Rising milk price weighs on Kraft

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Rising milk price weighs on Kraft

By David Sterrett
June 09, 2007

Kraft Foods Inc., already losing business to grocery store-branded cheese, has a new problem: soaring milk prices.

Reduced supply, increased demand and higher production costs are jacking up the cost of cheese's primary ingredient. Milk prices, up more than 30% this year, are expected to rise even higher in the next month. That's bad news for the maker of Velveeta: Kraft counted on cheese for 19% of its $34 billion in sales last year.

"It's going to squeeze companies like Kraft pretty bad," says Mike Hutjens, a University of Illinois at Urbana-Champaign dairy specialist. Candymaker Hershey Co. and dairy-products company Dean Foods Co. both said last month that they expect earnings to suffer amid rising milk costs.

Milk has joined corn, coffee and packaging as sources of escalating costs for the Northfield-based foodmaker, which is predicting lower profit this year as it spends more money researching new products. And with private-label competitors already selling cheese for less, Kraft has little room to raise prices. That all adds up to yet another obstacle for CEO Irene Rosenfeld as she tries to turn the company around.

In mid-May, John McMillin, an analyst with Prudential Equity Group in New York, predicted Kraft would spend around $3.5 billion this year on raw milk to make cheese. Since his estimate, the price of milk has shot up to about 18 cents a pound and is expected to rise another 14% by July. It takes about 10 pounds of milk to make one pound of cheese.

"It's a major cost for Kraft," says Diane Jaffee, a New York-based fund manager with Trust Co. of the West, which holds 18 million of the company's shares.

Kraft, which raised prices on some products earlier this year, says in a statement it will "continue to monitor dairy prices and adjust our selling price accordingly." On an investor call in April, Chief Financial Officer Jim Dollive said Kraft's share of the cheese market fell in first-quarter 2007 but it expects "to see improvement."

But raising prices to offset higher milk costs could drive more consumers to private-label store brands. "Consumers don't see a discernable difference between Kraft and Jewel-brand cheese," says Chicago-based Morningstar Inc. analyst Gregg Warren.

For Kraft, there appears to be little relief on the horizon. Milk prices will reach a record high this year, says Bob Yonkers, chief economist with the Washington, D.C.-based International Dairy Foods Assn. The cause: rising prices for corn used in animal feed, strong worldwide demand for milk and whey and a drought in Australia, a major milk producer. Whey, a milk protein, is used in feed and health-food supplements.

The price of milk is expected to decline this fall, but will likely settle at higher levels than previous average prices, industry officials say. For now, it's creating havoc for cheese producers.

"The cheese market is a mess," says Bob Wills, owner of Cedar Grove Cheese Inc. in Plain, Wis., which makes 5 million pounds of cheese a year. "Before we start making cheese, we are already losing money at current milk prices."

Cheese and dairy make up 75% of Kraft's North American Cheese and Foodservice division, which generated $886 million in pre-tax profit. Kraft had a net income of $3.06 billion in 2006. The company dominates the processed-cheese market with Velveeta and other brands but trails private-label brands for fresh block and shredded cheese.

Ms. Rosenfeld is trying to create premium products that command higher prices. That's key to winning consumers, says Thomas Russo, a partner with investment adviser Gardner Russo & Gardner in Lancaster, Pa., which holds more than 1 million Kraft shares.

"The prices aren't going to matter if Kraft is not able to innovate and drive excitement in the cheese category," he says.

©2007 by Crain Communications Inc.