Kraft Foods is taking drastic action to tackle problems of rising costs and lower margins but while the second swathing round of cost-cutting shows a firm resolve, analysts have questioned the company's new product development record and its response to falling operating margins. Ben Cooper reports.

If employees at US food group Kraft thought strong fourth-quarter earnings growth may bring some respite or protection from a draconian cost-cutting programme initiated in 2004, they were sorely disappointed. Instead, Kraft announced that it would be broadening its Sustainable Growth Plan, cutting an additional 8,000 jobs and closing as many as 20 production facilities by 2008.

However, if Kraft was expecting a pat on the back from the investment community for grasping the nettle, it too was in for a disappointment. In fact, many analysts expressed surprise at the extent and timing of the second wave of cuts, and doubts were also expressed concerning the company's strategy to reverse falling margins and its record on new product development.

Under the original three-year plan initiated in response to spiralling costs and sluggish sales, Kraft was to close 19 production plants with the loss of 5,500 jobs. But including the latest round of measures, the company will have cut around 14,000 jobs, reducing the total workforce from 102,000 to 88,000, and closed some 40 production facilities, between 2004 and the end of 2008. "We've had a lot of cost pressures," said Kraft's CEO Roger Deromedi. "That's exactly why we decided to expand our restructuring, to deal with these bigger costs."

Kraft's problems have been attributed primarily to rising raw material and energy costs - raw material costs rose by US$800m in 2005 and by $200m in the fourth quarter alone. In addition to escalating fuel prices, rising commodity costs in areas such as coffee, meat and packaging have been a particular concern. However, some observers have suggested that the company has proved less able to cope with rising commodity prices than its competitors. "Other companies have done a much better job of handling those commodity costs," said Citigroup analyst David Driscoll, "and also maintaining sales growth."

Comparisons in operating margins illustrate the point. Operating margins at Kraft fell from 21% in 2002 to 16.5% in 2004, and further to 15.3% in 2005. Meanwhile, operating margins at Kellogg have been stable during the last four quarters at around 18-19%, while General Mills' operating margins are currently around 18%. Deramadi said he expects profit margins to improve in 2006 but warned that they would not return to 2000 levels as the company was now operating in a "different environment".

In addition to the rising costs, Kraft's difficulties have been exacerbated by heightened competition from private label in both Europe and the US. Moreover, as UBS analyst David Palmer pointed out, Kraft has greater exposure to own brands because some of its principal product lines, such as cheese, cooked meats and nuts, are key areas for private label.

The growth and increasing consumer acceptance of private label can compromise a brand company's ability to cope with rising costs, as increasing prices can result in further share loss to own label. It is a delicate balance to strike, and it seems Kraft has had difficulties finding it.

Late last year, Kraft raised prices of certain lines - representing an estimated 14% of the company's portfolio - by 4%, but Driscoll suggested this was insufficient to offset the huge increase in costs. As if to illustrate the dilemma, Deromedi said that the price rises had adversely affected volume and that the company had eschewed price increases in certain categories for competitive reasons, which had negatively impacted on operating margins.

Kraft has also been criticised for a lack of product innovation which would give it scope to trade consumers up, another way of tackling increased costs and falling margins. "When you think of Kraft's portfolio, it's plain vanilla right up the middle," Deutsche Bank analyst Eric Katzman was quoted as saying. A general criticism has been that a company which regularly used to steal a march on competitors with product innovation such as cheese slices and Shake 'n Bake had lost its edge in recent years.

However, Deromedi said he believed that the company had had some success in introducing newer, more profitable lines, particularly in the healthier foods category, which is a prime new product development area for the group. He said it had been striving to adjust its product mix, dispensing with lower margin products in favour of more profitable ones. US sales of the company's Sensible Solutions product range were growing three to four times faster than other lines, the company reported. In addition, Deromedi pointed to strong sales of its South Beach Diet range and 100 Calorie Packs of popular cracker and cookie brands in 2005. "We get very positive feedback from consumers on our healthier products, whether the 100 Calorie Packs or wholegrain Mac & Cheese," Deromedi said.

In the view of many analysts, Kraft remains underrepresented in growth areas of the food market such as premium products and ethnic, organic and natural foods, and is lagging behind competitors such as Kellogg and General Mills in these areas. In addition Kraft has been accused of being slow to introduce innovations and to latch on to important market trends, with the company's late arrival in the cereal bar category a notable example.

David Driscoll observed that a giant company like Kraft needs multiple successful new product innovations, rather than just one or two. "With a $34bn-a-year company, one new successful product is not enough to move the whole system," Driscoll said. "You've got to have more, like six or seven."

While the jury is clearly out on Kraft's response to its current difficulties, uncertainty also remains over its ownership. The company is 86%-owned by the conglomerate Altria Group, whose other prime activity is tobacco. Altria has said that it intends to spin off Kraft when it has settled outstanding litigation with regard to its tobacco business although no time scale has been set.

The company may have derived some comfort from its fourth-quarter performance, which saw net income rise from $628m to $773m, actually ahead of Wall Street forecasts, but some signs of recovery and the initiation of further massive restructuring have failed to assuage its critics. Given the reservations being expressed, those doubters will only be convinced by positive results, so Kraft's management can only expect heightened scrutiny over the coming year.