Management's Discussion and Analysis of Financial Condition and Results of Operations

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Discussion and Analysis > Operating Results by Business Segment > Food > Business Environment

Kraft manufactures and markets packaged food products, consisting principally of beverages, cheese, snacks, convenient meals and various packaged grocery products. Kraft manages and reports operating results through two units, Kraft North America Commercial (“KNAC”) and Kraft International Commercial (“KIC”). KNAC represents the North American food segment (United States and Canada) and KIC represents the international food segment.

KNAC and KIC are subject to a number of challenges that may adversely affect their businesses. These challenges, which are discussed below and in the Cautionary Factors That May Affect Future Results section, include:

• fluctuations in commodity prices;
• movements of foreign currencies;
• competitive challenges in various products and markets, including price gaps with competitor products and the increasing price-consciousness of consumers;
• a rising cost environment and the limited ability to increase prices;
• a trend toward increasing consolidation in the retail trade and consequent pricing pressure and inventory reductions;
• a growing presence of discount retailers, primarily in Europe, with an emphasis on private label products;
• changing consumer preferences, including diet and health/wellness trends;
• competitors with different profit objectives and less susceptibility to currency exchange rates; and
• increasing scrutiny of product labeling and marketing practices as well as concerns and/or regulations regarding food safety, quality and health, including genetically modified organisms, trans-fatty acids and obesity. Increased government regulation of the food industry could result in increased costs to Kraft.

Fluctuations in commodity costs can lead to retail price volatility and intense price competition, and can influence consumer and trade buying patterns. During 2006, Kraft’s commodity costs on average were higher than those incurred in 2005 (most notably higher energy, packaging and coffee costs, partially offset by lower cheese and meat costs) and adversely affected earnings. For 2006, Kraft’s commodity costs were approximately $275 million higher than 2005, following an increase of approximately $800 million for 2005 compared with 2004.

In the ordinary course of business, Kraft is subject to many influences that can impact the timing of sales to customers, including the timing of holidays and other annual or special events, seasonality of certain products, significant weather conditions, timing of Kraft or customer incentive programs and pricing actions, customer inventory programs, Kraft’s initiatives to improve supply chain efficiency, the financial condition of customers and general economic conditions. Kraft’s operating subsidiaries generally report year-end results as of the Saturday closest to the end of each year. This resulted in fifty-three weeks of operating results for Kraft in the consolidated statement of earnings for the year ended December 31, 2005, versus fifty-two weeks for the years ended December 31, 2006 and 2004.

Restructuring

In January 2004, Kraft announced a three-year restructuring program (which is discussed further in Note 3. Asset Impairment and Exit Costs) with the objectives of leveraging Kraft’s global scale, realigning and lowering its cost structure, and optimizing capacity utilization. In January 2006, Kraft announced plans to expand its restructuring efforts through 2008. The entire restructuring program is expected to result in $3.0 billion in pre-tax charges, the closure of up to 40 facilities, the elimination of approximately 14,000 positions and annualized cost savings at the completion of the program of approximately $1.0 billion. The decline of $700 million from the $3.7 billion in pre-tax charges previously announced was due primarily to lower than projected severance costs, the cancellation of an initiative to generate sales efficiencies, and the sale of one plant that was originally planned to be closed. Approximately $1.9 billion of the $3.0 billion in pre-tax charges are expected to require cash payments. Total pre-tax restructuring program charges incurred during 2006, 2005 and 2004 were $673 million, $297 million and $641 million, respectively. Total pre-tax restructuring charges for the program incurred from January 2004 through December 31, 2006 were $1.6 billion and specific programs announced will result in the elimination of approximately 9,800 positions. Approximately 60% of the pre-tax charges to date are expected to require cash payments.

In addition, Kraft expects to incur approximately $550 million in capital expenditures to implement the restructuring program. From January 2004 through December 31, 2006, Kraft spent $245 million in capital, including $101 million spent in 2006, to implement the restructuring program. Cumulative annualized cost savings as a result of the restructuring program were approximately $540 million through 2006, and are anticipated to reach approximately $700 million by the end of 2007, all of which are expected to be used to support brand-building initiatives.

Asset Impairment Charges

As discussed further in Note 3. Asset Impairment and Exit Costs, Kraft incurred pre-tax asset impairment charges of $424 million, $269 million and $20 million during the years ended December 31, 2006, 2005 and 2004, respectively. These charges were recorded as asset impairment and exit costs on the consolidated statements of earnings.

These asset impairment charges primarily related to various sales of Kraft’s brands and assets, as well as the 2006 re-evaluation of the business model for Kraft’s Tassimo hot beverage system, the revenues of which lagged Kraft’s projections. This evaluation resulted in a $245 million non-cash pre-tax asset impairment charge related to lower utilization of existing manufacturing capacity. In addition, Kraft anticipates that the impairment will result in related cash expenditures of approximately $3 million, primarily related to decommissioning of idle production lines. Kraft also anticipates further charges in 2007 related to negotiations with product suppliers.

Acquisitions and Divestitures

One element of Kraft’s growth strategy is to strengthen its brand portfolio and/or expand its geographic reach through a disciplined program of selective acquisitions and divestitures. Kraft is constantly reviewing potential acquisition candidates and from time to time sells businesses that are outside its core categories or that do not meet its growth or profitability targets.

In September 2006, Kraft acquired the Spanish and Portuguese operations of United Biscuits (“UB”), and rights to all Nabisco trademarks in the European Union, Eastern Europe, the Middle East and Africa, which UB has held since 2000, for a total cost of approximately $1.1 billion. The Spanish and Portuguese operations of UB include its biscuits, dry desserts, canned meats, tomato and fruit juice businesses as well as seven UB manufacturing facilities and 1,300 employees. From September 2006 to December 31, 2006, these businesses contributed net revenues of approximately $111 million. The non-cash acquisition was financed by Kraft’s assumption of approximately $541 million of debt issued by the acquired business immediately prior to the acquisition, as well as $530 million of value for the redemption of Kraft’s outstanding investment in UB, primarily deep-discount securities. The redemption of Kraft’s investment in UB resulted in a $251 million pre-tax gain on closing, benefiting Altria Group, Inc. by approximately $0.06 per diluted share.

Aside from the debt assumed as part of the acquisition price, Kraft acquired assets consisting primarily of goodwill of $734 million, other intangible assets of $217 million, property, plant and equipment of $161 million, receivables of $101 million and inventories of $34 million. These amounts represent the preliminary allocation of purchase price and are subject to revision when appraisals are finalized, which is expected to occur during the first half of 2007.

During 2006, Kraft sold its pet snacks brand and assets, and recorded tax expense of $57 million and a pre-tax asset impairment charge of $86 million in recognition of this sale. During 2006, Kraft also sold its rice brand and assets, and its industrial coconut assets. Additionally, during 2006, Kraft sold certain Canadian assets and a small U.S. biscuit brand, and incurred pre-tax asset impairment charges of $176 million in 2005 in recognition of these sales. Also, during 2006, Kraft sold a U.S. coffee plant. The aggregate proceeds received from these sales during 2006 were $946 million, on which pre-tax gains of $117 million were recorded.

In January 2007, Kraft announced the sale of its hot cereal assets and trademarks. In recognition of the anticipated sale, Kraft recorded a pre-tax asset impairment charge of $69 million in 2006 for these assets.

As previously discussed, Kraft sold substantially all of its sugar confectionery business in June 2005, for pre-tax proceeds of approximately $1.4 billion. The sale included the Life Savers, Creme Savers, Altoids, Trolli and Sugus brands. Altria Group, Inc. has reflected the results of Kraft’s sugar confectionery business prior to the closing date as discontinued operations on the consolidated statements of earnings. Kraft recorded a net loss on sale of discontinued operations of $297 million in the second quarter of 2005, related largely to taxes on the transaction. ALG’s share of the loss, net of minority interest, was $255 million.

During 2005, Kraft sold its fruit snacks assets and incurred a pre-tax asset impairment charge of $93 million in recognition of this sale. Additionally, during 2005, Kraft sold its U.K. desserts assets and its U.S. yogurt assets. The aggregate proceeds received from the sales of businesses during 2005 (other than the sugar confectionery business) were $238 million, on which pre-tax gains of $108 million were recorded.

During 2004, Kraft sold a Brazilian snack nuts business and trademarks associated with a candy business in Norway. The aggregate proceeds received from the sales of these businesses were $18 million, on which pre-tax losses of $3 million were recorded.

During 2004, Kraft acquired a U.S.-based beverage business for a total cost of $137 million.

The operating results of businesses acquired and sold, other than Kraft’s UB acquisition and divestiture of its sugar confectionery business, in the aggregate, were not material to Altria Group, Inc.’s consolidated financial position, results of operations or cash flows in any of the years  presented.