Kraft scrambles to innovate, reverse slide in cheese sales

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Cotton-candy-flavored string cheese, cheddar infused with heart-healthy fish oil, cream cheese laced with probiotic bacteria to aid digestion. Kraft Foods is studying all these possibilities and more as it tries to stem the erosion of its mainstay product line: cheese.

The Northfield, Ill., food giant will launch two major cheese products in the third or fourth quarter. Without revealing specifics, Amy Wagner, a marketing executive in Kraft's cheese division, said the launches will involve two product lines that will "add convenience in very different ways."

In addition to packaging and flavor, a key long-term focus for Kraft is to reduce fat levels across its entire cheese portfolio. The research-and-development efforts are critical as Kraft struggles in a category that has become increasingly commoditized by private-label manufacturers, which now lead Kraft in market share in some categories.

FEAR OF A REPEAT

The battle against store brands intensified in the second quarter, when Kraft raised cheese prices even as retailers slashed prices on their private-label offerings. As a result, the volume of Kraft American cheese sold in stores other than Wal-Mart dropped 4.4% in the last 12 weeks, while volume across its entire cheese portfolio fell 1.5%.

"It seems like every time Kraft raises prices, they lose share and volume. But if they cut prices, their margins suffer," said Tim Ewing, senior VP-co-manager of the large-cap value portfolio at Mesirow Financial Holdings.

It's a significant quandary for a company that last year derived more than 19% of its $32 billion in revenue from cheese, its largest business.

Investors worry that if Kraft doesn't lower prices soon-and innovate quickly-it will face a repeat of two years ago. Back then, Kraft raised prices in response to soaring cheese costs, but retailers didn't follow suit and Kraft lost market share to store-brand cheese. Kraft's $6.2 billion in cheese sales have hardly increased from five years ago.

If Kraft is considering price cuts to win back market share, it isn't saying so. "Although our prices were higher in quarter two, our price gaps generally remained within targeted ranges," CEO Roger Deromedi said July 19 in the second-quarter-earnings call.

But if Kraft's new products fail to be blockbusters-and if volumes for cheese, nuts, coffee and other commodity-like products don't rise in the last half of the year-the company risks missing its full-year earnings guidance of $1.73 to $1.78 a share, analysts and investors warn.

"The big problem here seems to be that consumers do not value the Kraft brands enough to digest the price increases," Credit Suisse First Boston analyst David Nelson wrote in a recent report. That leaves Kraft's companywide turnaround effort, launched shortly after Mr. Deromedi became sole CEO in 2004, "at risk of stalling out and the company's aggressive back-half [earnings] guidance is starting to appear even more unrealistic."

Adding to the urgency is the fact that barrel-cheese costs-the price that a 500-pound barrel of cheese fetches at wholesale-have started coming down. That will make it easier for retailers to lower their prices even more.

Slow growth in cheese threatens to drag down Kraft's overall growth rate, a problem executives might be tempted to solve by making a big acquisition, Mesirow's Mr. Ewing said. Thomas Russo, a partner at Gardner Russo & Gardner, a Pennsylvania investment firm that holds almost 2 million Kraft shares, hopes they don't.

"I don't think Kraft's answer to the cheese problem is to make a large, dilutive acquisition," Mr. Russo said. "They have to distinguish themselves through product innovation, packaging and marketing. Otherwise, they'll bump up against commodity offerings that will become even less expensive."

Mesirow's Mr. Ewing, however, is dubious: "How do you innovate in cheese?"

Dean Sommer, a cheese technologist at the Wisconsin Center for Dairy Research in Madison, knows how. Scientists there are working on making string cheese in such kid-oriented flavors as cotton candy, bubble gum and sour apple. They're hoping to shop around their recipes to food marketers in the next six months.

The scientists also are working on adding such nutrients to cheese as probiotics, organisms commonly found in yogurt, and omega-3 fatty acids. "We're also trying to develop low-fat cheese that truly tastes good," said Mr. Sommer.

`HOLY GRAIL OF CHEDDAR'

John Gregg, Kraft's VP-global cheese and dairy R&D, acknowledges that Kraft has "a relationship" with the dairy center and says, "Kraft is considering a broad range of technologies that deliver different benefits in health and wellness."

And he said Kraft already has developed a better-tasting low-fat cheese. "We've found the Holy Grail of cheddar flavor," Mr. Gregg said, explaining that Kraft researchers created a process for fermenting dairy ingredients to deliver the same cheddar flavor with less fat.

Julie Jargon is with Crain's Chicago Business

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