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    kellogg  Q2 2008 Transcript  kellogg Q2 2008 Transcript Document Transcript

    • Kellogg Co. K Q2 2008 Earnings Call Jul. 31, 2008 Company▲ Ticker▲ Event Type▲ Date▲ MANAGEMENT DISCUSSION SECTION Operator: Good morning and welcome to the Kellogg Company 2008 Second Quarter Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer period. [Operator Instructions] Please limit yourself to one question during the Q&A session. Thank you. At this time, I will turn the conference over to Mr. Joel Wittenberg, Kellogg Company Vice President of Investor Relations. Mr. Wittenberg, please begin your conference. Joel R. Wittenberg, Corporate Vice President, Treasury and Investor Relations Thank you, Amanda, and good morning, everyone and thank you for joining us for a review of our second quarter results and for some discussion regarding our strategy and outlook. With me here in Battle Creek are David Mackay, President and CEO; John Bryant, CFO; and Gary Pilnick, General Counsel. We must point out that certain statements made today such as projections for Kellogg Company’s future performance including earnings per share, net sales, margin, operating profit, interest expense, tax rate, cash flow, brand building, upfront costs and inflation are forward-looking statements. Actual results could be materially different from those projected. For further information concerning factors that could cause these results to differ, please refer to the second slide of this presentation as well as to our public SEC filings. A replay of today’s conference call will be available by phone through Monday evening by dialing 888-203-1112 in the U.S. and 719-457-0820 from international locations. The passcodes for both corrected transcript numbers is #5646116. The call will also be available via webcast, which will be archived for 90 days. Now let me turn it over to David. A.D. David Mackay, President and Chief Executive Officer Thanks, Joel, and good morning, everyone. We’re pleased to announce another strong quarter despite the impact of continued commodity price volatility. This quarter’s performance provides further evidence of the strength of our business model. Our business momentum along with price realization drove reported sales growth of 11% and earnings per share growth of 9%. We continued to invest for the future absorbing upfront cost of $0.04 per share and increasing our advertising investments at a double-digit rate. In addition, we continued our expansion in emerging markets through the acquisition of Navigable Foods, a biscuit company in China. We’re entering the back half of the year with confidence in our ability to achieve our full year goals and we have raised our 2008 earnings guidance to $2.95 to $3 per share versus our previous estimate of 2.92 to 2.97. This increase in our guidance reflects our strong underlying business momentum. As we said previously, this year’s first-half performance would be measured against difficult 2007 comparables due to the timing of commodity market increases, various tax items and our very strong first-half performance in 2007. Given the tough comparables, we’re very pleased with our Q2 performance. As you know, we manage the business for the long term and we will drive performance through an ongoing commitment to investing in great ideas that keep consumers engaged and aware of our brands and 1 w w w . Cal l Street. co m • 212-84 9-40 70 • Copyri ght © 2001-2 008 C al l St reet
    • Kellogg Co. K Q2 2008 Earnings Call Jul. 31, 2008 Company▲ Ticker▲ Event Type▲ Date▲ their benefits. Our second-half innovation pipeline looks solid and we continue to focus on maximizing the value of our advertising dollars. Our business model and strategy continue to deliver strong results despite unprecedented volatility in the commodity and energy markets. To help recover some of these cost increases, we’re executing additional pricings across many of our businesses. On the cost side, we will continue to aggressively focus on SG&A optimization, productivity initiatives and longer term projects funded through upfront cost investments. As another sign of our continued confidence, we also announced this morning that our board of directors approved another 500-million share repurchase authorization. As you know, we completed our 650-million authorization during the first quarter. We do not anticipate that the purchases will have a meaningful impact on this year’s EPS as we plan to commence the repurchase late this year using our balance sheet cash. And now, I’d like to turn it over to John to discuss the financials. John A. Bryant, Executive Vice President and Chief Financial Officer; President, Kellogg North America Thanks, David, and good morning, everyone. Slide four highlights our financial performance. Reported sales increased by 11% in the second quarter, surpassing last year’s strong 9% growth. Internal sales growth, which excludes the effect of foreign exchange and our recent acquisitions, was 6%, building on last year’s strong 6% growth. Both reported and internal operating profit rose 2% against last year’s tough comp of 12% reported corrected transcript growth and 9% internal growth. We achieved this performance despite significantly higher commodity costs and a double-digit increase in advertising, offset by lower upfront project costs. For the full year, we still anticipate a mid-single-digit increase in internal operating profit. Our second-quarter earnings per share rose 9% to $0.82, compared to last year’s $0.75. Let’s turn to page five to discuss our second-quarter net sales growth components. As you can see, our price and mix initiatives continue to flow through with solid 4.7% growth. The price component contributed 3.4% of the total, even more than the first quarter’s 2.7% contribution and significantly ahead of last year. We continue to expect the price component to be higher in 2008 than prior year. Tonnage provided 1.3% growth and foreign exchange had a 3.1% impact on our sales. Our recent acquisitions performed well, adding 1.8% sales growth in the second quarter. Let’s turn to slide six to discuss our advertising investment. We continue to increase our investment in advertising with double-digit growth in the second quarter, on top of last year’s double-digit growth. Our commitment to advertising investment is a key component of our strategy, and our strong execution gives us the confidence that we will continue to achieve our goals. And as we previously discussed, we’re also driving a series of initiatives of cross-brand building to further improve the efficiency and effectiveness of these investments. For example, we’re driving cost savings through more efficient global media purchasing and production efficiencies. We will continue to focus on other efficiencies in our advertising spending as we move forward. Let’s turn to slide seven to discuss gross profit. Our gross profit for the quarter was $1.4 billion, a 5% increase over Q2 of last year. As you know, our focus is on gross profit dollars, as this is what allows us to continue to grow our investments in advertising and innovations. On a year-to-date basis, gross profit was $2.8 billion, a 6% increase over 2007. For the full year, we still anticipate gross profit dollars will rise at a mid-single digit rate. 2 w w w . Cal l Street. co m • 212-84 9-40 70 • Copyri ght © 2001-2 008 C al l St reet
    • Kellogg Co. K Q2 2008 Earnings Call Jul. 31, 2008 Company▲ Ticker▲ Event Type▲ Date▲ As some of you anticipated, our gross profit margin during Q2 declined by about 250 basis points to 43.2% versus last year’s tough comparables when gross profit rose by about 120 basis points. Contributors to the decline were our recent acquisitions, which reduced gross margin by about 70 basis points, as well as incremental commodity, fuel, energy and benefits inflation. Offsetting these were the benefits of price, mix, productivity initiatives and operating leverage. We now anticipate gross margin will decline by approximately 200 basis points for the full year, up from our prior estimate of 150 basis points, driven largely by our increased inflation estimate, which I’ll come back to you in a moment, as well as our recent acquisition in China. About half of the full year gross margin decline is due to our recent acquisitions as well as higher upfront costs in cost of goods while the remaining decline is driven by commodity inflation. As you know, even though we have priced to offset inflation, and that leads to a lower gross profit margin as a percent of sales. Now let’s turn to slide eight for a further discussion on our inflation outlook. Our full year outlook now includes approximately $0.90 of incremental commodity, fuel, energy and benefits inflation versus our prior estimate of $0.80. If we consider all cost pressures, the full impact of inflation on cost of goods is estimated to be approximately 9% for the full year. While we anticipate continued volatility in the commodity markets, our business model and strategy give us the ability to manage through this volatility. On the cost side, we’ve met the challenges through our continued drive for productivity savings and our focus on managing SG&A costs. On the revenue side, we’re focused on strong innovation backed by advertising support as well as price realization. These proactive actions have led us to meet or exceed our original targets in this quite significant cost volatility. corrected transcript Let’s turn to slide nine to discuss our operating profit. As expected, total internal operating profit rose by 2% versus last year’s strong 9% growth. The quarter was helped by our strong sales execution, price mix and productivity initiatives and was offset by significantly higher commodity inflation as well as a double digit increase in advertising. Our North American business reported internal operating profit increase of 5.3% building on last year’s 11% growth. This resulted from a mid-single digit increase in sales as well as productivity savings and lower upfront cost investments and was partially offset by significant cost inflations. Our European internal operating profit declined 4% versus last year’s difficult 19% comparison. Performance was driven by higher commodity cost and a strong increase in advertising investments. In Latin America, operating profit rose by 2.1% including the impact of commodity cost increases and higher advertising spending. And in Asia Pacific, internal operating profits increased by 1.4% despite a double digit increase in advertising. Upfront cost for the quarter totaled $0.04 per share including a $0.03 charge in corporate SG&A to eliminate a reload feature that was a part of our employee stock option program brands until 2004. The elimination of this feature from those brands will result in a lower option expense going forward. Below the operating profit line, interest expense was $77 million in line with last year and other income expense was an $8 million expense. The tax rate declined to 29.9% and we benefited from fewer shares outstanding. 3 w w w . Cal l Street. co m • 212-84 9-40 70 • Copyri ght © 2001-2 008 C al l St reet
    • Kellogg Co. K Q2 2008 Earnings Call Jul. 31, 2008 Company▲ Ticker▲ Event Type▲ Date▲ Let’s turn to slide 10 to review cash flow. In Q2, cash flow was $329 million versus last year’s 280 million. Year-to-date cash flow is above our expectation at 510 million versus last year’s $569 million. Cash flow benefited from our operating profits and other strong improvement in co-working capital; in fact, our cash conversion cycle improved by three days over last year to an impressive 22 days. For the full year, we continue to expect cash flow of 1 billion to $1.75 billion. Now let’s turn to page 11. For the full year, we continue to expect mid-single digit revenue growth driven by both strong execution and price realization. Operating profit is also expected to rise at a mid-single digit rate, driven by revenue growth, productivity initiative, operating leverage and lower upfront costs. We now expect earnings to be between $2.95 and $3 per share. We anticipate full-year upfront cost of about $0.14 per share in 2008. While we’ve determined that with $0.03 of the fifty-third week’s profits are being invested in the new acquisition, we are still evaluating alternatives for the remaining $0.02. Below the operating profit line, we expect interest expense to be slightly lower compared with last year and other income expense is forecast to be in 0.02 to $0.03 expense for the full year. Our full year tax rate is still expected to be approximately 31%. Finally, our additional $500 million share repurchase is now expected to materially impact our 2008 EPS. Although we generally do not provide quarterly guidance, we want to give you a feel for the shape of the second half outlook. During the third quarter, we will once again face tough comparables due to 2007 lower tax rates, which was driven by discrete items. We expect to post the year’s highest EPS growth in the fourth quarter due to last year’s high Q4 tax rate and the fifty-third week. The strength of our business model and strategy give us the confidence that we can meet our goals despite the volatile commodity and economic environment that we’re experiencing today. We’ll corrected transcript continue to invest for the future to deliver sustainable and dependable long term performance. And now, I would like to turn it back over to David on slide 12 A.D. David Mackay, President and Chief Executive Officer Thanks, John. If we start at North America, where we posted solid growth versus last year’s strong 6%, of 6%, our growth was broad based across all the business units and we’ll discuss each business unit in more detail starting with slide 13. North American cereal sales grew 5% during Q2, building on last year’s growth. The ready-to-eat cereal category growth remained strong and we are very pleased with our performance in the current competitive environment. During the quarter, our IRI measured channel share declined by about one point driven by a significant increase in our largest competitive incremental or trade driven sales. However, when we include the impact of retailers in the non-measured channels, we achieved a significantly better performance. In addition, price realization was strong and our price per pound in measured channels rose 4%. Our solid price mix performance resulted from the realization of our price increases and innovation like Special K Cinnamon Pecan. In addition, Corn Pops sales showed strong growth for the quarter. As we discussed last quarter, our cereal box size adjustments have now been completed. Kashi once again posted another double digit sales increase, driven by GOLEAN Crunch! and Organic Promise. And our second half innovation includes introductions from our Mini-Wheats, 4 w w w . Cal l Street. co m • 212-84 9-40 70 • Copyri ght © 2001-2 008 C al l St reet
    • Kellogg Co. K Q2 2008 Earnings Call Jul. 31, 2008 Company▲ Ticker▲ Event Type▲ Date▲ Smart Start and Kashi franchises. Our Canadian sales also rose by mid-single digits driven by innovations like Special K Satisfaction and the accelerated expansion of Kashi where we saw a strong cereal growth Let’s turn to slide 14 to discuss in our snacks performance. Snack sales was a strong 6% in Q2 on top of last year’s exceptional 9% comp. As we discussed during the Q1 call, the transition of Kashi cookies, crackers and bars as well as fruit snacks to DSD continues to deliver solid results. Sales of Kashi snacks are up sharply due to significant increases in distribution and quality merchandising. Our snacks business will continue to be driven by innovation and our recently announced second round of pricing. Let’s turn to slide 15 to look at more detail on the quarter. Our Pop-Tarts business posted a slight sales decline versus last year’s growth. While we achieved mid-single digit growth from our core Pop-Tarts, we were still lapping last year’s Go-Tarts sales, which are now declining. Our cracker business continues to post strong result with sales rising double digits during the quarter and we gained one point of market share. Innovation performed well ahead of expectations with products like Cheez-It Duoz and Town House Flipsides driving all of our share gains. Our cookie business also achieved low single-digit sales growth in Q2 as the category showed good growth and we achieved IRI share gains. We had strong performance from brands like Chips Deluxe, Fudge Shoppe and Right Bites portion control packs. Second half innovation is strong with the return of Hydrox by popular demand. Growth in the health and the snacks business was driven by products like Rice Krispies Treats, and Kashi TLC Chewy Granola Bar. corrected transcript If we turn to slide 16, we can discuss our Frozen and Specialty Channels’ performance. Frozen and Specialty Channels had another great quarter with sales rising 10% versus last year’s 7% comp. Our Frozen sales grew at double digits, which drove share gains across the business. Key to our growth was great innovation supported by strong advertising and promotion. Eggo waffles, pancakes and French toast varieties achieved solid base sales growth. In addition, new innovation performed well including new Eggo Mini Muffin Tops, resulting in frozen breakfast IRI share gains of more than two points during the quarter. The Morningstar Farms Veggie Food business also turned in another solid quarter as our healthy lifestyle message drove strong consumption. Once again our Kashi All-Natural Frozen Entrées and Pizzas performed very well and ahead of expectations. We drove strong IRI market share gains and we’ve just recently launched some new Kashi Pocket Bread sandwiches. Our Specialty businesses also achieved strong mid-single digit growth in foodservice and vending channels during Q2. If we turn to slide 17, we can review our international business performance. You can see on the slide that our international business posted another solid quarter with internal sales rising 6% versus last year’s 6% growth. Sales growth was broad based around the world. Let’s turn to slide 18 to discuss this in further detail. In Europe, we achieved solid 5% internal sales growth on top of last year’s strong 7% increase. A solid U.K. performance was above expectations driven by category growth and strong execution in both our cereal and snacks business. We also achieved growth in Italy as well as the Nordics, Benelux and the Middle East regions. 5 w w w . Cal l Street. co m • 212-84 9-40 70 • Copyri ght © 2001-2 008 C al l St reet
    • Kellogg Co. K Q2 2008 Earnings Call Jul. 31, 2008 Company▲ Ticker▲ Event Type▲ Date▲ In addition, our European snacks business achieved double digit sales growth driven by solid performance across the region. And we are also pleased to report that the integration and development plan for our United Bakers acquisition in Russia is progressing well. In Latin America, we posted 7% internal sales growth versus last year’s strong 8% increase. Growth was broad based with mid-single digit increases in both cereal and snacks. We saw a solid growth in Mexico behind our core brands, and in addition we saw good growth in Central America, Venezuela and Brazil. Our Asia Pacific business unit posted solid 9% internal sales growth. In a very competitive Australian market, our cereal business grew mid-single digits driven by brands like Nutri-Grain, Special K, and All-Bran. Our South Africa, India and South Korea businesses once again achieved double digit growth largely driven by per capita growth in ready-to-eat cereal. For the rest of 2008, we’ll continue to invest in advertising and innovation to drive further growth in these markets. Let’s turn to slide 19 to talk about our second half innovation. Our innovation plans give us additional confidence in our sales and price mix contribution. While this is only a sample of the new products we’re introducing, you can see that the variety spans geographic regions and categories. Our long term goal is for innovation introduced in the prior three years to account for roughly 15% of current year’s sales. As you know, we’ve exceeded this goal in recent years and it’s the contribution from this innovation that has helped drive our mix performance. If we turn to slide 20, now for a summary, we’re very pleased with our 2008 year-to-date performance. We came into 2008 anticipating earnings of 2.92 to 2.97 per share including more than $0.65 of incremental commodity, fuel, energy and benefits inflation, and despite our current corrected transcript expectation of approximately $0.90 of inflation we’ve increased our earnings expectation to $2.95 to $3 per share. We’ve responded to these challenging times by continuing to make the right decisions for the long-term. We will achieve our increased targets while countering the cost headwinds by driving price realization as well as increased cost and productivity savings. This is the strength of our consistent business model and strategy. We’ve also expanded our geographic footprint with the addition of United Bakers in Russia and Navigable Foods in China. Both acquisitions represent exciting opportunities to help build sustainable and dependable growth in the future. Overcoming the volatility we’re experiencing today requires a strong and dedicated workforce and Kellogg employees have met the current challenges. Executing our business plans with excellence, they continue to drive cost savings, innovation and strong marketing execution. Our long-term growth will be driven by our commitment to investing in great ideas and keeping consumers engaged with our brands and the unique benefits. Our focus remains steadfast on continuing our consistent track record of delivering sustainable and dependable growth. And with that, I’d like to open it up for questions. 6 w w w . Cal l Street. co m • 212-84 9-40 70 • Copyri ght © 2001-2 008 C al l St reet
    • Kellogg Co. K Q2 2008 Earnings Call Jul. 31, 2008 Company▲ Ticker▲ Event Type▲ Date▲ QUESTION AND ANSWER SECTION Operator: Thank you. Today’s question-and-answer session will be conducted electronically. [Operator Instructions] And we’ll take our first question from Alec Patterson of RCM. <Q – Alec Patterson>: Yes, good morning. On your cost of goods 9% increase, I just wanted to get a sense of that, that’s inclusive of all the hedging initiatives that you’ve put in place at the beginning of the year? <A – A.D. David Mackay>: Yeah, that’s correct. <Q – Alec Patterson>: And I believe you said that you were probably on the order of 80-85% covered at that point? <A – A.D. David Mackay>: That’s correct. <Q – Alec Patterson>: And that number still pretty much holds? <A – A.D. David Mackay>: That number is now higher, and we’re probably about 90% hedged where we can hedge. There are clearly some items that you can’t hedge, but we’ve taken as much hedging for this year as we can and I think for that reason now we feel very confident about the year even though volatility in commodities and energy remains high. <Q – Alec Patterson>: Okay, great. Thank you. <A – A.D. David Mackay>: Thank you. corrected transcript Operator: And we’ll take our next question from Andrew Lazar of Lehman Brothers. <Q – Andrew Lazar>: Morning. <A – A.D. David Mackay>: Good morning, Andrew. <Q – Andrew Lazar>: I guess you’d mentioned that ex-acquisitions and higher upfront spending that are flowing through cost of goods this year, your gross margin would be down about 100 basis points for the full year and I guess 200 including all that. I guess that’s not dramatically out of line with kind of what we’ve seen from a lot of other food companies but may be a bit at the lower end. And I guess it’s just that I thought, with your sort of productivity plan, both the base productivity and all the upfront projects that you’ve been doing, perhaps you’d be even maybe better equipped than some of your peers to sort of deal with some of this. So I am just curious if you think there are any – what some of the differences might be. Is it in the way you’re hedged versus others, do you think? Is it the way some of the commodity costs have hit you versus others? Or is there something around operating leverage that perhaps you’re not seeing that you want to? Just trying to get a sense of that because I would think you’d be frankly better equipped than many others. <A – A.D. David Mackay>: Well, I think, Andrew, we’re in pretty good shape with broadly offsetting inflation with pricing and when you do that, the math clearly will drive down your gross profit margin percent. As we have said before, we’re very much focused on gross margin dollars. They’re going to be up mid-single digit for the year. That enables us to invest back in the business to drive sustainable and dependable performance. And I think what you’re seeing in our current momentum, our strong first half, all the investments we’ve made and the continuing focus on cost reductions and efficiency gains are actually enabling us to weather what is a fairly volatile environment. Still continue to perform; they have a degree of confidence about the future. 7 w w w . Cal l Street. co m • 212-84 9-40 70 • Copyri ght © 2001-2 008 C al l St reet
    • Kellogg Co. K Q2 2008 Earnings Call Jul. 31, 2008 Company▲ Ticker▲ Event Type▲ Date▲ So I think we’re in pretty good shape. Others are doing a variety of things on hedging. I don’t really want to get into that. We have a fairly conservative approach where we’re trying to take volatility out because I think while you can hedge, those things roll off eventually and you do need to price for the market in the way you view it. So we feel very good about where we are and where we’re going. <Q – Andrew Lazar>: Thanks, Dave. <A – A.D. David Mackay>: Thanks. Operator: And we’ll move to our next question from Eric Serotta, Merrill Lynch. <Q – Eric Serotta>: Good morning. Couple of quick questions here. First, John, you mentioned with respect to the fifty-third week, I think that $0.03 would be attributable to reinvestment towards acquisitions and $0.02 of it would be – to be determined. From that I took that the full $0.05 would be reinvested. But then later on when you were talking about year-over-year growth on the breakout between the third and fourth quarter, you mentioned the extra week as being a factor in the fourth quarter. Is that just a timing difference or could you explain that to me a bit? <A – John Bryant>: That’s right, Eric. The fifty-third week will be reinvested back in the business but we’ll reinvest that back in the business across the year. In fact we’ve already started to do some of the reinvestment in Q1 and Q2 as we made those acquisitions. So then all of the reported benefit of 53rd week comes in the fourth quarter. <Q – Eric Serotta>: Okay. <A – John Bryant>: It’s just that, we’ll invest $0.03 or $0.02 is yet to be determined. corrected transcript <Q – Eric Serotta>: Okay; thanks. And to pick up on David’s comment about the reality of hedges continually rolling off, I know it’s early in year and it’s about a quarter earlier than you typically give an outlook for the following year, but given the commodity volatility and what was still a significant benefit from hedging this year, could you give us some sort of feeling as to how you’re looking at the commodity picture for next year? Do you have any coverage in place yet? Should we expect any kind of a step change as the coverage from this year rolls off? <A – A.D. David Mackay>: Eric, It’s a bit early to give too much on 2009. Our expectation for 2009 is that we will see cost inflation again, not in our view at this point to the levels of 2008 but likely above what we saw in 2007. That’s the current basis on which we are planning for the future. At this early stage, we feel that’s appropriate. We have taken some coverage but it’s not dramatic at this point. And as you are seeing the markets remain extremely volatile. But our belief is, as we have said to investors over the last 18 to 24 months, is we are in a new upward cycle in commodity inflation, and that’s our view that we will see a further increase in 2009. <Q – Eric Serotta>: Okay; thanks. I’ll pass it on. <A – A.D. David Mackay>: Thanks. Operator: We will take our next question from Chris Growe of Stifel Nicolaus. <Q – Chris Growe>: Good morning. <A – A.D. David Mackay>: Hi, Chris. 8 w w w . Cal l Street. co m • 212-84 9-40 70 • Copyri ght © 2001-2 008 C al l St reet
    • Kellogg Co. K Q2 2008 Earnings Call Jul. 31, 2008 Company▲ Ticker▲ Event Type▲ Date▲ <Q – Chris Growe>: Hi. I wanted to ask you a question just relative to kind of along the same lines but there has been seemingly a lot of shifting to the alternate channels, the nonmeasured channels. I wonder if you could speak to that for Kellogg and particularly, I think you’ve said it in cereal, for example. And then related to that, just your view of the kind of the private label tradedown. I mean just some feel for what happens to cereal in the second quarter? Does it become more of an issue or problem for the business? <A – A.D. David Mackay>: Yeah, I think what you are seeing is, I think growth is pretty strong in the nonmeasured and many of the measured channels are also doing very well. We did pretty well in the nonmeasured; we did okay in the measured channels. I think what we are seeing is in general a belief that within the store, sales are actually benefiting from a consumer trade or reduction in out-of-home consumption. I think casual dining is declining. I think people are buying more through the grocery stores, and us and many others are benefiting from that. We would expect that trend to probably continue. So I think that’s why we’re seeing – as we look at cereal, for example, the growth in the category for the second quarter was probably the strongest we’ve seen in a number of years. By our estimation, while we grew five, the category was up anywhere from five to up to 6%. We haven’t seen that level of growth in quite a while. So that’s a very positive indication that we are seeing people actually move to the grocery store. So we and many others are benefiting from that. And I think while consumers are under a lot of pressure, and private label is in aggregate doing pretty well, our view is that we’re seeing the benefit from out-of-home drop, we’ve got strong brands, we’ve got strong innovation. It’s the number-one or number-two in the categories in which we compete. We don’t think it’s going to have a massive impact on us. <Q – Chris Growe>: Okay. And then could you sort of clarify one comment from John, just on the $0.03 charge, that’s actually in this quarter but then does it just sort of reverse in the second half or corrected transcript ... <A – John Bryant>: The $0.03 charge in the second quarter is a charge of eliminating the reload feature on the options that we have outstanding. So what will happen is we’ll have lower option expense going forward. There will be some of that in the back-half of this year and we will have a full run rate in 2009. <Q – Chris Growe>: Is it a $0.03 benefit in ‘09, then? <A – John Bryant>: It is. <Q – Chris Growe>: Okay, okay. Great; thank you. <A – A.D. David Mackay>: Thank you Operator: We will take our next question from Jonathan Feeney of Wachovia. <Q – Jonathan Feeney>: Good morning. <A – A.D. David Mackay>: Good morning, Jonathan. <Q – Jonathan Feeney>: I wanted to ask a couple of questions if you don’t mind. The first is a big picture question. David, with all the discussions you’ve had with retailers and activity you’ve had taking pricing, what do you think would happen second half of this year, first half of next year, if commodities, particularly wheat, corn, soy continue their current relatively precipitous declines? Do you think it would change the pricing dynamic in a meaningful way? 9 w w w . Cal l Street. co m • 212-84 9-40 70 • Copyri ght © 2001-2 008 C al l St reet
    • Kellogg Co. K Q2 2008 Earnings Call Jul. 31, 2008 Company▲ Ticker▲ Event Type▲ Date▲ <A – A.D. David Mackay>: I think, Jonathan, we’ve said that we price typically behind inflation. We took around a pricing at the beginning of this year that we thought would offset inflation in 2008. We’re taking incremental pricing across a lot of the businesses in the second half because inflation as we said exceeded our expectations. So we typically do price behind inflation and the reasons for that is the one you are mentioning, we don’t want to price and then see commodities and costs drop precipitously, but I have to tell you that’s not our view and some of the reductions we are seeing, while they might look dramatic when you think of where that’s come from and even where they are today, most of the major commodities are more than double of what we would have seen two or three years ago. So we’re in a very different environment from a commodity and energy perspective and our view is that that will persist, some things could drop, others will continue to go up. In aggregate, we think we’re going to continue to see inflation as we go forward. <Q – Jonathan Feeney>: Okay, thanks. And just one other, on United Bakers, it seems to me there is just – there could be a huge opportunity here, I mean I know it’s an orthodox way of looking at it, but Kellogg has – it looks like it has about $440,000 in sales per employee and this company you just bought in Russia in fast – big fast growing market has about $25,000 in sales per employee. Seems like – I know there are some differences there but I mean it’s probably not 90% different and is there a huge opportunity to leverage distribution there? And how soon can we see new Kellogg products sort of going through that distribution network? <A – A.D. David Mackay>: I think, Jonathan that acquisition is going to prove a great one for us in the medium-to-long-term. We’re looking at the opportunities. Russia is a market that continues to grow rapidly. I think we’ve bought a fantastic platform for cookies, crackers and cereal of which we’ve no doubt we can expand and grow into the future. And yes, we did inherit with the acquisition a lot of employees. We intend to utilize them to continue to grow that business into the future. <Q – Jonathan Feeney>: And can you give us any sense of may be what products would be first and how soon we’d see new products in there? corrected transcript <A – A.D. David Mackay>: We’ll roll that up for you when everything is finalized and we’re closer to actually talking to the market participants. But there is a lot of work going on as we speak to ensure that we have the opportunity to maximize that business as we go forward. <Q – Jonathan Feeney>: Great. Thanks very much. <A – A.D. David Mackay>: Thanks. Operator: [Operator Instructions]. We’re going to take our next question from Vincent Andrews of Morgan Stanley. <Q – Vincent Andrews>: Hi, good morning, everyone. <A – A.D. David Mackay>: Good morning. <Q – Vincent Andrews>: If I could just ask a question on Europe, I understand the difficult comparison with last year but the first quarter did as well and the topline grew substantially in the second quarter. So I am just wondering what the difference was between 1Q where you grew operating profit and 2Q where it declined? <A – A.D. David Mackay>: I think as we said on the call, in the second quarter last year, our operating profit grew 19% and this year it was down 4%. So we had a very, very tough comp. Commodities as we said in the last couple of calls while it was predominantly a Latin America, U.S. issue, it has now spread to the EU over the last 12 months. That impacted us and also United Bakers, the acquisition in Russia had an impact on our profits. So we feel pretty good about Europe. It’s a challenging market, but we’re doing pretty well at the moment. 10 w w w . Cal l Street. co m • 212-84 9-40 70 • Copyri ght © 2001-2 008 C al l St reet
    • Kellogg Co. K Q2 2008 Earnings Call Jul. 31, 2008 Company▲ Ticker▲ Event Type▲ Date▲ <Q – Vincent Andrews>: Okay, and then the other question I had was just to make sure and I think this is the case, some companies have been reporting different types of hedging gains or losses within their results and I assume there was nothing material for you in that regard? <A – John Bryant>: No, there is nothing significant. Most of our hedges get hedge accounting treatment. Within other income expense, you see we are in a slight expense position. A part of that is because we are expensing some premiums on commodity options through that line. <Q – Vincent Andrews>: Okay, I’ll pass it on. Thanks so much. <A – John Bryant>: Thank you. <A – A.D. David Mackay>: Thanks. Operator: We’ll take our next question from Robert Moskow, Credit Suisse. <Q – Robert Moskow>: Hi, thank you. A big part of the story for Kellogg over the years has been the next to higher dollar per pound items. I am just wondering as you see a consumer that’s weakening, whether you have reassessed your portfolio or at least taken another look at whether it’s possible that consumers could trade down to lower dollar per pound item? Are there any parts to your portfolio that you think you might want to emphasis as value offerings to consumers? Thank you. <A – A.D. David Mackay>: Vincent (sic) [Robert] we will see and we are watching that closely. If you look at next year-to-date, for this year we’re at about 1.6. If we look at the prior three years we are around 2. So it’s pretty similar. We could see a mix within our portfolio where people go to more basic foods within the Kellogg portfolio. We are fortunate in that most of our portfolio, the operating corrected transcript margins and returns are pretty good. So we don’t – it’s concern and a watch-out but at this point, we are not seeing it. And who knows what the future holds but at this stage, we feel very good about our business and our portfolio in aggregate. <Q – Robert Moskow>: Okay, thank you. <A – A.D. David Mackay>: Thank you. Operator: We’ll go next to Eric Katzman of Deutsche Bank. <Q – Eric Katzman>: Hi, good morning, everybody. <A – A.D. David Mackay>: Hey, Eric. <Q – Eric Katzman>: One question, fourteen parts. No, I am serious. Gross profit dollars, I think getting back to – I think it was Andrew’s question but, the gross profit dollars up mid-single digit, John, can you kind of dice and slice that to the extent that we exclude M&A and we exclude 53rd week, I mean, are gross profit dollars for the full year expected to be flat if we exclude some of these items? <A – John Bryant>: The M&A does not have a significant impact on it because of the margin structure of the businesses we are acquiring. The 53rd week also is not a significant driver of that. So it would be probably around that mid-single digit, maybe a little bit lower than that, just a little bit of foreign exchange getting in that. <Q – Eric Katzman>: Okay and then just as follow-up maybe – we’ve been hearing some companies getting more concerned about the European consumer. I guess there’s also some 11 w w w . Cal l Street. co m • 212-84 9-40 70 • Copyri ght © 2001-2 008 C al l St reet
    • Kellogg Co. K Q2 2008 Earnings Call Jul. 31, 2008 Company▲ Ticker▲ Event Type▲ Date▲ concerns in emerging markets as to whether the consumer holds in there, Dave, perhaps you can kind of take us on a little bit of tour around the world just to kind of what Kellogg is seeing from the consumer outside the U.S.? <A – A.D. David Mackay>: Yeah, sure, Eric, I think when you go to Europe, we have a couple of markets there that for a variety of reasons are demonstrating a little bit of weakness. Spain has a particularly tough economic environment at the moment. And while our business is doing okay there, I think in general terms consumers are under pressure. That’s true in France. I think if you speak to most companies, I think 75% of the grocery categories in France are down due to economic conditions. And retailers there have actually cut inventories pretty significantly, so we are seeing a little bit of weakness there. Whether that persists depends on whether that inventory cut is one-time as we would expect. But in aggregate, we grew 5%. So even we’ve a couple of markets showing a little bit of weakness. Our business in totality continues to do well. We do track what’s going on with private label and hard discounters. As always, there is a concern there but that’s still growing but we haven’t seen a massive acceleration. You go to markets like Latin America, we saw pretty good growth. There were couple of markets there that I’d point out, we were a little bit weaker than normal. Venezuela where we grew double digits, it was significantly lower than we had seen for a while. And the key reason was there was an issue with milk and the price of milk and there was no milk available in Venezuela for probably the first three or four months of this year. And as we can imagine, in the cereal business, that can be a little problematic. So our growth there was significantly slower than it had been in the prior year. And then Columbia, the economy is a little weak there. I am not sure you can draw any aggregate conclusions from any of that because it’s all isolated. But again, in Latin America, our business grew 7% and while we are watching it, Eric, at this point, corrected transcript we feel fairly comfortable with the future for our business and the strength of our brands, I think and continued focus on innovations should hold us in pretty good stead. <Q – Eric Katzman>: Okay thanks, I’ll pass it on <A – A.D. David Mackay>: Thanks. Operator: And we will move now to our next question. This question comes from Terry Bivens of J.P. Morgan. <Q – Terry Bivens>: Hi, good morning, everyone. <A – A.D. David Mackay>: Hi, Terry. <A – John Bryant>: Hi. <Q – Terry Bivens>: David, just back on the cereal topic for a second, certainly a good growth rate, that’s not what we see in Neilson, I know, which only gives us part of the picture. Can you kind of parse what you’re seeing in terms of a growth rate in the measured channels versus Wal-Mart and/or unmeasured I should say in the aggregate and also if you could give us an update on market share, now that we are kind of nearing the end of General Mills’ strategy? <A – A.D. David Mackay>: I think on the category, as I said earlier, we believe the category across all channels grew anywhere at a low from 5 to a high of 6%. If you look at the IRI data through the 13 weeks ending the 29th of June, it was up 3.6. Typically, we would add anywhere between 2 and 3% of that to get to the overall market. So you can see that while IRI is 3.6, the category is doing 12 w w w . Cal l Street. co m • 212-84 9-40 70 • Copyri ght © 2001-2 008 C al l St reet
    • Kellogg Co. K Q2 2008 Earnings Call Jul. 31, 2008 Company▲ Ticker▲ Event Type▲ Date▲ significantly better in aggregate. Let’s call it 5.5%. We grew 5, so we did lose share in measured channels. We lost one share point. And I think one of our competitors was aggressive there that were probably lapping a weak comp because of their Right Size, Right Price initiative last year but that incremental is up 42% for the 13 week period, it was a long time. And we’ll probably see in the third quarter with our lapping weakness again, they will probably do well and I feel the business model looks so good but we are very comfortable with the way our cereal is going. I have to tell you we have started well as we go into Q3. So the cereal category actually does appear to be benefiting from this overall change in consumer behavior where out of home consumption and casual dining looks to be down at least double digits and center store in aggregate does appear to be picking a lot of that up as consumers buy more and eat more at home. So I think that’s reflected not only in cereal but across a number of the categories in which we compete, where we are seeing relatively strong and maybe even marginally stronger growth than we have seen over the last couple of years. Does that get at your question, Terry? <Q – Terry Bivens>: I think it does. I would just add that I continue to eat cereal in the evening. So I am doing my part, thanks a lot. <A – A.D. David Mackay>: We appreciate that. Thank you. Operator: Our next question comes from David Driscoll with Citigroup. <Q – David Driscoll>: Great, thanks a lot. Good morning, everyone, <A – A.D. David Mackay>: Hi, David. corrected transcript <Q – David Driscoll>: Gentlemen, on the last two calls you highlighted that the first half earnings would face very difficult earnings comparisons. Second quarter earnings are up 9%, a very solid number. So, David, I would just like to ask you what specifically came in better versus your plan in the second quarter. Can you call out a couple of factors? <A – A.D. David Mackay>: I think our topline was strong, and while we got impacted by higher commodities in the quarter and we had tough comps and we had a tax benefit last year that we didn’t have this year, our tax rate actually was positive during the quarter. So I think it was more of a momentum and strength of the topline in the quarter across almost all of the markets. We saw broad based growth almost everywhere and typically we will have a pocket of weakness somewhere. But in aggregate, it’s pretty hard to come up with one in the second quarter as far as topline goes. <Q – David Driscoll>: If I could sneak in one more, in the U.S. cracker business, it looks like competitive activity is picking up there. Can you talk to us a little bit about trends for Kellogg and your new product plans are coming, I did notice one new product on the slide, but just curious if there was any other announcements on new products in crackers? <A – A.D. David Mackay>: Yeah, we’ve got a few things coming out. Our innovations that we kicked off in the first half of the year continues to actually grow and that’s really the Cheez-It Duoz and the Town House Flipsides and I think we’re going to see a further momentum on upsides from that. We’ve got a low-fat white cheddar Cheez-It coming out and a couple of other innovations. But our innovation through the first half I still think has legs as we go to the second half. And we’re going to enhance on those as we go forward. 13 w w w . Cal l Street. co m • 212-84 9-40 70 • Copyri ght © 2001-2 008 C al l St reet
    • Kellogg Co. K Q2 2008 Earnings Call Jul. 31, 2008 Company▲ Ticker▲ Event Type▲ Date▲ And the whole category in crackers and cookies again are very strong. We saw strong growth and even though we priced early in the year, we have announced a second price increase for the back part of the year because probably if you look at snacks, it’s probably one of the most negatively impacted from a commodities inflation perspective as we look across our portfolio. I think the category is going to continue to do well and I think all players can continue to grow and succeed. <Q – David Driscoll>: Great. Thank you very much. <A – A.D. David Mackay>: Thank you. Operator: We’ll take our next question from the line of Alexia Howard, Sanford Bernstein. <Q – Alexia Howard>: Hello there. <A – A.D. David Mackay>: Hi, Alexia. <Q – Alexia Howard>: A question on commodity cost, I know that you said last quarter it was $0.15 a share that you were facing. Could you let us know what it was for this quarter? And given that outlook for commodities, what are the primary drivers of the better EBIT growth that you’re expecting in the second half of ‘08? I know you mentioned some of them earlier but could you rank order them, is it mostly pricing, is it a slowdown in the upfront cost, is it better productivity improvements coming through, is it a slowdown in marketing spend. If you could just give us an idea of which of those factors are the most important? <A – A.D. David Mackay>: I’ll let John take the commodity inflation in Q2. I think we have got the number. In the back half, as John said, the third quarter is going to be a challenge. The fourth quarter is going to be very strong. A number of factors in that, one-time costs; last year, our increase in advertising was extremely high. Our expectation would be while we will have strong corrected transcript advertising, we won’t see the levels of increase that we saw in the fourth quarter of last year. And in general terms, I think when you look at third quarter, the commodity impact is higher there than it is in the fourth. So those are some of the things. John, do you want to cover up there? <A – John Bryant>: Alexia, the commodity impact in the second quarter was about $0.24. <Q – Alexia Howard>: Great, thank you very much. <A – A.D. David Mackay>: Thanks. Operator: You have a question now from Judy Hong of Goldman Sachs. <Q – Judy Hong>: Thanks, good morning, everyone. <A – A.D. David Mackay>: Hello, Judy. <Q – Judy Hong>: Two quick questions. First, in terms of the price gap versus private labels and cereal, has that trend changed in anyway, up or down? <A – A.D. David Mackay>: Not dramatically. I think we are seeing them price maybe slightly below the branded players in the category but typically that’s a lag effect because they get pricing through probably a little slower than the branded players. We are up fourish. They are probably up in the low threes. But we would expect that they will catch up in that. They have cut the amount they promote too because I think they are trying to make their P&Ls work, but no real dramatic change in the spreads at this point. 14 w w w . Cal l Street. co m • 212-84 9-40 70 • Copyri ght © 2001-2 008 C al l St reet
    • Kellogg Co. K Q2 2008 Earnings Call Jul. 31, 2008 Company▲ Ticker▲ Event Type▲ Date▲ As we see historically, we are seeing occasionally a particular retailer or two have a greater focus on private label and drive it aggressively, and that can tend to skew the data until you dig into it and look at the fundamentals of what’s going on. And we’d expect that to continue. But in general terms, the price gaps really haven’t moved. And I think as we look at it, while given the consumer is under a fair amount of pressure, you’d expect private label to do well. We believe we can continue to do well because of the strength of our brands, our strong innovation and the high quality of our product offerings. <Q – Judy Hong>: Okay, and then you talked about the incremental pricing in the second half. Can you give us the magnitude of the price increases in the second half, particularly if you compared that against the price increases that were taken in the beginning of the year? <A – A.D. David Mackay>: No, I haven’t actually done the math. All I’d say is that it’s sort of broad across many of the businesses. A lot of them have been announced and some are coming probably in the low single digits, but... <Q – Judy Hong>: And not too different from what you’ve done earlier in the year? <A – A.D. David Mackay>: Not dramatically. <Q – Judy Hong>: Okay; thanks very much. <A – A.D. David Mackay>: Thanks. Operator: And our next question comes from Tim Ramey of D.A. Davidson. <Q – Timothy Ramey>: Good morning. Wondering if you can give me a little more clarity on the change in estimates in $0.90 of costs that you now adopt versus the $0.80 that you said before. corrected transcript There weren’t that many things that got worse in the 2Q except I suppose energy. Was it the $0.03 from the reset options or what else might have been in there? <A – A.D. David Mackay>: It was both energy and also edible oils, the two I’d point out. But in general terms, anything that’s energy based also continues to rise. So across a number of items, we did see an increase. <A – John Bryant>: To clarify, the $0.03 for the option expense was not part of that $0.90 estimate. <Q – Timothy Ramey>: Okay. And then, David, you mentioned that healthy snacks were up, but I don’t think you gave us an order of magnitude. Is that business doing as well as it’s done in the past given a weaker consumer? <A – A.D. David Mackay>: I think it’s growing about mid-single digit. It had grown historically probably a little higher than that and our expectation has always been that, in the medium to long term, it would grow mid-single digit. So it’s performing pretty much as we would expect it to perform, and we grew about with the categories for the quarter. So it was a pretty solid performance and it continues to be a category that I think will grow around that level going forward. <Q – Timothy Ramey>: And just to comment, I think it’s quite commendable to get rid of that reset or reload option feature; that’s good corporate governance. Thanks. <A – A.D. David Mackay>: Yeah and I think – thank you -- and I think that it was a positive move by the board. <A – John Bryant>: Amanda, we’ll take one more question, please. 15 w w w . Cal l Street. co m • 212-84 9-40 70 • Copyri ght © 2001-2 008 C al l St reet
    • Kellogg Co. K Q2 2008 Earnings Call Jul. 31, 2008 Company▲ Ticker▲ Event Type▲ Date▲ Operator: Okay, thank you. Our next question will come from Ken Zaslow of BMO Capital Markets. <Q – Ken Zaslow>: Hey, good morning, everyone. Thanks for squeaking me in. <A – A.D. David Mackay>: Hi, Ken. <Q – Ken Zaslow>: Just one question. Just going back to Europe, what steps can you do to reverse the profit trends in Europe? Is it more just doing the same or is there something that the pricing environment can get better or what steps can really change the profit outlook for Europe? <A – A.D. David Mackay>: I think, Ken, if you look at the year, when we finish the year, I think you will look back at the year and you’ll go, okay, the profit in Europe was pretty solid. So I wouldn’t be drawing any negatives from a quarter numbers because the comparatives are the single biggest driver of why it didn’t look so good. And I think when we finish the year, we’ll look at our European profit, it will be where we expect it to be, and it will be relatively healthy. So I wouldn’t draw too much from the quarter number because, when you go up plus 19 a year ago and you’re down four and you aggregate the two is still pretty healthy, as of the two year period. <A – John Bryant>: The only I would add to that is we will have more upfront costs in Europe this year relative to last year, so it will slightly deflate some of the reported numbers. <Q – Ken Zaslow>: Were there actually upfront costs in this quarter in Europe or no? <A – John Bryant>: There was a little bit, but it wasn’t that significant. <Q – Ken Zaslow>: Great, I appreciate it. Thanks corrected transcript <A – A.D. David Mackay>: Thanks. Operator: That does conclude today’s question-and-answer session. At this time I’d like to turn the conference over to Mr. Wittenberg for any closing or final remarks. Joel R. Wittenberg, Corporate Vice President, Treasury and Investor Relations Thanks, Amanda. We just want to thank everybody for attending our call today. We appreciate your interest in the Kellogg Company. Operator: That thus concludes today’s conference. We thank you for your participation. Please have a good day. Disclaimer The information herein is based on sources we believe to be reliable but is not guaranteed by us and does not purport to be a complete or error-free statement or summary of the available data. As such, we do not warrant, endorse or guarantee the completeness, accuracy, integrity, or timeliness of the information. You must evaluate, and bear all risks associated with, the use of any information provided hereunder, including any reliance on the accuracy, completeness, safety or usefulness of such information. This information is not intended to be used as the primary basis of investment decisions. 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