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 and KIC represents the international food segment. Beginning in 2004, results for the Mexico and Puerto Rico businesses, which were previously included in the North American food segment, are included in the international food segment and historical amounts have been restated.

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 and customer incentive programs, customer inventory programs, Kraft’s initiatives to improve supply chain efficiency, including efforts to align product shipments more closely with consumption by shifting some of its customer marketing programs to a consumption based approach, financial situations of customers and general economic conditions.

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;
• a trend toward increasing consolidation in the retail trade and consequent pricing pressure and inventory reductions;
• a growing presence of hard discount retailers, primarily in Europe, with an emphasis on private label products;
• changing consumer preferences, including diet trends;
• competitors with different profit objectives and less susceptibility to currency exchange rates; and
• consumer 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 cause retail price volatility and intense price competition, and can influence consumer and trade buying patterns. During 2004, Kraft’s commodity costs on average were significantly higher than those incurred in 2003 (most notably dairy, coffee, meat, nuts, energy and packaging) and have adversely affected earnings. Dairy costs rose to historical highs during the first half of 2004, but moderated during the second half of 2004. For 2004, Kraft had a negative pre-tax earnings impact from all commodities of approximately $930 million as compared with 2003.

To build its business while confronting these challenges, Kraft operates with seven business strategies: 1) build superior consumer brand value; 2) build shopper demand through superior customer collaboration; 3) transform the portfolio; 4) expand global scale; 5) drive out costs and assets; 6) strengthen employee and organizational excellence; and 7) act responsibly.

In January 2004, Kraft announced a multi-year restructuring program with the objectives of leveraging Kraft’s global scale, realigning and lowering its cost structure, and optimizing capacity utilization. As part of this program (which is discussed further in Note 3. Asset Impairment and Exit Costs), Kraft anticipates the closing or sale of up to twenty plants and the elimination of approximately six thousand positions. From 2004 through 2006, Kraft expects to incur up to $1.2 billion in pre-tax charges for the program, reflecting asset disposals, severance and other implementation costs, including $641 million incurred in 2004. Approximately one-half of the pre-tax charges are expected to require cash payments.



In addition, Kraft expects to incur approximately $140 million in capital expenditures from 2004 through 2006 to implement the restructuring program, including $46 million spent in 2004. Cost savings as a result of the restructuring program were approximately $127 million in 2004, are expected to increase by an incremental amount between $120 million and $140 million in 2005, and are anticipated to reach annualized cost savings of approximately $400 million by 2006, all of which are expected to be used in support of brand-building initiatives.

One element of the growth strategy of Kraft is to strengthen its brand portfolio through active programs of selective acquisitions and divestitures. Kraft is constantly investigating 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. The impact of any future acquisition or divestiture could have a material impact on Altria Group, Inc.’s consolidated financial position, results of operations or cash flows.

During 2004, Kraft acquired a U.S.-based beverage business for a total cost of $137 million. During 2003, Kraft acquired trademarks associated with a small U.S.-based natural foods business and also acquired a biscuits business in Egypt. The total cost of these and other smaller businesses purchased by Kraft during 2003 was $98 million. During 2002, Kraft acquired a snacks business in Turkey and a biscuits business in Australia. The total cost of these and smaller businesses purchased by Kraft during 2002 was $122 million.

On November 15, 2004, Kraft announced the sale of substantially all of its sugar confectionery business for approximately $1.5 billion. The proposed sale includes the Life Savers, Creme Savers, Altoids, Trolli and Sugus brands. The transaction, which is subject to regulatory approval, is expected to be completed in the second quarter of 2005. Altria Group, Inc. has reflected the results of Kraft’s sugar confectionery business as discontinued operations on the consolidated statements of earnings for all years presented. The assets related to the sugar confectionery business were reflected as assets of discontinued operations held for sale on the consolidated balance sheet at December 31, 2004. In addition, Kraft anticipates additional tax expense of $270 million will be recorded as a loss on sale of discontinued operations in 2005. In accordance with the provisions of SFAS No. 109, the tax expense will be recorded when the transaction is consummated.

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. In December 2004, Kraft announced the sale of its U.K. desserts business for approximately $135 million, which is expected to result in a gain. The transaction, which is subject to required approvals, is expected to close in the first quarter of 2005, following completion of necessary employee consultation requirements. In addition, in December 2004, Kraft announced the sale of its yogurt business for approximately $59 million, which is expected to result in an after-tax loss of approximately $12 million. The transaction, which is also subject to regulatory approval, is expected to be completed in the first quarter of 2005.

During 2003, Kraft sold a European rice business and a branded fresh cheese business in Italy. The aggregate proceeds received from the sales of businesses in 2003 were $96 million, on which pre-tax gains of $31 million were recorded.

During 2002, Kraft sold several small North American food businesses, most of which had been previously classified as businesses held for sale arising from the acquisition of Nabisco. In addition, Kraft sold a Latin American yeast and industrial bakery ingredients business for approximately $110 million and recorded a pre-tax gain of $69 million. The aggregate proceeds received from the sales of these businesses during 2002 were $219 million, on which pre-tax gains of $80 million were recorded.

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