KRAFT FOODS INC. $30 (New York symbol KFT; Conservative Growth Portfolio, Consumer sector; Shares outstanding: 1.7 billion; Market cap: $51.0 billion; Price-to-sales ratio: 1.2; Dividend yield: 3.9%; WSSF Rating: Above Average) is the world’s second-largest food company, after Swiss-based Nestle.

Kraft has 11 brands that each generate over $1 billion in yearly sales. Aside from Kraft (cheeses, pasta and salad dressings), these brands include Philadelphia (cream cheese), Maxwell House (coffee), Nabisco (biscuits), Oreo (cookies), Trident (gum) and Oscar Meyer (meats). Wal-Mart, the company’s biggest customer, accounted for 16% of its 2009 sales.

In February 2010, Kraft bought 71.7% of U.K.-based Cadbury plc, and acquired the remainder in April 2010. Cadbury is a leading maker of confectioneries, including chocolate, candy and gum.

Higher profit margins justify price

In all, Kraft paid roughly $9.6 billion in cash plus $7.3 billion in stock for Cadbury. The total price of $16.9 billion represents a third of Kraft’s $51-billion market cap. Cadbury’s products generate higher profit margins than Kraft’s other foods, so these new assets should spur the combined company’s growth.

Chocolates and candies now account for 29% of the combined company’s total sales, followed by snacks (22%), beverages (17%), cheeses (14%), meats (10%) and other grocery items (8%).

Moreover, Cadbury will add $8 billion to Kraft’s yearly sales. To put this figure in context, Kraft’s sales rose 25.4%, from $34.1 billion in 2005 to $42.8 billion in 2008. Sales fell 5.6%, to $40.4 billion, in 2009, mainly because Kraft sold its Post cereal business in 2008.

Earnings rose from $1.88 a share (or $3.2 billion) in 2005 to $1.94 a share (or $3.2 billion) in 2006. Earnings fell to $1.82 a share (or $2.9 billion) in 2007, but rose to $2.03 a share (or $3.0 billion) in 2009.

Cadbury has a larger international presence than Kraft, so this purchase will help Kraft sell more of its foods in developing countries. Right now, the combined company sells its products in over 160 countries. It gets 49% of its sales from North America, 25% from Europe and 26% from developing markets, including India and China.

Besides acquiring new brands from Cadbury, Kraft continues to improve the quality of its existing products and develop new ones.

In 2009, it spent $477 million (or 1.2% of its sales) on research. That’s down 4.2% from $498 million (or 1.2% of its sales) in 2008, because of the sale of the cereal business.

Big savings on the way

The company estimates that it will cost $1.3 billion to integrate Cadbury into its existing operations. However, combining the two companies’ distribution, marketing and product-development functions should lower the combined company’s annual costs by $675 million by the end of the third year.

To raise cash to buy Cadbury, Kraft sold its North American frozen pizza business to Nestle for $3.7 billion. This business accounted for about 4% of Kraft’s sales.

The company also issued $9.5 billion of new long-term notes to pay for Cadbury. Its long-term debt of $29.5 billion is equal to 58% of its market cap. That’s high, but the cash flow from Cadbury should help Kraft pay down the extra debt. The company holds cash of $3.9 billion, or $2.22 a share.

Despite the extra debt, Kraft intends to keep paying quarterly dividends of $0.29 a share. The annual rate of $1.16 yields 3.9%. However, the company will probably wait until it completely integrates Cadbury before it raises its dividend.

Goodwill writedown seems unlikely

The Cadbury purchase pushed up Kraft’s goodwill from $28.8 billion at the end of 2009 to $37.1 billion as of March 31, 2010. The company also has $25.6 billion in other intangible assets, mainly brand names, on its balance sheet. Together, these represent 123% of its market cap.

However, Cadbury is a well-established business that should fuel Kraft’s growth for years to come. Moreover, its well-known brands will help shield the company from significant downturns. These factors make a major writedown unlikely.

Kraft will probably earn $2.03 a share in 2010, excluding merger-related costs. The stock trades at 14.8 times that estimate. That’s a reasonable p/e ratio in light of the company’s strong earnings prospects and growing international operations.

Kraft Foods is a buy.