Moody's downgrades Kraft, sees short-term challenges

by Eric Schroeder
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NEW YORK — Moody’s Investors Service on Thursday downgraded the senior unsecured debt ratings of Northfield, Ill.-based Kraft Foods Inc. and its subsidiaries to Baa1 from A3 while maintaining a "stable" outlook for the company.

Moody’s said the downgrade reflected three key factors: credit metrics that are expected to weaken significantly due to the planned $5 billion of share repurchase over the next two years; ongoing operating challenges that reflect continued input cost pressures, higher spending and heavy competition in key categories; and the likelihood that critical elements of the new operating strategy, while promising, will take time to unfold.

Moody’s noted that while Kraft’s ratings are supported by its global market presence, strong market shares, and a well-diversified portfolio of branded packaged food products, its strengths are offset by a financial policy that has become more aggressive on share repurchases, and soft operating performance since 2004 that recently has shown stability, but is well below historical levels.

The ratings also take into consideration that Kraft will be subject to significantly higher effective tax rates than it was under Altria ownership, which will negatively impact free cash flow. Kraft spun off from Altria on March 30.

In its ratings report, Moody’s said it was less than convinced that the post-spin strategy announced by Kraft’s chief executive officer Irene Rosenfeld last February would be beneficial in the short term.

"While the new plan holds promise to improve volume growth and operating margins, its success is centered on Kraft’s ability to rebuild its product pipeline and reposition brands in broader markets," said Brian Weddington, lead analyst. "This could be difficult to accomplish with an already diverse and mature portfolio such as Kraft’s, but in any case, implementing the strategy will take time."

He continued, "2007 could prove challenging for the packaged food industry as a whole, as high feed and energy costs could begin to work their way into other inputs, including chicken, beef and other protein."

Moody’s said Kraft should be able to partially offset higher input costs through cost savings initiatives already under way, including $160 million in incremental savings expected in 2007. However, higher brand spending and IT development costs likely will limit the company’s operating profit growth though 2008 until the company delivers on new product offerings.

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