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Kellogg Company (NYSE:K)

Q2 2009 Earnings Call

July 30, 2009 9:30 am ET

Executives

Joel Wittenberg – Vice President, Investor Relations

David Mackay – President and Chief Executive Officer

John Bryant – Chief Operating Officer and Chief Financial Officer

Gary Pilnick – General Counsel

Analysts

Robert Moskow - Credit Suisse

Terry Bivens - J.P. Morgan

Alexia Howard - Sanford Bernstein

Vincent Andrews - Morgan Stanley

David Driscoll - Citigroup and Investment Research

Edward Aaron - RBC Capital Markets

Jonathan Feeney - Janney Montgomery Scott LLC

David Palmer - UBS

Eric Katzman - Deutsche Bank Securities

Ken Zaslow - BMO Capital Markets

Bryan Spillane - BAS-ML

Chris Growe - Stifel Nicolaus

Andrew Lazar - Barclays Capital

Operator

Good morning. Welcome to the Kellogg Company 2009 second quarter earnings call. (Operator Instructions)

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

Joel Wittenberg

Thanks Doug, and good morning everyone. And thank you for joining us for a review of our second quarter results. With me here in Battle Creek are David Mackay, President and CEO, John Bryant, Chief Operating Officer 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, up front costs, impact of the recalls 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 our public SEC filings.

A replay of today’s conference call will be available by phone through Monday evening by dialing 888-632-8973. The pass code is #20808846. The call will also be available by webcast which will be archived for 90 days.

Now let me turn it over to David.

David Mackay

Thanks Joel and good morning everyone. The second quarter was a strong one for Kellogg Company. Our double digit EPS growth was higher than expected, driven by strong operating profit delivery, favorability below the line and offset by higher [inaudible] spending. Furthermore, we enter the second half with even better visibility into the year and even stronger confidence that we’ll deliver another year of sustainable and dependable growth.

There’s no doubt the current economic environments’ difficult. However, our business approach is designed to achieve positive results, even during challenging economic conditions. The second quarter results illustrated the continued resilience and relevance of our focused strategy and business model. Internal net sales, which excludes the impact of foreign exchange, acquisitions and shipping days, grew 3% during the quarter, consistent with our expectation of 3 to 4% sales growth for the full year.

Our categories are performing well during the recession, and cereal is an especially strong category to be in right now as consumers seek to maximize the value received from every food dollar spent. Gross margin exceeded our expectations and we saw solid margin expansion in the quarter. Excellent delivery for our $1 billion challenge enabled us to deliver gross margin expansion. And while commodity costs have fallen as we expected, we’re still seeing, however, cost of goods inflation versus last year.

The double digit internal operating profit growth we posted exceeded our long term annual target of mid single digit growth, as momentum continued behind productivity and cost saving initiatives. We also saw benefit in Q2 from the timely advertising spend, which will be reinvested in the second half and which executed well across categories and regions, gaining share in most of our major markets. We’re on track to achieve our goal of delivering $1 billion in annual savings by year end 2011.

And importantly despite increasing our investments in the second half, we’re also raising our accounts and neutral earnings per share guidance to a range of 8 to 10% growth for full year 2009 from our original guidance of high single digit growth. As you can see, we remain committed to continue to deliver sustainable and dependable growth for our share owners in 2009 and going forward.

And now I’d like to turn it over to John to walk you through the financials.

John Bryant

Thanks David and good morning everyone. The headwinds we discussed during our first quarter call have continued. Despite the challenges of a tough competitive landscape, a weak economy and tough comps, we met or exceeded our long term annual targets of low single digit internal net sales growth, mid single digit operating profit growth and high single digit currency neutral EPS growth.

Reported net sales declined 3% for the quarter, including a negative foreign exchange impact. Internal net sales growth, which excludes the effect of foreign exchange, acquisitions and shipping days was 3%, building on last year’s strong 6% internal sales growth. We continue to project 3 to 4% internal net sales growth for the full year 2009.

Reported operating profit increased by 4% despite year-on-year inflation for the quarter of 4%. Internal operating profit grew by a strong 14%. This result was driven by excellent delivery from our $1 billion challenge and lower advertising expenditures due to timing.

We invested approximately $0.07 of EPS into up front costs this quarter and of last year’s $0.04 per share. Reported earnings per share rose ahead of expectations to $0.92, a 12% increase on a reported basis and a 23% increase on a currency neutral basis. This result was driven by strong operating profit growth and favorability from below the line items such as lower interest expense, lower tax and timing on other income expense.

Second quarter reported sales declined 3.4% driven by a 6.4% impact from currency. Internal net sales in the second quarter rose 2.6% as our pricing initiatives continued to flow through. While tonnage was down 0.5% in the quarter, our global cereal volume was up approximately 2% in the quarter.

The overall volume decline was driven by snacks, impacted by two items, the expected shift from lower margin bulk products, the higher value added [products] in Russia, where volume declined significantly but net sales grew by high single digits, as well as by the peanut related recalls in North America. In addition, our recent acquisitions added 40 basis points to sales growth in the second quarter.

On a year-to-date basis, internal net sales growth was a solid 3% and was delivered by North America contributing 4% growth, Latin America 8%, Asia-Pacific 7% and Europe was flat. Gross margin for the quarter was up 30 basis points over last year’s second quarter. Internal gross margin dollars grew a solid 4% for the quarter, ahead of internal expectations. The margin expansion was driven by pricing and delivery of our cost savings programs, despite continued inflation year-on-year and higher up front costs.

Year-to-date gross margin of 42.3% reflects a slight decline year-on-year. However, we now expect gross margin for full year 2009 to be up approximately 50 basis points versus our prior estimate of flat gross margin for the year.

As we expected, commodity prices have continued to decline and our full year outlook for cost pressures remains approximately 4% of cost of goods. We are now approximately 90% hedged on commodities for 2009 on a global basis.

Second quarter internal operating profit rose 14%, driven by solid internal sales growth, cost savings initiatives and timing of advertising spending, offset by cost pressures and higher up front costs. North America internal operating profit rose a strong 14% versus last year’s 5% comparable, driven by top line growth, timing of advertising spending and cost savings. In addition, increased up front costs reduced internal operating profit by more than 7%.

European internal operating profit grew approximately 4%. Lower sales growth and a difficult environment were offset by media deflation and productivity savings. Higher up front cost investments reduced internal operating profit by approximately 6% in the quarter.

Latin America continues to deliver solid internal operating profit growth. Second quarter internal operating profit rose by 12% over the second quarter of 2008, driven by high single digit internal net sales growth and cost savings. And in Asia-Pacific internal operating profit increased by a strong 36%, driven by effective cost discipline and timing of advertising spend.

Our commitment to investing in advertising will continue to be a key to our business model and central to achieving our goals. During the second quarter, internal advertising spending declined versus last year’s 10% comp and due to the timing of various advertising programs, media deflation, and production efficiencies. However, we achieved a significant increase in impressions as we continued to strongly invest in our brands by reinvesting these savings back into advertising.

For the second half of the year, we expect a double digit increase in internal advertising expense. We will also continue to drive efficiencies in our more than $1 billion of annual advertising spend. The combination of efficiencies, deflation and higher spending will result in a significant increase in consumer impressions in the back half.

Our reliable cash flow delivery continued in the second quarter. Cash flow for the quarter of $363 million outpaces last year’s strong delivery for this period. We are very pleased with this performance, which was negatively impacted by foreign exchange. Cash flow remains solid on a year-to-date basis as well. The $535 million of cash flow generated in the first half is again ahead of last year’s strong performance. We are very focused on this important metric and continue to have confidence that we will deliver cash flow for the full year 2009 of between $1.050 billion and $1.150 billion, which includes the impact of foreign exchange headwinds.

Now let’s turn to our full year guidance on the next slide. We have good momentum entering the second half of the year, which gives us even greater visibility and confidence in achieving our full year goals. We continue to anticipate 3 to 4% internal net sales growth. We now expect gross profit margin to rise approximately 50 basis points for the full year. We are also raising our full year 2009 guidance for internal operating profit growth to the high end of our previously guided, mid single digit range. Despite significantly increasing our up front cost investments from our initial estimate of $0.14 per share to approximately $0.26 per share, we are raising our full year earnings per share guidance to a range of 8 to 10% growth on a currency neutral basis from our original guidance of high single digit growth.

Below the operating profit line, interest expense is expected to be approximately $270 million and the full year tax rate is forecast at approximately 30%. We expect average shares outstanding to be relatively flat year-on-year. We now have even greater visibility into the year and are even more confident in our ability to achieve our short term and long term goals.

And finally, looking at the effect of foreign exchange on the P&L, the U.S. dollar has weakened since our first quarter earnings call. Assuming current exchange rates, the full year impact on EPS from translational foreign exchange will be approximately 6% instead of the previously forecast 9% impact.

Now I’ll turn it back over to David for the business review.

David Mackay

Thanks John. In the second quarter North America produced 3% internal net sales growth on top of last year’s strong 6% growth. As you can see, we posted growth in each of the North American businesses in the quarter.

In the second quarter our North American retail cereal business delivered a strong 4% internal net sales growth on top of last year’s 5% growth. The cereal categories robust and by our estimate grew about 4% in the quarter and our consumption for Q2 across all channels was up between 6 to 7%. We saw inventories drop versus last year, so shipments were up 4%. We increased our U.S. ready to eat cereal category share more than 1 point during the second quarter. The cereal category remains a great category to be in.

Our focused strategy of investing behind our top A brands plus Kashi is a key contributor to this success. Our spring Special K challenge promotion was our strongest yet. Kashi continued to deliver positive results in sales growth in the quarter, again outpacing the natural and organic cereal segment.

Kellogg Canada recorded another solid quarter of mid single digit net sales growth and category share gains. Ready to eat cereal’s grown to growth, posting another share gain on the strength of innovations like Special K 5 Grains, continued momentum in Kashi, equity advertising behind Mini Wheat’s and strong in store activity.

I’d like to highlight another exciting new development for our ready to eat cereal business in regard to strengthening the nutritional credentials of our cereal portfolio. Recognizing that fiber is an important nutrient that fewer than 1 in 10 children and adults get enough of, we recently announced we will add fiber to many of our ready to eat cereals in the U.S. and Canada. For the second half we’ll introduce innovations of Fruit Loops and Apple Jack cereals that provide 3 grams of fiber with the same great taste. These introductions are another step in our renovation initiatives to continually improve the nutrition profile of our products without compromising taste or quality.

As it builds on the company’s 100 plus year commitment to meeting consumer’s health and nutrition needs, we expect this initiative to contribute to the long term health of our ready to eat cereal business.

In the second quarter, our North American snacks business posted 3% internal net sales growth over last year’s solid 6% growth. It was a challenging quarter as warehouse sales were negatively impacted by the peanut related recall. However, our direct store delivery business continued to perform well, growing internal net sales a solid 4% over last year’s difficult comparable of 10% growth.

We’re committed to expanding our snacks business and are pulling all levers available in this very competitive environment. During the second quarter we invested heavily in brand building within our snacks business with strong campaigns behind snacks innovations such as Fiber Plus Bars and Special K Crackers, as well as behind our core cracker brand Cheez It and 100 Calorie Right Bites.

Our Pop Tarts brand delivered low single digit internal net sales growth in Q2 and our underlying blue box business is performing extremely well. Store door cracker sales rose low single digits after last year’s strong growth, driven by solid performance from Cheez It, Townhouse and Club. In addition our new Special K Crackers performed ahead of expectations. If we adjusted for the peanut related recall our cracker share would have been essentially flat.

For the second half we’ve some exciting innovations including Cheez It Whole Grain, Kashi Heart to Heart and Flip Side’s Gala Crackers.

Store to door cookie sales grew solid mid single digits in Q2 with strong performance from Sandies and Murray Cookies. In addition, our re-introduction of 13 Mother’s Brand Cookies into the market during the quarter is off to a strong start. Including Mother’s as a new business for us, we grew our store door cookie category share during the quarter.

Store door sales of wholesome snacks were solid and grew more than a point of ROI category share during the quarter. Our new Fiber Plus Bars continue to perform ahead of expectations and we also saw solid performance from Kashi TLC Bars and NutriGrain Bars.

Our frozen and specialty channels businesses continued to drive excellent results through a combination of effective innovation and great execution in the second quarter, delivering 5% internal net sales growth on top of last year’s difficult comparable of 10% growth. This performance is especially strong given the extremely difficult up [writing] environment that the food away from home channel is currently operating in across the U.S. Our food away from home business declined in Q2 but still continues to perform above general channel trends.

Our frozen business which operates in strong categories delivered double digit internal net sales growth during the quarter. Eggo continues to perform well and gained share in Q2. Our veggie food business delivered almost 2 points of share growth this year, driven by continuing solid base sales growth in meal solutions. Garden Burger is doing well and Kashi frozen meals saw a strong top line growth during the quarter.

Internal net sales for our international business grew 2% on top of last year’s strong 6% growth. Europe continues to present a very tough operating environment, with a high level of competitive activity. Internal net sales for Europe declined 1% for the quarter versus last year’s top 5% comparable. As we discussed during our Q1 earnings call, challenging negotiations with some retailers, though now resolved, negatively impacted sales for the second quarter. We continue to expect our European business to deliver second half internal net sales growth of low single digits.

Volume in the region declined mid single digits, with approximately half of the decline driven by Russia as we moved from a bulk snacks business to a branded business. In the UK we achieved 4% internal net sales growth, as well as category share growth for the quarter, driven by solid mid single digit growth in base sales. Our Crunchy Nut, Rice Krispies and Frosty cereal brands all performed well in the quarter and growth in the UK was offset by weakness on the continent.

In Latin America we delivered 3% internal sales growth. In Mexico we gained category share in the quarter and delivered mid single digit growth as core brands such as Zucaritas, Corn Flakes and Choco Krispies continued to perform above our expectations. We plan strong support behind our new All Bran cereal introduction that adds yogurt and fiber which will launch in Mexico in Q2. And in Venezuela, Colombia, Central America and Brazil we posted good internal sales growth in the quarter.

Our Asia-Pacific business delivered 3% internal net sales growth, building upon last year’s strong 9% growth. Our businesses in South Africa, Korea and India delivered strong internal net sales growth. In Australia, we were negatively impacted by challenging negotiation with a retail partner. However, the rest of the trade is supporting Kellogg well and we’re successfully holding our position in the Australian market.

So in summary, we’re pleased with the results we’ve posted in the second quarter and the first half of 2009. We’re seeing even better momentum this year than we anticipated. Our strong brand building programs and cost saving initiatives continue to drive these results, and we’ve continued to execute well around the world.

We’re off to a great start with our $1 billion challenge and we have confidence we will achieve our goal. We’ve significantly increased our investment in up front costs, which will help drive efficiency gains and help offset commodity and energy inflation in future periods, and provide the fuel to sustain our momentum.

We also plan to increase our investment in advertising at a double digit rate in the balance of the year. All these elements support our increased confidence that we can deliver our targeted rates of growth again in 2009 and demonstrates our commitment to manage the business for long term, sustainable, dependable performance. And our increased EPS guidance for 2009 shows how resilient our business remains in these tough times.

Finally, I’d like to thank Kellogg employees around the world for their continuing commitment to excellence and dedicated work.

And now I’d like to open it up for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from Robert Moskow - Credit Suisse.

Robert Moskow - Credit Suisse

I just had a question about the sales growth. You know it came in a little bit lighter than what we had hoped. The Nielsen data for the U.S. showed that, you know, you had pretty strong retail consumption but you mentioned inventory reductions and can you give us a little more color on those inventory reductions? Is it just a Kellogg specific situation? Or is it a category situation?

David Mackay

I think it’s more, Robert, specific to Kellogg as we looked at it. We’re always very, very pleased when inventories drop and they did drop in Q2 for us in the cereal category. As we look at our growth it was very strong. Consumption was up 6 to 7%, shipments up 4. The biggest differential between the two was the inventories coming down in Q2 so they are at a lower level than we saw them Q2 last year. So we’re very pleased with that.

And really if you look around the world, we feel very good about Q2 and the year-to-date growth. That’s in line with our targets. A few factors in there that impacted apart from what we mentioned on the difference in consumption versus shipments in Q2 cereal, we mentioned some customer issues in Europe and one in Australia, a small impact from the snacks recall. We did see a couple of inventory reductions in Q2 in Italy and the UK. Nothing significant but meaningful for those two markets. But in general terms, we’re very happy with the performance in the quarter.

Robert Moskow - Credit Suisse

So in the U.S., if I could focus on that, there’s no evidence that you were shipping ahead of consumption over the last couple of quarters and this is some kind of a snap back or something?

David Mackay

No, I don’t believe so. As we looked at the inventory levels as we finished Q2 this year versus last year, it was down significantly. And there wasn’t anything that untoward from the year ago. It might have been a tad higher but nothing significant. I think this is really a Kellogg issue and you know we are constantly working with our retail partners to try and reduce inventory across the board, particularly in the current environment.

But I don’t think it was category specific. I think it was more Kellogg specific and to be quite frank while it might have shown our shipments a little lower than you would have expected, we did grasp 1 point of share in the category. We’re very, very happy with the performance.

Operator

Your next question comes from Terry Bivens - J.P. Morgan.

Terry Bivens - J.P. Morgan

Dave I know there’s always, you know, talking about the data, it always includes a certain amount of risk. But I think the thing missing from Rob’s question might have been this. According to the data at least you guys were a bit more promotional than you had been in the second quarter. So I guess my look at it is this. You did, I would avoid the term loading inventory, but I think you may have shipped pretty robustly in the first quarter in advance, knowing that you were going to promote a bit more heavily in the second quarter. And then going forward I would expect, you know, pretty close to that 4% kind of consumption number you mentioned which is very consistent with the data. Is that a reasonable way to look at it?

David Mackay

Unfortunately not, Terry. We don’t pre-ship in anticipation of promotions. I mean occasionally that will happen if we’ve got something right at the end of a quarter that starts at the beginning of the next quarter. But we didn’t deliberately build inventories Q1 for Q2. You know I mean really we think the category is very strong. If you look at the category out four, that was again the toughest comp we had in 2008 for category growth. Q2 2008 was the strongest growth in the category, so we’re up against very tough category growth from a year ago. That’s that 4% of net context is very good.

And if you think about, you know, what’s going on in the general market, we’re very happy that our consumption was up so strongly and we gained share. We continue to try and offer consumers value wherever we can. In this market we think that’s a very pragmatic approach.

Terry Bivens - J.P. Morgan

Just one quick follow. As you look into the second half, you’ve obviously signaled advertising is going to be up quite a bit. Can you just give us some flavor for what you’re going to put that behind in the cereal category?

David Mackay

Well it’s both cereals, snacks, frozen, right across the business. And it’s not only in North America but globally. You know we had some programs that were due to run in Q2 that have slipped into Q3. We saw probably slightly more media deflation through the first half than we were expecting. We have some great opportunities to add some incremental programming in the back half that we think will give us great momentum as we go into 2010. So it’s a combination of factors, Terry.

Operator

Your next question comes from Alexia Howard - Sanford Bernstein.

Alexia Howard - Sanford Bernstein

I wanted to focus on the margin [audio impairment]. On the commodity cost side, could you talk a little bit about the outlook? I think you mentioned that commodities were beginning to come down, but the total cogs are continuing to go up. Could you maybe give us a bit of color on what it is within the cogs line that’s still causing you pressure.

David Mackay

Alexia, when we gave the forecast of around 4% I think it was originally they were a little high, but 4% is where we’re seeing it. And you know in that forecast we had an anticipation of commodities coming down this year. And that has proven to be the case. You’ve got pension costs, wages in there, factory expenses. Some of the other things that are going up around the world for us are things like rice and some packaging elements. But in general terms, when you look at 4% inflation that’s the best we’ve seen in about 4 or 5 years. So it’s more consistent with the 3 to 4% we were seeing in the early part of 2000. So it really is pretty much where we expected. Maybe slightly lower, because we saw some benefit from fuel that may or may not stick for the year.

Alexia Howard - Sanford Bernstein

And I guess just really quickly, bolt on acquisitions. Can you tell us how much they reduced gross margins by this quarter? And are we sort of anniversaring that at this point?

John Bryant

They had about a 20 basis point for the quarter, Alexia, and I think we’re very close to anniversaring that for the year.

Operator

Your next question comes from Vincent Andrews - Morgan Stanley.

Vincent Andrews - Morgan Stanley

Dave could you just give us maybe some sequential commentary on how you’re seeing consumer behavior change? Maybe more specifically in the U.S. but also anywhere else in the world that you think would be relevant.

David Mackay

You know really I think nothing dramatic. I think what you’re seeing in the general marketplace is, you know, it’s a very tough economy. Unemployment’s still rising. People looking for value. I think one of the issues that investors have had is a concern about you know the growth in private label. The one thing I would say on that is I think we’ve started to see its growth moderate in many categories, not only in the U.S. but around the world. One would call it sequentially flat, whether you’re looking at cereal, you know, crackers, waffles. When you go to the UK, Australia, Canada private label is down. So while it did have a very strong spurt of share growth, it’s now leveling off a little bit.

But I think consumers are still going to be in a mindset of looking for value and trying to extract as much value as they can out of every dollar they spend. We’re very pleased to be in categories like cereal and snacks where we think we can offer great value. And with people I think still being a little nervous about moving their expenditure back from in home to out of home, I think the trend towards more in home consumption is probably going to prevail for a while where we see unemployment is high and not coming down.

Vincent Andrews - Morgan Stanley

And John could you just quickly remind us what your transactional exposure to foreign exchange is?

John Bryant

We do have transactional exposure. It’s not that significant because we hedge that pretty thoroughly in our financial year. So the transactional exposure would be things like raw materials coming from the U.S. into Mexico or finished goods coming from the UK onto the continent. So it’s part of our normal operating model and even if I wanted to I’m not sure I could sum up and tell you what it is. It’s largely hedged though.

Operator

Your next question comes from David Driscoll - Citigroup and Investment Research.

David Driscoll - Citigroup and Investment Research

Just two relatively brief questions. The first one is on non-measured channels in the United States. David, could you comment on those channels and specifically it just seems to me by looking at your reported results versus the food, drug and math data that we received that the non-measureds weren’t as positive this quarter as we had seen them in past quarters. So can you just comment on what you’re seeing in those channels and is my observation correct?

David Mackay

Well, David, I would say the trends are pretty consistent in the non-measured channels. You know if you look at Club, Dollar and some other retailers that don’t fall under our eye, they’re all doing pretty well. And you know as you’d expect in an economy where people are looking for value, I think that trend has held pretty constant to be honest.

David Driscoll - Citigroup and Investment Research

When I look at your cereal data for the quarter specifically our FDM data was indicating up 4.7%. You reported up 4 for your internal sales number and historically what I’ve been watching at a number of companies including Kellogg is a substantially higher reported number from the company’s when you take into account the non-measured. So that’s where my confusion is coming from.

David Mackay

Well I think David then you really go back to what our consumption was in the quarter which was 6 to 7%, probably towards the high end of the 6 to 7. Our shipments were 4. As I mentioned on the call and in a previous question, we did see inventories year-on-year come down pretty significantly, more Kellogg issue or opportunity I think than a category thing. So I think if you look at consumption versus shipment, I think then you’d find that the data is very consistent with what you’d normally expect.

David Driscoll - Citigroup and Investment Research

Can you just comment on the competitive environment in U.S. cookies and crackers just a bit further?

David Mackay

Yes, it’s pretty intense. But we did see a pretty big step up there through the second quarter. I would expect that to probably continue. I mean in this sort of environment I think most branded manufacturers have been quite pragmatic. They’re looking to offer consumers value during this recession. So you know we see that continuing.

Operator

Your next question comes from Edward Aaron - RBC Capital Markets.

Edward Aaron - RBC Capital Markets

My main question is about the media opportunities but I wanted to follow up on the inventory issue. Is that a function do you think of your competitors maybe being a little bit more aggressive on trade promotions? Or is it more of a conscious effort on your part, working on inventory?

David Mackay

I think we’re always aiming to pull inventories down wherever we can because that’s a positive, not only for our trading partners but for us. I’m sure part of it was that. There could have been other elements in there. We just know that as we look at inventory year-on-year that it had a significant impact on the 6 to 7% consumption data for the 4% shipment data. It was the overwhelming differential between the two. And to be honest as we look at it we feel great about that, because our inventories as we finished Q2 and go on to Q3 in U.S. cereal are lower than we’d normally expect, which is a very positive place to be.

Edward Aaron - RBC Capital Markets

And then on the media deflation opportunity, is the back half weighting of your ad spending this year, does that relate in any way to your expectation for costs to come down more in the back half than what you might have seen in Q2? So just maybe more opportunistic with that? And then I know you don’t have perfect visibility yet probably, but how would you characterize what you’ve seen so far in just the up front negotiations, the negotiations in the up front market for the advertising?

David Mackay

There’s nothing opportunistic in it. I think maybe deflation is relatively consistent around the world. The U.S. as you know it’s probably going to come a little later in the year because, you know, we are on the up fronts and we have commitments that are locked in. But for us a pile of it is as I mentioned timing of programs. Some of the things that we planned to do in Q2 have slipped into Q3. So that gave us a benefit in the quarter but, you know, we’re going to spend that money back. But it is just an opportunity in a recessionary environment to continually insure that consumers are seeing our brands and we’re able to get the quality and value perception up in this environment.

As far as the up fronts, I think they’re just starting so I couldn’t give you any specifics on that. I don’t think we’re far enough in.

Operator

Your next question comes from Jonathan Feeney - Janney Montgomery Scott LLC.

Jonathan Feeney - Janney Montgomery Scott LLC

I guess if you look at this earning season for food retailers versus the earning season that food’s had so far, there’s a stark disconnect. And I think, I’m talking about the U.S. companies here. And I know you mentioned European retailers as far as tough negotiations, but how do you see the tone of your conversations or conversations you’ve had with people internally touch your food retailer customers change in the past 3 or 4 months as it seems times have gotten tougher? You know at the margin what can Kellogg do to, you know, what’s the message Kellogg is sending to food retailers, you know, how you can help them grow their business in the next 12 months?

David Mackay

Okay Jonathan, I think a few things. One is anything we can do to work with all of our retail partners to reduce inventory, to take cost out of the system, we will do and continue to do wherever we can. Driving value and offering growing opportunities for all of our retail partners to attract consumers into their stores and working collaboratively with them on that, insuring that we’re investing heavily against our brands so we can keep category growth going is also essential for us. And things like renovating our products. You know some of the work we’re doing on adding fiber to our products we think is going to be a very positive thing from an overall category and consumer perspective.

So it’s a combination of a number of factors. But probably most importantly listening to what specifically they want to do in their particular retailer outlet and trying to channel their support so we meet their needs and our needs for mutual benefit.

Operator

Your next question comes from David Palmer – UBS.

David Palmer – UBS

You mentioned some specific reasons for weakness in Europe and you still expect small revenue growth there for the year. Several players in Europe and many consumer companies have noted that trends are slipping on the continent but you know of course you say things are kind of unchanged. Are you really seeing things slip at all there due to economic drag or perhaps any market share issues? And then separately, why do you think your trends through the second quarter were stronger in the UK than in continental Europe?

David Mackay

I think, you know, when you look at Europe in totality there are some differentials by market. The continent’s clearly tougher. Markets like Italy and Spain and to a lesser extent France, you know, have really struggled. Spain I think is running with an unemployment rate around or over 20% but certainly it’s close to that level. So you know it’s very hard to talk just about Europe without getting into some of the market differences.

Europe last year slowed dramatically around July, August. That’s when some of the markets really started to slow. So part of the reason for our confidence in being able to do low single digit in the back half, even though we’re flat through the first half, is the fact that the comps for us and I think for many companies get easier in the back half because we’re now lapping those slowdowns. And then of course in the first half as we’ve mentioned while we’ve resolved some of the retailer issues, we’re not fully back into promotional swing with all of them. That’s broadly behind us at the end of the second quarter. You know that’s really it. The general belief is that when you look at our categories they’re still doing pretty well. The UK’s probably been the most solid but you know in general terms we feel pretty confident about doing low single digit in the back half in Europe.

David Palmer – UBS

And it’s not one of those trends right now we’re through even through the quarter it looks like it’s slipping. It seems like it’s stable enough on almost a two year basis such that you should enjoy a re-acceleration with the easing comparisons in the second half.

David Mackay

Yes. Certainly as we look at our categories and the trends we’re not seeing, you know, sort of quarter-to-quarter deterioration but some of the drop offs that we saw July, August last year, once we lap those the comparisons are going to be significantly easier. And the performance in the back half we feel pretty good about.

Operator

Your next question comes from Eric Katzman - Deutsche Bank Securities.

Eric Katzman - Deutsche Bank Securities

I believe I’ll just follow up on David’s question with regard to international. I’m kind of wondering specifically in Mexico if there was any let’s say quote, unquote benefit to the business because of the H1N1 virus alert down there? And then also in Australia I think David you mentioned that the other retailers were kind of supporting you. But I mean you guys know Australia better than I do but I thought there was only basically two retailers there. So could you kind of clarify those two issues? And then I have a follow up.

David Mackay

Sure. In Mexico we had a very strong quarter and very strong in cereal in particular. You know I think we did see when H1N1 first came out that earlier in the quarter we saw what we assumed was a bit of a spike in shipments because people might have been loading up the pantries. That probably worked itself out during the balance of the quarter. So I’m not sure it had any material impact in the quarter. It was positive in the first part of the quarter but that did die down as you went through the back half of Q2. So I’m not sure that was really meaningful.

So you know I think Mexico’s strong performance and you know we still are a little cautious on the back half. But things are going pretty well there. Australia, yes you’re right there are really two major retailers and our third player is a retailer-wholesaler. We have an issue with one of the major retailers and we’re working our way through that and we are getting very positive support from the other retailers. So while it’s challenging, you know, I’m sure we’ll resolve it in due course.

Eric Katzman - Deutsche Bank Securities

And then John if I could ask as you noted you’ve moved the up front spending from $0.14 expected up to now $0.26 for this year. You know can you kind of frame that in terms of your I guess comfort level with the $1 billion cost savings target? Is that basically a signal that you’re that much more confident and therefore you’re willing to spend more up front to deliver on those targets? Just maybe a little more clarification.

John Bryant

We have great visibility into the $1 billion. When we first mentioned the $1 billion to the street back in Cagney we didn’t have the same level of visibility as to how we were going to go about getting it. We had a general sense but without the details. Now we’re further along in that. We have a much better sense of where we’re going to go to get the savings. And as we’ve done that we’ve identified some additional up front costs associated to get that $1 billion.

So I’d say as we look at this year we’re well on track and we’re getting a sort of good component of those savings in this year and those $0.26 of up front costs are all related to getting that $1 billion cost saving.

Operator

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

Ken Zaslow - BMO Capital Markets

I know you guys mentioned on the call that you were 90% hedged on the commodities. Have you begun to think about 2010 on the commodities particularly given that they’re lower? Have you started to be more aggressive or is it typical of what you’re doing for 2010?

David Mackay

We’re certainly looking at ’10 and we’re taking some actions but what we’ll do, Ken, is give you an upside on that as we do the third quarter and give you guidance for next year. We’ll give you a sense of where we are and what we’re doing.

Ken Zaslow - BMO Capital Markets

Can you talk a little bit about your strategy with Kashi? How healthy is it now and how broad do you think it can get? If you can talk just a little about that trend because it seems to be one of those, you know, I wouldn’t say hidden gems but not something that you talk as much about or could you just broaden out a little bit on the strategy on Kashi.

David Mackay

Sure. Kashi is a very strong brand and equity. It continues to do well, well in excess of $0.5 billion. And growing. I mean it came up through the natural organic channel and that channel as you’d probably be aware is struggling at the moment. We’re doing better than the channel is but it slowed a little. So we continue to see Kashi growing. Maybe the growth will slow a little bit in this sort of tough environment. Potentially people are trading in now to that particular natural and organic segment but a very strong equity for us in the long term.

Ken Zaslow - BMO Capital Markets

My last question is how little will it take before sales and takeaway will be more aligned? Are we done with the inventory and so going forward? Just the duration part of it.

David Mackay

That was really a specific and probably noticeable impact on U.S. cereal only. And it’s only because I think investors watching U.S. cereal saw dramatically that we drew that out because you know growing 6 or 7 in consumption, gaining share is inconsistent with 4% shipments. So we normally don’t see that big a swing in a given quarter. As I’ve already said I think it’s a positive because as we go into Q3 inventories are lower but I don’t think it’s more than a bit of an aberration to be quite honest.

Ken Zaslow - BMO Capital Markets

Okay. For the third quarter and going forward we don’t need to be worried about that issue.

David Mackay

No. If anything happens in the third quarter that’s material, we will tell you.

Operator

Your next question comes from Bryan Spillane - BAS-ML.

Bryan Spillane - BAS-ML

Just a couple of points of clarification on the outlook for the year. First on share repurchases, are you expecting, is an expectation for share repurchases for the second half built into the guidance?

David Mackay

We do have the authorization for $650 million for the share buyback. In putting together our guidance we have very little benefit from that in our guidance. So to the extent that we execute that authorization it will be very back end loaded.

Bryan Spillane - BAS-ML

If I remembered it right, at one point there was an expectation for interest expense for the year, net interest expense for the year to be about $270 to $275 million. But you’ve swapped some debt from long term debt. Is there any change in that interest expense expectation for the year?

David Mackay

We’re now saying around $270 for the year.

Bryan Spillane - BAS-ML

Gross margins at one point you were expecting gross margins to be unchanged for ’09. Is that still the expectation?

David Mackay

No. I think when we gave guidance last time we even said we could a little bit better than that and in this quarter we’ve taken the guidance up to 50 basis points for the year.

Bryan Spillane - BAS-ML

So that would imply that gross margins for the back half of the year, though, would be basically flat. Is that?

David Mackay

No. I think we’re down year-to-date minus 20 basis points. That actually implies the back half is quite strong.

Bryan Spillane - BAS-ML

And then just the last part, you know, if you look at the internal sales goal, you know, goal for internal sales growth for the year I guess it implies that it accelerates in the back half of the year. And I guess part of it would be you wouldn’t have anymore inventory reductions. But you look at the second half of the year, would you expect that you’re going to see more volume, volume contribute more to your revenue growth in the back half of the year relative to pricing? Or just trying to get an understanding of what’s going to drive that acceleration in internal sales growth in the back half of the year.

John Bryant

Just to clarify. Where we are year-to-date is actually at 3.5% in sales growth so we’re right on our 3 to 4% for full year guidance. So you know the back half could be a very similar rate of growth. The front half is still meeting the full year outlook. And then on price mix volume I think we’re seeing pretty good price mix through the first half. We’d expect that to continue in the back half. Volume might be a little bit better but we’ll see how it plays out.

Bryan Spillane - BAS-ML

You’re in a range at least relative balance wise in terms of what we would expect in the back half of the year.

John Bryant

Yes.

Operator

Your next question comes from Chris Growe - Stifel Nicolaus.

Chris Growe - Stifel Nicolaus

I’d like to thank you for the incremental disclosure on the back of the release as well. You’re making it easy for us. Thank you.

So I just had two quick questions. The first one is just a bit of a follow on to that. The retailer issues that you had that were disclosed in the first quarter, in terms of their effect on the business, I know they’ve gotten better but was there a heavier effect on the second quarter? I’m focusing more on Europe where the volumes got a little worse. Would it have been a little heavier hit to the volumes this quarter than maybe it was in the first quarter?

David Mackay

Probably similar. You know I think when you look at volumes for Europe you’ve got to remember that half of it was Russia, so, you know, Russia I think the volume was down 15% but net sales were up 8%. So and then the other half there was a little bit of an element towards the fact that while we resolved most of those issues we’re still not fully back into the promotional swing.

And then in Italy and the UK we did see a little bit of an inventory reduction. Italy specifically because a year ago there was a belief that in Q2 there was going to be a freight or transport strike, so the trade built up inventories anticipation of that. And you know this year we didn’t have that so they came down, quarter on quarter. So you know a combination of factors but probably slightly less, but Russia was really the big volume impact.

Chris Growe - Stifel Nicolaus

And then I just wanted to clarify on the up front costs, the $0.26 for the year. Did that in any way pull forward expenses from next year? It would be one element of the question. The other one would be are those still focused on Q2 and Q3 in terms of your heaviest quarters for the up front costs?

David Mackay

The up front’s cost, Chris, now $0.26, is pretty evenly straight across the back half of the year. So Q3 and Q4 probably look pretty similar to Q2 in terms of how it’s phasing out. And then in terms of I wouldn’t describe them as pulled forward projects. I think we’re going to wait until our third quarter conference call to give you guidance on next year’s up front costs. We’re still working through what that will look like.

Chris Growe - Stifel Nicolaus

And you had said $0.22 before, so that’s kind of the current guidance for next year. Is that correct?

David Mackay

Last time we took the up front costs up to $0.22 for this year. We said we expect it to be a similar number for next year, but again we’re still working through that in more detail. We’ll give you better guidance on the third quarter call.

Joel Wittenberg

Let’s take one last question.

Operator

Your last question comes from Andrew Lazar - Barclays Capital.

Andrew Lazar - Barclays Capital

Just a quick one. I realize that your gross margin year-over-year looks a lot better when you account for you know some of the up front costs that fell into cost of goods this year versus last year, and obviously some of the acquisition impact and such. I guess one of the questions I’m getting a lot this morning is where some of the food companies that we’ve seen report in the last couple of weeks seem, you know, probably much more dramatic year-over-year gross margin improvement, you know, in their quarters. I’m trying to get a sense whether perhaps there’s a difference maybe in some of the way you know you’ve hedged some of your inputs or maybe a difference in some of the inputs maybe you’re using versus some of the others. Just you know I realize that you’re expecting gross margin improvement to accelerate a bit in the back half of the year. But I guess I was just wondering what the disconnect is between some of the more outsized improvements we’ve seen versus yours.

David Mackay

Well, Andrew, I think you’re right. First up front costs are limiting our growth and in the second quarter our up front costs impacted gross margin by about 80 basis points. I can’t talk to what other companies are seeing, what’s driving their gross margin. But from our perspective we’re seeing good price mix performance in the business as well as delivery on our $1 billion cost challenge. And those two in combination, even though we’re still seeing year-on-year inflation and higher up front costs are enabling us to drive positive gross margin.

Joel Wittenberg

All right. Well thanks everybody for listening in today. We’re here to answer any additional questions and we appreciate your interest in Kellogg Company. I’ll turn it back over to Doug.

Operator

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

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Source: Kellogg Company Q2 2009 Earnings Call Transcript
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