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Kellogg Company (K)

Q1 2009 Earnings Call Transcript

April 30, 2009 9:30 am ET

Executives

Joel Wittenberg – VP, IR

David Mackay – President and CEO

John Bryant – COO and CFO

Analysts

Judy Hong – Goldman Sachs

Chris Growe – Stifel Nicolaus

Bryan Spillane – Bank of America/Merrill Lynch

David Palmer – UBS

Eric Katzman – Deutsche Bank

Eric Serotta – Consumer Edge Research

Ed Roesch – Soleil Securities

Alexia Howard – Sanford Bernstein

Jonathan Feeney – Janney Montgomery Scott

Rob Moskow – Credit Suisse

Ken Zaslow – BMO Capital Markets

Terry Bivens – J.P. Morgan

Tim Ramey – D.A. Davidson & Co.

Andrew Lazar – Barclays Capital

Operator

Good morning. Welcome to the Kellogg Company 2009 First Quarter Earnings call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer period. (Operator instructions) Thank you.

At this time, I will turn over the call over Joe Wittenberg, Kellogg Company Vice President of Investor Relations. Mr. Wittenberg, you may begin your conference.

Joel Wittenberg

Thanks Christina and good morning everyone and thank you for joining us for a review of our first quarter results.

With me here in Battle Creek are David MacKay, President and CEO; John Bryant, Chief Operating and Financial Officer, and Gary Pilnick, General Counsel.

We must point out that certain statements made today such as projections for Kellogg Company’s future performance including earnings per share, net sales, margin, operating profit, interest expense, tax rate, cash flow, cost savings, brand building, upfront costs, impact of the recall and inflation are forward-looking statements. Actual results could be materially different from those projected.

For further information concerning factors that could cause these results to differ, please refer to the second slide of this presentation as well as to our public SEC filings.

A replay of today’s conference call will be available by phone through Monday evening by dialing 888-632-8973 in the US and 201-499-0429 international from international locations. The passcode is #43296486. The call will be also available via webcast which will be archived for 90 days.

Now, let me turn it over to David.

David Mackay

Thanks Joel and good morning everyone. We are pleased to report that our first quarter results were ahead of our expectations, driven by broad based internal sales growth of over 4%. As we discussed previously, the first quarter was expected to be one of our more challenging quarters. But by continuing to execute against our strategy and business model, we performed well despite the tough economic conditions, the peanut related product recalls and the impact of some of challenging European retail negotiations which have now been resolved.

Internal net sales which excludes the impact of foreign exchange, acquisitions and shipping days rose 4% versus last year’s 5% comparable. Internal operating profit rose 7% driven by a solid sales growth as well as relentless focus on cost saving initiatives and efficiency.

In addition, we faced a difficult quarter of commodity cost pressures and absorbed cost related to the recalls. Earnings per share were $0.84, a 4% increase on a reported basis and a 14% increase on a currency neutral basis.

EPS was also significantly above their target. With a solid momentum, we are now even more confident we’ll achieve our most recent full year guidance of 3% to 4% internal sales growth, mid-single digit internal operating profit growth and high-single digit currency neutral earnings per share growth. We will reinvest advertising savings and strive to increase our consumer impressions at a lower cost. In addition, in this difficult economic environment, we are focused on driving a strong value message to consumers.

We now plan to significantly increase our investments at upfront cost saving initiatives. From our original expectation of $0.14 per share to approximately $0.22 per share and we expect this heightened level to continue in 2010.

These investments keep us on track to achieve $1 billion of annual cost savings by the end of 2011. The annual savings which will be achieved over three years combined with our business momentum gives us increased visibility into our future earnings.

Last, we will continue to return cash to shareholders’ during 2009. We have confidence in our long-term business model as evidenced by the Board of Directors decision to increase the dividend by 10% starting in the third quarter. And now I would like to turn it over to John to take you through the financials.

John Bryant

Thanks David and good morning everyone. Slide 4 highlights our financial performance for the first quarter. During our last call, we discussed the significant challenges we faced during the quarter including a tough competitive landscape, the weak economy, the impact of the peanut related recalls and tough comps.

Despite these headwinds we exceeded our long-term targets of low-single digit internal sales growth, mid-single digit operating profit growth and high-single digit currency neutral EPS growth. Reported sales declined by 3% during the first quarter driven by an 8% negative impact from foreign exchange.

Internal sales which excludes the effect of foreign exchange and our recent acquisitions were up 4% building up last year’s 5% growth. While reported operating profit declined by 3% driven by foreign exchange and lapping last year’s strong 9% growth Internal operating profit rose 7%, driven by sales performance and productivity initiatives and offset by cost pressures.

In addition, the recalls reduced operating profit by approximately 5% and reduced earnings per share by about $0.05 per share. Upfront costs during the first quarter were $0.03 roughly in line with last year. Reported earnings per share rose to $0.84, a 4% increase on a reported basis and a 14% increase in a currency neutral basis.

Let’s turn to Slide 5 to discuss our first quarter net sales growth in more detail. First quarter reported sales declined by 2.7% due to a 7.7% decline from currency. Internal sales are as 4.2% as their pricing and mixed initiatives continue to flow through with solid 5.8% growth.

Tonnage declined by 1.6% in the quarter. However, it is important to note that our global cereal volume was up approximately 1% in the quarter. Our consolidated decline in volume was driven by snacks, which was impacted primarily by discrete items including the impact of the peanut related recalls, select cracker box size adjustments and a shift from lower-margin bulk products to higher value-added products in Russia where volume declined 16%, the net sales grew 9%. In addition, our recent acquisitions added 80 basis points to sales growth.

Let’s turn to Slide 6 to discuss our gross profit performance. Our reported gross profit for the first quarter was $1.3 billion, a decline of 5% driven by recall costs and an 8% foreign exchange impact. On an internal basis, gross profit rose 3%. Gross profit margin declined in 2008 by about 80 basis points due to the peanut related recalls and acquisitions.

In the quarter, we incurred approximately 5% cost inflation driven primarily by $77 million in additional commodity costs which we offset with pricing. In 2009, we continue to anticipate gross margin to approximately unchanged from 2008.

Now let’s turn to Slide 7 to discuss cost pressures. 2009 cost pressure is forecast at approximately 4% of cost of goods. The increase is primarily driven by rice, packaging and factory inflation, skew to Europe and Latin America. For the year, we are about 80% hedged.

Let’s turn to Slide 8 to discuss operating profit growth. First quarter internal operating profit rose 7%, driven by solid internal sales growth and cost savings offset by cost pressures and the peanut related recalls. For the upfront cost investments are roughly unchanged from last year, they are falling in different regions year on year which impacts their comparability.

North America operating profit rose by 2% versus last year’s tough 10% comparable. The results were adversely impacted by high commodity costs and upfront costs as well as the recalls. European internal operating profit rose 9% due to lower upfront costs and mediate savings partially offset by higher commodity costs.

In Latin America, internal operating profit rose by 28% versus 2008, driven by high-single digit internal net sales growth and lower upfront cost. And in Asia Pacific, internal operating profit increased by 16%, driven by double digit internal net sales growth. Below the operating profit line, we benefited from fewer shares outstanding and our interest expense declined to $67 million offset by a tax rate of about 31% which is slightly higher than last year.

Let’s turn to Slide 9 to review our advertising investment. Our commitment to investing in advertising will continue to be a key to our business model and essential to achieving our goals. During the first quarter, internal advertising spending rose by about 3% only in line with internal sales.

As you can see, our spending rose mid-to-high single digits around the world except in Europe where we experienced a positive impact of efficiencies and media deflation. Despite a lower level of spend in Europe, we believe we are achieving a higher level of consumer impressions across the region.

As you can see, we continue to invest more in advertising in other markets around the world and we are achieving increased efficiency year on year. As we discussed with Cagney, we continue to drive efficiencies in more than $1 billion of spending which will result in an increase in consumer impressions at lower cost. For the full year, we expect advertising spending to grow in line with sales.

Let’s turn to Slide 10 to discuss cash flow. This quarter cash flow was $172 million in line with last year. We are very pleased with this performance which was negatively impacted by foreign exchange and the timing of a net $82 million interest payment in the quarter. For the full year, we anticipate another strong year of cash flow. Our forecast for cash flow is between 1,050,000,000 and $1,150,000,000 which still includes the impact of about $100 million foreign exchange headwind.

Let’s turn to Slide 11 to review some of the key areas effecting out outlook. We have set an ambitious goal of $1billion of annual cost savings by the end of 2011 ramping up over three-year period. As we discussed with Cagney, we continue to focus on these cost savings initiatives, help drive sustainable and dependable growth.

As a result, we expect 2009 through 2011 productivity savings to be closer to 4% of cost of goods versus our historical 3% rate. This gives us increased future earnings visibility. In order to achieve ambitious goals, we now plan to increase our investment in upfront costs from our original expectation of $0.14 to $0.22 per share during 2009 and a similar amount in 2010.

We expect to absorb the higher level of upfront cost and still deliver our guidance of 2009 of high-single digit earnings per share on a currency neutral basis. We are on track to deliver the first year of savings to the Kline [ph] initiative, indirect procurement and overhead discipline. We will keep you updated on the progress of these savings initiatives going forward.

Let’s turn to Slide 12 to discuss the foreign exchange impact on EPS. Since we last update you at year end, the US dollar has weakened slightly against some of the key currencies and strengthened against some others.

Slide 12 shows that key currencies with the 2008 actual rates in recent spot rates. Assuming current exchange rates, the full year impact on EPS from translational foreign exchange will be approximately 8%. As we discussed last quarter, our 2009 guidance of high single-digit EPS on a local currency basis excludes this foreign exchange impact. We continue to update you on the impact of FX on a quarterly basis.

Let’s turn to Slide 13 to review our outlook for full year. We will continue to stick to our business model and strategy. For 2009, our full year outlook has not changed and we remain confident in our ability to deliver another year of sustainable and dependable performance. We continue to forecast 3% to 4% internal net sales growth which is ahead of our long-term target.

Gross profit margin is expected to remain unchanged as our cost savings initiatives and price realization offset cost pressures. We plan to significantly increase our investment and upfront cost savings initiatives from our earlier expectation of $0.14 per share to approximately $0.22 per share. These investments give us the confidence that we will achieve our target $1 billion of annual cost savings by the end of 2011.

We continue to expect mid-single digit operating profit growth in line with our long-term target despite higher upfront cost investments and approximately 4% inflation. Finally, we expect high-single digit earnings per share growth on a currency neutral basis. Below the operating profit line, interest expense is now expected to be between $270 million to $275 million while the full year tax rate is forecast at between 30% and 31%.

Shares outstanding are expected to decline in the back half of the year. In summary, despite the difficult economic environment and volatile markets, we will stick to our business model and strategy and continue to reinvest back into our business with future visibility.

Now, I would like to turn it back over to David on Slide 14 for the business review.

David Mackay

Thanks John. Our first quarter North American internal sales growth was a solid 4% versus last year’s 5% comparable. If you turn to Slide 15, we’ll discuss each business unit in a bit more detail. We continue to be very pleased with the Ready-To-Eat Cereal category which we estimate grew roughly 6% to 7% during the quarter, and North American Ready-To-Eat Cereal internal net sales growth was 6% during the first quarter, a strong performance against a fairly tough year ago comparable.

As mentioned at Cagney, our first quarter IRI category share comparables will be the most difficult of the year, and while our IRI share declined, strengthened non-measured channels resulted in only a modest overall share decline year on year.

Sales growth was broad based with solid performance from their core nine brands as well as innovations like Jumbo Rice Krispies, Special K Blueberry, and Frosted Mini-Wheats Little Bites. As discussed before, we are also reviewing our – brands for efficiency opportunities.

Our Kashi business grew at mid-single digits during the quarter and we are pleased with the performance of Bear Naked which delivered strong base sales growth. Our Canadian business also grew internal net sales by mid-single digits for the first quarter despite aggressive competitive pricing where the highly successful resolution promotion which drove strong Special K and all brand sales.

Our Kashi business still in its early stages in Canada continues to show strong momentum in both cereal and snacks.

Let’s turn to Slide 16 to discuss the North American snacks performance. North American snacks internal net sales grew 2% on top of last year’s 5% growth. Sales were negatively impacted by about 4% due to the recalled product much of which is not sold through our DSD system. We continue to be pleased with our DSD business which grew about 6% during the quarter.

If you turn to Slide 17, we’ll look at more detail about our snacks business performance. Our Pop-Tarts business posted a solid quarter with mid-single digit internal net sales growth. We achieved solid performance across both measured and non-measured channels. This quarter’s crackers (inaudible) grew double digits and we gained IRI categories share.

We achieved solid performance by our new Special K Crackers which performed ahead of expectations. In addition, we continue to drive double digit Cheez-It growth. Cookies store door sales grew low-single digits in a competitive category with solid performance from Sandies, Chips Deluxe and Right Bites on the Go Packs.

Our snacks store door sales achieved mid-single digit growth and our IRI category share grew with strong performance from Kashi TLC bars and Rice Krispies Treats. And our new FiberPlus bars are off to a very good start.

And if we turn to Slide 18 to discuss our Frozen and Specialty Channels performance. Now Frozen and Specialty Channels Q1 sales rose 6% versus last year’s 10% comparable. We continue to achieve strong performance from Eggo Waffles and Pancakes. In addition, their premium priced Nutri-Grain and Special K Waffles as well as our Baked (inaudible) continue to perform well.

Morningstar Farms Veggie foods continue to perform well driven by solid base sales growth in meal solutions. Kashi Frozen meals continue to grow IRI’s share driven by increased distribution and strong base sales.

On Slide 19, you see international internal net sales grew 4% versus last year’s strong 6% growth. We achieved these results despite the headwinds of a weak global economy. European internal sales grew 1% during the first quarter. Sales were impacted by challenging negotiations with some retailers which all are now being resolved will also impact our Q2 results.

We achieved mid-single digit sales growth in the UK driven by strong performance from Frosties, Crunchy Nut and Snacks. This was partially offset by significantly lower sales in Ireland due to the downward price adjustments caused by exchange rate movements between the euro and British pound.

As we discussed last quarter, we anticipate Europe’s full year internal net sales growth at low-single digits and we expect softer first half sales followed by stronger second half.

In Latin America, internal sales was a solid 8% during Q1 on top of last year’s 7% growth. We achieved high-single Ready-To-Eat Cereals sales growth and mid-single digit Snacks sales growth. Core brands like (inaudible) Corn Flakes and Chocolate Krispies performed well in the difficult economic climate.

In Asia Pacific, Q1 internal sales grew 11% driven by strong performance in Australia, South Korea, India and South Africa. In Australia, we continue to grow ahead of a very strong cereal category and gain share. We have also achieved double-digit internal sales growth in South Africa and India.

And if you can turn to Slide 20 for a summary. We remain confident in our ability to deliver sustainable and dependable performance in 2009 and beyond. The current economic environment while challenging and difficult for our consumer base gives us even greater incentive to focus on cost control and continuous improvement so we can strengthen our business while driving future visibility.

Our strong first quarter performance provides early momentum and give us the ability to significantly increase this year’s upfront investments from $0.14 to $0.22 to draw the $1 billion cost savings initiative. These savings give us increased confidence to deliver future growth.

We will continue to focus on reinvesting in our brand through strong advertising. We have identified efficiencies and areas for improved effectiveness and we will continue to invest in strong consumer engagement, so our consumer impressions increase at a rate faster than sales.

In addition, as we discussed with Cagney, we are driving fewer, bigger and better innovations and renovations to meet consumers needs in this environment and to further differentiate and enhance our portfolio.

In summary, our business model and strategy remain relevant and we are committed to our operating principles of manage for cash and sustainable growth. We are making the right investments in our business to drive visibility and flexibility and are well-positioned to continue delivering long-term sustainable and dependable growth.

And now let’s open it up for questions.

Question-and-Answer Session

Operator

(Operator instructions) Thank you. Our first question comes from Judy Hong of Goldman Sachs. Please take your question.

Judy Hong – Goldman Sachs

Thanks. Good morning everyone.

David Mackay

Good morning, Judy.

Judy Hong – Goldman Sachs

David, just looking at the cereal in North America up 6% internal sales growth in the quarter looks pretty encouraging. I’m just wondering if you can may be strip out how much pricing and mix added to that growth, and as you think about your commitment to gain share again in the cereal category whether the pricing improvement in that part of the segment can be seen over the period of time?

David Mackay

Yes. I think when you look at out performance, the great thing about in the US cereal category was the growth overall, up 6% to 7%. So, very strong performance from the category, and to be frank, we are seeing that from a lot of the larger cereal markets around the world. Price mix, given we took some pricing early in the third quarter and we left an increase from 2008 where with price protected was probably a little higher than would expect it to be for the balance of the year. And our volume also grew 1%. So, we saw a good combination of volume growth probably higher price mix in the first quarter than would expect for the balance of the year. So, overall, while we never lose share. If you look at the total market performance, we did lose probably a few tenths a share. Very strong performance from the category and a very solid performance from Kellogg and what is our toughest comparative for year.

Judy Hong – Goldman Sachs

And then if I can follow up, in terms of your guidance, you are now expecting $0.08 of higher upfront cost, but you are basically sticking with the full year guidance. So, that implies the underlying momentum is actually stronger. Where do you think that there is upside in terms of the underlying momentum that gives you confidence you can offset the $0.08?

David Mackay

The whole K-Lean initiative and the $1 billion challenge we laid out at Cagney. We started on that in 2008. We’ve got great traction across the business, not only in North America but in many markets around the world and that’s going extremely well for us. We mentioned the indirect procurement work that’s going on, that’s playing out extremely well for us. And the overall process we have looking to simplify and standardize all we do. I think is going to give us great visibility and benefit as we go through the course of 2009. So, I think they are probably the primary reasons why we are seeing greater visibility and increased confidence in a very, very difficult market where consumers they are clearly looking for value.

Judy Hong – Goldman Sachs

Okay. Thank you.

David Mackay

Thanks.

Operator

Our next question comes from Chris Growe of Stifel Nicolaus. Please take your question.

Chris Growe – Stifel Nicolaus

Hi, good morning.

David Mackay

Hi, Chris.

Chris Growe – Stifel Nicolaus

Hi. I want to ask you first on the increase in the upfront cost that you initially had talked about this K-Lean initiative and how you could sort that within kind of the $0.14. I’m just trying to get a feel for the expenses to achieve the ability in cost savings greater than you thought, is it just a matter of kind of employing [ph] forward?

David Mackay

Well, as I think as we have got into all of the aspects of the $1 billion challenge and started to quantify some of the costs. We have seen that to actually achieve that. We will have some expense in ’09 and certainly through ’10. We are fortunate to be able to absorb that and stay with that guidance for this year. And we think that’s the right thing for the business for the long term particularly in the tough economic times where I think most shareholders’ will appreciate the fact that we are going to drive future visibility and the ability to have the confidence to stay in dependable performance over the medium term.

Chris Growe – Stifel Nicolaus

Okay. That’s very – then the last question I had for you. The Kellogg model has been – has been heavily relying on mix. And I’m just curious in this kind of environment you talked about you are bringing more of value metrics [ph] to the consumer. Does that complicate that strategy in terms of achieving mix improvements in the business? You obviously have good pricing coming through and we should see better volumes through the year, but I’m just curious on the mix side of it. Any change in your thoughts there?

David Mackay

Yes. I think certainly mix is still important to us. Our expectation would be that they will be a little bit of mix, probably more predominantly price of the price mix in the first quarter, but as we mentioned that will abide as little bit as we go through the year given overlapping price protected first quarter increase in last year. So, we won’t see that high level. So, I would expect to see some mix, little bit more price, not as much as Q1 and volume to be solid in this environment.

Chris Growe – Stifel Nicolaus

Okay. Thank you.

David Mackay

Thanks.

Operator

Our next question comes from Bryan Spillane of Bank of America/Merrill Lynch. Please take your question.

Bryan Spillane – Bank of America/Merrill Lynch

Hi, good morning. Just a question on gross margin. Looks like you got a little bit better price realization in the first quarter. It looks like your outlook for the year, your expectation on cost inflation is a little or at least the low end of that range. So, curious as to why the gross margin expectation for the full year won’t be better than expected. Is it because some of the upfront cost are running through there or is there something else I’m missing?

John Bryant

I think it’s a great question Bryan. And certainly you are right, we have lowered some of you pricing expectations because at Cagney we said 4% to 5%, we are now 4% cost reduction to the – and as you see in the first quarter, we are seeing good performance from price and mix. We are saying flat for the year in gross margin. The higher fund [ph] cost for the year as some of that will follow through cost of goods. And as I said at Cagney where I (inaudible) to be flat, we certainly have the opportunity to potentially do better than that.

Bryan Spillane – Bank of America/Merrill Lynch

Okay. Great. And just I want a clarification on Chris Growe’s question. Is K-Lean or the upfront cost is more higher because it’s just more expensive or is it because you are pulling cost forward. I guess it was a little unclear on the answer to that?

David Mackay

When we laid up the $1 billion challenge at Cagney, we didn’t have complete visibility and how we were going to do that. Over the last couple of months, we have given substantially higher visibility how actually going get that $1 billion. These are actually additional new projects as opposed to increase in spend on prior projects.

Bryan Spillane – Bank of America/Merrill Lynch

Got it. Okay. Great. Thank you.

Operator

Our next question comes from David Palmer of UBS. Please take your question.

David Palmer – UBS

Thanks. Hi, guys. Question on just looking at some of the scanner data may be you cold get some color behind maybe the market dynamics behind two categories and that is cereal, what do you attribute aside from just a simple comparison to may be is just that simple. With regard to cereal, your last three months share trends have certainly improved versus the category, and are you at all alarmed at the category at least in the metric channels is not doing better up until lately or do you just see that channel migration? And then separately on cookies, it does look like that category while it’s not been one of your best categories in recent years, it seems to be getting to fairly alarming trends. Is that just the peanut butter issue or do you think there is something else competitively? Thanks.

David Mackay

David, firstly on cereal. I mean the category in IRI for the quarter showed up 3.5% and typically we would add anywhere between 2.5% to 3.5% to get a true picture of what’s going on in the market. That’s the way our view is that total category, all segments they grew 6% to 7%. So, a very strong performance. So, – and I think if you look at that 3.5% even on IRI year ago in the same quarter was up 1.5%. So, the significant acceleration even on IRI data in the category, I think that’s a great performance. We saw that that category start to accelerate in back half of last year. But I think this is really related to the fact that cereal remains great value, it’s versatile, convenient, nutritive. So, the category is growing strongly. Hard to know whether it will grow that level for the balance of the year, but certainly would expect it to grow well. On cookies, when you look at again all channel performance, we did grow. I think the category is still growing low-single digits and would expect it to continue to probably grow low-single digits for the balance of the year. So, we are not seeing anything that you must be seeing to draw another conclusion for that belief.

David Palmer – UBS

And within cereal, is it just simply comparisons because it doesn’t seem like there is any sort of mega introduction behind the special K trademark or whatever to be helping your case so to speak. What – is there any sort of shining star within cereal business that’s helping your trend lately?

David Mackay

Kellogg in particular?

David Palmer – UBS

Yes.

David Mackay

Yes. I think really when you look at the core icon R [ph] brand that we are focusing on. We grew share in those even on IRI basis. Base was up strongly. So, I think that really is the key for us as we continue to focus on driving the category. The performance was very good and while we did lose a few tens this year, even taking all channels into account, David, I think it was our toughest comparison for the year, so we feel pretty good about the rest of the year. I’d also say outside of the US that the field category globally in most of the major markets has shown a similar resilience in growth both through Mexico, Australia, Canada, the UK and the US, we’re seeing anywhere from 5% to 8% growth. So, I think this is a great category to be in and one that in tough economic times, continue just figuring out who represents great value.

David Palmer – UBS

Thanks, David.

David Mackay

Thanks.

Operator

Our next question comes from Eric Katzman of Deutsche Bank. Please state your question.

Eric Katzman – Deutsche Bank

Hi. Good morning, everybody.

David Mackay

Hi.

Eric Katzman – Deutsche Bank

I guess my first, let’s say, detailed question has to do with the increase in the upfront charges and where you see those hitting. Is that mostly going to be North America for K-Lean?

John Bryant

The upfront cost charges, Eric, are going to be fully for across North America and international. So we don’t know the position to give guidance as to exactly how they’re going to fall by geography or even by line between cost of goods and overhead. What I will say is of the 22 pennies, we saw about 3 pennies in the first quarter. We expect a similar amount in the fourth quarter, so mostly, the upfront cost are going to come through in Q2 and Q3. But until we disclose publicly what the projects are, I’m not in the position to tell you which geographies.

Eric Katzman – Deutsche Bank

Okay. And then, I guess just to clarify, David, did you mention Bare Naked in terms of the internal sales growth in North America in cereal and was that even material to the growth because I guess I view that as more of a snack business than a cereal business?

David Mackay

Well, it is primarily cereal. And what I mentioned in the prepared remarks was that the base sales were up strongly and we’re very pleased with that.

Eric Katzman – Deutsche Bank

Okay. And last thing, I guess I’m just a little bit surprised that your view of global cereal is so positive whereas cereal partners worldwide, their public comments have been that the category is slowing. And you can talk, obviously, individually about performance and market share, but it – I’m just surprised that the two biggest players in global cereal are viewing the market differently?

David Mackay

I think, Eric, you really got to look at where they skew versus us. We skew very much to the mature Anglo markets making up over 70% of our global cereal performance. They’re very strong and central in Eastern Europe and have some pockets of strength in other parts of the world where we are not valued as typically slowing from the fast rates that we’re seeing; whereas, we’re seeing somewhat the reimburse in the more mature markets where the categories are actually picking up a little bit. That might explain the difference.

Eric Katzman – Deutsche Bank

Okay. I’ll pass it on. Thank you.

David Mackay

Thanks.

Operator

Our next question comes from Eric Serotta of Consumer Edge Research. Please state your question.

Eric Serotta – Consumer Edge Research

Thanks. It’s Consumer Edge Research. Good morning. Last year, you guys were pretty vocal about the competitive dynamic going on in the cereal category with your largest competitor having a higher percentage of their growth coming from incrementals, in your view, at least. It looked like, according to the Nielsen data for the latest quarter and the latest four weeks, a significant portion of your growth came from incrementals. I guess Nielsen shows that your baseline sales dollars for the quarter and the latest four weeks were down. I’m just wondering whether you could provide some color, as for all outlets, how your baseline versus incrementals in US cereals did and whether it’s fair to read into your results that promotional activities increased, at least on sequential basis?

David Mackay

If you look at the first quarter, the title categories I mentioned, our estimate is it grew 6% to 7%. We’re up about 6%. If you look at our top item, non-brand, we grew share. Their base was up with or above the category. That’s over 80% of our business. We do have two issues if you’re looking at base. Some filed innovations, Straws being one of those, and brands that either aren’t working or that we have de-emphasized year on year. Brands like All-Bran and Smart Start, still strong parts of that portfolio, but a heavy investment in the first half of last year, not as much investment this year. So, I think our role in strong business is nothing unusual. So, that would be my conclusion on our first quarter. The IRI incremental, the category was up about 8-ish percent, I think we’re up 10%, so we were slightly above the category. The most market increase in incremental has been in private label where, I think, retailers are clearly jumping on the current economic conditions and pushing it very, very hard.

Eric Serotta – Consumer Edge Research

Okay. And then, to circle back on some of the, I guess, non-core brands and your strategy there. Can you talk a little bit about the strategy to either – is the strategy there to fix them and to increase investment over the next couple of quarters behind them or is it to just continue to gradually de-emphasize things like Smart Start and the other one that you just mentioned, All-Bran, I believe. I realize Cereal Straws innovations that are missed, but for some of those other brands that had been some strong contributors in the past, could you talk a bit about the strategy going forward and what should we expect to see in the baseline data as you start to cycle these comparisons?

David Mackay

I think this is a natural thing for all class in the category with innovation sometimes not working. It’s not big in the scheme of things with the top eight, nine brands making up an excess of 80% of our portfolio. You are going to see some natural gravitation there. Then it will be dramatic if you take a brand like All-Bran. It’s been around since 1960 and it’s going to be around a long, long time. It may come down from a 1 to a 0.8, but long term, I think it’s still going to be a very vital brand set. Nothing major, but we did believe in our own reviews, Eric, that some of our innovation needed to be cleaned up and we’re doing that proactively. And we’ll probably let the bulk of that, anything over and above what would be typical or normal through the first half.

Eric Serotta – Consumer Edge Research

Great. Thanks a lot. I’ll pass it on.

David Mackay

Thanks.

Operator

Our next question comes from Ed Roesch of Soleil Securities. Please state your question.

Ed Roesch – Soleil Securities

Hi, good morning. Just wanted to check in on retail inventory levels, was there any impact during the quarter?

David Mackay

In the US, nothing noticeable, but a couple of international markets, we did see a little bit of reduction, Mexico being one, but nothing dramatic.

Ed Roesch – Soleil Securities

Okay. And then, thanks for the color on the European business. I wanted to get a little bit more, if you could, on Latin America. I know the upfront costs were down, but margins there were particularly strong. Was there anything that surprised you there?

David Mackay

No. It was actually a little bit above our expectation of 8%. We had said mid-single digits for the year. I think there’s a lot of concern that as the US economy has slowed, the impact on Mexico could be dramatic. We didn’t see that to the extent that we’d expected in the first quarter and Latin America actually grew pretty strongly. We’re watching it because I think there’s a general sense that there could be a degree of volatility in Latin America through the course of the year.

John Bryant

I think, also, Latin America had the benefit of lapping some upfront costs last year, so that was a good portion of the year-on-year growth.

Ed Roesch – Soleil Securities

Okay, great. Thank you.

Operator

Our next question comes from Alexia Howard of Sanford Bernstein. Please state your question.

Alexia Howard – Sanford Bernstein

Good morning.

David Mackay

Good morning.

Alexia Howard – Sanford Bernstein

Just wanted to follow up on some of the earlier questions on productivity improvement. By my calculations, I guess 4% of COGS this year translates into about $300 million of savings or about a little bit over $0.50 a share. Can you talk about how that’s likely to save in through the course of the year? We already hit the run rate and it’s going to come in fairly evenly through the four quarters or is it something that’s going to ramp up during the course of the year as the increase in upfront investments phases in Q2 and Q3?

John Bryant

Alexia, the productivity is relatively smooth. It might increase a little bit towards the back part of the year, but it’s not a step change. It’s more of a reasonably smooth allocation throughout the year.

Alexia Howard – Sanford Bernstein

Okay, great. Thank you very much. I’ll pass it on.

John Bryant

Thank you.

Operator

Our next question comes from Jonathan Feeney of Janney Montgomery Scott. Please state your question.

Jonathan Feeney – Janney Montgomery Scott

Good morning. Thank you. I wanted to dig in a little bit on Europe. Your performance and outlook has been a little bit more bullish than some others doing business in Europe, yet there is still that difference there. Maybe just a big picture question, I mean, what is it – David, you mentioned in your prepared remarks a difficult negotiation you had with, I think, with a couple of retailers there. I mean, what’s fundamentally is different about the value chain that’s driving what seems to be pretty dramatic private label shared growth and dramatically more value-seeking among consumers and more hostile relationship with retailers than you’re seeing in the US or, in fact, other markets globally? Any insight you could provide there on a big-picture basis would be appreciated?

David Mackay

I think there is probably two things, Jonathan. One is some of the more traditional larger retailers are concerned with what’s happening with the high discounters and the growth of high discounters. And a reaction to that, we saw that with Pesco [ph] in the UK, bringing in a new range of private label. So, I think that’s playing out not only in Europe but right across our entire business. I think all of our retail profits have a heightened sensitivity to the economic conditions and the stress they’re placing on consumers, and we are trying to work closely with them globally to ensure that we’re delivering value to consumers and why that works for both of us. You have some markets in Europe like Spain where unemployment is 18%, so that is a particularly difficult economic environment. And you asked, being a private label here as you’d expect, people force, at a greater extent, to try them, so it’s a bit of a mixed bag. But as I mentioned in the prepared remarks, we worked our way through those. There were a number of them. And as we actually start to reinvigorate our trade promotions, we’ll see the positives of that in the second half. So, I don’t think there’s any dramatic difference apart from the economy and pockets. They’re just probably a little bit worse than we’re seeing across North America and some concerned by traditional retailers about a high discounter growth.

Jonathan Feeney – Janney Montgomery Scott

Great. Thank you very much.

David Mackay

Thanks.

Operator

Our next question comes from Rob Moskow of Credit Suisse. Please state your question.

Rob Moskow – Credit Suisse

Hi, thank you. I guess I have a two-part question. The updated [ph] data today shows that your percent of sales sold on promotion is around 53%, it’s the highest it’s been in the last 15 months. At General Mills is down sequentially quite a bit from like 45% right around COGD [ph] to around 34% today. So, I guess my question is at COGD, you had a pretty negative tone and you’re expressing a lot of caution. Has anything changed – what changed since then? Did you promote more aggressively? Did you have more merchandising out than you had earlier in the quarter? And then, secondly, maybe you could also wrap that in with your comment that pricing will be weaker sequentially and this is as high as it gets in the first quarter. How should we read – why should pricing be weaker sequentially for the year?

David Mackay

Let me start with the last one and work backwards. If you look at our price mix in the first quarter, up 5/8, we don’t expect that level again forward. As I mentioned, we are lapping last year’s price increase, which was cost protected, so once we roll through that, that will bring it down. Also, in the first quarter, the recall impacted the business on mix because there were a lot of margin products coming out, so it tended to exaggerate it somewhat. And we’re seeing very high inflation international, so more pricing there. And, again, once some of that lull is over, we’d see it abate. As far as Kellogg and the promotional involvement goes, what we mentioned was that General Mills would lap very strong increase and incremental at the end of the first quarter, so we’re probably going to see that as we go through April and on. Kellogg is very focused on driving a strong value message to consumers in this environment, as I think are most companies. We’re working with our retail partners and through our marketing groups to stress value and quality of our brands, and we think that’s a focus in our orientation that is absolutely appropriate for the current global environment.

Rob Moskow – Credit Suisse

Okay. David, to what extent is the declining sequential price mix that you’re talking about? To what extent is that going to be driven by this peanut butter issue? Is that all of it? Is that 100 dips or –?

David Mackay

That’s high. We calculated our – I know it’s an impact, but I don’t think we’ve actually calculated how much it is, Rob.

Rob Moskow – Credit Suisse

Okay. I’ll follow up later. Thank you.

David Mackay

Great. Thanks.

Operator

Our next question comes from Ken Zaslow of BMO Capital Markets. Please state your question.

Ken Zaslow – BMO Capital Markets

Hey, good morning, everyone.

David Mackay

Good morning, Ken.

Ken Zaslow – BMO Capital Markets

At some point, the upfront cost should be somewhat self-funding. Is that a thought that you have that should be going forward? Is there a point in time that you think that’ll happen or is it just always that you’re going to – I won’t say manage to the mid-single digit – high-single digit operating profit, but how does that work through?

John Bryant

Ken, I guess one of our issues is we’ve been executing upfront cost projects for several years now and the savings from those projects are coming through our P&L every year. So, if you were to go back over the last five or six years and add up all the savings from the upfront costs, it probably is an excess of our normal $0.14 of upfront cost in 2009. But because those costs have been – those savings have been coming through each year, we’ve been using that to offset inflation, to offset other things in the business. It’s not a case about having an accumulated saving, but now, we can somehow offset against the upfront costs.

Ken Zaslow – BMO Capital Markets

Okay. Would you have increased the upfront costs if you didn’t have such strong earnings in the quarter?

John Bryant

Yes. I think we would have insisted going up the $1 billion challenge. These are upfront costs that we need to execute to get that $1 billion challenge. It’s the right thing to do for business. We’re fortunate to be in a position to be able to afford that, to be able to get our prior EPS guide.

Ken Zaslow – BMO Capital Markets

And my last question, have you seen any anecdotal evidence that there’s been a change in the demand in Mexico in any of your products or – can you just give a little color on that?

David Mackay

Not for the first quarter but –

Ken Zaslow – BMO Capital Markets

But recently. I mean, obviously, the last couple of week or so and, obviously, because of Swine –

David Mackay

Yes, in the last couple of days because of the – I think it’s called H1N1 virus now. There’s been a couple of large orders come in the last couple of days, so yes, that’ll probably play through in the second quarter, so we’re not expecting that it’s going to have a material effect.

Ken Zaslow – BMO Capital Markets

Okay, I appreciate it.

David Mackay

Thanks.

Operator

Our next question comes from Terry Bivens of J.P. Morgan. Please state your question.

Terry Bivens – J.P. Morgan

Hi. Good morning, everyone.

David Mackay

Hi, Terry.

Terry Bivens – J.P. Morgan

Dave, as you look towards private label, we were looking at the Nielsen numbers, I guess, for the last month, March 11th, and then transitioning to the ones that came out today. Originally, it looked like you may have gotten hurt in some of the brands that one would think would be pretty competitive with private label cornflakes, for example, but it seems to – it’s down but down a little bit less some of the other brands, perhaps All-Bran. Have you recently made a stronger push against private label and if you could just address the trends there that seems to be a big concern with a lot of people?

David Mackay

And the concern is, Terry?

Terry Bivens – J.P. Morgan

Private label.

David Mackay

The growth of private label?

Terry Bivens – J.P. Morgan

Yes. Which brands might be more vulnerable is what I’m trying to get at –

David Mackay

Okay.

Terry Bivens – J.P. Morgan

– and what you may be doing there?

David Mackay

Well, I think we’re looking at it more generally. And, I mean, private label has grown strongly, but I think the key point for now first is the category is doing incredibly well. So, if you look at the category, it’s up very strong. Private label is growing ahead of the category and I think that’s clearly because consumers are under pressure in trading down. It’s also a reality that retailers are seeing that as an opportunity to push private label, that their incremental is up as high as I can remember it, and that’s why I think our focus is on driving a strong value message to consumers. The part is differentiation between parts for that portfolio. There may be areas where you have stronger match-ups and that could be an area where we could see a little bit more impact, but I think nothing too dramatic at this point, Terry. And we may see it, but in an overall sense, if we could draw any positive because the private label is going to be an issue for all of it as we manage through the year. If you look at this year in the US and the first quarter of this year 10/3, and you look at this year in the fourth quarter of last year at 10/8, it was the first time that sequential share had actually come down. So, while they’re growing strongly, we watch it carefully, but we think we can continue to do well in this environment by driving a strong branded messages and a value orientation.

Terry Bivens – J.P. Morgan

Okay, great. Thanks very much.

Operator

Our next question comes from Tim Ramey of D.A. Davidson. Please state your question.

Tim Ramey – D.A. Davidson

Good morning. You were on the topic of managing down at spending through efficiencies last fall and Proctor was talking this morning about rates being significantly lower. Might there be a much bigger opportunity in delivering the same or greater messaging at significantly lower costs this year? Should we be thinking that way?

David Mackay

Well, certainly, there is a potential opportunity as we through the year. We’re seeing more media deflation in Europe than we have thus far in the US, although we will probably see some. And some of the other efficiency measures we’ve taken consolidated media buying and how we manage our commercial production, etc, applying through across the business. Our intent, as we said in the prepared remarks, this is a great opportunity for us. As you go back to the founder of W.K. Kellogg back in 1929, he said in a recession was a great time to increase your advertising. We have that type of orientation, Tim. If we get significantly more savings, our intent at this point will be to increase our impressions to make sure we are getting through to consumers about our value, about our value and about our qualities are very strong and even more strongly enforced. One area that we are seeing play through is consumer promotions where we have challenged the cost benefit of some of those and we are seeing that benefit actually flow through but are less so in advertising cost. Our current orientation would be invest there.

Tim Ramey – D.A. Davidson

And just a quick one for John. The peanut recall, if you had to split it between cost to goods and SG&A, about what percent would be?

John Bryant

In the first quarter, about $23 million was cost to goods. About $4 million was SG&A.

Tim Ramey – D.A. Davidson

Thank you.

Joel Wittenberg

Christina, we’ll take one more question, please.

Operator

Thank you. Our last question comes from Andrew Lazar of Barclays Capital. Please state your question.

Andrew Lazar – Barclays Capital

Good morning, everyone.

David Mackay

Good morning, Andrew.

John Bryant

Good morning.

Andrew Lazar – Barclays Capital

I know when you started the upfront cost spending projects five or six years ago, I know some of the early projects had some very attractive payback period; if I’m not mistaken, two-, three-year paybacks. Given you’ve been at this awhile and even though you’ve identified a lot more opportunity, are the projects you’re looking at now still that attractive from a payback period standpoint or are we pushing it out a little bit at this big?

David Mackay

I don’t think, Andrew – we’ve actually upped our focus on this area and I think almost of the projects that we’ll undertake will have a, worst case, four- or five-year payback; some of them may be significantly better. So, I know there’s always been a belief that you eventually run out, but I think we continue to find the great projects that can really give us very good paybacks.

Andrew Lazar – Barclays Capital

Great. And then, just a last thing. I guess I’m just a little surprised that the phasing of the cost inflation for the year, I guess, was up 5% in the quarter and will be up 4% for the year. For whatever reason, I thought it’d be more lopsided; meaning, a lot higher earlier in the year and potentially a lot lower in the back half. Perhaps just a little more color on that, give me a sense of why that is?

David Mackay

I think we’d expect the first half to be a little bit worse than the second, but as we look at it, it’s not going to be dramatic as you’d expect but a little bit as you’re indicating. John, anything?

John Bryant

A couple things in there. One is that our hedge. Hedges go on and off year on year, and the second is remember that our inflation is not just commodities, but also as general factory inflation is – well, some of those are much more smoothly allocated across the year.

Andrew Lazar – Barclays Capital

Thanks very much.

Joel Wittenberg

Great. Thank you, everybody, for tuning in today. We’ll be here if you have any questions. Thanks again. Bye.

Operator

Thank you. This does conclude today’s teleconference. We thank you for your participation. You may disconnect your lines at this time and have a great day.

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Source: Kellogg Company Q1 2009 Earnings Call Transcript
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