KRAFT FOODS INC. $36 (New York symbol KFT; Conservative Growth Portfolio, Consumer sector; Shares outstanding: 1.6 billion; Market cap: $57.6 billion; WSSF Rating: Above average) is the world’s second-largest food company, after Nestle. It owns some of the industry’s top brands, including Kraft (cheese), Maxwell House (coffee), Nabisco (biscuits and cookies), Post (cereals) and Oscar Meyer (meats). North America accounts for two-third of its sales.

The company was a 100%-owned subsidiary of Altria Group Inc. up to June 2001. That’s when Altria sold about 12% of Kraft’s shares to the public at $31.00 each. Altria handed out its remaining Kraft shares to its own investors in March 2007.

Kraft’s sales grew steadily, from $29.7 billion in 2002 to $34.4 billion in 2006. However, profits before unusual items fell from $2.02 a share (total $3.5 billion) in 2002 to $1.87 a share ($3.2 billion) in 2004, mostly due to rising costs. Total earnings were flat at $3.2 billion in 2005 and 2006. But per-share earnings rose to $1.88 in 2005 and to $1.94 in 2006, due to fewer shares outstanding.

Cheese accounts for 20% of Kraft’s sales, so it’s particularly vulnerable to rising dairy prices. Higher prices for other commodities such as grains have also squeezed its profit margins. Kraft recently raised some of its prices to help offset rising costs. But it could take several months for these increases to translate into higher profits.

The company is now restructuring its operations. It has already cut $600 million from its annual costs, and aims to ultimately save $1 billion a year. Kraft plans to use the savings to expand advertising and marketing of certain products, such as coffee and cheese. It’s also spending more on new product development, particularly on healthier foods that sell for more than its regular products.

For example, Kraft recently launched a new line of cheeses that contain probiotics to improve digestion. Innovative products like these will help Kraft compete with private label brands.

Kraft’s balance sheet is in good shape, so it can afford to spend more on marketing and development. Long-term debt of $7.1 billion is just 25% of equity. However, goodwill of $25.4 billion is a high 46% of its total assets. Most of that comes from Kraft’s purchase of Nabisco in 2000.

Kraft’s stock got as high as $44 in 2002, but stayed between $28 and $36 for most of the past four years. It moved up to the top of that range after billionaire investor Nelson Peltz confirmed he is now Kraft’s largest stockholder with 3% of the company.

Mr. Peltz is the investor who helped force Wendy’s to spin off its Tim Hortons coffee- and-donut chain. Last year, he put pressure on Heinz to move more aggressively with its restructuring.

We don’t agree with every investment Mr. Peltz makes. But we do share his opinion that Kraft has plenty of hidden assets that enhance its prospects.

Mr. Peltz will probably pressure Kraft’s managers to sell under-performing brands, particularly the cereal and coffee businesses. The extra cash would let Kraft increase its $1.00 dividend (2.8% yield), increase its current $5 billion share repurchase plan, or make acquisitions. He will also push Kraft to expand its international operations, which offer greater potential than its slower-growing domestic operations.

The involvement of the Peltz group should also help attract more institutional investors. Most money managers avoid tobacco stocks like Altria, so they had little interest in Kraft while it was an Altria subsidiary. Institutions own just 17% of Kraft, well below the 60% average for the S&P500 Index.

Kraft now trades at 20.0 times the $1.80 a share that it will probably earn in 2007. That’s reasonable in light of the strong earnings potential of its brands. It’s also attractive at 1.7 times its sales of $21 a share.

We are adding Kraft Foods to our WSSF Conservative Portfolio. It’s a buy for long-term gains.