Tickers in this Article: KFT, SLE, K, CAG, RAH, SBUX
Rising costs have had a negative effect on many food companies. Kraft Foods (NYSE:KFT) reported higher revenue, but lower first quarter income due to discontinued operations. The company also lowered its full-year outlook due to rising commodity costs which have increasingly pressured food companies.

TUTORIAL: Risk and Diversification

A Transitional Quarter
Kraft earned 45 cents per share compared to $1.16 a share in last year's quarter. Last year's quarter, however, saw the one-time gain from proceeds of the sale of its DiGiorno Pizza unit, which was in part done so as to concentrate on its $20 billion Cadbury acquisition. Acquisition and integration costs were also factored into the quarter's results, which offset the contribution Cadbury made to operating earnings.

Net income was $799 million, compared with $1.883 billion in last year's quarter, a figure which reflects the one-time gain from Q1 of last year. Revenue rose 11.1% to $12.6 billion from $11.3 billion, while organic revenue grew 4.6%. Pricing accounted for 3.7% of the organic growth.

Food Companies Feel Commodity Prices
Kraft's Tim McLevish, executive VP and CFO, said that raw material costs "continued to escalate," and that the company faces an "unsettled economy." Other foodmakers are singing the same tune. Sara Lee (NYSE:SLE) lowered its outlook despite price increases.

Cereal maker Kellogg (NYSE:K) also raised prices, while food producer Con Agra (NYSE:CAG) has made the biggest splash in the industry with its pursuit of Ralcorp Holdings (NYSE:RAH).

The issue of the food conglomerates bulking up in part to give them increased product line diversity to go along with massive scale is in response to both rising input prices and future market positioning. Kraft's buyout of Cadbury pre-dated the Con Agra-Ralcorp thus far unhappy courtship. More consolidation may not be enough in the industry, though, to head off the rising food commodity prices if they do indeed continue to escalate.

More Moves
Kraft made moves in its coffee business, a segment that brings in $5 billion a year. Kraft's distribution arrangement with Starbucks (Nasdaq:SBUX) terminated in March, but the company hopes to introduce its Gevelia coffee late this summer in the U.S. to make up for the $500 million in revenue its Starbucks distribution business used to bring in.

Kraft has not only become larger with its bolt-on Cadbury acquisition, but continues to alter its product mix. The problem with any move in the food industry is that when wheat, corn, coffee, cocoa just about any raw ingredient that's made into a finished food product all continue to go up in price, while cost-cutting elsewhere and price hikes can help, at some point there's really no place to hide.

At the risk of overstating the input cost story, words like "escalate" along with Sara Lee's specific outlook that its commodity costs would triple compared to earlier expectations, to $650 million this year, puts Kraft and the other food makers under increasing pressure.

Kraft's Prospects Against the Headwinds
Wall Street's not very enamored of the food stocks' prospects, except perhaps for Ralcorp, which is assumed to succumb to a sweeter Con Agra bid. Kraft, however, still maintains that it is going to produce $2.20 in full year EPS, a figure that is down only slightly from its previous projection of $2.24. This would be organic net revenue growth of 4% and EPS growth of 11 to 13%. With food commodities still accelerating, that will be a mean feat. (For related reading, also take a look at Analyzing An Acquisition Announcement.)

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