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Executives

Chris Jakubik - Vice President Investor Relations

Irene Rosenfeld - Chairman and CEO

Tim McLevish - Chief Financial Officer

Analysts

Jonathan Feeney - Wachovia

Todd Duvick - Bank of America

Judy Hong – Goldman Sachs

Christine Mccracken – Cleveland Research

Terry Bivens – JP Morgan

Alexia Howard - Sanford Bernstein

David Driscoll – Citi Investment Research

Eric Katzman - Deutsche Bank

Chris Growe - Stifel Nicolaus

Ken Zaslow - BMO Capital Markets

Eric Serotta - Merrill Lynch

Bryan Spillane – Banc of America

Robert Moscow - Credit Suisse

Andrew Lazar – Barclays Capital

Kraft Foods Inc. (KFT) Q3 2008 Earnings Call October 29, 2008 8:00 AM ET

Operator

(Operator Instructions) Welcome to Kraft Foods Third Quarter 2008 Earnings Conference Call. I’d now like to turn the call over to Mr. Chris Jakubik, Vice President Investor Relations for Kraft.

Chris Jakubik

I'm Chris Jakubik, Vice President of Investor Relations. With me are Irene Rosenfeld, our Chairman and CEO, and Tim McLevish, our Chief Financial Officer.

Our earnings release was sent our earlier today and is available on our web site, Kraft.com. Also available on our web site are slides that we will refer to during our prepared remarks. As you know, during this call we may make forward looking statements about the company's performance. These statements are based on how we see things today so they contain an element of uncertainty.

Actual results may differ materially due to risks and uncertainties. Please refer to the cautionary statements and risk factors contained in the company's 10-K and 10-Q filings for a more detailed explanation of the inherent limitations in such forward looking statements. Some of today's prepared remarks will exclude those items that affect comparability. These excluded items are captured in the GAAP to non-GAAP reconciliation within our news release, and they are also available on our web site.

Irene will first provide her perspective on our results and outlook today. Then Tim will highlight our financials and review the results for each of our business segments. After that Irene will open it up for questions. With that, I'll hand it off to Irene.

Irene Rosenfeld

At the risk of stating the obvious the world has changed quite dramatically since our last business update. Within that environment I’m very pleased that we’ve just reported strong third quarter results. Taken together our revenue, market share and profit are all trending in the right direction despite a very challenging environment. While the global economy has worsened I feel even more confident about our business prospects.

Specifically our Q3 results have again shown that we’re able to build our business momentum despite significant headwinds and although we face some new macro economic challenges I am confident we can successfully navigate through them and that Kraft will emerge from the present environment even stronger.

Why do I feel that way? In terms of our business momentum we’re continuing to see good payback from our investments in quality, marketing and innovation across our major categories and markets around the world. We’re seeing the benefits on both the top and bottom lines. We’ve invested to improve product quality and rebuild brand equity since 2007 and that has given us renewed pricing power. As a result, 2008 represents an important landmark. It will be the first year in many that Kraft will fully offset input cost inflation through a combination of pricing and productivity.

Going forward I’m very comfortable that our pricing at current levels and our strength in brand equities leave us well positioned to continue to manage changes in input costs either up or down. At the same time our volume has held up better than expected despite significant cost driven price increases in an increasingly unsettled economic environment. As consumers have traded in to food at home and traded down to value oriented meal offerings we’ve given them many reasons to come home to Kraft.

We’re driving solid growth in a number of high margin businesses like Mac & Cheese, Kool-Aid, Jell-O and DiGiorno by emphasizing our value oriented positioning versus higher cost alternatives. We’ve successfully innovated into new segments with products like Oreo and Nilla Cakesters, upper mainstream Milka Dark and Milka filed chocolates, Bagel-fuls, and microwaveable DiGiorno and California Pizza Kitchen pizzas for one. Our restaging efforts are paying off in other categories like mainstream coffee and salad dressings in which we’re beginning to reverse years of share declines.

As the result of our stronger than expected volume performance we are raising our guidance for 2008 organic revenue growth to 7% up from at least 6%. Overall our revenue fundamentals have improved significantly. In fact the next two slides put this improvement into perspective. Slide six shows that on a year to date basis our volume mix is up 80 basis points and we’ve achieved that growth despite unprecedented pricing of almost 700 basis points.

Slide seven shows our US market share. In Q2 the temporary dislocation from our pricing actions affected both our 13 week and our 52 week market shares. As competitors appear to be catching up to market costs and consumers continue to respond favorably to our investments we are pleased to see our shares rebounding from 42% to 47%. Not surprisingly our performance in value oriented non-measured channels has been particularly strong reflecting our successful focus on value meals.

Going forward we’ll continue to invest in our brand equities and the value positioning of key brands. We’ll benefit further from product news in core categories like crackers. As a result we expect to see market shares continue to improve. We also feel good about the sustainability of our business momentum because we’re taking advantage of our unique strengths.

First, we’re leveraging the scale of our broad portfolio. Our growth is now sufficiently broad based to enable us to disproportionately allocate our resources behind the biggest opportunities. We’re seeing results from the highest margin, highest growth categories in North America. From our 5/10/10 strategy in Kraft International where our focus on five categories, ten brands and ten markets is paying off nicely.

Second, our decentralized structure is leading to better, faster decisions that are driving profitable growth. Our business leaders are focused on their largest most profitable brands and looking at them holistically. In some cases they’re trading volume for profit. This includes optimizing trade spending, cutting less productive skews and exiting certain product lines. In fact, more than half of our Q3 volume decline was due to conscious decisions to sacrifice less profitable volume.

Third, we continue to generate significant cost savings and we see considerably more savings opportunities ahead of us. As we outlined in September we now expect $1.4 billion in restructuring savings well in excess of our original plan. We have a strong pipeline of cost reduction initiatives beyond our restructuring program which will be implemented in the normal course of business over the next few years.

Net net I feel quite good about our business performance in a very challenging environment. Having said that the world has changed considerably since our update only one month ago. Obviously there are a number of moving parts and the recent turmoil in the financial markets has reduced our upside potential. We will continue to pursue opportunities to backstop our plans and to offset those variables outside of our control. From an operating perspective we remain confident that we will deliver at least $2.00 GAAP EPS in 2009.

Why do I say that? Three reasons; first we’re well positioned to navigate through the current financial crisis. Yes credit markets are tight but we have ample liquidity. Our balance sheet and cash flow remain strong. Our investment grade credit rating is serving us well and we’ve maintained regular access to the Commercial Paper market.

Second, we’ve adjusted our brands for the possibility of weaker near term volumes. That’s covered within our guidance. We’ve done this because tight credit may lead to some retailer inventory liquidation that could impact our fourth quarter shipments, because changes in consumer sentiment and consumer spending remain a concern.

Third, we are well positioned in the current environment because we have strong underlying operating momentum as we head into 2009. Our year to date volume, operating income and taxes are all better than expected. We will continue to invest in quality, marketing, and innovation to build our competitive advantage. We have a strong pipeline of cost savings both from our restructuring program and from future initiatives. In 2009 we will realize significantly more synergies from our LU biscuit acquisition.

In summary, despite some significant headwinds I believe the investments we’ve made over the past two years will enable Kraft to emerge from this environment even stronger.

Now I’ll turn the call over to Tim.

Tim McLevish

Please keep in mind that unless otherwise noted my comments will exclude the items affecting comparability that were highlighted in our press release. I’ll begin my comments by starting at the top line. Our Q3 net revenues increased 7% on an organic basis. As we had expected the balance of organic growth in Q3 shifted to pricing. We’ve acted decisively this year taking a series of cost driven price increases in virtually every category and every market around the world.

The cumulative effect of our actions is playing out over successive quarters. The 8.4 percentage point increase in Q3 compares to about 7 points in Q2, 4 points in Q1 and less than 2 points in all of 2007. This trend should continue into Q4. At the same time we remain encouraged by our overall volume and mix performance. It held up better than expected reflecting the benefits of our investments in quality, marketing and innovation.

In fact, as Irene mentioned more than half of our Q3 volume decline was due to a conscious decision to sacrifice less profitable volume. This is most evident in three areas. Natural cheese and food services service in the US, roast and ground coffee in part of the EU and ready to drink beverages in Asia. As a result we’ve raised our organic revenue growth guidance to 7%.

Turning to the drivers of Q3 earnings per share, we delivered strong gains from our operations in the quarter. As you can see on the chart our operating gains in the third quarter accelerated versus the first half of the year. Consistent with the guidance we provided in January. This reflects the fact that benefits of pricing and productivity are now catching up to the increase in our input costs. I’d also note that the Q3 operational improvement reflects $0.02 of negative timing impact due to commodity hedging gains that were recognized earlier in the year.

Additionally the quarter was negatively impacted by $0.06 related to the mark to market or our commodity hedging activity. We largely anticipated this as we flagged our significant mark to market gains in Q2. If we were to adjust for the timing impact of our hedging activity in the same manner we did in Q2 our ex items EPS would have been about $0.52.

This is a good place to stop and discuss our input cost situation. This chart shows prices by year versus the 10 year average for our key commodity inputs. Despite recent declines from all time highs prices of key inputs remain well above prior year and historical levels. To put this in context for Kraft, in Q3 our input costs were up about $700 million over last year.

Year to date our input costs are up about $1.5 billion and for the full year we continue to expect input cost inflation of about $2 billion or up about 13% over 2007. Going forward we’re comfortable that our pricing levels are appropriate for the current input cost environment.

Back to Q3 earnings, the strong contribution for operations just discussed was offset by two factors below the line. One was higher interest expense a $0.06 headwind versus the prior year. For the full year we expect interest expense to be at the higher end of our $1.2 to $1.3 billion range. That’s slightly more than we anticipated and reflects higher borrowing costs including the higher rates we’re currently paying for Commercial Paper.

Second was the $0.05 negative impact due to lower earnings from discontinued operations. The negative impact was slightly more than anticipated due to certain adjustments associated with the closing of our Post transaction.

While not a significant contributor year over year our tax rate was worth mentioning. Excluding items our Q3 effective tax rate was lower than expected. Its due to three things; a shift in our geographic mix of earnings this year, recent tax legislation and a favorable resolution of several discrete items. These changes have lowered our expected average effective tax rate to 31.5% for all of 2008, down from the 33% we had previously forecasted.

About half of the reduction comes from our geographic mix and the remainder is split about evenly between legislative changes and discrete items. As it relates to our 2008 EPS guidance favorable taxes will help to cover the negative impact from currency and interest expense. We remain comfortable with our 2008 EPS guidance of at least $1.88 despite headwinds from the current macro economic environment.

I’ll take a few minutes now to share some highlights of our business segment results. I’ll start with North America where a second wave of investments, better execution at retail from wall-to-wall and our new organization structure are all having a significant impact. Our results are benefiting from a focus on our highest margin, highest growth categories. Our programs to highlight the value proposition of our brands are gaining traction across a number of businesses. In fact, half our North American reporting segments posted positive volume in the third quarter.

Looking at individual segments, in US Beverages organic net revenue grew 7.4% again solid gains in both volume and pricing. Ready to drink, powdered beverages and coffee all contributed to growth. In ready to drink beverages our investments in quality and marketing behind Capri Sun and Kool-Aid led to volume growth. This is a significant turn around from the price related volume declines we saw earlier in the year.

In coffee our efforts to restage the business continued have a positive impact. We posted double digit growth in Maxwell House and more than 40% growth in Tassimo. In fact, Maxwell House drove a market share gain in the mainstream segment for the fourth quarter in a row. Powder beverages also delivered solid growth; this is driven by continued strong volume gains in Kool-Aid and Country Time as we’ve improved our value marketing to consumers.

However, at the profit line beverages operating income was down slightly. Here the benefits from cost driven price increases and volume growth were offset by higher input costs and to a lesser extent unfavorable product mix.

In US Cheese organic net revenues were up 7%. This reflected double digit cost driven price increases that were partly offset by related decline in volume. Four factors are worth noting here. First, even considering our recent price decline in September list prices versus a year ago remain up between 5% and 20% across our cheese categories. Second, we made a conscious decision to not chase unprofitable volume during the quarter particularly in the natural cheese business.

In the near term as absolute price points remain at historic highs we would expect volume pressure and difficult comparisons to persist. On the other hand innovations such as Bagel-fuls continue to deliver solid benefits. More importantly we’re benefiting from new advertising that highlights the great value of Kraft Singles and Velveeta, two of our highest margin cheese products.

Most importantly this played through to operating income. It was up strongly versus Q3 2007 as the multiple pricing actions we’ve taken have caught up with the input cost increases we’ve seen over the past year. Going forward we expect margins to be in the mid to upper teens on a normalized basis. There will be some variation quarter to quarter but it will be within a might tighter band than we have experienced in the past as the result of our decision to price closer to market.

Moving on to US Convenient Meals, our investments in quality, base marketing and new products drove 8.6% organic revenue growth. We had strong gains from cost driven pricing and one point from improved mix. In Oscar Mayer the strength of our Deli Fresh cold cuts platform continued. It delivered strong double digit revenue growth an about a point of share gain in the overall cold cuts category.

Our Deli Creation sandwiches also grew strongly in Q3, driven by the new flat breads line. This continues to be highly incremental to our base Oscar Mayer business and it’s on its way to see the $100 million mark as consumers continue to see significant value compared to take out sandwiches.

Finally, strong volume growth in pizza continued not only from our base DiGiorno and California Pizza Kitchen offerings but also from the roll out of our new line of single serve offerings under the “For One” banner. This drove more than a point of market share gain in frozen pizza during the quarter.

Operating income in the segment declined about 6% versus the prior year. Here our pricing actions do not fully cover the combination of the steep recent escalation in input costs specifically in beef and pork used in Oscar Mayer products as well as higher marketing and overhead costs. As we move forward we expect our year over year profit performance to improve as pricing catches up with the input costs.

On to US Grocery, organic net revenues were up about 6% and operating income grew 5%. Jell-O and Mac and cheese again delivered a combination of pricing, market share gains and higher profit margins in the quarter. Both categories continue to benefit from the current economic environment as consumers search for value oriented meal solutions. These gains were partially offset by declines in other parts of the business such as spoonable dressings where pricing actions led to volume declines.

Our Kraft Pure salad dressing roll out continues on tract with significant cost driven price increases, slowed volume growth in this category as well. Overall we’re encouraged by the progress we’re making in growing our high margin grocery portfolio and we expect more to come.

Looking at US Snacks organic net revenues were up 4% in Q3 entirely due to pricing. At the category level solid gains in biscuit were partially offset by two things, a decline in snack bars due in part to product pruning and pricing related volume declines in snack nuts as a number of competitors have taken pricing actions later in the quarter.

In biscuits our focus on our largest brands is paying off. Our top five brands grew 16% in Q3 and are up 10% year to date. The addition of Nilla Cakesters and the ongoing strength of Oreo Cakesters pushed this platform further towards the $100 million mark and resulted in double digit growth for both the Oreo and Nilla brands.

Overall revenue performance in crackers improved versus last year with double digit gains in Triscuit and strong growth in Ritz due to successful marketing investments and terrific consumer response to our new Kraft Mac and cheese crackers. Going forward we expect our cracker performance to improve further behind new products and improved Q4 marketing programs. This should lead to an even strong biscuit performance in the fourth quarter.

At the operating income line profit grew about 4% however Q3 results were negatively impacted by approximately $25 million or about 15 percentage points of growth. This is due to the benefits of commodity hedging activities that were recognized in the second quarter rather than offsetting the related input costs in Q3. On an adjusted basis profit for the Snacks segment would have been up about 19%.

Turning to Canada and North America Foodservice, organic revenue growth was up 4.5% versus last year. We had another solid quarter in Canada driven by pricing, strong volume and share growth. The ongoing success is due to increased investments in marketing and innovation across all categories and the implementation of improved customers plans as we leveraged our scale with the reestablishment of Canada as a stand alone business.

In North America Foodservice growth came from a combination of pricing and innovation in the form of new menu items in quick service channels. Its worth noting that our Foodservice volume was down only about 1% in the quarter despite a significant slowdown in restaurant traffic and the effect of exiting a low margin unbranded supply contract.

At the operating income line strong growth was driven by gains in both Canada and Foodservice. Top line growth, manufacturing efficiencies and overhead cost leverage more than offset higher input costs. Volumes will continue to be a challenge in the near term but given the base business gains from marketing and innovation we expect solid year over year margin improvement to continue.

Now we’ll turn to our International business. Our 5/10/10 strategy five categories, 10 brands, and 10 markets is clearly paying off across Kraft International. We continue to show very good organic growth especially in developing markets. With the balance of growth now shifting to pricing we’re beginning to catch up to cost increases especially in the EU.

In the EU organic revenue growth was drive by about five points of cost driven pricing that was partially offset by nearly three points of volume decline. However, the volume decline is primarily due to pruning lower margin products and pruning will continue to play a role in our volume growth profile for the next three quarters, growth in our focus areas however remain solid.

In Chocolate we continued to lever strong growth from the ongoing success of marketing innovation investments particularly behind our billion dollar Milka brand. Cheese also grew in the quarter from investments behind our leading Philadelphia brand. In coffee revenue declined slightly as gains in Gevalia and Tassimo were up because of planned volume losses and less profitable brands.

At the profit line EU operating margins improved 170 basis points versus last year and they continued to improve sequentially from prior quarters. The LU biscuit business added substantially to top line results this year but even excluding the acquisition EU operating profit was up strong double digits as higher pricing and favorable product mix more than offset higher input costs. As we continue to integrate the LU biscuit business still in its first year we’ll deliver more revenue and cost synergies which will drive improved top and bottom line performance.

In Developing markets we saw continued strength with organic growth of 19% driven by solid mix gains and 13 points of pricing. Volume was down slightly in the quarter entirely due to lower volume in Asia. In Asia volume declines were primarily due to pruning activities and a timing shift due to a distributor consolidation between Kraft and the LU biscuit business.

The obvious factors we’re continuing to see strong growth across our Developing Markets due to our focus on and investment in core categories, core brands and key markets. Operating profit growth was very strong up more than 50% even excluding profit impact from the LU acquisition. We delivered solid growth in every region.

Finally a few notes on cash flow. In addition to our solid earnings base we’re making good progress in working capital. Our improvement program delivered six day reduction in our cash conversion cycle with inventory being the main contributor. CapEx through nine months was $900 million and we remain on pace to spend just over 3% of net revenue for the year.

As a result we’ve generated about $1.6 billion of discretionary cash flow through nine months and are on track to beat last years level of $2.3 billion.

With that I’ll hand it back to Irene for some closing comments.

Irene Rosenfeld

To sum it up we continue to build momentum despite significant headwinds. Our investments in the business are paying off in stronger top and bottom line performance in all geographies. Obviously though it’s a new world and there are a number of external factors whose impact on 2009 will be clearer as the new year begins. We’ll certainly keep you posted but I am confident that within this challenging environment Kraft is well positioned to win.

Now we’d be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jonathan Feeney – Wachovia.

Jonathan Feeney - Wachovia

I wanted to think about this right, the $180 million in commodity hedging activity those are non-cash hedging adjustments, if you added that back to operating margin you’d get to sort of an apples to apples type number sort of on margin progress am I thinking about that right?

Tim McLevish

That’s correct. If you think about it in Q2 at the end of the quarter we had some hedges that for accounting purposes were considered non-effective and we had to mark them to market. During this quarter essentially the sourcing that we did for these related input costs was unprotected by those hedges and consequently it cost us not cash but earnings reduction.

Jonathan Feeney - Wachovia

Was there any kind of similar impact in ’07 to think about as I try to figure out a year over year, apples to apples is?

Tim McLevish

It was very minimal if anything.

Jonathan Feeney - Wachovia

You mentioned specifically trade de-loading as a potential phenomenon. I’ve heard reports of that as well. Could you talk about, is that a retailer driven thing, is it a consumer driven thing and what regions will be most impacted? If you could just put a little more color around it I’d appreciate it.

Irene Rosenfeld

I’m not making a forecast I was just trying to characterize our guidance and be clear to you that we believe we have taken an appropriate planning stance. The kind of potential inventory impact is at the retailer level as they are struggling with some of the same economic issues that our industry is suffering from.

Jonathan Feeney - Wachovia

Is that mainly in Europe where I’ve heard about that is a big factor in Europe. You said it’s a factor also in the US you believe.

Irene Rosenfeld

Absolutely, I think you look at the earnings profile of a number of our key customers this is a tough environment for them.

Operator

Your next question comes from Todd Duvick - Banc of America Securities.

Todd Duvick - Banc of America Securities

I appreciate your comments on the liquidity situation. I had a question with respect to potential refinancing. You had a note that matured on October 1st and it looks like you must have refinanced that with Commercial Paper in the short term. Can you confirm that and also tell us if you have plans to tap the debt capital markets at any point in the near term?

Tim McLevish

Let me first say our balance sheet remains strong, Kraft has a strong name and we have good access to Commercial Paper market. We did have the bond you identified that matured on October 1st and we did refinance that with short term Commercial Paper. We’ll just have to consider the market conditions as whether we could come up any of our Commercial Paper in the next several months.

Todd Duvick - Banc of America Securities

Do you have any target level with which you’re comfortable having short term debt versus long term debt is there like an average Commercial Paper balance that you like to have on the balance sheet for flexibility?

Tim McLevish

We think we’re well served by having an active Commercial Paper program. You can estimate approximately what that would have been considering the balances at the end of the quarter and the refinancing of the $700 million. Remember we have a $4.5 billion backup facility that remain un-drawn and that was reduced by a small amount as Lehman withdrew from that credit line. We have ample liquidity as Irene mentioned and feel good about our position.

Operator

Your next question comes from Judy Hong – Goldman Sachs.

Judy Hong – Goldman Sachs

I was hoping to get your perspective on your market share trend obviously it improved in the third quarter versus your second quarter but its still down versus the first quarter and I’m just wondering how you feel about the direction of the overall market share trend in the US. As it relates to that you talked about food at home sales getting benefits and trading down to value oriented offerings to what extent is the private label sled more concerning going forward?

Irene Rosenfeld

I feel very good about the progress we’re making on market share, there’s no question that the investments we’ve made over the last couple years are serving us well. It’s strengthened our brand equity and its given us the ability to take the pricing while having less impact on our volumes than we had expected going into it.

We do see, as we look out, as the marketplace continues to catch up to some of the cost profiles in a variety of categories we do see that a number of our price gaps are narrowing and as we look ahead we do expect to see continued progress as I mentioned in our market share. The other thing I’d mention to you with respect specifically to share is that we are seeing an increasing disconnect between free outlet shares and total market performance as consumers are increasingly value conscious and they’re doing some channel shifting.

In some respects you don’t have full visibility to our total share performance. That said, I think we are well positioned in the current environment. Our categories are clearly consumer staples and are definitely part of the general consumption patterns. Our increasingly broad geographic, particularly the position of LU biscuits I think is serving us well. A number of our brands provide very strong value propositions at any time but especially in the current environment brands like Jell-O, Kool-Aid, Mac and cheese for example.

Even within categories very good coverage across price points. If you look at a given category like Pizza for example we’re covering the spectrum of pricing from Tombstone all the way up to California Pizza Kitchen. Importantly I think the most overriding trend that’s impacting and its helping our business is that we are benefiting as more consumers eat at home and we have offerings that compare quite favorably things like Deli Creations or even DiGiorno frozen pizza.

Net net I feel good about the progress that we’re making on share in large measure as we’ve suggested to you in the past there was some temporary dislocation in the second quarter which we can now see to get into correct itself and I’m quite optimistic about our prospects going forward.

Judy Hong – Goldman Sachs

If you look at your 2009 guidance at least $2.00 per share that hasn’t changed I guess since September. I’m just wondering how much of the currency fluctuations recently that you’re factoring into your ’09 guidance at this point.

Tim McLevish

Obviously as Irene mentioned the world has changed since September. We still remain committed to our $2.00 earnings per share in 2009. There are a variety of factors that go into that, the exchange rate certainly is an element of that. All things considered as we look forward in our anticipation of 2009 we remain committed to our 2009 EPS guidance.

Operator

Your next question comes from Christine Mccracken – Cleveland Research.

Christine Mccracken – Cleveland Research

In terms of your outlook on commodity prices and as it relates to the price increases that you’ve taken already I’m wondering we’re hearing a little bit about the retailers pushing back and the pass through of the cost reductions that deflation and how quickly do you think at this point you’ll have to pass through some of those reductions. I think you’ve done it in coffee already. Maybe you could comment on that.

Irene Rosenfeld

Our pricing strategies are competitively sensitive. What I will tell you is that I feel very good that the focus we had over these last couple of years on brand equity has clearly paid dividends and the ability to price we’ve certainly been able to price our brands much more so then we’ve been able to in the past. At this point, as we’ve said, we’re substantially priced to the current market environment.

Having said that, we are well positioned to deal with market conditions. We do see some costs declining but in most cases we’re still looking at costs that are above a year ago. In a couple of cases, for example, wheat and soy beans we’re seeing prices from the chart that we showed you in our deck that were up actually 150% to a 10 year average. We’re still looking at some fairly significant prices.

All that said I need to remind you that our long term growth outlook assumes that we’re simply going to use pricing and productivity to cover costs. Our market expansion actually comes from the leverage of our volume and mix performance. We remain focused on driving our brands and adding value to our brands to enable us to expand our margins through volume mix.

Operator

Your next question comes from Terry Bivens – JP Morgan.

Terry Bivens – JP Morgan

One thing I get a lot of questions about these days is kind of the calculus between what appears to be some commodity help next year versus the currency headwind. One of your competitors in fact mentioned that for roughly every $1.00 they’ve received recently in foreign exchange they paid out about $5.00 in commodities. I know clearly a lot has changed and probably will change as we go into ’09. Can you give us some indication of how you’re thinking about that trade off as we go into next year?

Irene Rosenfeld

As we’ve said we feel very good about the operating momentum as we head into 2009. Clearly the investments that we’ve made in our brand equity and our product quality is paying off well. We’re seeing good performance in all of our geographies around the world. We’ve got a very solid pipeline of cost savings initiatives and as we look into 2009 we have the added benefit of incremental synergies from our LU biscuit business. Our underlying operating momentum is quite strong and as we continue to see the opportunity to invest in the business we will do so and I feel quite good about that.

Obviously though the world has changed and we certainly expected more upside in September then we might see today and as we look at current market rates we see that there are some significant non-operating headwinds but we’re spending all of our time working to offset them. Clearly we’ll have a stronger perspective as we head into next year. Net net I feel very good that within a very challenging environment we are well positioned to succeed.

Terry Bivens – JP Morgan

In line with your comments about a channel shift if you look at the Nielson numbers for what basically covers your quarter in North America sales are indicated down 1% yet your revenues reported are up 6%. Do you think that kind of, clearly there’s a lot of growth going on in the non-measured channels whether its price or volume. Do you expect that to be sustainable?

Irene Rosenfeld

The simple answer is yes. As consumers increasingly are looking for value I think we provide a unique set of offerings, brands like Kool-Aid, Mac and cheese, Jell-O are faring particularly well in the current environment and I see no sign that that will stop in the future. We feel very good about the ability to hold up across all channels as well as our future prospects look quite good.

Operator

Your next question comes from Alexia Howard - Sanford Bernstein.

Alexia Howard - Sanford Bernstein

EBIT growth next year I remember when you made the Danone cookies acquisition late last year you were talking about $200 million in cost synergies from that acquisition. Can you confirm roughly how far through that process you’re at, at the moment and how much of that we could expect to see coming through in ’09.

Is that part of the $1.4 billion of the restructuring, I don’t believe it is but just to confirm we should have a lot of those savings coming through plus the extra $300 million of the restructuring program that’s due to come through beyond the end of 2008, really just trying to get a handle on productivity savings next year.

Then in terms of some of the additional things that you have to put into the pot next it seems that pensions are likely to be something of a headwind next year depending upon the market and then finally advertising spending I’m not sure where you expect to be in terms of advertising as a percent of sales by the end of 2008 maybe you could give some color on that and where you expect to be perhaps by the end of 2009?

Irene Rosenfeld

Let’s start with LU, the $1.4 billion does not include any synergies from the LU acquisition and we remain confident that we see our way clear to deliver those savings. The synergies that we laid out at the time of the acquisition were over a two to three year period and those are more back end loaded but as I mentioned in my remarks we certainly see some incremental opportunity year over year both in terms of revenue and in terms of costs as a consequence of our integration of that business in selected regions.

Net net we see not only our base restructuring opportunities and fundamental cost savings initiatives but we also have some incremental opportunities as a result of the LU integration.

Tim McLevish

As you perhaps know we maintain a balance, an asset allocation of about 70/30 equities through fixed income in our pension plan. You can assume that the plan is performing just about as the rest of the market is. Obviously that puts some downward pressure on our asset value in the pension plan. On the flip side interest rates spiking the discount rate on our pension liability is also increasing.

On balance there’s a fairly significant offset in that and we’ll have to see how those things play out at the end of the year to determine on our measurement base exactly what impact that will have for our pension expense in the next year. I think it’s important to note that our plans remain well funded and we don’t anticipate any required cash contributions this year or going into next year.

Irene Rosenfeld

On your advertising and marketing spending question I feel very good about the investments that we’ve made over the last two years and I think they’ve given us an exceptionally strong base from which to build. You’ll see our A&C will be up again in 2008 despite the challenging cost environment. We should come in at about 7% of net revenue. I feel particularly good about that as we watched some of our peers take their spending down. Net net we will continue to invest in the business and build on the equities that we have been creating and I feel very good about our prospects going forward.

Tim McLevish

It’s important to know that the beginning of the year we had indicated that we anticipated 7.5% of A&C spend a percent of revenue. We will spend the same number of dollars that we had anticipated at that time however the percentage of revenue will come down to a little over 7% as Irene identified purely as a result of the denominator impact of the significant growth.

Operator

Your next question comes from David Driscoll – Citi Investment Research.

David Driscoll – Citi Investment Research

I wanted to talk to you a little bit more about the market share issue. It seems that you’re interested in the sequential improvement but maybe you could talk a little bit about the year on year declines on the 13 week data. Specifically what I want to understand is these numbers are still negative and when we look at volume data that we can see in Food, Drug and Mass data the volume data is concerning to me. In cheese, for instance, your top category in the United States, Kraft equalized volumes were down 19% in FDM data while private label was up 11%.

It was a 30 point gap between the two and I’ve never seen a gap that large. The question really is with market shares declining and with volumes declining at least in the data that I can see in the measured channels what’s your outlook here for the sustainability of your pricing and really why shouldn’t we be concerned about this a bit more than I think you guys were in the prepared comments?

Irene Rosenfeld

Let me just remind you again, we are seeing tremendous channel shifting in the current environment. For starters, it’s increasingly difficult for you to look at IRI data for example and forecast our total market share performance and I think as you look at our shipments and certainly recognizing nobody’s building inventory right now. As you look at our shipment profile it is clear that we are consuming more than you can see in the traditional channels. There’s clearly some channel shifting going on.

We knew that there would be some temporary dislocation we were quite active and aggressive in our pricing in relation to the cost situation earlier in the year. We knew that there would be some temporary dislocation and we talked about that quite a bit at our second quarter call. If you look at categories like cheese, for example, and there’s no question we are not pleased with our cheese share performance.

If you look at the relative segments we are consciously sacrificing some volume and less profitable segments like natural cheese which is the bulk of our share decline relative to segments like process cheese and cream cheese, and Velveeta in particular if you look at that business is exceptionally well positioned in the current economic environment.

We’re making some very conscious trade offs, category by category, segment by segment within our categories and we remain confident that our outlook going forward is that we will see more than half of our shares growing on a sustainable basis. I come back to the fact that there’s some temporary dislocation as a consequence of our pricing in response to the cost environment but we are clearly seeing that begin to recover and I have great confidence that it will continue to recover in the coming months.

Operator

Your next question comes from Eric Katzman - Deutsche Bank.

Eric Katzman - Deutsche Bank

My first question has to do with the international and EU results excluding both acquisition and currency. Maybe you could talk a little bit about what those numbers look like because we’ve been hearing some very distressing things about what’s coming out of Europe and I want to try to judge how you’re doing on the core business with the understanding that you now own Danone and that’s going relatively well.

Tim McLevish

We’re quite pleased with all of the progress we’ve made in the International business, particularly the EU has shown good progress from levels it has in the past. We showed solid organic revenue growth and we showed a significant improvement in OI margin. Obviously the LU was a contributor to the reported numbers but even in absence of that we showed a nice profit improvement in the EU.

Clearly there are signs that the EU is slowing. You’ll have to follow up with Chris after the call as to the specifics. We lay out an EU number but I can’t give you a sub-breakout of that.

Eric Katzman - Deutsche Bank

I’ve heard from a number of companies that are competitors of yours or just in the food space and watching from afar and it sounds like your efforts at Wal-Mart in particular are spending something like $120 million on a promotional program trying to maybe have your own aisle. I know it’s difficult to talk about a specific retailer but it seems like I guess from your numbers that that’s been a correct decision. Can you talk a little bit more about your willingness to spend so much on promotion in that channel?

Irene Rosenfeld

Let me be clear, we are not spending so much in promotion in that channel. Clearly the information you’re getting is coming from other companies and its an interesting thought but we are spending fortunately in the marketplace and I feel particularly good about our performance with a customer like Wal-Mart because they are a growing retailer, they are well positioned in the current economic environment and our value positioning is working quite well together with them.

I feel particularly good as we move forward here that as we see the success of some of those value meal programs other of our customers are jumping on board and particularly with the wall-to-wall capability that we now have at retail I am quite comfortable that we will see continued progress with other key customers as well. I feel very good about the program that we have with Wal-Mart.

We look forward to continuing to build on that success but going forward we have some very exciting programming across the marketplace really driven by the fact that we have so many product and brands that really are fitting uniquely well into the current value space.

Operator

Your next question comes from Chris Growe - Stifel Nicolaus.

Chris Growe - Stifel Nicolaus

You had anticipated cutting back on your trade promotion spending this year. Has that changed throughout the year whether it be the pricing environment or the competitive environment where you’ve actually had an increase that level of promotion?

Irene Rosenfeld

We’re not giving a specific numbers with respect to the mix of our spending but we remain committed to the opportunities as I mentioned in my remarks of continuing to refine our trade spending to make sure that it’s much more performance based that it’s serving the businesses that get the most impact for that spending. As a consequence of that we’ve been able to make some terrific progress in building our brand equities while still maintaining our volume. I think that will be a program that will continue as we go forward and we are committed to making that shift over time.

Chris Growe - Stifel Nicolaus

Earlier in the year you talked about reducing trade promotions $200 million for this year is that something you can confirm?

Irene Rosenfeld

Yes I can confirm that in fact is in the numbers we’ve given you today.

Chris Growe - Stifel Nicolaus

Are there any other categories where you anticipate price increases whether you want to discuss which ones they are or not are there any areas where you’re still looking to take a little bit of pricing given your current cost environment?

Irene Rosenfeld

As I said earlier obviously our pricing strategies are competitively sensitive. I feel terrific about the brand equities of our core brands as a result of the investments that we’ve made. We are substantially priced to current market prices today. Importantly I think we’re well positioned as we go forward here to respond to market condition either up or down.

Chris Growe - Stifel Nicolaus

Relative to your wall-to-wall program can you give any numbers around that what that’s adding to sales growth especially if you can define that?

Irene Rosenfeld

At this point we’ve essentially rolled wall-to-wall out to all the markets that we intend to. We believe it is a key reason that our volumes in North America have held up better than expected. If you look at our North American volume it was down about 1.5% against about 6.5% pricing. I feel awfully good that the merchandising capability that we have at retail is a key driver of that. I truly believe it will continue to be a source of competitive advantage for us.

Operator

Your next question comes from Ken Zaslow - BMO Capital Markets.

Ken Zaslow - BMO Capital Markets

When you talk about volume and pricing is there, I see what you’re saying the volume wasn’t down as much as you anticipated, is there a balance that you want to have where you can get like 2% to 3% volume and then 3% to 4% pricing? How do you maximize that and where do you think that stands right now?

Irene Rosenfeld

We’re in a little bit of a dislocation right now. I think we all understand that the cost environment has been disproportionately high over the course of the last year and a half. I want to remind you our long term growth algorithm is that we will rebuild our brand equity to the point where pricing and productivity will cover costs and we will rely on volume growth and mix to essentially expand margin. Clearly volume growth in the range that you’ve laid out is part of our long term algorithm. As we’ve said, in the short term pricing is contributing disproportionately to our revenue growth.

Ken Zaslow - BMO Capital Markets

There is no difference in the margin, what I think about is if you have less volume does that increase your fixed costs in that operation an then does the pricing fully offset that in margins. I guess that’s what I was trying to get at. I don’t know if you can comment on that.

Irene Rosenfeld

First of all it’s pricing together with productivity that is meant to offset input costs. The answer is as we look today at market pricing we feel very good about our profile. A key for us still going forward is to ensure that we continue to drive brand equity and drive the growth of our categories.

Ken Zaslow - BMO Capital Markets

With the channel shifting are there any channels that you’re under indexed that you think that there might be some extra growth opportunities there? In terms of channel shifting is there any margin compression based on bigger sizes or anything like that we should be aware of?

Irene Rosenfeld

We’re well represented across all channels and that’s why I think that we are uniquely well positioned to win in the current environment. To the extent that there are different margin profiles from one channel to another that’s something that we continue to work on over time so that as the consumer moves from channel to channel that’s not impacting our margins. To date that has not been an issue.

Operator

Your next question comes from Eric Serotta - Merrill Lynch.

Eric Serotta - Merrill Lynch

To pick up on one of Ken’s questions in terms of pricing versus volume clearly as you mentioned this year as expected organic top line is driven primarily by pricing with a much smaller contribution from volume. As we look to calendar 2009 I think it’s fair to assume that absent the tremendous cost pressures or looking at more moderate cost pressures or even cost relief you’re not going to be able to lean on that pricing lever so much. It seems that volume has to play a much larger role in the overall organic top line growth mix.

I’m wondering whether you could dimensionalize for us qualitatively at least what some of the drivers that you expect volume growth to be between on the one hand you have a softer consumer environment on the other hand that could play well into some of your category growth, your internal efforts in terms of rebuilding your brand equities and other factors behind that. If you could talk about some of the drivers you’re looking at for volume growth next year.

Irene Rosenfeld

One of the reasons I feel particularly confident that within this very challenging environment we’re well positioned to win is the nature of our portfolio. We’ve got a number of categories that are consumer staples and will be relatively consistent regardless of the economic environment. Our geographic footprint is increasingly broad particularly with the addition of the LU biscuit business.

We have a very strong value proposition across our portfolio with brands like Kool-Aid and Macaroni and Cheese and Jell-O. We’ve got very good coverage within categories on key price points as we look at individual categories so we cover Maxwell House up to Tassimo and biscuits we cover Biscuits all the way up to Oreo. We’ve got very good price coverage within categories to address the fact that we do see some consumers trading down.

Importantly we are clearly benefiting as more consumer come home to Kraft, that eating at home and businesses like DiGiorno, like Deli Creations have very strong value propositions relative to away from home alternatives. The other point is that as our wall-to-wall capability continues to improve and we learn more and more about what we need to do to train this army alloys we are an increasingly valued partner to our customers and I think that opportunity will continue to drive our volume particularly in North America.

Net net I think there’s a number of characteristics about our portfolio as well as our sales capabilities that will enable us to continue to grow within the current environment. As you rightly point out as we look forward the contribution of volume mix to our revenue performance is likely to improve as we exit the exceptionally high input cost environment that we’ve been dealing with.

Eric Serotta - Merrill Lynch

At the level of volume growth that you’re looking at for next year is it reasonable to expect to see some material improvement in your operating leverage or fixed cost leverage versus what we’ve been seeing in 2008?

Tim McLevish

I’ll remind you we have guided to 4% organic revenue growth in 2009 and we would expect to see a much better distribution back to our normal long term distribution between volume mix and pricing as we go into next year. Obviously with more volume contribution from it we would expect more leverage contributions to the bottom line from that.

Eric Serotta - Merrill Lynch

A lot of people seem to be focused on the three outlets of syndicated data which you’ve pointed out the results clearly show there’s a real disconnect between that and the all outlet data. Do you have any numbers that you could share with us in terms of composite category growth or growth in some of your key categories in all outlets?

Irene Rosenfeld

We don’t provide a specific number like that because it actually wouldn’t be a meaningful number but what I will tell you is the vast majority of our categories across the board are growing quite healthily. In response to the fact that these are consumer staples that offer exceptional value in the current economic environment. It’s one of the reasons that we are optimistic about our prospects going forward.

Operator

Your next question comes from Bryan Spillane – Banc of America.

Bryan Spillane – Banc of America

Thinking about volume drivers for next year given what you’ve done in terms of pricing and productivity and thinking about that relative to your competitors and especially private label are you now the low cost producer in many of your product categories? If so is that going to help change the way you try to manage volume and share going forward?

Irene Rosenfeld

Obviously our divisions with respect to how to best to manage revenue growth, profit growth and our share performance is going to continue to be important to us as we go forward and we’ll be making the appropriate trade offs category by category. We feel very good about the productivity that we’ve turned in over the last few years.

I think particularly with our new organizational structure the decentralization is not only making our business unit managers more accountable for productivity but its causing them to look at their business on a end to end basis and that’s turning up a whole host of productivity opportunities that we might not have seen in the past. It’s one of the reasons I am so optimistic about our prospects going forward. I feel very good about our cost position. We will continue to focus on that as an opportunity to make sure that to enable us to invest appropriately in our business.

Operator

Your next question comes from Robert Moscow - Credit Suisse.

Robert Moscow - Credit Suisse

The concern I get from investors is about emerging markets and whether they can withstand the global credit crisis and how consumers are going to behave there. A lot of your growth this year has come at 50% run rate in profit growth in emerging markets. What are you doing in those markets to make sure that we don’t have a repeat of blow up that we’ve had in the past I remember 2003 was a very bad year for Latin America. Having been to Russia I’ve heard that some retailers are starting to push back and not allow price increases. Can you give us a sense of what you’re seeing in those markets?

Irene Rosenfeld

To date we’re seeing a lot more indications of consumer weakness in the media headlines then we’ve been seeing in our numbers. Without a doubt we are concerned about the economic environment particularly in developing markets going forward. I feel very good about the focus strategy that we’ve implemented within our international business. This idea of focusing on the brands, the categories and the markets where we have the highest potential and we’ve made significant investments and will continue to do so behind the brand equities in those markets.

I think that will continue to serve us well even in the event of a slow down. Most importantly as you look at our performance particularly in International we’ve been growing well in excess of our long term target. Even if these markets soften somewhat I think we’re well positioned from a portfolio standpoint and we certainly have a little bit of headroom to be able to see those numbers come down a little bit and still deliver the guidance that we laid out for you.

Robert Moscow - Credit Suisse

You’ve kept your guidance for commodity costs unchanged for the year despite the fact that a lot of these commodities have come down a lot. Can I assume that means that you were hedged for the year and therefore there’s no impact? As we look into ’09 should we expect your commodity inflation headwind to be just much less severe and maybe more like a single digit number than a 13% number?

Tim McLevish

As we look at the remainder of the year we’re closing in on the end of the year and obviously we do have hedged positions on most of our major commodities. In normal course, according to our natural hedging program the prices have very recently come down and most of those are either already in inventory or have short term hedge positions.

Clearly as we look out into 2009 we wouldn’t anticipate the amount of increase that we saw in 2008 in our major commodities so to the degree it will come down we’ll just have to play that out. As of right now we wouldn’t anticipate significant increases in commodities. Given the very recent volatility and changes it’s too early to anticipate what impact it will have on 2009.

Robert Moscow - Credit Suisse

Is it even conceivable that the number could go to zero?

Tim McLevish

The increase?

Robert Moscow - Credit Suisse

Yes.

Tim McLevish

I think that’s not inconceivable for it. We’re not in the business of forecasting those obviously we have to manage those inputs. We have to manage our hedging position and so forth but clearly we’re at historical 10 year highs on virtually every one of our major commodities and to assume that we’re going to see significant increases past that is probably a bit of a stretch.

Operator

Your last question comes from Andrew Lazar – Barclays Capital.

Andrew Lazar – Barclays Capital

To follow up quickly from Rob’s question, is there a way you can give us sense of how much you either are or are not hedged into ’09 at this stage. The reason I ask is it begs the question I think there’s an expectation now building in the group as a whole that as we move into ’09 if year over year inflation is a lot less substantial perhaps there’s a case to be made for margin improvement to really snap back in some cases maybe dramatically in the group. I’m trying to get a sense of whether this is really a reasonable expectation in your mind.

Tim McLevish

Let me start with the question of our hedged position. We run as we’ve said before an ongoing hedging program to protect our margins going out until our ability to price at the end of the day we’ve communicated to you our algorithm that pricing and productivity will cover costs and that volume will provide overhead leverage and improve our margins.

Our normal program would naturally be hedging out some six to nine months on some commodities where we see that we need protection and our view of the pressures upward or downward of those individual commodities. I can’t give specifics about how long on specific of the commodities but generally we haven’t made a change to our hedging program in recent months.

Irene Rosenfeld

I want to underscore again we are not relying on our pricing for margin expansion. We are priced, we feel very comfortable that we’re priced to market costs right now and we will be able to go with the market up or down but that’s not the basis for our ability to expand margin over time.

Tim McLevish

Before we close can I go back to Eric Katzman’s question which was EU margins ex LU and ex currency. I’ve cleared with our disclosure experts here and can say that ex FX which contributed about 5% of the EU operating income and ex LU we would be in double digits operating income in the EU in the third quarter.

Chris Jakubik

Thanks very much for joining us and have a good day.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Kraft Foods Inc. Q3 2008 Earnings Call Transcript
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