Welcome to the Kellogg Company 2009 Third Quarter Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. (Operator Instructions).
At this time, I will turn the call over to Mr. John Bryant, Kellogg Company Chief Financial Officer. Mr. Bryant, you may begin your conference.
Thank you, Audrey. Good morning, everyone. Thank you for joining us for a review of our third quarter results.
With me here in Battle Creek is David Mackay, President and CEO and Gary Pilnick, General Counsel. I'm also happy to introduce [Kathryn Kessel] our new Head of Investor Relations.
We must point out that certain statements made today, such as projections of Kellogg Company's future performance, including earnings per share, net sales, margins, operating profit, interest expense, tax rate, cash flow, cost savings, brand building, up-front costs and inflation are forward-looking statements. Actual results could be materially different from those projected.
For further information concerning factors that could cause these results to differ, please refer to the second slide of this presentation as well as to our public SEC filings.
A replay of today's conference call will be available by phone through Monday evening by dialing 888-632-8973. The passcode is 72183663. The call will also be available via webcast replay which will be archived for 90 days.
Now, let me turn it over to David.
Thank you, John. Good morning, everyone.
The third quarter was a strong one for Kellogg Company, continuing excellent momentum from earlier in the year and there's no doubt the current economic environment is difficult. However, our business approach is designed to achieve positive results, even during challenging economic conditions. We have sharpened our marketing and tried initiatives to reflect the pressure on our consumer, and we have been relentless in our pursuit of increased productivity through our three-year $1 billion cost reduction challenge.
The current environment also creates opportunities for us. We have seen consumers trade into some of our core categories, such as cereal, in market like the US and the UK, as consumers seek to maximize the value received from every food dollar spent.
We have also taken advantage of media deflation to significantly reinvest back into our brands. We still expect our advertising spend to be up double digits in the back half, with an even greater increase in underlying impressions. We believe that while the current economic environment is challenging, it also gives us the opportunity to build an even stronger Kellogg Company for the future.
The third quarter results illustrate the continued resilience and relevance of our focused strategy and business model. Internal net sales which exclude 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.
Gross margin exceeded our expectation in the quarter. Excellent delivery from our $1 billion challenge enabled us to deliver gross margin expansion and while commodity costs have fallen as we expected, we are still seeing overall cost of goods inflation versus last year. We posted double-digit internal operating profit growth, exceeding our long-term annual target of mid single-digit growth, as momentum continued behind productivity and cost saving initiatives.
Our EPS growth for the quarter was higher than expected, driven by strong internal operating profit delivery. Importantly, despite significant reinvestment in the business, we are also raising our currency neutral earnings per share guidance for 2009 and providing 2010 guidance above our long-term targets.
As you can see, we remain focused on delivering sustainable and dependable growth for our shareowners in 2009 and going forward. We continue to have excellent visibility into our future financial performance.
Now, I'd like to turn it over to John to walk you through the financials.
Thanks, David. 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 internal operating profit growth, and high single-digit currency neutral EPS growth.
Reported net sales were relatively flat 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 7% internal net sales growth. We continue to project 3% to 4% internal net sales growth for full year 2009.
Reported operating profit increased by 6% despite the adverse impact of foreign exchange, significant reinvestment in advertising and higher up-front cost. Internal operating profit grew by strong 11%. This result was driven by our strong top-line performance and excellent delivery from our $1 billion challenge.
We also delivered a high quality of earnings. We took advantage of our momentum to reinvest in the long-term health of our brands by increasing advertising by 17% on an internal basis in the quarter, and we executed up-front cost projects which adversely impacted operating profit growth by 6% year-on-year.
Reported earnings per share rose ahead of expectations to $0.94, a 6% increase on a reported basis and a 12% increase on a currency neutral basis. This result was driven by strong internal operating profit growth, partially offset by unfavorability from foreign exchange. On below the line items, we had some discrete items, which reduced our tax rate to 26.8% for the quarter and lower interest expense year-on-year. However, this was more than offset by other income and expense.
Let's take a closer look at the drivers in our sales growth on slide five.
Third quarter reported sales declined 0.3%, driven by a 3.5% impact from currency. Internal net sales in the third quarter rose 3.1%, driven by pricing and volume growth. It is important to note that the third quarter is our toughest comparable for the year.
We were pleased to see tonnage growth of about 1% in the quarter, driven by strong growth in global cereal volume, partially offset by softness in our US frozen and specialty channels business. On a year-to-date basis, internal net sales growth was a solid 3%, delivered by North America contributing 3% growth, Latin America 9%, Asia Pacific 6%, and Europe 1%.
Gross margin for the quarter was up 120 basis points over last year's third quarter. The margin expansion was driven by price realization and delivery from our cost savings programs, despite continued inflation year-on-year and higher up-front costs. If we adjust for up-front costs in the quarter, our gross margin would have been up a 190 basis points year-on-year.
Internal gross profit dollars grew a solid 7% for the quarter. Year-to-date gross margin of 42.9% is up 30 basis points year-on-year. If we adjust up-front costs, our gross margin would be up 90 basis points year-on-year.
As expected, commodity prices and distribution costs have continued to decline and we now anticipate full year 2009 cost pressures at approximately 3% of cost of goods. For 2009, we are over 90% hedged on commodities on a global basis.
Year-to-date results from our cost savings initiatives have offset inflation. Currently, our 2010 full-year outlook for cost pressures is approximately 3% of cost of goods, and we are approximately 40% hedged for 2010.
Third quarter internal operating profit rose 11%, despite significant reinvestment back into the business in the form of increased advertising and up-front costs. North America internal operating profit rose a strong 10% versus last year's tough comparable of 15%, driven by top-line growth and gross margin expansion, offset by a significant increase in advertising. In addition, increased up-front costs reduced internal operating profit by approximately 3%.
European internal operating profit grew approximately 7%. After a tough start to the year, our European business delivered internal net sales growth of 5% in the quarter, which helped drive a strong internal operating profit delivery, despite a mid single-digit increase in advertising on a currency neutral basis.
Higher up-front cost investments reduced internal operating profit by approximately 8%. Latin America's internal operating profit declined by 3% in the quarter, due, in part, to a significant increase in advertising. Higher up-front cost investments also reduced internal operating profit by approximately 10% in the quarter, and in Asia Pacific, internal operating profit increased by 9%, driven by top-line performance and effective cost discipline. Higher up-front costs investments also reduced operating profit by approximately 10% in the quarter for Asia Pacific.
Our commitment to investing in advertising continues to be key to our business model and to achieving our goals. During the third quarter, internal advertising spend increased versus last year by 17%, bringing our year-to-date growth to 4%.
For the back half of the year, we continue to project that advertising will increase at a strong double-digit rate on an internal basis. We will also continue driving efficiencies in our more than $1 billion of annual advertising spend. Rather than take advantage of lower rates to reduce the cost of our advertising investment, we see this as a great opportunity to increase our investment and build even stronger brands for the future. Higher spend, combined with media deflation and a push on efficiency, is driving a significant increase in advertising pressure.
Manage for cash has been a key operating principal for Kellogg for several years and we have redoubled our efforts in this difficult economic environment. This has helped drive a record cash flow performance, despite the adverse impact of foreign exchange. Cash flow for the quarter, $443 million, outpaces last year's strong delivery for this period. This brings our year-to-date cash flow to $978 million, well above last year's very strong performance.
Given our strong cash flow performance year-to-date, we are now raising our full year cash flow guidance to approximately $1.2 billion, which still includes the impact of foreign exchange headwinds. This will be a record performance for Kellogg.
Now let's turn to our 2009 guidance on the next slide.
We have good momentum entering the fourth quarter, 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 100 basis points for the full year. This is driven by higher than expected cost savings, slightly lower inflation and solid price mix performance.
Note that we expect the impact from up-front costs to adversely impact gross margin by 40 basis points for the year, which indicate that the underlying gross margin expansion is closer to 140 basis points.
The strong growth in gross margin has enabled us to increase our internal operating profit growth expectation to a range of 8% to 10%, despite the significant level of reinvestment in advertising and up-front costs. We continue to expect up-front costs to be approximately $0.26 per share for the full year.
Below the operating profit line, we have a number of moving pieces. We now expect our full year tax rate to be between 28% and 29%, reflecting the benefit of some discrete items year-to-date. However, this will be more than offset by increases in both interest expense and expense items in the other income and expense line.
We now expect full year interest expense of approximately $300 million, up from our prior estimate of $270 million. This reflects our intention to refinance part of our 2011 bond maturity and issue new long-term debt. This enables us to improve our long-term liquidity position and take advantage of attractive long-term rates.
On other income and expense, we have historically guided this line to be neutral. However, this year we expect a loss of approximately $10 million to $20 million, reflecting the impact of repatriating cash from some of our international operations and a charitable contribution.
Regarding shares outstanding, during the third quarter we executed a portion of our $650 million share buyback authorization for 2009. We will continue to execute against this authorization and we will roll over into 2010 any unused portion. We do not expect our share repurchase activity to have a meaningful impact on earnings per share in 2009.
The net impact of below the line items since our second quarter guidance is approximately $0.02 of adverse impact to EPS. However, this is more than offset by an anticipated increase in operating profit, which enables us to increase our full year earnings per share guidance to a range of 10% to 12% growth on a currency neutral basis, up from our original guidance of high single-digit growth.
Please remember that this is despite the additional headwinds, increasing up-front costs from $0.14 per share last year to $0.26 per share this year.
Moving from currency neutral to reported EPS requires us to estimate the impact of foreign exchange on our EPS performance. Slide 12 gives you a sense of how difficult it can be to reliably forecast foreign exchange.
On the second quarter conference call, we provided the spot rates and estimated an adverse impact to EPS of 6% from foreign exchange. Some current spot rates would suggest that we should have good news from foreign exchange. However, there are two key reasons that this is not the case.
First, the US dollar actually strengthened slightly in the intervening months and secondly, approximately 25% to 30% of our full year international net income is generated in the third quarter compared to only about 12% to 16% in the fourth quarter. The result is that we expect to have a 7% adverse impact to EPS due to foreign exchange for full year 2009, despite a weaker dollar today compared to the second quarter call.
Also note that we have incurred approximately $0.23 of adverse impact to EPS from foreign exchange year-to-date. This would imply that all the bad news is in our actual results and we do not expect a foreign exchange headwind in the fourth quarter.
For those of you looking to convert our currency neutral EPS guidance to a reported EPS guidance, if you assume current spot rates hold for the balance of the year, this would result in a $0.21 adverse impact from foreign exchange, providing a reported guidance range of $3.08 to $3.14 per share.
Since this is the third quarter conference call, I would like to give you a sense on slide 13 of what we expect to see for 2010. We expect to continue to drive volume and mix, which will enable to us deliver top-line growth in the range of 2% to 3%, in line with our long-term annual target. Our continued focus on productivity, a relatively benign inflation environment and lower up-front costs should enable us to expand gross margin by approximately 100 basis points.
We currently expect cost inflation of approximately 3% in 2010, offset by savings resulting from our $1 billion cost reduction challenge. We expect our up-front costs to decline to a range of $0.14 to $0.16 of EPS, down from this year's $0.26 per share. We intend to drop the $0.10 reduction to the bottom line in 2010.
Going forward, we expect an ongoing annual base line of $0.14 to $0.16 in up-front costs. These up-front costs will be absorbed into the P&L as a regular part of our business operations. We will let you know if the level of up-front costs for a particular year is significantly different from this range. Lower up-front costs should help accelerate our internal operating profit growth to high single digits.
Below the operating profit line, interest expense is expected to be approximately $265 million and the full year tax rate is forecast at a range of 30% to 31%. We also expect to execute the 2010 share buyback authorization of $650 million, which should help lower shares outstanding by 2% to 3% for 2010. We expect EPS to grow at a rate of 10% to 12% on a currency neutral basis in 2010, which is above our long-term guidance of 7% to 9% and largely reflects the lower level of up-front costs year-on-year
On a currency neutral basis, we anticipate 2010 full year EPS in the range of $3.40 to $3.52. We plan on allowing the impact from foreign exchange to flow through to reported earnings per share, and we will provide updates as we progress through the year. However, for those of you looking to convert our currency neutral EPS guidance to a reported EPS guidance, if you assume the current spot rates from slide 12 hold throughout 2010, this would result in an $0.08 favorable impact from foreign exchange providing a reported guidance range of $3.48 to $3.60 per share.
Now, I'd like to turn it to David for a review of the business.
Thanks, John. In the third quarter, North America produced 2% internal net sales growth on top of last year's strong 9% growth. As you can see, we delivered growth in retail cereal and retail snacks while posting a decline for frozen and specialty channels. In the third quarter, our North America ready-to-eat cereal business, delivered 2% internal net sales growth on top of last year's tough comparable of 7% growth.
The cereal category by our estimate grew about 2% during the quarter. Despite a competitive environment, category share growth in measured channels was up 20 basis points. As you remember a year ago, Quaker's promotional activity was down significantly due to a supply issue. With Quaker back in play this year and bringing increased competitive activity, holding share during Q3 is a strong performance. Also Kellogg ready-to-eat cereal consumption across all channels increased by approximately 2%.
Our focused strategy of investing behind our top eight brands plus Kashi is a key contributor to this success. During the quarter, these brands grew net sales at a strong 8% with Special K, Raisin Bran and Kashi each delivering double-digit growth. This strong growth from our top brands was driven by double-digit increase in our advertising investment as well as successful promotions.
Given the positive momentum of our core business, we are discontinuing our on-the-go cereal offerings, as their attractiveness to consumers is low during this tough economic environment. Excluding on-the-go items, our ready-to-eat cereal business grew 4% during the quarter.
Our innovation efforts during Q3 supported our commitment to continually improve the quality of our foods as well as our commitment to offer a product portfolio that provides dietary fiber. During the quarter, we launched renovations of Froot Loops and Apple Jacks with three grams of fiber per serving.
Kellogg Canada continued to perform well with strong performance by Kashi and the recently launched Mini-Wheats Blueberry cereal. In the third quarter, our North American snacks business posted 3% internal net sales growth over last year's strong 10% comparable. This quarter's overall results were supported by double-digit growth in wholesome snacks.
Our direct store delivery business continued to perform well, growing internal net sales a solid 4% over last year's difficult comparative of 7% growth. Our Pop-Tarts brand delivered low single-digit internal net sales growth in the third quarter and our underlying Blue Box business is performing extremely well.
Store-door cracker sales rose low single digits versus last year's strong growth, driven by ongoing solid performance from Cheez-It and Town House. In addition, our new Special K crackers continued to perform ahead of expectations. We gained share in the cracker category in the third quarter.
Store-door cookie sales for the quarter declined slightly year-over-year in line with the overall category decline. However, Fudge Shoppe posted a strong performance and Mother's brand cookies continued to deliver above expectations. Including Mother’s, as a new business for us, our store-door cookie share grew slightly in the quarter
Store-door sales of wholesome snacks was strong, delivering double-digit internal net sales growth and more than two points of share growth. Our new Fiber Plus and Cinnabon bars are performing ahead of expectations and Nutri-Grain bars continue to be a solid performer.
As I mentioned earlier, our frozen and specialty channels business posted an overall decline for the quarter. Third quarter top-line growth for North American frozen was negatively impacted by lapping strong growth and a significant forward buy against a price increase a year ago, as well as by a temporary supply disruption.
Our Food Away from Home business posted a year-over-year decline versus last year's strong Q3 performance, but continues to perform above general food service trends, despite ongoing industry headwinds.
Our international business returned to strong growth in Q3, delivering 6% internal net sales growth. In particular, Europe had a very strong quarter in a difficult operating environment. Internal net sales for Europe grew 5% for the quarter versus last year's 3% comparable. As we discussed during our Q2 earnings call, we expected a stronger back half from Europe and we are seeing that come through in our results.
Internal net sales growth for the European area was broad-based, including double-digit growth in Russia. In the UK, we delivered mid single-digit internal net sales growth and gained share in the ready-to-eat cereal category. In Latin America, we continued to deliver strong results with 9% internal net sales growth.
Our business in Mexico delivered mid single-digit internal net sales growth in the quarter and driven by continued strong performance from Zucaritas gained more than two points of category share in ready-to-eat cereal. The cereal category in Mexico is strong and grew approximately 4% in the quarter.
Brazil, Columbia, Central America and Venezuela all posted good internal sales growth in the quarter, and our Asia Pacific business delivered 4% internal net sales growth building upon last year's strong 10% growth. Our businesses in South Korea, Australia and India delivered strong internal net sales growth.
So in summary, we are pleased with the results we posted in the third quarter and are on track to deliver strong results in 2009 and 2010. We are seeing even better momentum this year than we anticipated, and our strong brand building programs and cost saving initiatives continue to drive these results, and we've executed well around the world.
More importantly, we are excited to take this opportunity to build an even stronger Kellogg Company for the future. We are optimizing our global organization and striving for enhanced effectiveness in many areas of our business. We off to a great start with our $1 billion challenge and we have confidence we will achieve our goal.
We have significantly increased our investment in up-front costs, which will help drive efficiency gains, help offset commodity and energy inflation in future periods and provide the fuel to sustain our momentum.
As I mentioned earlier, rather than pull back on advertising and take advantage of lower rates, we see this as a great opportunity to increase our investment and build even stronger brands for the future. Higher spending, combined with media deflation and a push on efficiency, is driving a significant increase in advertising pressure.
All of these elements support our increased confidence that we can deliver our targeted rates of growth in 2009 and 2010, and demonstrate our commitment to manage the business for long-term, sustainable, dependable performance. We have excellent financial visibility and are committed to running the business the right way for the long term.
Once again I'd like to thank Kellogg employees around the world for their continued commitment to executional excellence and dedicated hard work. Also, I'd like to remind everyone that we are hosting an analyst conference here at Kellogg on November 12, and hope that you will join us.
Now, I'd like to open it up to questions.
(Operator Instructions). Our first question comes from Andrew Lazar of Barclays Capital. Please state your question.
Andrew Lazar - Barclays Capital
So I am just curious if we just think about gross margin for a moment in the full year of 140 basis points if we exclude the up-front costs. I guess, what I'm trying to get a better sense of is after five plus years of kind of the up-front costs and the productivity savings, I'm curious about is the leverage you are seeing from that, along with stable volume, positive pricing.
I guess, I'm curious why that hasn't necessarily even brought better gross margin expansion sort of this year than we are going to see, particularly because you have seen a lot of other peers obviously deliver gross margin gains for this year in many cases well beyond that.
I'm just curious is the on-the-go cereal platform, is that a new event such that we are likely to get another three quarters of sort of some drag on cereal shipments? Thank you.
I take the gross margin and David on-the-go cereal. Our gross margin Andrew, we feel very good about our gross margin performance. I think if you look at our gross margin relative to the peer group, we are actually at a very high level to start with.
We have about 100 basis points of reported gross margin improvement this year and another 100 basis points next year. The $1 billion challenge is providing great visibility and helping us expand the gross margin. Again we feel very good about the gross margin performance and expect it to continue to grow and expand in 2010.
I think Andrew on the on-the-go, we are working very closely with our retail partners trying to streamline and simplify the category Straws and go-packs really didn't work. We are effectively taking those out proactively.
That's about half a share point for us and I think we said in the prepared comments without that our 2% in cereal would have been up 4.
Our cereal performance remember is up against a very tough comp, but that will probably last through the first and second quarter of next year. There will be a bit of a drag and then we will anniversary it.
Andrew Lazar - Barclays Capital
Then as part of that and then I'll pass it. Do you feel like the cereal category as a whole has gone through already maybe some of the more major changes from an SKU perspective or brand perspective that all of you might expect or is that not the case?
No I think the category is doing very well, so I think it will probably be more stable and have less change than maybe some others.
You might see a little bit more rationalization in the number and scope of SKUs as retailers are looking to streamline and simplify but I don't think it will be material Andrew, as we go forward.
Our next question comes from Judy Hong of Goldman Sachs. Please state your question.
Judy Hong - Goldman Sachs
Dave just following up on the North American cereal category, you've talked about some increased competitive activity that you are seeing in the category.
Could you just talk a little bit more about that the nature of the competitive activity and how aggressive some of these activities are and whether you think that this will continue as the company looks towards more volume improvement.
Yes Judy. I think the reference was really regarding Quaker. You remember last year Quaker had a disruption in one of their plants, and they were pretty much out of the market for a big chunk of Q3. So this year in Q3, they were back in business and that was probably the biggest single change in the competitive dynamics.
Nothing untoward just they were out of the market last year, they are back in the market this year. I don't think the category has got any more influence on us, a fairly competitive category but we don't actually anticipate anything that dramatically different as we look to the future.
Judy Hong - Goldman Sachs
My second question is really relates to 2010 guidance, It seems like there's really a sizable tailwind. You talked about the lower up front cost next year, you're lapping the peanut recall related costs this year that you are probably not going to have next year, and you’ve got the cost savings kicking in as part of the $1 billion challenge.
I'm just wondering if maybe even the internal operating profit projections that you have could be even stronger, and if there's some level of conservatism built in, in terms of your guidance.
I think at this stage we've not finished the year yet. If you look at the current market environment and our view on 2010, we expect it to be a little bit volatile and it's going to be a fairly tough economic environment.
So I think the guidance we've given which is above our long-term guidance is very strong. We feel very comfortable with it and if there's anything we see different as we go through the year then we'll update you on it.
Our next question comes from Eric Serotta of Consumer Edge. Please state your question.
Eric Serotta - Consumer Edge
Just wanted to talk a bit about some of the items that you mentioned that you are going to be flowing to the bottom line next year rather than reinvesting, it seems like it's been more your strategy in the past to reinvest the benefit from things like changes in up front costs, which I realize many years have gone up, but why the decision not to increase not to reinvest that essentially $0.10 benefit and instead to forecast higher or guide to above your long-term targets?
Yes. I think Eric twofold. One is we still as we look at 2010, have very strong investment against the business. So we are investing heavily against the business in marketing and in driving efficiencies. Really when you look at one time costs, the history has been to spend broadly around $0.14 to $0.16 has been pretty average for us.
This year was significantly higher, as we were driving K-LEAN. It required a lot of external help. We're looking to reduce that reliance as we head into 2010. We've got more savings from process changes and how we operate than necessarily having to impact plant costs.
So we feel very good about what we are doing with our productivity and we don't need the level of up front costs as we look at 2010 at this stage.
So we thought the best thing to do would flow through. We will then be hitting a level which is more consistent with our ongoing levels and as John said if that looks to change, we will update you when and if we have that clarity.
Eric Serotta - Consumer Edge
A follow-up question on the competition in US cereal. It seems from the scanner data that Post was still having their logistical and other issues for the third quarter. I'm surprised to see that Kellogg didn't materially benefit from that disruption at Post.
Could you give some indication as to why you think that was the case? Could you also comment on what you are seeing in terms of competitive activity from Post as they are starting to get their house in order?
If you look at cereal for the quarter, we are very pleased with the performance. We had tough comps. A year ago we grew 7%, this year we are about 2% in shipments, probably 2.5% in consumption. As we mentioned the top eight grew 8%, Quaker was really as I mentioned the jury was one that had come back in. I think Post you have to talk to them specifically, but I'm sure as they settle things down, we will see them come back into the market a little bit more.
That would be our expectation but we wouldn't expect that to have a material impact. As I also mentioned managing retail or own and working with retailers to optimize the category from an SKU perspective had a bit of an impact on us as it may have had on others.
Eric Serotta - Consumer Edge
Lastly and I'll pass it on but you mentioned 2.5% consumer take away or consumption in all outlets for US cereal. If I remember correctly, last quarter you talked about 6%, 7%, all outlet consumption. Just wondering what the driver of that slowdown was. Was it simply a matter of a tougher comp as things accelerated in the second half of last year or are you seeing some underlying deceleration?
Last year in Q3 the category grew 5% to 6%. This year it grew 2% to 3% by best we can calculate looking at ROI and non measured channels. That's probably a reflection of a couple of things. I don't think the category is slowing.
Last year it was probably a little stronger than we've seen for awhile, and I think as we start lapping some of the pricing impact, I think 2% to 3% is probably more consistent with our expectation as we look to the future.
Thank you. (Operator Instructions). Our next question comes from Ed Roesch of Soleil Securities. Please state your question.
Ed Roesch - Soleil Securities
First question was on advertising. You're increasing your spending at a pretty healthy rate. Could you just comment on the ROI on that advertising especially in this consumer environment and then how that is offset of course by some deflation in media?
I think ROI in advertising is a perennial challenge. We have a number of methodologies to ensure that we are getting the best return from our advertising possible. We pretest all of our commercials through a research methodology called Millward Brown.
We’ve seen improvements in the breakthrough on those ads. That's a good indication. We are working on other ways to actually measure the ROI. If you look this year, we are going to be up mid single digits in a market where we are probably seeing a degree of media deflation.
We are seeing media buying efficiencies and some consolidation benefits in Europe and we are seeing reduction in non-working advertising. So the increase in impressions is probably double-digit while the absolute dollar spend is around mid single-digit.
We think it's a great time to invest behind our brands and make sure consumers are fully aware of their benefits and keep them at the forefront for as many consumers as we can. As we go into next year our expectation would be that we will see advertising grow in line with sales and again we would expect to see some but less deflation in media costs in 2010.
Ed Roesch - Soleil Securities
David on that latter point at this time of year are you able to lock in any way your media rates?
Certainly for North America, we typically contract for the first six to nine months of 2010 in the next few months.
Ed Roesch - Soleil Securities
One last question if I could. SKU rationalization you mentioned fairly minor impact. I recall that you were extending the Special K brand in some alternate aisles outside of the cereal aisle. I guess in the diet and nutrition in some instances. I haven't heard a whole lot about that effort recently and is that pretty safe from this rationalization effort please?
We've launched Special K bars. We've launched a Special K shake. They are doing very well. We have had some rationalization where some of the products we tried didn't work is to our expectations, but in general terms the bars and the shakes are doing very well. For those who do attend the Day at K, will give a little bit more flavor on some of the thing we are doing on SKU rationalization.
Thank you. Our next question comes from Chris Growe of Stifel Nicolaus. Please state your question.
Chris Growe - Stifel Nicolaus
I just had a quick question for you regarding, the comment I think you made earlier in the call about trade promotion efficiency and it’s really trying to sharpen your trade programs. Does that imply increased spending?
I wonder if you can give us a feel for how you are looking at that in this kind of environment. Or does this imply better programming and better returns on the money you are spending?
I think it's hopefully a combination of both. We are always looking to drive efficiencies and what we get in return from our investment with our retail partners, but it also implies that we are being pragmatic about the pressures consumers are under the issues they're facing and the orientation that consumers have towards value in this new age of thrift as I've heard it called. So we are working very closely with our retail partners to try and ensure that we encourage people to try and repeat on our products.
Chris Growe - Stifel Nicolaus
Okay. Just one follow up if I could? Does an age of thrift mean weaker mix? Do you plan on that for 2010 for example?
When we report on price mix if you look at this year, the bulk of it has been price. I think as we go forward and we have seen not dramatic but some shifts in mix where people are looking to buy more all-family, more familiar products.
It hasn't had a dramatic impact on mix. As we go into next year, I would expect price mix to be positive, not as high as it's been in the previous three to five years. I would also expect that volume will continue to contribute in 2010.
Thank you. (Operator Instructions). Our next question comes from Bryan Spillane of Bank of America Please state your question
Bryan Spillane - Bank of America
Just wanted to ask on your net interest expense guidance, it implies that if I've got it right, $300 million for this year implies about $100 million in the fourth quarter, which is about $35 million more than the run rate's been. You've just refinanced or tendered for the 6.6% notes, which presumably you are going to refinance at a lower rate. So one why is the expense going to be so much higher in the fourth quarter?
In terms of your guidance for next year, I had factored that you could save about $10 million to $15 million by terming out the notes you're tendering for. Does it imply that you are going to be borrowing more money terming out more debt next year, just trying to get an understanding of the moving parts there.
Just to clarify the tender offer for the bond is in the fourth quarter. That's in the $35 million to $40 million range of additional expense, which is why our outlook moved up to $300 million for the full year. As you go to 2010, we expect our absolute debt to be fairly in line with 2009, but we do expect and our outlook is higher short term rates.
So we are paying higher interest expense on the commercial paper, which will be partially offset by the savings we're getting from the 6.6% bond to whatever bond we end up issuing.
It's either a five-year or ten-year bond or whatever it looks like based upon the rates that are out there when we get around to issuing that bond.
Bryan Spillane - Bank of America
So in the fourth quarter that interest expense guidance includes the cost of tendering for the bond as well as the rate.
Our next question comes from Eric Katzman of Deutsche Bank. Please state your question.
Eric Katzman - Deutsche Bank
First John, I had of bit of a technical question. I've always wondered why your fourth quarter profits are seasonally so much lower than the other quarters. It's not because people are eating less, so what exactly takes that how does that factor into the FX stuff you were talking about?
Eric there is a seasonal pattern if you look over the last four or five years of our last fourth quarters, I think it also has to do with how we reinvest back in the business. If you look at the fourth quarter this year, we actually expect the fourth quarter to continue to grow strongly in terms of top line growth and very strong gross margin expansion.
If you look at what we are doing in the fourth quarter, we have a double-digit increase in advertising in local currency. We have about $0.10 of up front costs, and then below the line we have the bond buy back.
In addition don't forget we are lapping the 53rd week that was in last year's fourth quarter, obviously it’s not in this year's fourth quarter. There are some anomalies in the fourth quarter as well as the normal seasonal pattern that you see.
Eric Katzman - Deutsche Bank
Is there an accrual issue that you basically back load everything? Not so much year-over-year, but I'm talking sequentially, if you look over the last four or five years, the fourth quarter is always lower by $150 million or plus in EBIT.
Yes. I think that Eric reflects our historical pattern of reinvesting back in the business, and quite frankly I think we have the ability going forward at some point to increase the profitability in the fourth quarter and move some of that investment around in the year.
Eric Katzman - Deutsche Bank
Then on the cash flow efficiency, I think you said $1.2 billion for this year which is very strong probably equal to your earnings per share, which is pretty good. Is there any outlook for that number for ’10, is there any swing factors that we should think about in terms of cash flow?
Eric we only give cash flow guidance on the fourth quarter conference call, once we have this year closed, we have a balance sheet at the end of the year. So we're giving cash flow for next year. I think in terms of things that we’re moving around little bit, this year our CapEx is around the $400 million mark.
Next year we expect our CapEx to be more like $500 million, but we have good earnings growth next year and hopefully FX tailwinds and we will see where the numbers actually end up.
Eric Katzman - Deutsche Bank
Then sorry if I could sneak one last in. This would go to Dave, one of the questions I get as I go around and visit with investors is where has all the volume gone in the industry not necessarily for you.
It seems as if with the tailwind from people eating more at home that just generally speaking the industry should be reporting better volume performance. Maybe you can just comment on that as you see it broadly across the industry?
I think you are going to see more volume come back. Certainly that's our expectation as we look at the business for 2010. Particularly when you think about what's going on with the mix of top line, where more likely than not if the commodities environment stays benign, there will be limited potential pricing. So you will probably see slightly more volume a little bit of price mix, but significantly less than you have seen historically.
That's why when you look at our guidance for 2010, we are around the 2% to 3%. I think volume for us was positive in the quarter. As we look going forward to 2010, it will be more positive than we are seeing potentially over the last few years, where I think price mix has been the key driver of top line.
Our next question comes from Terry Bivens of JPMorgan. Please state your question.
Terry Bivens - J P Morgan
First of all John thanks for the explicit guidance on the foreign exchange, for those of us still working on an abacus it was a little bit confusing, but I think I've got it now. The question is this, there's clearly a lot going on at retail these days certainly.
Wal-Mart with the great value initiative and the SKU rationalization et cetera. It's early days, but we've looked at some data that suggest that maybe what we've seen over the past several years that is when you look at Nielsen numbers, there's always a fairly positive addition from the channel shift to Wal-Mart and other outlets suggests at least in Wal-Mart maybe that's slowing down a little bit.
Dave I just wanted to get your opinion there. Do you think what we've seen as generally an accretive channel shift does that appear to you to be decelerating?
I can only talk what we've seen Terry, and certainly for us in Q3 we did see a slightly lower non major channel growth. Part of that was because of the year ago comp, so it's a bit early for to us draw any conclusions on that. So just the Q3 we would agree, but we are not sure what the underlying dynamics are versus the year ago comp.
Terry Bivens - J P Morgan
Just in regard to the UK, if I could ask one quick follow? Obviously you've changed the trend there from years past where it used to be a very tough business. Just in brief, what seems to be the delta there? It seems you're doing quite well in the UK, what do you attribute that to?
I think we've got strong performance in our cereal and snacks business. If we look at cereal for the quarter we grew over a share point. The category was up 5, we were actually up 8. So it was a very strong category growth. A very strong Kellogg performance, I think it's a combination of things.
Strong brand building has been relatively good innovation, a great focus on the core again there is really helping us. People are coming into the category, because you probably don't see that many categories a number, but not that many that are growing around 5% in the UK.
So overall very positive category dynamics, pretty stable trading relationships and I think that's really the key elements in the UK.
Our next question comes from Jonathan Feeney of J Montgomery Scott. Please state your question?
Jonathan Feeney - Janney Montgomery Scott
Dave I just wanted to ask about a big picture question about the role of productivity savings and the long-term growth of the company here. You talked about the $1 billion challenge and I think others in the industry have a fair amount of that productivity. I think that it's probably fair to say that's what's going to pick up the slack in 2010 for what's been a pretty giant commodity tailwind.
Looking forward why is it that Kellogg shareholders and consumer staples companies broadly shareholders are participating more fully in that productivity savings as far as expanding the earnings base versus continually reinvesting in value and in some cases prices?
Maybe a more simpler way of putting it is, why should retailers and consumers continue to share and get probably most of those benefits at the margin when the business itself should grow in addition to those productivity savings?
I think Jonathan that the key for us is sustainable dependable performance. We called our earnings this year 10 to 12 and likewise for next year, which many would say is bold for Kellogg Company. So I think you are seeing the visibility in the productivity and efficiency drives we've had flowing through the P&L.
It's also given us the fuel to invest beyond our brand to continue to do the right things for the long-term. Plus also to reflect the fact that we are trying to give where we can appropriately back to consumers at a time when they are feeling under pressure and work closely with our retail partners who are also striving to give the best value they can to consumer.
So I think I would disagree that we are not giving back in this time to shareholders. Over and above that all the cash we generate, it’s going back in share buy-backs. We've got strong dividends, so I think what our task is, is to ensure that we don't in what is a very volatile environment get the balance too far out of skew and I think we hopefully have the balance right.
Jonathan Feeney - Janney Montgomery Scott
So the idea is that shareholders do get it back, but we get it back on the installment plan over several years through the reinvestments you make?
That's one way of looking at it. I'm not sure I'd quite articulate it that way. I think sustainable dependable performance when people are investing in Kellogg Company I think is pretty critical. We want to deliver overtime.
Our final question comes from Ed Aaron of RBC Capital Markets. Please state your question.
Ed Aaron - RBC Capital Markets
Just wanted to follow up quickly on the strategic thinking behind your decision to exit the on-the-go category. I understand there's some cyclical pressure on that business, but it's not an immaterial piece of your overall cereal business, and it seems like there should be a sustainable market for that category as a whole.
Just as the market leader, I'm struggling to understand why it doesn't make strategic sense for you to continue to be there in some capacity?
Yes, I think Ed when you look at the two specific items that we are removing Straws and go-packs, they really didn't resonate as well with consumers as we had thought. Now very hard to be exact in why, but I think when you look at this environment consumers are typically drifting to larger packs versus smaller packs to drive value.
So I think in general terms while portion control will potentially do well over time, it hasn't worked as well as we thought in the cereal category and it's probably been a little adversely impacted, because of the economic environment.
Ed Aaron - RBC Capital Markets
One quick follow up if I could. Just on the SG&A line, you talked about higher gross margin expectations, but on SG&A there was some pretty good cost control there when you factor in what you did on the advertising spend.
It seems like there might be a little bit of room on that line item relative to your expectations as well. Is that a fair statement?
In the SG&A line, obviously we've got the overhead line in there and we've been driving very aggressively to keep strong discipline on overhead costs, so I think we're doing well and that in some respects masking the increase in advertising on that line.
Thank you all for the attendance this morning and we look forward to seeing you all at Day at K.
Thank you. This does conclude today's teleconference. We thank you for your participation. You may disconnect your lines at this time and have a great day.
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