cash on the balance sheet, Kraft has plenty of room to implement an announced share buyback program. Even so, Kraft's stock is smack dab where it stood when Altria spun it off in March 2007, closing at $32.80 on August 8. The reason, say the stock's detractors, is that it's too soon to tell whether Rosenfeld's leadership will make a long-term impact as Kraft faces such a headwind from higher input costs. "While we are not ready to call Kraft's results in the second quarter a tipping point, we admit that there is more upside at Kraft than their peers if they can get it right," say Credit Suisse analysts in a recent report. The results were impressive indeed, more so given today's difficult climate. For the quarter ended April 30, earnings rose 15.5%, to 58 cents a share, from the year prior, beating the average of analyst estimates by 8 cents. Revenues, meanwhile, climbed a stunning 21.4%. The stock sells at 17 times estimated 2008 earnings of $1.93 per share and 16 times forecasted 2009 profits of $2.05 per share. Company officials cautioned that results for the remainder of the year may not be so positive as input costs continue to weigh heavily on the company. "This year Kraft showed us it can increase sales, but next year Kraft needs to show that it can increase sales profitably," says Warren. Even so, isn't the new Kraft worth more than the one that operated under Altria? If the company's revenue gains aren't consumed by the higher prices of cheese and other raw foods, the answer would seem to be yes.