By: Brad Dorfman and Jessica Hall

January 12, 2006, Reuters

CHICAGO/PHILADELPHIA (Reuters) - Investors eager for a major legal ruling that could pave the way for Altria Group Inc. to spin off Kraft Foods Inc. might not like what they see in the maker of Oreo cookies and Jell-O pudding once the smoke clears.

Altria management has said it is preparing to break itself into two or three parts. Investors have bid the stock up 26 percent over the past year, hoping that separating Kraft from the Philip Morris tobacco units would create more value.

But analysts caution that Kraft and the rest of the packaged-food industry faces scant growth options and rising costs for fuel, packaging materials and certain ingredients, such as nuts.

Sales growth in the packaged food industry has been tough to come by for several years amid strong competition among branded companies and private-label competitors that keep prices down. The industry has been somewhat less successful than other consumer products makers in introducing blockbuster new products.

Some food companies also have been burned by raising prices too much to offset their increased costs, only to see consumers migrate to lower-priced competitors.

Kraft is "just a packaged food company," said analyst Gregg Warren, who follows the food and tobacco industries at Morningstar Inc. in Chicago. "The packaged food industry is one where I don't see many generating 3 percent topline growth and 8 to 10 percent earnings growth."

While Altria's stock has surged in the past year because of favorable court rulings on tobacco litigation and expectations of a restructuring, Kraft has fallen 20 percent amid the malaise in the packaged food industry.

"For now, we've seen some shuffling of products back and forth between the consumer products companies, but no one is going to see any real change in their growth by adding a new cracker," said one investment banker. "The growth has to come from outside, from a new asset or acquisition."

Altria, which owns about 85 percent of Kraft's outstanding shares, could not be immediately be reached for comment. The company in the past has declined to discuss its legal strategy or timeline for any potential restructuring. Kraft officials were be immediately available.

EYES ON FLORIDA COURT

Right now, investors and analyst are awaiting a Florida Supreme Court ruling that could be the last major legal hurdle to breaking up Altria.

If the court refuses to reinstate a $145 billion ruling against the tobacco industry, Altria could move very quickly with a Kraft spinoff, said one investment banker, who expects the separation to occur this year.

"The playbook has been written. It's been the same playbook for years. They know what they want to do. It's just a matter of when," said another investment banker, who specializes in the consumer products industry.

"Then Kraft can really work to get some focus," said the banker, who said the food company needs to do more beyond its efforts to cut thousands of jobs, close up to 20 factories and shed businesses to focus on core products like cheese, coffee and cookies. Last year, Kraft sold its Life Savers and Altoids candy and mint businesses, as well as Nabisco's fruit snacks.

Altria has been waiting for a resolution to its biggest legal woes so that tobacco plaintiffs don't come after Kraft's assets once it is an independent company.

Altria is taking such a conservative approach to avoid any appearance of "fraudulent conveyance" -- disposing assets to protect them from being used to pay damages.

"The argument is, 'Are you defrauding creditors here?'" said Stephen Presser, a professor at both Northwestern University's School of Law and its Kellogg School of Management. "And that's where Altria wants to say is: 'No, we're not."

OTHER HURDLES CLEARED

Altria has already seen victory in the two major cases.

In December, the Illinois Supreme Court threw out a $10.1 billion class-action verdict in a case that accused the company's Philip Morris USA unit of defrauding smokers into thinking "light" cigarettes were safer than regular smokes.

Attorneys for the smokers have not decided whether to appeal that ruling to the U.S. Supreme Court.

In February, a federal appeals court in Washington barred the Department of Justice from seeking a potential $280 billion penalty in a racketeering lawsuit against the tobacco industry. The U.S. Supreme Court rejected an appeal of that decision in October.

Yet all the effort to spare Kraft from tobacco litigation could end just as plaintiffs' attorneys increase their efforts to target food companies as the next villains, said one investment banker.

U.S. food makers have faced criticism from health and nutrition advocates who blame sugary and fatty foods, and the millions of dollars spent on advertising those products, for contributing to the rise of childhood obesity.

"You've had asbestos, you've had tobacco, now fast food is under fire," the banker said. "Food is the new bad guy."