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H.J. Heinz Company (NYSE:HNZ)

F3Q09 Earnings Call

February 24, 2009 8:30 am ET

Executives

Meg Nollen - Vice President Investor Relations

Art Winkleblack - EVP and CFO

Ed McMenamin - Senior Vice President, Finance and Corporate Controller

Analysts

Chris Growe – Stifel Nicolaus

Eric Katzman – Deutsche Bank

Terry Bivens – JP Morgan

Alexia Howard – Sanford Bernstein

Robert Moskow – Credit Suisse

David Driscoll – Citi Investment

Andrew Lazar – Barclays Capital

David Palmer – UBS

Ed Roesch – Soleil Securities

Operator

(Operator Instructions) I would like to welcome everyone to the H.J. Heinz Company Fiscal Year 2009 Third Quarter Earnings Release Conference Call. I’d now like to turn the call over to Meg Nollen, Vice President of Investor Relations.

Meg Nollen

Welcome to our conference call and webcast. Copies of the slides used in today’s presentation are available on our website at Heinz.com. Joining me on today’s call are Art Winkleblack, EVP and CFO and Ed McMenamin, Senior Vice President, Finance and Corporate Controller.

Before we begin with our prepared remarks please refer to the forward looking statement currently displayed. This is also available in our release this morning as well as in our most recent SEC filings. To summarize, during our presentation we may make forward looking statements about our business that are intended to assist you in understanding the company and its results.

We ask you to refer to our April 30, 2008, Form 10-K, which lists some of the factors that could cause actual results to differ materially from those in these statements whether as a result of new information, future events, or otherwise, except as required by Securities law. We undertake no obligation to update or revise.

We may also use non-GAAP financial measures in our presentation as the company believes such measures allow for consistent period to period comparison of the business. The most directly comparable GAAP financial measures and reconciliations of these non-GAAP measures are available in the company’s release, at the end of this presentation and on our website at Heinz.com.

Please note we plan to file our 10-Q this afternoon. Related financial highlights pages or stat pages will then become available in the Investor Relations section of the website towards the bottom of the page. Now with the formalities out of the way let me turn the call over to Art Winkleblack.

Art Winkleblack

Since we saw many of you in Florida last week we’ll try to be brief today. The key is that this was a solid quarter for Heinz and we remain on track for our full year targets. Ed’s and my remarks this morning will be focused on helping you understand the key drivers that shaped the results. Overall, the quarter included growth in organic sales of 2%, net income of 11%, EPS of 12% and operating free cash flow up a very strong 25%.

I’m particularly pleased that we posted positive organic sales growth in light of the current environment and during a quarter in which we lapped our strongest growth quarter from last year and where the timing of price increases negatively impacted volume in our US Consumer Products business. I’m also gratified to see our significant increase in cash flow largely driven by improvements in inventory.

For the quarter, reported sales were down 7.5% but after screening out the impact of currency we are up about 4%. This is a solid result given that the quarter included a very tough month of January for the entire industry. Operating income was a similar story; reported OI was down 6% but up a very strong 9% when you exclude both translation and the UK transaction currency impacts. Net net very solid numbers on a constant currency basis.

Stepping back, you can see that while the third quarter organic sales were slower then recent quarters we continued a string of 15 quarters of positive organic growth despite lapping almost 9% growth in Q3 last year. Continued organic top line strength in Europe and in the emerging markets was partially offset by Food Service and negative timing impacts in US consumer products after a very strong first half. Year to date, organic sales growth is up approximately 6% and we remain on track for reaching our target of around 6% for the year.

Clearly pricing has become a more important driver of our organic growth based on the unprecedented commodity cost inflation that we and the industry have experienced. Third quarter pricing hit 8%, a high watermark for the company over at least the last 10 years. As you know, we’ve been driving very strong profit growth over the last three years by pricing somewhat behind inflation in order to optimize organic growth. In so doing we traded off a couple of gross margin points shown on the bottom of this chart, while strategically focusing on growing gross profit dollars.

At CAGNY we discussed the shift of our strategic focus back to margins and driving cash flow in this new environment. Encouragingly we believe that we have completed the bulk of the pricing we need for now in most markets and have already begun to stem the gross margin erosion this quarter, down 40 basis points year over year, 30 basis points of which relate to the UK transaction costs.

Taking a deeper look at sales now, our top 15 brands were up almost 2% for the quarter despite the timing impact of price increases on volume. Growth this quarter was driven by the Heinz brand which was up 8% year on year. Importantly, on a year to date basis our top 15 brands are up 7.5% organically.

Let’s take a quick spin around the Heinz world and outline some of the key factors driving our growth. We posted 9% organic growth in our flagship product, Ketchup, largely driven by net price improvements in most markets. To achieve this growth we leveraged new packaging and the grown not made campaign across Europe and as we discussed at CAGNY we’re now adapting the campaign for the US market.

We’re also executing further packaging standardization and upsizing strategies across our developed markets. Finally, Ketchup is becoming a staple in more Latin American markets such as Mexico where we are rapidly gaining share in the world’s ninth largest Ketchup market.

Infant nutrition was another key growth driver for the quarter with organic sales up 7%. Growth was paced by strong performances in India, Latin America, China and Canada. Additionally, in Italy we are seeing improved share performances in both biscuits and milks and in jarred baby food on the strength of new bonus packs and on pack couponing. We’re very pleased with our consistent organic growth in this category. On a year to date basis we’re up nearly 10%.

Turning toward Europe, we grew organic sales by 5% led by strong pricing in the UK, continental Europe and Russia. Our growth was underpinned by strong results in our large UK Soup and Beans categories. These recession resilient categories have responded well to our extensive innovation and marketing initiatives. We have better than a 60% share of the UK soup market and drove organic growth of more than 20% for the quarter.

In beans we saw heavy competitive promotional activity in the category beginning in December and responded with a flight of new advertising and in store activity including the return of the Beans Means Heinz campaign and in store displays of our innovative snap pot beans in the bread aisle to capitalize on Britain’s hunger for beans on toast.

Looking to the continent, we had another success story with our Honig brand which posted organic sales growth of almost 10% in the quarter. Honig soups and ready meals are another great example of our on trend products perfect for an economy where consumers are seeking convenient economical meal solutions.

Turning to the US, the overall grocery market had a difficult 12 week period and January was especially tough. Nielsen reported total US Grocery unit sales across all center store categories down 3.6% for the 12 weeks ending January 24, widening to a 4.6% decline for the most recent four weeks. This contraction suggests potential pantry de-loading by consumer and a shift in non-measured channels such as club and mass merchandisers.

We believe this is a cyclical shift and our categories have been holding up reasonably well as we adapt our go to market strategies to maximize performance across a full range of channels. I believe this shows the severity of the jolt to consumers coming out of the holidays and seeing all of the doom and gloom in the press. While it’s still early we are seeing a bit of a rebound from this trend in February.

Another factor affecting Heinz in the US this quarter was the impact of the recession on the Frozen Nutritional Meals category. The category in Q3 was down 7.5% in volume and about 7% in value terms. As Bill discussed last week at CAGNY mothers tend to cut back spending on themselves as they focus on meeting the needs of the family within a constrained food budget. We saw similar behavior in the economic downturns of the 1990s and through the first half of this decade.

Our base off the shelf volume remains the healthiest in the category remains the healthiest in the category but our less profitable promoted volume was down significantly in the quarter. Again, as Bill mentioned, we will resist chasing promotional volume preferring to continue adding value to consumers.

Examples of added value in Smart Ones include the expansion of the franchise to a 24/7 Lifestyle Brand including our new Morning Express range of breakfast sandwiches and quesadillas that many of you enjoyed at CAGNY, and the new range of Artisan Creations pizzas that feature a superior bread technology.

Again, Smart Ones base trends continue to out pace the category but total organic sales for Smart Ones in North America declined 7% in the quarter although they remain up 4% on a year to date basis. Overall, we’re confident in our ability to resume strong growth for the brand as economic conditions improve just as we have done in the past. We firmly believe that we are employing the right strategy of patience and prudence, up to a point.

Turning to frozen potatoes in the US, Ore-Ida has been an ongoing success story driven by a steady diet of innovation. Steam n’ Mash for example was timed extremely well with what Bill called the current meatloaf and mashed potatoes economy we’re now in. Year to date, Ore-Ida’s organic sales are up double digits, reflecting innovation and pricing required to cover significant cost inflation on potatoes.

Retail take away for Ore-Ida remains solid but our shipments were down for the quarter. Last year, retailers built inventory in the third quarter ahead of a February price increase. This by itself created a tough comparison for this year’s quarter which was exacerbated by a commodity based price increase this October effectively pulling cases into Q2 and reducing shipments in Q3. Importantly, we’re off to a good start in the fourth quarter.

A real success story in the quarter was Classico in both the US and Canadian markets. Like Steam n’ Mash, the product is right on trend for the times. People are coming home to prepare inexpensive meals such as pasta and Classico is the perfect way to top off the meal. Overall, Classico’s organic sales grew 9% in the quarter as we implemented pricing and launched a consumer preferred, easier to open jar. We posted another strong quarter with organic sales growth of 9%.

As we discussed at CAGNY a part of our strategy and an increasing component of our growth story. Our strong brand, infrastructure and go to market capabilities allow us to drive disproportionate growth in these markets. We expect this to continue as economic growth in these markets, while slowing a bit from their torrid pace of the past few years is considerably outpacing GDP in developed markets.

Emerging Markets represented 13% of Heinz total sales in Q3 up from Q3 last year and up two points from Q3 FY07. We’ve been growing in these markets for many years through good times and bad. In this quarter, Emerging Markets stepped up and delivered more then two thirds of the organic sales growth for the total company. Emerging Market growth was led by Latin America, India and Russia, with infant nutrition and Ketchup being the stand out categories.

Latin America increased organic sales by 36% related to continued gains on Ketchup and baby food and strong net pricing in line with increased commodity costs. India experienced strong organic growth of 14% reflecting continued gains in Complan distribution for Glucon-D. Russia increased organic sales 6% despite a very difficult economic setting driven by record Ketchup results and a growing presence in baby cereal and in baked beans.

Another growth driver for the quarter was acquisitions. Over the last 10 months we’ve made four relatively small but strategically focused bolt on acquisitions. We bought Wyco in April, Benedicta in August, La Bonne Cuisine in November and Golden Circle in December. These acquisitions contributed about $65 million or 2.5% of sales during the quarter and we expect them to be slightly accretive to earnings in FY10.

Wyco and Benedicta are core sauces businesses but leverage our strength in the Ketchup condiments and sauces category in continental Europe. La Bonne Cuisine is a small dip business that adds incremental chill capabilities in New Zealand and Golden Circle is an iconic health and wellness brand that will have great synergies with our Australian business. The acquisition increased the size of Heinz Australia, elevating it to a $1 billion Aussie dollar company. For the coming quarters our focus now turns from making acquisitions to profitably integrating these businesses into Heinz operations.

Turning to the bottom line, EPS is $0.76 was a very strong result and frankly above our expectations much of which was timing related. In a nut shell we had very strong constant currency operating income and a lower then normal tax rate. Going the other way we had a significant negative impact from foreign currency both from translation and transaction which was only partially offset by mark to market gains.

Our pricing, productivity and austerity measures helped improve operating margins in the quarter despite the continuation of major commodity cost inflation. Again, I’m pleased with our cash flow which was up 25% from year ago. In addition to strong profitability we held the line on CapEx and our inventory reduction initiatives began to make a real impact.

With that let me turn it over to Ed.

Ed McMenamin

I’ll now take you through a detailed review of Q3 results and a brief overview of our year to date performance. Let’s first take a look at our P&L Scorecard. As a result of an 11.4% headwind from currency translation sales for the quarter were down 7.5% despite gains in organic sales and contributions from recent acquisitions. Gross margin at 35.4% was down only 40 basis points from last year as increased commodity costs offset significant pricing and productivity improvements.

Consumer marketing was down $14 million for the quarter primarily due to currency. Operating income was off 6% to prior year but up 6.8% if you exclude the effects of foreign exchange translation and almost 9% when adjusting for the cross currency impact in the UK. As a result of tight cost controls and favorable insurance benefits operating margins rose 20 basis points to 15.8%. Looking below operating income, we were able to offset a portion of the foreign exchange translation impact that hit us at OI with currency hedges.

In addition, we recognized gains on the swaps related to the daily re-marketable securities that we closed in December. Aided by a reduction in the effective tax rate we drove an 11.8% increase in EPS to $0.76. Looking at the whole P&L currency translation reduced FY09 results for sales by 11% and operating income by 13%. I’ll go into a more detailed explanation on net sales, gross profit and operating income in the upcoming slides but would like to comment on several other P&L line items at this point.

SG&A was down almost 10% this quarter and at 16.3% of revenue intensity improved by 40 basis points from last year. In the current economic environment we will continue our focus on controlling costs by pruning discretionary spending while prioritizing our efforts on initiatives that will drive long term success of Heinz.

The $33 million improvement in net interest and other expense was driven by two significant items. We recognized $17 million in currency gains resulting from the FX contracts we purchased early this year to protect the translation of earnings from four of our largest marketing for fiscal ’09. Additionally, we recognized favorable mark to market gains on the total rate of return swap which we entered into in conjunction with the re-pricing of the company’s re-marketable securities on December 1st. Since then, debt markets have improved resulting in a $14 million benefit to the quarter.

The additional interest expense from the re-marketable securities themselves was largely offset by the reduced cost on the balance of our floating rate debt.

The effective tax rate for the quarter was 26% compared to 31.6% last year. This improvement is primarily due to favorable resolution of foreign tax reserves, foreign tax planning as well as lapping its charge last year due to an Italian tax law change. At this point we expect our full year effective tax rate to be approximately 29% an increase from the 28% average year to date.

Shifting to revenue, you can see that we drove organic sales growth for the quarter by 1.6%. Price increases have been broadly implemented across the company’s portfolio and contributed 8% to the top line and helped to offset higher commodity costs. Buying decreased 6.4% in part due to the effect on customer purchase patterns resulting from the timing of price increases as well as some volume trade offs in order to realize price and recover some of the lost margin we’ve experienced the last couple of years.

Acquisitions net of divestitures increased sales by 2.3% reflecting the acquisitions Art discussed. Finally, we faced an 11.4% decline from unfavorable foreign exchange primarily in Europe but the dollar has strengthened this year against virtually all markets.

Turning to net sales by segment, we delivered solid organic growth in Europe and outstanding performance in the Rest of World segment. Also our emerging markets posted 9.1% organic growth as we continued focus on these markets where economic growth remains well above the global average.

Looking first at Europe, organic growth was almost 5% with a 9.7% price benefit led by increases across most of the product ranges in the UK, Russia and Italy. Volume decreased 4.8% across Europe primarily in these same markets. Acquisitions increased sales by 3.2% with the additions of Benedicta this year and Wyco late last year. Unfavorable foreign exchange translation rates decreased sales by almost 21%.

Our North American Consumer Products segment realized pricing of 5.8% while organic sales decreased 1.8% reflecting a 7.6% volume decline. New product introductions including TGI Friday’s Skillet Meals and Ore-Ida Steam n’ Mash as well as volume improvements in Heinz Ketchup were more then offset by declines in Ore-Ida Fries, due to the timing of price increases and softness in frozen entrées that Art discussed earlier. Unfavorable Canadian exchange rates decreased sales by 3.8%.

US Foodservice continues to be hit hard by the economic trends which have resulted in reduced foot traffic at many of our restaurant customers. Pricing in the segment was up 4.6% while volume declined 8.7%. As we continue to simplify the business and reduced complexity by eliminating numerous skus and exiting unprofitable businesses.

Asia/Pacific organic sales were off slightly as a 7.2% price increase was edged out by a 7.6% volume decline. Volumes were down as we implemented price increases and in some cases were confronted with competitive promotions and difficult economic conditions for our consumers. One standout was our Indian business which delivered solid volume and price growth driven by the Complan brand. The acquisitions of Golden Circle and La Bonne Cuisine increased sales 8.9% while unfavorable translation rates decreased sales by 16.9%.

In the Rest of World segment total sales increased 22% driven by 32% organic growth. Volume increased 2.7% driven by increases in Latin America and the Middle East. Higher pricing increased sales by almost 30% largely due to inflation in Latin America and commodity related price increases in South Africa and the Middle East. Foreign exchange translation rates decreased sales by 9.7%.

As I noted earlier, gross margin was down 40 basis points in Q3. This is the narrowest gap to prior year we have seen in almost two years. We estimate the market inflation on our basket of commodities was approximately 11% for the quarter with packaging, potatoes and tomato products up from prior year levels. Additionally, the cost of goods in the UK sourced from Europe were impacted by the change in the Pound/Euro cross rate which on its own cost us around 30 basis points of the total 40 basis point decline this quarter.

In aggregate, inflationary increases represented an impact of 560 basis points to our gross margin. The combination of net price gains together with other productivity initiatives completely offset inflation this quarter. Inefficiencies due to product cut backs to reduce inventories and increased maintenance offset some of our productivity benefits.

The balance of the margin change is primarily driven by the new acquisitions which have lower margins then our base businesses but we expect to improve the margins in these businesses as we realize synergies in the coming months.

Turning to operating income by segment, North American Consumer Products grew 4.4% overall and achieved 8.2% growth on a constant currency basis. The growth was driven by pricing and productivity improvements, reductions in S&D aided by declining oil prices as well as reduced G&A and more tightly focused marketing. As I mentioned before, both volume and commodity costs provided some headwinds which we more then compensated for in delivering solid results again this quarter with a 240 basis point improvement in operating margins.

Europe was faced with over 20% headwinds this quarter from translation and another 4% from cross currency transaction movements. As a result, operating income was down almost 19%. Without these currency headwinds operating income would have been up a very healthy 6%. Increased pricing, compensated for commodity inflation and reduced volume while enabling us to continue to increase marketing support and invest in new systems and processes continued to drive the business.

US Foodservice was down to prior year by 22%. The reduced earnings reflect the impact of lower traffic at restaurant customers, limited pricing and significant commodity cost increases.

Operating income in Asia/Pacific was down 23%, 27 points of which related to currency translation. The balance reflects the favorable impact of recent acquisitions and increased pricing partially offset by increased commodity costs and reduced volume.

Finally, our Rest of World segment delivered strong results this quarter up 5.4% driven by volume and significant pricing across the region. Before the impact of translation the Rest of World segment was up over 9%.

Looking at the cash flow statement for the quarter, our 25% increase in operating free cash flow was the result of working capital management. In fact, our cash used for quick operating working capital was about one half of last years requirements in Q3. The increase in other items was largely due a higher tax payment this year.

Additionally, we’ve reduced capital expenditures in the quarter by $10 million. Cash paid for acquisitions of $171 million relates to the Golden Circle and La Bonne Cuisine transactions. The acquisition of Golden Circle also included the assumption of about $70 million worth of debt which have since refinanced. Finally, the dividend payments of $132 million represented dividend yield of about 5% based on yesterday’s close.

Now let’s take a quick look at our performance through the first nine months. Year to date reported sales at $7.6 billion are up a little over 3% and approaching 6% on an organic basis. EPS has grown almost 17% for despite the economic environment we are in we posted solid nine month results at both the top and bottom lines.

A few points to note, gross profit dollars were up slightly while gross margins down 100 basis points reflecting pricing, more then offset by higher commodity costs and the effect of the Pound/Euro cross rate. Marketing spending was down 2.5% on a reported basis but up slightly on a constant currency basis.

Operating income was down 2.8% year to date but adjusting for the impact of currency movements on translation and transaction costs in the UK we would be up over 3.5%. EPS at $2.35 benefited from lower net interest costs, almost 2% fewer shares outstanding, the currency and total return swap hedges and a 140 basis point improvement in the tax rate.

Organic sales on a year to date basis are up about 5.7% reflecting net pricing of almost 7% while volume decreased 1.2% primarily driven by Foodservice. The impact of currency translation was 3.9 points unfavorable while acquisitions have contributed about 1.5 to top line growth.

All of the segments expect Foodservice delivered top line growth both on a reported and organic basis through the first three quarters. In fact, Europe, Consumer Products and Asia/Pac drove organic sales of around 6% while the Rest of World segment delivered gains of around 30%.

Now let’s move to the year to date balance sheet and cash flow metrics. CapEx at 2.4% is better than prior year by 30 basis points despite increased investments in our global SAP implementation. The cash conversion cycle at 58 days is up eight days from the prior year primarily due to payables which were down as a result of net investment hedges that were a liability this time last year but have since been paid.

Net debt to EBITDA improved to 2.4x as net debt increased about 2% from last year while EBITDA has improved by 5%. Finally, we’re pleased that we have continued to improve our after tax ROIC which is up 170 basis points over the last 12 months.

Operating free cash flow is up about 20% or $53 million on a year to date basis driven by increased profits including the cash benefits of the translation hedges. QOWC was relatively flat but we did spend a bit more on pensions and prior year incentive accruals. We also reduced capital expenditures by $18 million from last year.

Before turning it back to Art, I would like to take a minute to discuss the currency translation hedges that we’ve mentioned on all the earnings calls this year. As you can see in this chart, we’ve recognized about $109 million in gains on these contracts so far this year with $92 million in Q2 and another $17 million this quarter. A little over half of those gains relate to contracts designed to protect earnings through January.

In simple terms, if we could apply traditional hedge accounting year to date earnings would have been about $0.09 less and we would be able to add $0.09 to what we will eventually report in Q4. If the Pound, Euro, Australia or New Zealand dollars fluctuate further in Q4 we may see further movements below operating income with offsetting translation impact within OI.

With that I’ll turn it back to Art.

Art Winkleblack

Let me build on the topic of currency and then summarize our outlook for FY09 before we open it up for Q&A. Overall we incurred an 11% negative impact of sales in Q3 and a 15% negative impact to operating income from foreign currency including both translation and UK transaction. Fortunately we hedged our key currencies for this fiscal year and have offset much of the net income impact of these movements for all of FY09.

However, there are a number of other currencies that we did not hedge from a translation standpoint that cost us about $11 million or $0.02 per share during the third quarter. Our belief is that this currency issue is cyclical and therefore we will not allow it to deter us from our strategy or our long term plans.

The other currency factor is the transaction cross rates of the UK Pound with the Euro and with the US dollar since the majority of our raw materials in the UK are imported and cross rates are significantly worse then historic norms. We estimate that this cost us $7 million in the quarter and about $23 million

year to date.

Even with these unplanned currency impacts we’re still tracking to full year targets. As Ed and I mentioned, the volatility and timing of mark to market impacts plus a reduced tax rate in Q3 have acted to shift earnings between quarters, in effect, pulling fourth quarter earnings into this quarter.

With these factors in mind I want to reaffirm that we expect to deliver our key financial targets for fiscal ’09. These are organic sales of 6%, EPS in the range of $2.87 to $2.91 which is a growth of 9% to 11% and operating free cash flow of around $850 million. In delivering these results we anticipate a higher then average tax rate in the fourth quarter and a larger impact to the transactional cross rate in the UK.

Finally, as we mentioned at CAGNY the top priority for us is to strengthen our balance sheet and continue growing our dividend.

With that let’s open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Chris Growe – Stifel Nicolaus

Chris Growe – Stifel Nicolaus

Regarding what I’ll call the volume price balance in the quarter clearly you’re volumes are a little worse then expected but I know also North America had some timing factors that led to that. Is there a way you can tell me what volumes would have been ex the North American factor and how you would see generally Heinz pricing which you put in place then the related volume weakness? Is that the right balance right now if you take out that North American factor?

Art Winkleblack

It is the right balance. As I mentioned, we’re about 6% organic growth year to date. We expect to finish the year at about 6% organic growth. Q4 will be stronger then Q3. Certainly there were some timing factors. As you think about it with North America down we estimate roughly about 4.5 percentage points of the drop in North American volume was related to the timing and the price increases on our write up.

Probably two percentage points or so related to Smart Ones and then a bit on an impact from the pantry de-loading, trade de-stocking, things like that but those are hard to quantify. I think we’re striking the right balance and we feel good about where we’re going to end up for the full year.

Chris Growe – Stifel Nicolaus

On retail de-loading or de-stocking have you seen that in your business in this quarter?

Art Winkleblack

As you look at the chart we showed on total US Grocery sales across all categories you saw in the quarter that grocery unit sales were down about 3.5%, in January they were down about 4.5% so that can speak to one of two things going on. Either a shift to the unmeasured channels which I think there was some of that. Also I do think that there was some pantry de-loading going on by consumers as they just got jolted by the economic situation. Certainly we’re hearing about some of the retail inventory trade de-stocking I think there is some of that but its very hard to quantify that. It was a factor but probably not big.

The other point I’d made on that, as you know, it’s a finite thing because the consumers pantry can only go down to so low a level and retail inventories can only go down to so low a level. I think that’s a temporal thing.

Meg Nollen

That was slide 15 we were referring to.

Operator

Your next question comes from Eric Katzman – Deutsche Bank

Eric Katzman – Deutsche Bank

My first question goes to CapEx, if I recall you were maybe a year or so ago talking about raising CapEx as a percentage of sales because of demand in particular in frozen entrées in the US and maybe in some other markets overseas. Is the reversal of the demand outlook the reason why you’re able to cut back on CapEx?

Art Winkleblack

No, we have indeed increased our capital spending over the last couple of years a bit from where we had been. In fact, we’ve put in two new plants over the last few months and completing the one South Carolina on frozen meals. No, we’re going ahead with that. Even with that we’re able to very much tighten the belt on the remaining capital spending.

During this timeframe you would expect us to be very tight on non-essential investments so we’re ramping back on that, continuing to push forward on obviously the capacity that we need and certainly the investments in SAP we’re continuing with. It’s the things in the periphery that are nice to do that we can do them another day.

Eric Katzman – Deutsche Bank

My second question has to do with your marketing spending in the quarter. It was down 15%, can you talk a little bit about that is there any deflation going on, was it a tough comp and was that offset by maybe more promotion above the line.

Art Winkleblack

The marketing spending below the line it was down a bit as you say and most of that, virtually all of that was related to currency. If you look at our full year number we expect our marketing on a constant currency basis to be about flat. As we look forward what you’re going to see is the cost of media coming down and we’re hammering away at that to make sure that we get the benefit of that so that same spending ought to go further in this kind of marketplace.

The other thing as Bill mentioned at CAGNY last week, you’ll see some things like coupons and things like that increase which do just by the nature of the accounting these days show up above the line on promotional spending. Yes, I think you’ll see a bit more of that but not a huge shift.

Eric Katzman – Deutsche Bank

On currency, can you talk a little bit, I know you don’t want to give guidance on fiscal 2010 but can you give us just some sense as to how to think about both the translational and the transactional impact given where we are today on spot rates for fiscal 2010.

Art Winkleblack

We’re going to hold thought on that for now because things are moving so dramatically that it seems like every time we peg a number you wait two days and it’s a different number. We’ll reserve comment on that. We’re also working at ways to offset certain elements of it in terms of the cross rate and things like that. We’re working on a number of elements. A lot of moving parts so I’d rather hold thought on that. As we get to the end of the year we’ll certainly give you a very full picture of the way things look.

Eric Katzman – Deutsche Bank

All else held equal understanding that you can do a few things, so I understand it, you’re expecting to have $110 million hedge benefit that’s run through your other income line in ’09 and you’ve been running about $21 million year to date on the transactional Pound/Euro thing and assuming that that doesn’t change so that’s running at what a $28 million run rate?

Art Winkleblack

Transaction impact this year will probably be a bit larger then that. In fact, we would expect fourth quarter impact of that to be higher then the third quarter.

Operator

Your next question comes from Terry Bivens – JP Morgan

Terry Bivens – JP Morgan

Currency is going to be the big issue in May so we’ll talk about that when we get there. On the operating front, I asked Gary Rodkin this question down at CAGNY, there’s some information to suggest that Conagra’s velocities were waning in the frozen case and now we’ve got this big wall of innovation coming from Conagra. What I’m trying to get at here, have you guys seen anything in terms of what grocers are doing with their frozen allotments, is there less of Conagra, more of Heinz, how is that shaping up so far in January and February?

Art Winkleblack

It would be hard for me to say. Dave Moran would have a better perspective on it. Nothing that has reached me in terms of some seismic shift one way or the other. As you know there is some deep discounting going on in the frozen entrée category. As Bill mentioned its profit less prosperity because fundamentally even with all that promotional spending the category is down.

We feel good about the strength of the base business in Smart Ones where we’re trying to keep our powder dry and sit on the sideline being patient and hopefully prudent. At some point if the environment doesn’t change we will need to respond in one way shape or form.

Meg Nollen

We’ve got innovation coming in Smart Ones and it continues. We’re very excited about the pizzas and how strong they’ve been doing in test markets as we’re rolling out. We’ve got more products coming out in May. We’ll talk to you about those at our analyst day. Smart Ones has a very strong loyal base user. Our sales are the higher margin sales; we’re losing on the incremental low margin sales. The retailer isn’t necessarily disappointed with us.

Terry Bivens – JP Morgan

You clearly referenced the competition coming from Premier Foods in beans and soup. How has that tracked following the end of the January quarter, has that ramped up, stayed about the same, what’s the situation with that?

Art Winkleblack

I don’t have visibility of the Nielsen on a more recent basis. The guys have done a nice job of reacting to the more promotional environment, the new marketing campaign that they’ve come out with and they’ve changed their promotional strategy to be a bit more effective and a bit more responsive to bring some additional value to consumers without spending a great deal more money. The guys are reacting nicely. Time will tell as we go forward. We’ve got such a strong share of that category and by appealing to the nostalgia of Heinz beans its really striking a responsive cord with UK consumers.

Operator

Your next question comes from Alexia Howard – Sanford Bernstein

Alexia Howard – Sanford Bernstein

Are you able to tell us how much the acquisitions contributed to operating income growth this quarter? The 9% constant currency growth included those I’m just wondering what the underlying would have been.

Art Winkleblack

Quite small. They’re relatively small acquisitions but even beyond that the timing of the acquisitions just wasn’t a lot of impact. Once you get down to EPS probably about break even.

Alexia Howard – Sanford Bernstein

Productivity improvements it seems as though on the last couple of quarters those seem to have slowed down at least as it’s presented on the gross margin driver’s line. As I understand it that productivity improvement also includes any savings that you get between what the spot markets are doing on commodity increases then what you actually paid as a procurement and benefit in there as well. Is there something going on that’s cause a bit of a slowdown in productivity improvements or perhaps even causing it to turn negative at this point.

Art Winkleblack

Your point is correct that the productivity has included some of our better then market purchases. Certainly as we come off of some of the very high cost that will tend to slow down in that productivity number. The other thing, Ed mentioned it is that from a productivity standpoint, in order to control inventory we shut factories and things like that, we did the appropriate things to drive our cash flow. As you do that you’re going to take more of an absorption hit from a fixed cost standpoint. That will slow productivity somewhat.

As you know, we’re working very hard on SAP; we’re working hard with the Keystone project and the global supply chain task force to drive not only long term productivity but short term productivity as well. We feel good about where we are but there are a couple of factors that cause Q3 to be a bit slower then where we have been. On a year to date basis we’re probably above the 2.5% productivity markdown that we had talked about at the start of the year.

Operator

Your next question comes from Robert Moskow – Credit Suisse

Robert Moskow – Credit Suisse

The interest expense line at $96 million can I assume that that’s the new run rate on a quarterly basis and will that flow into fiscal ’10 that $96 million?

Art Winkleblack

There’s a number of moving parts in there. As you know, we did the deal of re-marketable securities that has a tendency to drive up the interest expense. We’ve offset that with lower floating rate debt and we’ve also got a bit of a benefit this quarter from the mark to market. There’s a number of moving parts in there so I’d hesitate to project too much going forward other then to say that our interest expense is fully baked into our full year EPS forecast. As I mentioned last week at CAGNY we are working hard to deliver an interest expense number for next year that is relatively close to what it is this year.

Robert Moskow – Credit Suisse

The interest income line had this benefit from this one time $14 million gain which you haven’t stripped out. Is that gain going to continue in this quarter because the debt markets continued to get better since you entered into that $800 million remarketing?

Ed McMenamin

There could be some movement in there. When you take a look at where we were in December versus now where we’ve seen the bulk of the change in the debt market so we wouldn’t see that moving a lot that mark to market on the swap would a standout we wouldn’t expect much movement going forward the rest of this year or even throughout the remainder of the swaps.

Robert Moskow – Credit Suisse

What do you think you’re going to do to get interest expense to be flat year over year for fiscal ’10 and fiscal ’09?

Ed McMenamin

The way to look at is that floating rate debt and we’re about 55% floating rate debt is running pretty favorable now with Libor. The lions share of the on cost of the re-marketable securities we’re going to be able to offset with benefits from the floating rate debt. We think we’ll be able to stay relatively flat year on year. I would look at interest income and interest expense net when I make that statement going forward.

Art Winkleblack

As for the rest of the 2010 fiscal year plan we’ll hold comment on that because we’ve still got work to do to finalize the plans. That’s our perspective at this point.

Robert Moskow – Credit Suisse

The next question would have been pension expense for fiscal ’10 but our models show it somewhere only $0.03 to $0.05 but I’ve seen other predictions that show it to be much higher headwind.

Art Winkleblack

I mentioned at CAGNY last week that we believe we have the cash generation capabilities to put an infusion into the pension plan to moderate or offset much of the impact of pension next year. We’re still working through the plans and unfortunately with the darn pension accounting we won’t know what the discount rate is until April 29, so that’s been a volatile thing. At this point, we’d expect to offset most of any incremental hit there.

Robert Moskow – Credit Suisse

North America volume should we expect a material improvement in fourth quarter once we get past these Ore-Ida comparisons like can you get back to positive again in fourth quarter. A lot of investors are going to feel a lot more comfortable with the story if you could just get that volume number back into positive territory. Investors would be willing to sacrifice a lot of the price. It doesn’t sound like that’s the strategy thought it sounds like the strategy right now is to hold price at all cost.

Art Winkleblack

We’ll always balance it to optimize shareholder value. Stepping back if you think about it, we were about 2% in terms of organic growth in the third quarter just by virtue of the math we laid out you need to be around 6% organic growth in the fourth quarter. We would certainly need North America and we project North America to be stronger then what they were on the overlap basis in Q3.

Operator

Your next question comes from David Driscoll – Citi Investment

David Driscoll – Citi Investment

Regarding the interest expense, can you say what your guidance is then for the full year F09?

Art Winkleblack

I don’t think we’ve pegged a line by line through the P&L. As you know, we’re looking at 6% organic top line and between $2.87 and $2.91 for the bottom line. We don’t see much upside in over delivering on that. We would look for investment opportunities if we found it. The mix of lines in between sales and down to EPS could vary. I’m not sure we have given any specific guidance on that.

Meg Nollen

Particularly with the hedges.

David Driscoll – Citi Investment

That’s somewhat confusing. When I look at these numbers the interest income line was running around $10, $11 million in the first couple of quarters and then you posted $25 million of interest income this quarter. What was the reason for the big change right there?

Ed McMenamin

That was the swap that we talked about, the $14 million.

David Driscoll – Citi Investment

The $14 million swap shows up in interest income not on interest expense. The interest expense number is a pure number that only shows two effects then that change from last quarter, the first effect would be the remarketing of the debt, second effect is the lower rates applied to your floating debt. Is that true?

Ed McMenamin

And any movements in the debt itself, yes.

David Driscoll – Citi Investment

On the currency cross rates that you guys talk about here in the United Kingdom the question I had is you mentioned that you source your raw materials predominantly from outside the UK and thus these cross rates are so important. In many cases when we’ve seen issues like this they are broad sweeping, meaning that they affect all of the players within the industry selling that particular type of product.

While yes it’s a transactional issue related to foreign currency it really is just a raw material cost issue and that’s generally offset by pricing. Why is that not happening in this case, do your competitors no source from the same places you do?

Art Winkleblack

You’re thinking about it the right way. It comes through the raw material costs. We’ve got a huge share of ketchup and beans in particular; beans come in from the United States. Our competitors pull most of their beans from there as well. Ketchup for us comes in from the continent. It’s a factor of driving off raw materials and finished goods on a disproportionate basis.

The question is at what inflation rate can the UK consumer stand it these days given the economic situation. It’s something that we haven’t seen before because that cross rate for many, many years was extremely stable. It spiked up. Do we hope it goes back the other way at some point? Yes, absolutely. It hasn’t yet.

David Driscoll – Citi Investment

If I say it another way, in many of our past conversations you’ve indicated that the company’s pricing plan was to offset the dollar impact of raw material costs. The UK, it really doesn’t feel like it should be any different to me. Would you think that ultimately that’s how it plays out that this whole cross rate issue effectively from our seat goes away because you’re able to offset it again over the course of time?

Art Winkleblack

It’s just the compounding effect of some of the raw material costs very significantly higher it seems like potatoes, things like beans set aside currency are up significantly year on year and look like they will continue to be up. You’ve got that then you combine that with the cross rate it causes tremendous inflation potentially for the UK consumer. The UK given the weakness of their Pound its going to be an interesting environment for the UK consumer on that front.

Over time we certainly hope to pass along all those kinds of price increases. In this case that may be a difficult thing but we’ll see.

Ed McMenamin

Over time the Pound and the Euro have been fairly tightly correlated currencies. What we’re looking at right now is a disproportionate shift unlike anything that we’ve seen probably since the Euro has been out. One would hope that that would start to come back a bit going forward.

David Driscoll – Citi Investment

What was the dollar impact of inflation in the quarter, I don’t think I heard that, I apologize if I missed it?

Art Winkleblack

Total commodity inflation was around 11% from a market standpoint. From the gross margin chart you can probably back into that number.

Meg Nollen

I’ll work with you to back in. We didn’t quote it. We can back into it from the gross margin chart.

David Driscoll – Citi Investment

I believe that Bill said that you expect growth on both sales and EPS on a constant currency basis in FY10. Can I get a little bit more clarity is that in line with the long term model so the issue here is not the fundamental business model being off kilter here it’s the foreign exchange rate would you agree with that characterization?

Art Winkleblack

We feel good about the fundamental business. Our strong constant currency operating income this quarter reinforced that point. Beyond what Bill said, for FY10 we’ll just stick with what Bill said. As we then lock down our plans over the coming weeks and as soon as we have it pulled together we’ll bring you in.

Meg Nollen

Somebody did the back of the envelope for me. Inflation is about $110 million.

Operator

Your next question comes from Andrew Lazar – Barclays Capital

Andrew Lazar – Barclays Capital

With gross margins almost flat year over year when you exclude the transaction costs in the UK. I would have expected pretty significant de-leveraging impact due to the 6% volume decline. Is there a way to give us sense of how much that negative impact might have been on gross margins separate? You netted out from productivity separate from productivity was it a significant negative that you overcame or is that something that we may see the impact of going forward if it didn’t impact the quarter itself. Whenever these companies report volume like that unusually you do see a pretty significant impact on the gross margin line.

Art Winkleblack

I’m not sure I can quantify it for you. We can probably work on that over the coming weeks here too to try to understand that. If you think about the strength of the pricing and the remaining productivity initiatives they offset the commodity inflation. We feel good about that. Clearly productivity was impacted by the absorption related to the lower volume and also tightly managing inventories. I’m not trying to evade the question I just don’t know that number off the top of my head.

We had acquisitions going the other way which would have impacted the mix a little bit. There are a number of factors there. It was a factor, not huge but we’ll try to see if we can help you with that going forward.

Andrew Lazar – Barclays Capital

It’s fair to say that was clearly a headwind that you didn’t have obviously a quarter or two ago when volumes were helping you and we’ll have to see where that goes from here.

Art Winkleblack

Yes, that would be accurate.

Andrew Lazar – Barclays Capital

Bill was pretty clear in being unwilling at this stage to call the end of retailer and/or consumer pantry de-loading and what not. I think he made a comment around February looking a little better. Maybe that suggests potentially the worst of some of this as you described it temporal type of impact is somewhat over. Am I reading too much into that comment around February or not?

Art Winkleblack

February we’re seeing a bit better numbers and a bit of a rebound. Yes, we would hope that the pantry de-stocking and the retail inventory reductions would largely be behind us. Again, how far can you go on that at some point you just get to the minimum you can’t operate either as a household or as a retailer. We’ll keep an eye on it. I would certainly hope that that’s largely behind us. We’ll see.

Andrew Lazar – Barclays Capital

You talked about a base rate of productivity it was around 2.5% or so. Does that include the incremental stuff that you’re getting from Keystone or is Keystone on top of that? I can’t remember if you’ve quantified that.

Art Winkleblack

In terms of Keystone at this point because we’ve gotten through the blueprint phase we’re not doing the programming to turn the blueprint into SAP code. The savings there so far pretty negligible. We are getting some benefit of global supply chain task force initiatives particularly on indirect procurement. Keystone will be a benefit that grows over time as we roll out the systems and get them up and operational in the different business units.

Operator

Your next question comes from David Palmer – UBS

David Palmer – UBS

Has there been any change in competitive behavior recently that you can comment on especially in the frozen aisle? What we’re seeing lately the Conagra has promotions going on with their old green Healthy Choice boxes, the 4/$10 type of deal presumably that would be a temporary thing to get rid of some old inventory. Perhaps just big picture do you think that there’s any light at the end of the tunnel here in terms of the competitive pressure in that category and more broadly if you feel like bringing in other categories or just simply too early to tell at this point.

Art Winkleblack

There has certainly been a lot of promotional pressure during what we call diet season. Diet season will be waning here before too long and we’ll see if we see any slowdown in that. I’m probably not the most up to date on the latest daily trends and things. We’re going to see pretty heavy promotional activity by competitors over the next coming couple of months. We’ll see.

David Palmer – UBS

US Foodservice your volume decline was 9%. You showed the MPD press data which showed overall volume or traffic declines in the restaurant category of about 1%. A lot of folks that have food service businesses certainly and correctly blame the consumer environment. The type of volume performance here isn’t necessarily just described by the overall industry. Could you go into what is going on there, do you have the wrong type of customers, product mix; is their inventory reductions by the restaurants what are going on there?

Art Winkleblack

What we’re trying to do there is revamp the portfolio. As Bill mentioned at CAGNY we are dramatically reducing skus. We’re getting out of low margin businesses; we’re getting out of low profit customers to be quite honest. We are trying to revamp that portfolio to focus on the places where we think we have the right to win and that we can grow going forward. What you’re seeing is a re-shifting or restructuring of the portfolio going on as we try to work through the difficult environment. Certainly the environment is not helping. Beyond that you’re seeing us doing some shifts within the business that ought to set us up for better results going forward.

Meg Nollen

They’re doing the right things. One of the things that I’d point out is this is the highest price we’ve taken in years. This is a 4.6% price increase for the quarter and so there’s probably some of the buy and roll off type going on in addition.

Ed McMenamin

The guys over there are making some really tough choices in terms of customers where we may have had a proliferation of skus, we’ve cut back some of the unbranded, if you will, portion control stuff and either it would be Heinz branded or some of our big customers and just saying we’re going to bite the bullet, pull back on volume and then try to drive some efficiencies in the plants that we have left so that we can make more money going forward but stop chasing cases.

Art Winkleblack

Focus on the front of house more so then the back of house that we have had a preponderance of historically.

Meg Nollen

A lot of success and very pleased with the Burger King co-marketing alliance and hopefully you’re going to see more.

Operator

Your next question comes from Ed Roesch – Soleil Securities

Ed Roesch – Soleil Securities

I was looking at the tax benefit that you got in the third quarter and you mentioned if you’d seen any upside to the outlook for fiscal ’09 your preference would be to reinvest that. Is that the way to think about that tax benefit that maybe that $0.06 or so that came from lower taxes got put back into some discretionary funding towards the business?

Art Winkleblack

Keep in mind a lot of that is just timing. We are probably about $0.04 better on tax then we had anticipated in Q3 that came out of Q4. That moves just one quarter to the other. The other timing factor being those mark to markets. That’d be the way to think about it.

Ed McMenamin

When we previously discussed it we said that tax rate around 30% we’re now saying a tax rate around 29% so the benefit to Q3 we don’t think is going to fall all the way through for the year so as Art said it’s more timing then incremental benefit.

Art Winkleblack

We’re picking up the extra impact of an un-hedged currency and that cross rate. We’ve got a lot of factors moving around there but we do feel very good about our range for the year.

Operator

Your last question comes from David Driscoll – Citi Investment

David Driscoll – Citi Investment

On frozen foods when I look at the data I’m seeing Nestle it’s a clear as day standout here in the latest four weeks they have 60% of their volume sold on promotion. That’s definitively different then about their 45% 52 week average. It looks to me like the change here is happening from the number one market share player in frozen its Nestle. Can you make some comments on what’s happening here and why has Nestle done this. Do you agree with my thoughts that the player to watch it feels like its Nestle who has been driving these massive promotions throughout the frozen case?

Art Winkleblack

Nestle clearly is a large player in the category and they have been very aggressive promotionally. I would come back to the fact that the category is still down despite all that promotional effort. You’re seeing a lot of trade between their promoted volume and base volume. It’s not something that we want to play in and I can’t comment on what their strategy is. They’re doing their thing and we will manage our business as we see appropriate.

David Driscoll – Citi Investment

Do you have any sense that this Nestle promotional surge is abating or does it just look like its going to continue for at least whatever visibility you do have?

Art Winkleblack

I’m not sure how to comment on that. I think they’ll make up their mind on what they’re doing on that front. We’ll stay tuned and watch it and see where we go.

David Driscoll – Citi Investment

When you talked about the fact that this is diet season and that we do have at Heinz a fantastic brand with the Smart Ones Weight Watchers. It does feel to be somewhat disappointing that the January trends were so weak. Is there any additional insight you might have on how impactful this might be to your thought process going forward? In the month of January in my mind is supposed to be a home run because it is the diet season.

Art Winkleblack

If everything is relative and the home run here is that the strength of our base franchise, the base business is holding up very well during a real onslaught from a promotional standpoint. Our loyal consumer base is hanging with us and we appreciate that support. The base business is going well, is well above the category norms. That’s a good thing and in fact if you look at overall North American consumer products if you come down to the bottom line our operating margin is up very strongly for the quarter.

We’re trying to balance all elements but again at some point we’ll see what the strategy needs to be. The base business holding up well, promoted volume is down pretty significantly. We make a lot less money on the promoted volume. Over time we think things like that will balance out.

Operator

There are no further questions at this time. Do you have any closing remarks?

Meg Nollen.

We’ll be around all day in the Investor Relations department feel free to give us a call 412-456-6020. Have a great day.

Operator

This concludes today’s conference. Thank you for your participation you may now disconnect.

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Source: H.J. Heinz Company F3Q09 (Qtr End 1/28/09) Earnings Call Transcript

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