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Executives

Chris Jakubik - Vice President Investor Relations

Irene Rosenfeld - Chairman and CEO

Tim McLevish - Chief Financial Officer

Analysts

Robert Moscow - Credit Suisse

Eric Katzman - Deutsche Bank

Terry Bivens – JP Morgan

David Palmer – UBS

Alexia Howard - Sanford Bernstein

Ken Zaslow - BMO Capital Markets

Tim Ramey – D.A. Davidson

Judy Hong – Goldman Sachs

Jon Feeney – Janney Montgomery Scott

Bryan Spillane – Bank of America

Andrew Lazar – Barclays

David Driscoll – Citi Investment Research

Eric Serotta – Consumer Edge Research

Chris Growe - Stifel Nicolaus

Vincent Andrews - Morgan Stanley

Christine McCracken – Cleveland Research

Kraft Foods Inc. (KFT) Q2 2009 Earnings Call August 4, 2009 5:00 PM ET

Operator

Welcome to Kraft Foods’ second quarter 2009 earnings conference call. (Operator Instructions) I would now like to turn the call over to Mr. Chris Jakubik, Vice President Investor Relations for Kraft. Please go ahead, Sir.

Chris Jakubik

Thank you. Good afternoon. Thanks for joining us on our conference call. With me are Irene Rosenfeld, our Chairman and CEO and Tim McLevish, our Chief Financial Officer. Our earnings release was sent our earlier today and is available on our website www.KraftFoodsCompany.com. We have also made available on our website a set of slides that we will refer to during our prepared remarks.

As you know, during this call we may make forward-looking statements about the company's performance. These statements are based on how we see things today so they contain an element of uncertainty. Actual results may differ materially due to risks and uncertainties. Please refer to the cautionary statements and risk factors contained in the company's 10-K and 10-Q filings for a more detailed explanation of the inherent limitations in such forward-looking statements.

Some of today's prepared remarks will include non-GAAP financial measures and you can find the GAAP to non-GAAP reconciliations within our news release.

With that out of the way, I will hand it off to Irene.

Irene Rosenfeld

Thanks Chris. Good afternoon. I hope you are enjoying not having to wake up quite so early to hear our results. I know we are happier.

Earlier today we reported strong second quarter results. Results that built on our solid first quarter. Our performance was broad based across our businesses and around the world and our results played through on both the top and bottom lines.

As we have said, our Q2 results began to reflect the transition from growth based on price to growth based on mix. As we begin to lapse the significant pricing actions we took last year, contribution from pricing has moderated and as a result of our targeted incremental investments we are seeing sequentially improving vol/mix.

Specifically, in North America and Europe our focus brands are growing in the mid single digits. In developing markets our focus brands continue to grow at strong double digit rates. Of course we also benefited from the Easter shift into the second quarter but this benefit was more than offset from our decision last year to discontinue a number of less profitable product lines.

On the bottom line, our profitability increased substantially despite the year-ago benefits from certain hedging gains and a value added tax credit. Importantly, margins expanded across all geographies. Gross margin rose by 30 basis points driven primarily by improved vol/mix. Operating income margin increased by 190 basis points. The completion of our restructuring program certainly contributed to the OI margin gains but improved vol/mix was an important driver as well.

Looking ahead, this strong operating momentum will continue. For the full year despite a challenging economic environment and significantly lower dairy costs, we are maintaining our target for organic revenue growth of about 3%. Pricing will be less of a factor and vol/mix in priority categories, core brands and key markets will continue to improve as the year progresses. Although we are seeing weakening category consumption trends in certain European and developing markets we are offsetting much of that gains in market share.

At the EPS line, we are raising our full-year forecast to at least $1.93 from $1.88. This represents double digit growth on a constant currency basis versus 2008. This forecast not only reflects our strong year-to-date performance but it also includes increased investments in marketing and cost savings initiatives. In particular, we are increasing our AMC spending to grow our share of voice. As a result, we expect 2009 AMC to increase as a percentage of net revenue even though advertising rates have come down considerably.

In addition, we are accelerating some cost savings initiatives to stage our earnings growth in 2010 and beyond. We now expect to spend at least $50 million more on these initiatives in the current year. That is in addition to the approximately $200 million we announced in the first quarter. These incremental investments will accelerate margin growth and provide more funds to reinvest in driving our top line.

Looking at these results within the context of our three-year turnaround I would say we are now in the home stretch. We have clearly hit our stride and have staged the business for sustainable, profitable growth. Our forecast for 2009 builds on the success of the past two years. We will again grow both the top and bottom lines while expanding margins and improving market share.

Equally important though we have made progress in a number of areas; rebranding our brand equities, increasing our pricing power, strengthening our innovation pipeline and identifying additional areas for future cost savings. As a result, we are poised to deliver profit margins at or above industry benchmarks and to consistently deliver against our long-term earnings target of 7-9% growth. We are finalizing our strategic plan right now and in the coming weeks will share more specifics with you about our cost savings pipeline and about our game plan to deliver significant margin expansion in the next two years.

Now I will turn the call over to Tim.

Tim McLevish

Thanks Irene and good afternoon. Let me start by saying that our Q2 results provided further evidence our financial turnaround is on track. Our top and bottom line trends continue to move in the right direction. We are beating the expectations we established at the beginning of this year and we have zeroed in on the specific levers that will deliver the growth we laid out in our long-term plan.

On the top line we achieved solid organic revenue growth. As you can see in this chart organic growth in the quarter was 2.9% including a modest, but positive contribution from vol/mix. Higher pricing drove 2.7 points of revenue growth but that included a 70 basis point hit from lower dairy prices. Additionally, Q2 organic growth was negatively impacted by about 40 basis points from a value added tax credit in the year-ago quarter.

Excluding these factors, organic growth would have been closer to 4%.

Going forward we expect vol/mix to become the primary driver of organic revenue growth and a significant contributor to higher earnings and profit margins. This change signals a more balanced growth profile on the top line for the full year and one that is more consistent with our long-term model.

Here is what we foresee. Pricing plus productivity will cover our input costs while volume growth and stronger product mix leverage our overhead costs to increase profit margins. As Irene mentioned, the Easter shift benefited us by about one percentage point in Q2. Again, this was more than offset by planned discontinuations of less profitable product lines announced last year. As you know, this lessens our volume and revenue growth but the net effect is a positive to both mix and profit margins which you see playing through in our results.

Turning now to the drivers of earnings per share. As you look at this chart there are two things I would like to highlight. First, our year-over-year improvement from operations in Q2 was $0.05, mainly from improved vol/mix and cost savings. This included $0.02 of headwinds due to certain realized hedging gains last year.

Second, on the year-to-date basis, gains from operations were $0.10. This also includes the $0.02 headwinds from the hedging gains I just mentioned. Importantly this operating improve came while offsetting more than $550 million of higher input costs through a combination of pricing and productivity. The key takeaway is this; we are growing our earnings in a very high quality manner. Specifically, our top line growth is becoming more balanced between pricing and vol/mix. Margin gains reflect a strong contribution from improved vol/mix that is a function of both investing in priority brands and walking away from unprofitable volume.

We continue to fund higher marketing spend to fuel future growth and we are carefully managing our overheads to further enhance our bottom line. As a result, we are comfortable in raising our EPS guidance to at least $1.93 for the year while making further incremental investments in marketing and cost savings initiatives to set the stage for next year.

We are also making excellent progress on cash flow. As you know we have been very focused on improving this very important financial metric. These efforts have certainly intensified since the financial crisis hit and we entered cash preservation mode. The benefits from our actions are now showing up in a stronger cash flow outlook driven by contributions from earnings, lower capital expenditures and working capital improvements.

As a result, we expect our 2009 discretionary cash flow to be higher than originally anticipated, approximately $2.6 billion in total. On an apples-to-apples basis that would be up from $2.4 billion in 2008. That also represents good progress towards our target of $3 billion of annual discretionary cash flow by 2011.

I will take a few moments now to share some highlights of our business segment results starting with North America. Overall we turned in solid growth in a difficult economic environment. As you can see organic revenue growth was 1.8% including 0.8 points from pricing. It is worth noting the impact of lower dairy prices in the quarter reduced North American revenue growth by about 1.5 percentage points.

In our priority categories revenue was up 5%. This demonstrates once again our focused investments in product quality, innovation and marketing are working. On the bottom line, North America delivered a 170 basis point increase to operating margins to 18.5%. Operating gains from favorable vol/mix and lower overheads contributed 110 basis points of that margin improvement.

Going forward, in the second half of the year we expect vol/mix to drive growth as segment pricing drives negative in Q3. This primarily reflects the impact of our adaptive pricing model in natural cheese. Before we get to individual North America segments let’s take a look at U.S. market share.

As you can see on this slide our 52-week share trends are beginning to stabilize and improve. About 41% of our U.S. retail revenue gained or held share. Clearly we are not satisfied with our U.S. share performance but it does reflect stabilization of market trends as consumers adjust to the significant cost driven pricing in 2008. Going forward we see further market share improvements as we lap the pricing actions and declining consumer sentiment in the back half of last year.

Now let’s take a look at results by segment. In U.S. beverages strong vol/mix drove organic revenue growth of 6%. Specifically the re-stage of Capri Sun with the lower sugar formula drove double digit revenue gains in our ready to drink category. In addition, solid performance by Maxwell House in response to our quality improvements drove double digit growth in mainstream coffee as well.

OI margins rose 60 basis points to 17.7%. Overhead leverage and the completion of our restructuring program contributed to the margin upside. We continue to invest in incremental marketing behind our priority brands. As we look ahead we expect year-over-year improvements in vol/mix to continue and the second half will benefit from new products and marketing programs in both powdered beverages and coffee.

In U.S. cheese our Q2 profile demonstrates our adaptive pricing model at work. Organic revenues fell 8.7% almost entirely due to lower pricing as diary input costs have fallen dramatically. At the same time, volumes have stabilized. More importantly we achieved a 16% increase in operating income which reflects pricing that is better aligned with our input costs.

In the second half we expect vol/mix to turn positive as we focus incremental marketing investments behind advantaged categories such as Kraft Singles and Philadelphia Cream Cheese. At the same time, barrel cheese costs have stayed close to government support levels longer than we had anticipated and therefore the impact of lower prices will be a greater drag on second half revenue growth.

This will not, however, impact our profit stream. Our adaptive pricing approach for natural cheese is now enabling us to reduce volatility in our income stream. That will enable our U.S. cheese business to be a more consistent contributor to our overall growth.

Now let’s move on to U.S. convenient meals where consistent gains continue. Our focused investments in quality and innovation drove improvements in vol/mix. This in turn contributed to strong revenue growth and margin gains. On the top line, organic revenues grew 7.1%. DiGiorno pizza and Oscar Mayer Deli Fresh each grew 20% or more in the quarter. Oscar Mayer Deli Creations also grew strongly. At the profit line, operating margins jumped 260 basis points to 12.1%.

Higher pricing and better vol/mix drove the improvement overcoming input cost inflation and incremental marketing investment. Going forward we expect the momentum we have established in convenient meals to continue with strong revenue growth and cost savings.

On to U.S. grocery where we delivered solid gains on both the top and bottom lines. Organic revenues were up 6.7% as carry over pricing actions drove strong growth. Kraft Macaroni and Cheese was up double digits as it continued to benefit from value oriented marketing, new formats and flavor extensions. Operating margin rose 120 basis points to 34.8%. Margin benefited from better price cost alignment and overhead leverage that offset higher marketing costs.

Now let’s look at U.S. snacks. Organic revenues rose 1.3% in the quarter due to pricing and vol/mix gains. Biscuits had a strong quarter with revenue up about 5% driven by solid performance of our top five brands. The strength in biscuits, however, was largely offset by a decline in nuts and bars. We expect these businesses to recover as the year progresses.

At the profit line, margin fell by 160 basis points. However, this included a headwind of more than 300 basis points due to significant realized gains on certain commodity hedging activities last year. Excluding the impact of hedging gains, margins would have been up strongly from improved vol/mix and overhead leverage. As we move forward, we have new marketing campaigns and new products planned for the second half of the year. We expect these activities to drive solid top line growth and deliver margin upside.

Turning to Canada and North America Food Service, our business in Canada continued to perform well delivering strong organic revenue growth. This was driven by higher price levels and continued vol/mix improvements fueled by marketing investments and improved customer programs. However, declines in food service reflecting an industry wide slow down in casual dining traffic more than offset the gains in Canada.

In addition, the discontinuation of a less profitable product line negatively impacted revenues by about 2 percentage points. Operating margin rose by 260 basis points. This was driven by three things. Growth in Canada, overhead leverage as we have taken steps to offset weak trends in the food service industry and lower costs from the completion of the restructuring program.

Now let’s turn to our businesses outside North America. In Europe revenues rose modestly as we grew share in a very difficult economic environment. The 0.4% increase in organic included two points of contribution from pricing. We are pleased that our investments in brand equity enabled our volume to hold up well in the face of strong pricing and a weakening economic environment.

However, vol/mix declined by 1.6 points in the quarter largely due to our decision to forego unprofitable volume. At the profit line, operating margins more than doubled to 10% despite additional investments in cost savings initiatives and higher marketing costs. This margin expansion was largely a result of improved pricing, favorable vol/mix and lower manufacturing costs as well as the completion of our restructuring program and lower divestiture related losses.

In developing markets, our focus on priority categories, core brands and key markets continues to drive strong growth. Organic revenues grew 9.3% with double digit gains in priority brands. For example, in Asia Pacific Oreo Cookies grew more than 40%. In Latin America, [lactic] chocolates were up more than 30%. In CEMA Jacob’s Coffee grew about 10%. Tang powdered beverages grew strong double digits across each developing market region.

Operating margins increased strongly, 160 basis points to 13.3%. This came despite the absence of a $40 million Brazilian value added tax credit a year ago. The economic environment remains challenging and we continue to see weakening consumption trends particularly in Central and Eastern Europe. Nonetheless, we remain cautiously optimistic about performance in the second half as our investments behind priority brands continue to drive top and bottom line results.

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

Irene Rosenfeld

Thanks Tim. I will sum up our year-to-date very simply. We continue to deliver strong results across all geographies. We have raised our full-year outlook to at least $1.93 while increasing our investments in the business. As a result, in the next two years we are poised to deliver profit margins at or above industry averages and to consistently deliver against our long-term earnings target of 7-9% growth.

Now we would be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Robert Moscow - Credit Suisse.

Robert Moscow - Credit Suisse

I wanted to know about the revenue growth. It was just a little bit lighter than what we had expected and I guess it must have been due to the discontinuations. Was Easter originally supposed to be 200 basis points of a shift instead of 100?

Irene Rosenfeld

No, we essentially expected it to be about 100 and as we mentioned it was offset by the discontinuation of some of our less profitable product lines. We actually felt quite good about our revenue performance in the quarter particularly in light of the fact that dairy was considerably lower than we had expected it to be.

Tim McLevish

I think what you are getting confused on was in the first quarter there was about a 200 basis point drag but that was a combination of the Easter shift as well as the discontinuation of certain product lines.

Robert Moscow - Credit Suisse

So that was both of those things.

Tim McLevish

Yes.

Robert Moscow - Credit Suisse

On the gross profit margin it is up 30 bips from a year ago. I think other companies are showing some big margin gains. Did the discontinuation of these items help your margin? If so, was that in that 30 bips?

Irene Rosenfeld

The net impact is positive from a margin standpoint. It is a little bit of a drag on revenue as we said and it certainly is an enhancer to our bottom line operating margins as well as our operating income.

Robert Moscow - Credit Suisse

But gross margin up 30 basis points for the year, was that in line with your expectations?

Tim McLevish

It was probably a little bit ahead of our expectations. Keep in mind some of the factors that come through that would have enhanced the gross margin last quarter that we talked about in prior meetings such as the benefit from the realized hedging gains, etc. The fact it was above it actually overcame a number of pretty significant headwinds.

Operator

The next question comes from the line of Eric Katzman - Deutsche Bank.

Eric Katzman - Deutsche Bank

Just a few specific questions first. Did you mention how much advertising and promotional spending was either up or down in the quarter?

Irene Rosenfeld

We are actually not going to give you a number for the quarter. What I did say is that we expected it will be up on the year. It was in fact up on the quarter despite the fact that the costs have come down. We feel very good about the investment we have made to increase our share voice.

Eric Katzman - Deutsche Bank

The corporate expense was a lot higher even though I thought you had recognized a fair amount of pension expense in the first quarter. Is there any one particular thing that is driving that up so much sequentially quarter-over-quarter?

Tim McLevish

No, the pension contribution should have been about the same as the first quarter. Mark to market gains and losses run through corporate until they are realized. So there was some impact from that which may have been the delta you are seeing.

Chris Jakubik

Certainly year-over-year it would have been up pretty significantly.

Eric Katzman - Deutsche Bank

From a conceptual and strategic standpoint, I understand that you are now managing the cheese business to reflect more of the pass through and focusing on the higher margin pieces but with the pricing down 8% in this past quarter and volumes still not really recovering, in fact probably a little bit weaker because you had the benefit of Easter in there. Why shouldn’t we have seen more of a recovery in volume within the quarter?

Irene Rosenfeld

I think you will see a progressive improvement in the performance. There are a number of factors at work in the second quarter numbers. We benefited from Easter certainly in our cream cheese business. It doesn’t have much of an impact on the other forms but the facts are we are continuing to de-emphasize some of our lower margin businesses. So the net of that puts a little pressure in the short-term on the vol/mix line. You will see improvement though as that works its way through and I think certainly we have good visibility to our share performance as we start to look out into the current quarters as well as the out quarters. We are feeling quite good about the performance of that business. Most importantly, as Tim mentioned, we feel very good about our ability to manage the volatility of the earnings on the business as a consequence of the approaches we have taken on adaptive pricing.

Operator

The next question comes from the line of Terry Bivens – JP Morgan.

Terry Bivens – JP Morgan

On Europe granted there was some nice improvement there but I think you might agree with me that 10% operating margins are probably not where you want to be. Can you just give us a little color on how you see European margins evolving? I know you have a new person in there and presumably we will hear some more from that person. What is your two-year goal there to improve Europe?

Irene Rosenfeld

We have been pretty clear that we are targeting to get ourselves closer to peer margin in that geography as we are elsewhere in the world. The reality is as you look at the performance in the second quarter our operating income is up over 90% despite an almost 30% currency hit. We actually feel quite good about the progress they are making. Without a doubt 10% is not our end goal but it is a significant improvement year-over-year and I think we have the programming in place to continue to make progress on our margins in Europe as well as elsewhere.

Tim McLevish

We are very focused on the expense side of the equation and we will talk with you more about that in the back to school conference coming up next month.

Terry Bivens – JP Morgan

As we look, we should look at perhaps European food companies to get kind of a barometer of where you think that may go?

Irene Rosenfeld

Yes.

Terry Bivens – JP Morgan

Tim you mentioned $550 million in input costs if I heard that correctly. What period was that over?

Tim McLevish

$550 million is year-to-date.

Operator

The next question comes from the line of David Palmer – UBS.

David Palmer – UBS

A question on promotions and the effectiveness around promotions these days in certain categories in 2009 versus maybe previous years where promotions and activities in store may not have made as much sense. For instance, are you thinking about dedicating more resources in-store behind the convenient meal categories or some of your categories within grocery that may be more pure and simple meals for the family and there is a better ROI attached to that than what you had seen before? Was there a higher impact on your pricing from increased promotions in this last quarter?

Irene Rosenfeld

We really feel very good as a result of the investments we have made in these businesses. We are in a much stronger position to be able to market these businesses and to essentially grow them with a variety of tactics. So particularly our value oriented businesses, our value meals; products like Mac & Cheese, products like frozen pizza, beverages like Kool-Aid, Crystal Light and Country Time, those kinds of products are doing exceptionally well with value messaging and we don’t necessarily have to spend a lot more to promote them at this point in time. We have very strong brand equity that we have been able to leverage quite successfully.

The reality though is given the volatility of input costs we have invested more in the short-term in promotions because it has been our method to adjust pricing while we wait to see how the market shake out. Our intent long-term is continuing to shift our mix from more short-term promotional tactics to longer term equity building tactics like marketing innovation.

Operator

The next question comes from the line of Alexia Howard - Sanford Bernstein.

Alexia Howard - Sanford Bernstein

On the commodity input cost pressure, do you have a full year number you talked about I think at one point it was $200 million for the full year. Has that gone up?

Tim McLevish

It has gone up a little bit. It is probably a little over $300 million is our expectation today.

Alexia Howard - Sanford Bernstein

It has been $550 million year-to-date so this is the point where it actually starts to turn negative?

Tim McLevish

We will see it turn the other direction in the second half.

Alexia Howard - Sanford Bernstein

Talk about increasing, or since the last quarter you talked about increasing your investment in marketing and cost savings in the back half of the year. Can you give us some sort of number on how much that has been raised since we last spoke?

Tim McLevish

None of the increases, we talked about a couple of pennies of initial restructuring and a couple of pennies of additional AMC investment, neither of which were in our first guidance or expectations.

Alexia Howard - Sanford Bernstein

In the upward revision of guidance is there any foreign exchange movement in there? That seems to have turned a little bit more favorable over the last couple of months or in fact completely foreign exchange neutral.

Tim McLevish

If you kind of sequence it, as you know in January we talked about $0.16 on year-over-year pressure from FX. What happened at the end of the first quarter we had about another $0.05 worth of additional pressure and we thought we would be able to cover that with operational improvements. So we kind of held our guidance at that point. As FX has essentially come back to about the $0.16 level we originally started now we have let that $0.05 worth of operational improvements flow through.

Operator

The next question comes from the line of Ken Zaslow - BMO Capital Markets.

Ken Zaslow - BMO Capital Markets

In the categories you expect to gain market share that you haven’t gained market share can you talk about specific examples of what you are going to do to gain share?

Irene Rosenfeld

I will start with the situation in cheese. We will see progressively improved market share in our cheese businesses as we continue to focus our marketing efforts and our dollars on our advantage categories particularly singles and cream cheese. In a number of our other categories I would remind you we have about 10% of our revenue that is losing share but they are in categories like Mac & Cheese, hot dogs and Velveeta for example where we have very strong market share position and we are growing very nicely at high single digit rates. It just happens that the category is growing a little bit faster.

So we really see a number of our categories continuing to improve as the year progresses both through a combination of increased marketing support as well as the fact that a number of our innovations will hit in the back half.

Ken Zaslow - BMO Capital Markets

The second question I have is in terms of your hedge position how much are you more incrementally hedged this quarter than last quarter? Does that preclude you from or does that actually enable you to have more margin expansion in 2010 as they roll off?

Tim McLevish

Our hedge position is a pretty stable program. We are always essentially hedging until our ability to price reflects the changes in the underlying costs. Our hedge position has not changed appreciably from quarter-to-quarter.

Operator

The next question comes from the line of Tim Ramey – D.A. Davidson.

Tim Ramey – D.A. Davidson

A quick follow-up on Ken’s question. Does that mean your hedges don’t extend into fiscal 2010 at this point?

Tim McLevish

There may be a couple of them that extend into 2010 but that would be more of a [inaudible] product. Then we may have a bit of a oil hedge out into 2010 because that is a little bit less impact but the effects our fuel for our logistics and it also effects some of our packaging materials and films. We may extend a little bit of that out into 2010 but there really shouldn’t be any direct input costs that are hedged out into 2010.

Tim Ramey – D.A. Davidson

The volume recovery is very impressive and heartening. You talked about improved volume in the second half and that is great. Could you be more specific about what you think volume might do and just my vote that mixing volume and mix together is not at all intuitive to me.

Irene Rosenfeld

As we have told you, our expectation is that we will see the contribution of vol/mix driving our revenue growth in the back half of the year as we lap the pricing actions we took. We are quite confident we will be able to deliver that because we have been focusing our resources on those categories, brands and geographies where we have the greatest potential for revenue growth as well as the greatest profit potential. We are seeing that play through in each of our core geographies. In North America our focus brands are growing about 5%. In Europe similarly. In developing markets our priority businesses are growing about 19%.

I feel quite comfortable the focus we have got and the investments we are making in these core brands, and categories and markets will be a key driver of our performance in the back half of the year.

Operator

The next question comes from the line of Judy Hong – Goldman Sachs.

Judy Hong – Goldman Sachs

Can you maybe give us a little more color in terms of your margin expansion opportunities as you are finalizing your strategic initiatives? I am just curious as to what buckets of cost savings really are out there for you to achieve. If you sort of look back a few years ago when you had the cost savings initiatives it sounds like a lot of that sort of went back towards brand investments to improve your brand equity and market share performance and in it sounds like maybe going forward more of the cost savings will really flow to the bottom line because you feel pretty good about your brands’ strength at this point. Am I thinking about this in the right way?

Irene Rosenfeld

Very much so. The reality is productivity has always been a hallmark of Kraft. Over the last couple of years even with the rise in input costs we have been using a lot of that to offset costs. Now that we have stronger brand equities we are able to use pricing much more effectively. As we look forward we are going to spend quite a bit of time at the back to school conference talking about our cost initiatives. I would tell you we are expecting to see margin expansion from a couple of sources. One is just the vol/mix improvement that will continue to play through as a consequence of our stronger brand equities. Second, we will give you a lot more visibility into our end to end productivity. We talked a little bit about this at CAGNY where we have got some very specific programming in a couple of areas including procurement, manufacturing and logistics and we will talk some more about that as well as continued focus on managing our overhead costs. That is what gives us great confidence that we can achieve at or above peer margin in the next two years.

Judy Hong – Goldman Sachs

Is it still your intention to include these costs as part of your EPS?

Irene Rosenfeld

Absolutely.

Judy Hong – Goldman Sachs

Just a quick follow-up on the mix component. A lot of companies were more realistic of mix not being as beneficial just given that consumers are under more pressure and could remain so for the foreseeable future. How does that sort of play into your algorithms? Your mix components specifically?

Irene Rosenfeld

I think in some cases there was a point where a number of us thought about mix in terms of trading consumers up. Actually it is just about not changing less profitable volume. So what you are seeing a lot of our businesses that are value oriented whether it is Mac and Cheese or powdered drinks, for example, have very attractive margins so that as we continue to market those businesses particularly in the current environment we are benefiting from the mix and we are getting mix benefit as a result. We feel quite comfortable that mix will continue to be a benefit to us. In fact, as we now lap a number of the more significant discontinuations that we made in the first half of last year we will start to see stronger pull through in our mix component.

Operator

The next question comes from the line of Jon Feeney – Janney Montgomery Scott.

Jon Feeney – Janney Montgomery Scott

A few companies have kind of proceeded down this path of sort of foraging their categories between certain focused brands and certain focused categories and others that are a little less profitable and getting less focused. I think the risk as I see it is communicating that to customers directly or indirectly tends to have an impact and maybe can get a little out of control. How have you dealt with retailers in categories where you are maybe putting a little bit less investment? How are you managing that risk that maybe those categories decline a little bit more than you had planned?

Irene Rosenfeld

Let me be clear. When we talk about focus these are categories are getting incremental investment. The balance is just getting investment that is essentially in line with the company average. We are not talking about walking away from business. What we are talking about is disproportionately investing incrementally in businesses that we feel have greater growth potential. So it is not a difficult conversation with our customers. They are as anxious to grow some of these core categories as we are. The businesses that are not part of our focus categories are still receiving support and in fact they are some of the businesses that benefited from the investment that we made over the last couple of years. We are just not looking to invest any further incrementally in those businesses. We feel quite comfortable that the level of support they have today is adequate.

Jon Feeney – Janney Montgomery Scott

You mentioned in your opening remarks thinking about margins and productivity aligned with industry benchmarks. Can you give us a sense of what those benchmarks are? Are we talking about operating margin and industry averages? Any color around what you can give us around what your internal benchmarks are from that long-term perspective.

Irene Rosenfeld

We will be giving a lot more color on how we are thinking about it and more specifics. Margins as we are thinking about them are operating margins and as we said before we set our sights on getting ourselves back at least to peer average margins which we would define to be the global food and beverage margins. We see those in the mid teens. That is the target we have set for ourselves. As a result of the good work we have done on a number of the cost initiatives that I mentioned a moment ago. We have much better visibility to the impact of those kinds of initiatives. We will talk a lot more about that at the back to school conference.

Operator

The next question comes from the line of Bryan Spillane – Bank of America.

Bryan Spillane – Bank of America

First, on the input inflation outlook for the year going up from $200 million to $300 million what moved against you that caused it to go up for the year?

Tim McLevish

It is not really…it is a variety of factors. I can’t point to one specific input cost that has changed. That is kind of our latest view of the overall impact.

Bryan Spillane – Bank of America

Just trying to get a sense for whether there is something we should be watching that could move that. How much volatility can we expect that to have in the back half of the year I guess is what I’m after.

Tim McLevish

We feel pretty good about that number. It may be a little bit more than that $300 million number maybe closer to $400 million for the whole year. Again, that reflects a decline in the second half of the year some $750 million.

Chris Jakubik

Just to clarify, I think Alexia said that we had our original forecast was $200 million. That would be incorrect. In fact our forecast at the beginning of the year was higher. It has actually come down a bit to that $300 million range.

Bryan Spillane – Bank of America

I thought it was $200 million at the end of the first quarter. For some reason I had that written down. The other question in terms of getting back to the mid teens operating profit margin targets over the next two years, if you hit your organic revenue assumption and you hit that target it seems like EPS would grow faster than the 7-9%? Am I thinking about that right?

Tim McLevish

It would be at the upper end of the range. There is a little bit of variation in all of that. I would say you are right it would drive an EPS at the upper end of that 7-9% target range for the next several years as we enhance that considerably.

Operator

The next question comes from the line of Andrew Lazar – Barclays.

Andrew Lazar – Barclays

A quick follow-up. I know you will get into a lot more of this in the coming weeks but as we think about how you get ultimately to the margin goals that you want to, just thinking about your North American margins versus those overseas, the bigger opportunity right from a margin perspective is overseas but it would seem where those outsized margin gains and improvements really need to come from. Is that where you have identified disproportionate amounts of cost synergies relative to North America as a percent of sales?

Tim McLevish

Disproportionate I would say is accurate. More to come from upside in North America. A big piece of it, as we talked about, is to come from Europe. Developing markets has margin opportunity but they are really the growth driver. The EU has OI margin improvement opportunity and there is still some room in North America. We have said before the 21-22% is not a sustainable level and that is reflected very high North America. We don’t think it is healthy to go back to those levels. Clearly we think there is upside across all of our geographies. Probably the biggest opportunity is in Europe and then developing markets. Then you are right North America still has some but not the preponderance of it.

Andrew Lazar – Barclays

In thinking about the 3% organic rate of sales growth this year with you mentioned dairy obviously was a bigger hit to the downside to that organic growth rate maybe than you thought at the beginning of the year. Is it accurate to say for the operating side of organic top line growth outside of that dairy piece is better to make up for that to keep the 3% organic growth rate for the year?

Tim McLevish

Exactly right. The rest of it is built in a little bit better than we had originally anticipated to make up for the shortfall in cheese and the dairy products.

Andrew Lazar – Barclays

Your vol/mix went from minus 3.4 in the first quarter to plus 0.2 this quarter. Without getting into the specific components, is there a way to say which one drove the majority of that improvement? Was it primarily mix that drove that? Was volume at least sequentially better if not positive in the quarter?

Tim McLevish

Again, I will reiterate. I know some of you don’t particularly care for combining the two but we think it is a really more accurate reflection because the inherent tradeoff between vol and mix can become actually misleading if you look at them individually. In the first quarter vol was about 2.2% of the 3.4%. This quarter vol was essentially flat. So we picked up 0.2 from mix in this quarter and 1.2 from mix in the first quarter.

Operator

The next question comes from the line of David Driscoll – Citi Investment Research.

David Driscoll – Citi Investment Research

A question on the second half of 2009. Year-to-date you earned $1.00 per share. That leaves $0.93 for the back half of the year. I believe you said commodities would be a significant tailwind and I think the computation is somewhere around a $200 million benefit in terms of commodity deflation. Something we haven’t seen in a very long time. Why then are the second half earnings at just $0.93 and below that first half? I have gone back and looked at the pattern and there really is no significant seasonality pattern over many, many years at Kraft. Can you go into some factors here? Is it just being conservative?

Tim McLevish

There are a couple of things. You are right, when you go back to the seasonal patterns at Kraft you have a fair number of moving parts with restructuring reserves and charges and all those sorts of things. On balance, front half and back half I would say on average is about 50/50, a little bit maybe more weighted to the second half by a couple of percentages. On balance about the same. The input costs going down in the second half of the year will also come with it some expectation as we talked about with pricing in cheese and natural cheese. You will see some of the pricing come down as well. We are in fact anticipating that pricing in the second half of the year will actually be a negative contributor to revenues. We do have a number, as we talked about, as well of things…we have about $0.02 of cost savings initiatives that weren’t in our prior forecast that with the strong performance we have had that we are taking the opportunity to accelerate some of the cost savings initiatives. So we have picked up about $50 million. We originally came out with about somewhere between $150-200 million that we were investing in cost savings initiatives.

We have kicked that up by about $0.02 or $50 million. Also as we mentioned earlier we are increasing our investment in brand building and increasing our AMC by about $0.02 to $50 million. So that makes up substantially the difference in first half and second half. I think it is a realistic expectation considering the environment out there. We feel pretty good about it quite frankly.

David Driscoll – Citi Investment Research

Bigger picture here on the commodity side, over the last four years by my calculations the commodity inflation hit to Kraft foods has been just over $4 billion. Gross margins are down 385 basis points ended 2008. I think there is just a wide expectation there that a deflation of commodities is a significant positive for Kraft. Is this one of the fundamental drivers in your comments about the margin goals? I think you are leading us to the conclusion that at this upcoming conference you are going to spell out these margin goals in the next two years. It would seem that a deflationary environment would be a key component of it. Am I reading that correctly?

Irene Rosenfeld

No, I wouldn’t say that. I talked earlier about what we see as the key drivers of the margin expansion. We will give you a lot more detail on that in a couple of weeks. I feel particularly good we have staged the business for long-term growth because of the investments we have made in our brand equities, the pricing power that we have been able to demonstrate. The fact we have a much stronger innovation pipeline. All of which make us feel quite comfortable that the vol/mix expectations we have which will be the key driver of margin expansion are quite realistic. We are going to basically add to that some of the good work that has gone on in creative ideas in end to end productivity as well as some of the actions we have continued to take to manage overhead costs.

It is really a combination of those three areas. The end to end productivity, the vol/mix improvement and managing our overhead costs I think that will drive our margin expansion.

Tim McLevish

All of the margin expansion we have talked about and will talk more about in the coming weeks is attributable to operational improvements. None of it is a forecasting an expectation we will see a tailwind from input cost deflation.

David Driscoll – Citi Investment Research

If I were just to restate what you are trying to say then is the things that are under your control are really the basis for the margin forecast, if I or any one of us were to take the view that commodities were deflationary and the view that this is a benefit to Kraft would you agree that would be additive to what you all are doing?

Tim McLevish

I would say anything we have guided or set expectations for is purely operations or under our control and we are committed to deliver them. To the extent there are changes in the input costs some of that would play through. If you had a dramatic downward change in dairy prices again some of that presumably would have to be given back as pricing. Again, we have built the strength of our brands, we have innovative new products, we think we have pricing power but we have to see exactly how that would play out in the environment if we saw a material change in some of those input costs.

Operator

The next question comes from the line of Eric Serotta – Consumer Edge Research.

Eric Serotta – Consumer Edge Research

A couple of quick housekeeping questions and then a broader question. First, it looks like you have about $26 million or so of asset impairment exit costs this quarter. If I remember correctly there were about $25 million of restructuring type costs that were embedded in the P&L in the first quarter. Were there additional costs, restructuring costs embedded this quarter or should we expect now $200 million or so in the second half?

Tim McLevish

Actually I think the $26 million you are seeing is actually a credit of $26 million attributable to some charges we took last year under the program. We found a better means for accomplishing that, essentially sold the business rather than shut it down or a manufacturing plant. So we took back the net of $26 million worth of restructuring. So that was a credit. Embedded within the second quarter is about $40-45 million worth of restructuring costs. You won’t see it broken out in the P&L because it is embedded within the individual liens. As we have talked about moving away from tax item reporting and carving out restructuring it is embedded but there is about $40-45 million worth of costs in the second quarter and a similar amount in the first quarter. Year-to-date we are about $90 million and we are expecting that to step up in the second half. We had originally said $150-200 million so that would kind of normalize that. Now we have stepped that up about $50 million additionally as we see opportunity to accelerate some of that restructuring.

Eric Serotta – Consumer Edge Research

To follow-up on the commodity outlook for the second half could you give a rough guidance as to how much of the commodity deflation you expect to come from lower cheese costs which would obviously be passed on given your adoptive pricing model? Is that the bulk of the $250 million delta in commodities? Or can you give us an order of magnitude there?

Tim McLevish

It is a big piece of it. As you know, dairy prices have come down pretty dramatically from the last half of this year to where they are at today. There has been some recent shifts in that as the regulatory environment has made some changes. I would say other of the input costs, some of them are moving upward a little bit. Some are moving downward. On balance I would say the cheese thing is the primary driver of it.

Eric Serotta – Consumer Edge Research

In terms of your priority brands versus the rest of the portfolio, if I remember correctly the priority brands represent something like 45-50% of the U.S. business at least. It seems like you are showing some very solid, mid single digit top line growth from those. Do your current targets and does the current model work if the other 50% or so of the portfolio does not improve in terms of performing from current levels? Or is there some expectation the non-priority or non-focus part of the portfolio is going to start to improve from these levels built into your expectations?

Irene Rosenfeld

Our major assumption here is that these priority brands will be the key drivers of our aggregate performance as they have been so far. So again if you look at our aggregate results in North America, for example, where our priority brands grew about 5%, they represent as you said, over half of our revenue. Similarly we are seeing a disproportionate contribution from these brands in the other regions of the world. So we are counting on continued strong performance from these focus businesses because that is where we are putting the incremental investment and essentially sustained performance from the balance of the portfolio which is quite consistent with what we have seen so far.

Operator

The next question comes from the line of Chris Growe - Stifel Nicolaus.

Chris Growe - Stifel Nicolaus

First off, on the cost savings you are expecting for the year you have taken the charge a little bit. Are we still looking for around $200 million of cost savings for the year?

Tim McLevish

Yes, that is from the last restructuring program that we finished last year. The full year 2009 effect of that is about $200 million. The cost savings initiatives we are undertaking in the back half of the year that we talked about, the additional $200 million or $200 plus million is new programs that will benefit us in subsequent years.

Chris Growe - Stifel Nicolaus

On the cheese price increases we have seen recently, it has moved up pretty quickly obviously. Does that temper your comment about the negative pricing in the third quarter? Will we see that flow through in the third quarter or is that more of a fourth quarter shift for you in terms of retail pricing?

Tim McLevish

I would say where the cheese pricing is today is pretty consistent with our forecast. The increase we have seen really was reflected in our expectations.

Chris Growe - Stifel Nicolaus

As a bigger picture question regarding trade promotion, IRI data says a lot of your categories are seeing increased levels of promotion and I wonder if you could make a general comment about that across your business. Also, competitively if you are seeing increased levels of promotion and pricing promotion in your categories, X cheese because I think we have seen that in cheese pretty clearly.

Irene Rosenfeld

As I mentioned, we are seeing some increases in some respects because of the volatility of input costs. We have been using promotions tactically to adjust pricing. We are seeing some impact in a number of our categories. Occasionally we are seeing some sporadic aggressive price points that are really being funded by our customers as well. So there has been some activity but it is our long-term expectation that as the dust settles and we see input costs stabilize we will continue to move our spending from short-term tactical spending to more long-term equity building investments.

Chris Growe - Stifel Nicolaus

Was that a drag in your overall price realization in the quarter?

Irene Rosenfeld

Not really because net/net we essentially spent a little bit more in promotions. In some cases we actually used that rather than take a risk price reduction. We actually used the trade promotion to adjust prices. So essentially our net price was essentially where we expected it to be.

Operator

The next question comes from the line of Vincent Andrews - Morgan Stanley.

Vincent Andrews - Morgan Stanley

If I look out to next year now, and maybe it is a little bit early to be doing this but it looks like you would have input cost inflation of at least 3% and maybe as high as 5%. That probably would be pretty manageable from a cost productivity perspective. Is that similar to what you see at this point?

Tim McLevish

It is a bit early to be giving any indication or guidance on 2010 or future. I would rather not make those prognostications at this point.

Vincent Andrews - Morgan Stanley

From a vol/mix perspective, where are we in the pruning process? Are you done pruning? Is there just going to be a few more quarters before we lap the effort you have already got underway or is there more to come?

Irene Rosenfeld

I will tell you the heavy lifting is pretty much behind us. As we exit the third quarter we will have lapped most of the significant reductions we have made. We will continue on an ongoing basis to do some pruning but we took out some significant product lines in a number of our businesses and we would not expect that to replicated.

Vincent Andrews - Morgan Stanley

At what point does the growth in the non-measured channels, at what point do the comps there start to get tough? It seems like there is still pretty good growth coming out of those channels. When will it get difficult?

Irene Rosenfeld

I think certainly some of the trends that are fueling the growth of these other channels, the value orientation and just the shopper traffic we expect will be something we will continue to see for the foreseeable future and it is one of the reasons we continue to make sure we are appropriately represented there.

Tim McLevish

Operator, one more question.

Operator

The final question comes from Christine McCracken – Cleveland Research.

Christine McCracken – Cleveland Research

Not to get too specific but in fairness given the commodity cost favorability you are expecting in the second half should it be heavily concentrated in North America with the dairy and pricing cost outlook and not in Europe where sugar and coffee are moving higher?

Tim McLevish

We have a much heavier cheese business and pizza business is more heavily weighted towards dairy input costs. You are right. We continue to see a little bit higher cocoa costs and sugar and so forth. I would say that is fair that North America will be most impacted.

Christine McCracken – Cleveland Research

Separately, on DiGiorno and Deli Fresh it seems to be more premium products that might be benefiting from the shift away from food service you noted [inaudible] well known that is happening. When you look at the launch of new products you are going to be coming out with in the second half are you tailoring that innovation at all to kind of hit those same trends or are you expecting thinking kind of longer term when you are rolling those things out?

Irene Rosenfeld

No I would tell you that we have certainly a number of items in our pipeline that would be more premium kinds of offerings and we have chosen to just hold those in abeyance while we wait for the economy to recover. I would say the focus of our near-term innovation pipeline is on snacking. It is on health and wellness products and continued focus on value.

Christine McCracken – Cleveland Research

On the frozen area, there hasn’t been any noticeable shift down in sales trends there? We have been picking that up here in the last couple of weeks. I just wanted to follow-up with that.

Irene Rosenfeld

No, we have had I think our seventh straight quarter of double digit revenue growth in our pizza business. We are quite optimistic about the outlook.

Operator

This concludes the question and answer portion of the conference. I will now turn the call back over to Chris Jakubik for closing remarks.

Chris Anderson

Thanks very much. Thanks everybody for joining us this evening. For those people in the media who have further questions, Mike Mitchell will be available to you. For any analysts who have follow-up’s myself and Dexter will be around for awhile to take questions. Thanks very much. We will speak to you very soon.

Operator

This concludes today’s Kraft Foods second quarter 2009 earnings conference call. Thank you for your participation. You may now disconnect.

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Source: Kraft Foods Inc. Q2 2009 Earnings Call Transcript
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