Peltz Has His Slice of Kraft - Now what?

The investor's likely moves: a much bigger stock repurchase and selling-off of second-tier brands.

By Fortune's Shawn Tully and Matthew Boyle

NEW YORK (FORTUNE) -- Nelson Peltz's new adventure, his campaign to rescue ailing Kraft Foods, could be titled, "Son of H.J. Heinz," or "Heinz, the Sequel." The activist investor's hedge fund, Trian Investments, has quietly bought 3 percent of the owner of Nabisco, Maxwell House, Oscar Mayer and scores of other famous brands, a stake worth around $1.8 billion. Sources close to Peltz tell Fortune that he's extremely upset that news of the purchases leaked out before he could spring the news - and his new plan - on the new CEO, Irene Rosenfeld, who returned to Kraft last June after running Frito-Lay for three years. But investors are already getting a lift from the Peltz tonic that revived Cadbury Schweppes, Tiffany, and Heinz: Since the leak on Thursday, Kraft's shares have surged around 5 percent, putting almost $3 billion in investors' pockets.

Lest you think that a 3 percent stake is not enough for Peltz to throw his weight around, consider this: The 3 percent stake he took in Cadbury in mid March prompted the company to announce, just a few days later, that it would split itself in two, spinning off its U.S. beverage operations, whose products include Dr Pepper and Snapple.

Though Peltz hasn't presented a plan for Kraft, of Northfield, Ill., Fortune's conversations with people who know him well, and an analysis of his typical template for consumer goods companies, provides a good picture of where he's likely to go. The best model for Peltz's strategy is his blueprint at Heinz. Like Heinz, Kraft offers just the combination Peltz relishes. First, it's a collection of prestigious but tired brands that are ripe for revival. Peltz relishes nothing more than rebuilding tarnished brands, a skill he honed at Snapple and Wendy's. Second, its balance sheet is extremely underleveraged. That gives Peltz an opening to force a big share buyback without at depressed prices, without overburdening Kraft's strong cash flow.

Another weakness shared with Heinz undoubtedly attracted Peltz: Kraft discounts heavily to supermarkets to keep its products moving, a sure sign of decline in Peltz's lexicon.

So here are Peltz's most likely moves. First, he will pile on the leverage - and Kraft can easily afford it. Today, Kraft has only around $11 billion in debt; that's less than two times its EBIDA. Peltz typically likes the ratio to stand at around six times EBIDA. Hence, Kraft has the potential to safely borrow an additional $15 billion. The company has already announced a $5 billion share buyback over two years. Look for Peltz to raise that figure to $15 billion, and demand that Kraft make the giant repurchase today.

Second, he will undoubtedly push Kraft to sell second-echelon brands. If a player has no hope of becoming No. 1, Peltz usually favors an exit.

That's the case with the Post cereal business, a distant No. 3 to Kellogg and General Mills. On the other hand, rumors that he will push for the sale of Maxwell House could well be mistaken. Though Maxwell House has slipped to the No. 2 position behind Procter & Gamble's Folgers, it's the kind of flagging but big-name brand that Peltz would relish rescuing. Peltz believes on concentrating on a few powerful, or potentially powerful, brands. Hence, he's undoubtedly appalled that Kraft has more brands than P&G or Nestle, and will undoubtedly push to cull the weak sisters. "Most Kraft brands tend to look a lot like Post and Maxwell House - aging, and increasingly irrelevant to consumers," says D.A. Davidson analyst Tim Ramey.

Third, he will probably push to boost ad spending in two key areas: frozen foods and cheese. Kraft's frozen foods business, which includes its DiGiorno pizza brand, is its star attraction, with operating income up 15 percent last year. Margins are excellent, and frozen foods merit marquee placement in the freezers on the perimeter of supermarkets, far from the lower-margin center of the store. At Heinz, Peltz was shocked at the promotional payments necessary to keep ketchup sales moving briskly. He correctly identified that Heinz was not spending enough on advertising to make the brand a glamorous must-buy.

The same situation exists at Kraft, which slashed its ad spending on Maxwell House nearly in half between 2004 and 2006, according to data from TNS Media Intelligence. Ad spending on Post cereals was also down over that same period. Peltz will undoubtedly push for more ad support in frozen foods, as well as coffee and cereal.

Fourth, Peltz will want Kraft to substantially improve its flagship cheese business, which accounts for roughly a quarter of the company's overall earnings. Kraft's $4 billion cheese business is overly dependent on processed slices, and is currently buffeted by high commodity prices - block cheddar cheese hit $2.06 a pound this week on the Chicago Mercantile Exchange, a 55 percent increase from the end of 2006 - and private label competition. Look for Peltz to push for an aggressive move into higher-margin specialty cheeses, a strategy that Rosenfeld has already begun with products like the new Singles Select, which hit stores this month.

And fifth, Peltz may favor daring moves on the merger front. Kraft missed an opportunity to buy Cadbury's confectionary business after Peltz helped force Cadbury to split into two companies, pushing up the share price in the process. He's likely to encourage Rosenfeld to act boldly. Peltz lives by the credo that fortune favors the daring. What could be a better credo for CEOs? Top of page