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Kellogg (NYSE:K)

Q2 2010 Earnings Call

July 29, 2010 9:30 am ET

Executives

Kathryn Koessel -

John Bryant - Chief Operating Officer and Executive Vice President

Ronald Dissinger - Chief Financial Officer and Senior Vice President

A. D. MacKay - Chief Executive Officer, President, Director and Member of Executive Committee

Analysts

Alexia Howard - Bernstein Research

Judy Hong - Goldman Sachs Group Inc.

Vincent Andrews - Morgan Stanley

Jonathan Feeney - Janney Montgomery Scott LLC

Christopher Growe - Stifel, Nicolaus & Co., Inc.

Terry Bivens - JP Morgan Chase & Co

Eric Katzman - Deutsche Bank AG

Robert Moskow - Crédit Suisse AG

David Driscoll - Citigroup Inc

David Palmer - UBS Investment Bank

A. D. MacKay

Thanks, Kathryn, and good morning, everyone. Our second quarter results were modeled and expected, reflecting weakness in the Cereal category, combined with the impact of our voluntary cereal recall at the end of June and softness in that area of business.

The weakness in the Cereal category have the greatest bearing on our Q2 results. Throughout the first half of the year, we talked about the challenging Cereal category and deflation. Our results and those of other cereal manufacturers reflected this trend.

Although we anticipated a difficult quarter, the severity of the impact to our business was greater than we expected. Our low cereal sales resulted from difficult year-on-year comparables, the cereal recall and inventory reductions. John will talk about these in greater detail.

We continue to feel confident in the Cereal category and believe trends will begin to improve in the back half of the year. Let me talk briefly about the voluntary cereal recall, which was due to an item that came from the line up. While we had relatively few complaints at the time of the recall, we knew that removing the production store shelves was the right thing to do for our consumers. The cost was high, the total anticipated EPS impact for the year including lost sales is approximately $0.12. And we're currently pursuing all legal recourse to recoup the cost.

Over the past 18 months, we've experienced two events that have adversely affected our business. The payment-related recalls at the end of 2008 and the recent cereal line of recall. We're frustrated by these business disruptions, both supply related, but I can confidently say that they were unrelated to one another and unrelated to our cost savings programs. And when it comes to quality and food safety, over the last few years, we've actually increased our vigilance and ramped up our investment across the company.

What these issues do have in common is the pressure that they place on our resources, both time and money. While we're working to minimize the impact, they will cause disruption to our business, our employees, our customers and our consumers and to this quarter, to our total company results. The weakness in our Cereal business in Q2, combined with the size of the cereal recall, drove our decision to call down our 2010 guidance.

It has always been our intent to take a realistic, open and pragmatic approach to running our business for the long term. This call down, while disappointing, will ensure that we can continue to do the right things for the long-term health of the business. As we said at the beginning of this year, we expect a stronger back half as we anticipate category trends will gradually improve. Of course, this will not happen overnight. We also expect to have stronger innovation in the second half of the year.

We just introduced FiberPlus cereal at the end of June, with strong initial results. And our Snacks business has launched a strong line-up as well. And we will continue to invest in our business through increased advertising. John will review the business in more details shortly. Even though we had a tough quarter, we feel good about the underlying health of our business and the remainder of the year.

And with that, I'd like to turn it over to Ron to discuss our financials.

Ronald Dissinger

Thanks, David. Good morning, everyone. Let me begin with a summary of our second quarter and first half results on Slide 4. As we have mentioned, we expected to have some tough comparisons in the first half, as well as some challenging operating conditions across our business. What we did not anticipate was the degree of weakness in the Cereal category and, of course, the voluntary cereal recall in June that directly impacted our results.

For the quarter, net sales declined 5% on a reported basis and 4% on an internal basis. Approximately one point of the sales decline was attributable to the recall. The softness in the Eggo business also contributed roughly one point to the decline in sales. The remainder was primarily due to weakness in our U.S. and U.K. Cereal businesses and the reduction of cereal inventory levels in the U.S.

Operating profit for the quarter also fell as a result of lower net sales, the recall and an increased investment in advertising. Operating profit was down 13% on a reported basis and down 11% on an internal basis.

Earnings per share declined 14% on a reported basis, and 11% on a currency-neutral basis. The recall reduced operating profit by approximately 10% and earnings per share by $0.10, including loss sales in the quarter.

As we look at recent consensus estimates, we recognize that it was difficult to estimate the impact of the recall, given that we provided no guidance until today. The accounting rules required us to book the majority of the impact in the second quarter. We also expect a small impact in the third quarter.

For the first half, internal net sales declined 1%. However, year-to-date internal operating profit was up 3% and currency-neutral earnings per share grew 7%. Excluding the impact of the recall, internal net sales would have been flat. Internal operating profit would have increased approximately 8%. And earnings per share would have increased approximately 12% on a currency neutral basis. While sales were softer than expected without the recall, year-to-date operating profit and earnings per share would have been in line with our previous full year guidance.

On Slide 5, we'll walk through the components of our internal net sales performance. On a reported basis, our second quarter net sales declined by 5.2% year-over-year. Internal net sales declined 3.9%. The following components contributed to the overall change. Lower volume reduced our internal net sales by 4.5 points, our lower volume performance was impacted by three different factors. Over two points of the total company volume decline was attributable to our U.S. Cereal business, which included approximately one point from the recall. Softness in the Eggo business contributed one point and the continued transition from bulk-to-packaged products in our Russia Snacks business contributed another point to the decline.

Volume across the remainder of our business was relatively flat. Price and mix were positive and contributed 0.6 points of growth and currency negatively impacted growth by 1.3 points.

Now let me turn to Slide 6 to discuss gross profit. On a reported basis, gross profit declined 7% in the second quarter and gross margin contracted by 90 basis points to 42.6%. The impact of the recall contributed 120 basis points to this year-over-year decline. So without the recall, our gross margin would have expanded modestly.

As a result of the recall and an expectation of higher commodity costs, we now expect gross margin to increase approximately 50 basis points for the year, in line with our year-to-date results. We now expect cost pressures to be in the range of 4% to 5%, up from our prior estimate of 3% to 4%. For the remainder of the year, we are approximately 90% hedged on commodities. As we said on our first quarter call, our outlook includes commodity inflation in future quarters as we begin to lap lower costs in 2009. We plan to share our outlook for 2011 on our third quarter earnings call.

Now let's turn to Slide 7 to discuss advertising. As David stated, we are committed to reinvesting in our business. The categories in which we participate respond well to investment, and we believe it is important for the long-term health of these categories and our business. As a result, we have not pulled back on advertising. Instead, we have continued to invest.

Internal advertising increased 4% in the second quarter. U.S. Retail Cereal, Europe, Latin America and Asia-Pacific all increased advertising expenditures by at least mid-single digits this quarter. Advertising was up 1% on an internal basis for the first half. And as we said last quarter, we expect our advertising investment for the full year 2010 to grow in the mid-single-digit range.

Slide 8 reviews our internal operating profit growth by area. Total company internal operating profit declined 11%. In North America, internal operating profit declined 16%, with the recall contributing 13 points to the decline. In addition, the cereal pricing environment, trade inventory reductions at key customers and softness in the Eggo business contributed to the decline were partially offset by lower-upfront costs in the quarter.

Europe realized a 6% increase in operating profit as a result of lower commodity costs, cost savings and lower upfront costs. These more than offset the softer sales and increased advertising spending.

The 10% decline in Latin America was a result of commodity inflation, increased advertising, the difficult operating environment in Venezuela and to a lesser extent, the residual impact from the temporary closure of our Brazil plant in the first quarter. These items more than offset a mid-single-digit increase in sales.

While sales also increased in Asia-Pacific, increased cost pressures and advertising investment contributed to a 10% decline in operating profit. Note that Latin America and Asia-Pacific are lapping strong double-digit operating profit growth in the second quarter 2009.

Now let's turn to Slide 9 to discuss cash flow. We remain committed to generating cash and returning it to share owners. Year-to-date, cash flow was $446 million, $89 million lower when compared to last year. Lower cash flow was primarily due to the timing of cash tax payments. We now expect our cash flow to be in the $1.15 billion to $1.2 billion range for the year, in line with our revised business outlook, which I will discuss shortly.

Now let's turn to Slide 10 to discuss the impact of foreign exchange on earnings per share. Since our guidance is on a currency-neutral basis, each quarter, we provide an estimate of the foreign currency impact on our full year earnings per share. Slide 10 shows our key currencies with 2009 actual rates and current spot rates as of July 26, 2010. Based on these spot rates, we estimate full year 2010 foreign exchange to be unfavorable $0.04. We will continue to update you on the impact of foreign exchange on a quarterly basis.

Now let's turn to Slide 11 to discuss adjustments to our full year 2010 outlook. As David mentioned, we are lowering our guidance for 2010. This change reflects the weaker business performance in the second quarter and the voluntary cereal recall. We still expect to have a stronger back half based on the comps, coupled with increased innovation and advertising. But remember that we have more difficult sales and earnings comps in the third quarter and easier sales and earnings comps in the fourth quarter. We expect internal net sales growth to be flat to up 1%. Internal operating profit growth is now expected to be in the 4% to 6% range.

As you recall, we had strong operating profit growth in Q1 and for the first half, we were up 3%. This guidance also includes our intent to grow advertising in the mid-single digit range. We will continue to execute our three-year $1 billion-plus cost savings challenge and expect that gross profit margins will expand approximately 50 basis points for the year.

With this outlook on internal operating profit and slightly lower average shares outstanding, we expect our currency-neutral earnings per share growth to be in the range of 8% to 10%.

On the next slide, we have laid out the key changes to our 2010 earnings per share guidance. The primary driver to our lower earnings per share is the voluntary cereal recall, which is expected to have a negative 4% impact. In addition, softer business performance reflects another 1% to 2% decline. However, embedded in this guidance is up-front costs of $0.12 per share for 2010 compared to our prior guidance of $0.16. This contributes a positive 1% to the earnings per share guidance. Note that lower up-front costs were driven by reduced costs of the initiatives, not the number of initiatives. In addition, we remain on track to achieve our three-year $1 billion-plus cost challenge.

We estimate that the reduction in the average shares outstanding should contribute another 1% to 2% to our earnings per share. As I mentioned earlier, we now expect full year 2010 cash flow to be in the range of $1.15 billion to $1.2 billion. We will continue to return cash to share owners under our current three-year $2.5 billion share repurchase authorization. Year-to-date, we have repurchased $356 million worth of shares. We currently assume that we would decrease average diluted shares outstanding by approximately 1% to 2% in 2010. We will update you on the third quarter call on our progress.

And now I'll turn it over to John Bryant to cover our North America and International results.

John Bryant

Thanks, Ron. Let me begin with North America. Internal net sales declined 6% in the second quarter and we were down 2% for the first half of 2010. In the second quarter, net sales from North America Ready-to-Eat Cereal business decreased by 13% versus last year. While disappointing, the 13% decline can be explained in part by three factors. The first factor is weak consumption against tough costs. Second, is the cereal recall at the end of the quarter. And finally, the correction of elevated trade inventory, which we flagged at the end of the first quarter.

First, looking at consumption. We estimate that the category's declined by 2% to 3% in value during the quarter. We believe that our total channel consumption was down around 5% leading to a loss of approximately one share point. A large part of the decline in the category and in our consumption can be explained by the comparables.

In the second quarter last year, the category grew around 4% in value and our total channel consumption was up approximately 6% to 7%, resulting in approximately one share point of growth. Our share gain last year was largely due to Post going through some integration issues. As we lapped last year, Post has regained some share.

It is also worth noting that the SKU actualization last year adversely impacted our second quarter results by 1% to 2%. In addition, our innovation this year is more back-end loaded.

The second factor, as David has already talked about at length, was the voluntary cereal recall. While this occurred at the end of the quarter, we were required to reverse the sales of all products, which was subsequently returned. The net impact was a reduction in sales of 5% in the second quarter in North America Retail Cereal sales.

Finally, we flagged at both the end of last year and the first quarter that we had higher retail inventory than we were comfortable with. And we saw this reverse out in the second quarter, resulting in an estimated 3% adverse impact on shipments. So contributing to the 13% net sales decline is a 5% impact from weak consumption, largely due to tough year-ago comparison, a 5% decline from the recall and approximately 3% from a retail inventory correction.

While these three factors help explain the results, we do not pretend to be satisfied with the performance of our Cereal business. On a more positive note, we gained cereal share in Canada in the quarter and are seeing some very promising early results from innovation in the U.S. Both FiberPlus and Cinnabon cereals have shown strong early performance with a 0.4 share and 0.3 share, respectively.

As we look at the remainder of the year, we expect to have weak consumption in the third quarter as the impact of the recall will show up on shelf, but expect better performance in the fourth quarter. We will have more advertising project and more innovation in the back half, and we remain excited about our long-term prospects in this important category.

North America Retail Snacks posted internal net sales growth of 1% for the second quarter and 3% for the first half, reflecting strengths in the Pop-Tarts and Wholesome Snacks businesses. The Pop-Tarts business delivered another strong quarter with net sales up mid-single digit and gained two points of share. Innovation and strong brand building supported this iconic brands continued growth.

Store door cracker sales was down slightly in the quarter. Our overall share was flat as we decreased our promotion activity in the second quarter in order to return to more balanced levels. Late in the second quarter, we launched a range of new products including two varieties of Town House Flatbread Crisps, Club Minis and Cheez-It Double Cheese Snack Mix.

Our Cookie business declined in the quarter against a tough year-ago comparable when we launched the Mother's business. Recent innovations including Fudge Shoppe Coconut Dreams and 100-Calorie Right Bites mini-Brownies are performing well. We expect Cookies to continue to be a tough category for the remainder of the year.

Momentum in our Wholesome Snacks business continued into the second quarter, delivering strong sales growth and maintaining our share leadership in this growing category. The successful introduction of Special K Fruit Crisps at the end of 2009 and the strong performance of FiberPlus bars continue to drive growth. We also launched two new SKUs of Nutri-Grain bars in the quarter.

For the remainder of the year, we anticipate continued growth in Wholesome Snacks and the Pop-Tarts, combined with a slight improvement in Crackers and slight performance in Cookies. We feel good about our strong innovations throughout the back half of 2010, much of which was introduced at the end of the second quarter.

Turning to the Frozen and Specialty Channels business. North America Frozen and Specialty Channels second quarter sales declined 9% versus last year. This was driven by the softness in our Eggo business, which was adversely impacted by our supply constraints and a tough double-digit growth rate comparison in the prior year. It is also worth noting that the performance in the second quarter was weaker year-on-year compared to the first quarter, due to a higher trade inventory rebuilt in the first quarter.

Towards the end of the second quarter, we have enough capacity in our network to return to demand-driving activities such as advertising and trade promotion. We are beginning to see the business respond to these drivers and expect it to return to modest growth in the back half of the year. We also introduced new products with Eggo Cinnabon Pancakes and Eggo Real Fruit Breakfast Pizzas, launching at the end of the second quarter.

We continue to work with our customers to help reset freezers, to regain space that we lost when we were unable to maintain supply. The combination of new products, improved freezer space and increased advertising pressure should help drive improved performance in the back half of the year. In addition, the Veggie Foods business continue to perform well in the quarter and our Food Away From Home business also showed positive growth.

Turning to our International business. Our Latin America and Asia-Pacific businesses continue to deliver solid sales growth while weakness in Europe muted the growth of our overall International business.

Europe internal net sales declined 3% in the second quarter, driven primarily by two factors, a weaker U.K. Cereal category and continued volume declines in the Russia Snack business. Similar to the U.S., many food categories across Europe experienced deflation. In the U.K., our largest European market, we gained share in the quarter, but our sales were down, reflecting a 4% decline in the category, which is up against a very tough 7% growth in the second quarter last year.

At the end of the first quarter, trade inventory in the U.K. was increased in preparation for Easter promotions. The U.K. ended the second quarter with inventory levels similar to a year ago.

In Russia, the migration from bulks to packaged snacks drove lower volumes and contributed to Europe's lower top line results. With a weak local economy, the transition has taken longer than we originally anticipated. To stand in the short-term volume declines, we are protecting our Bulk business while pushing harder the game, more trade support for our packaged snacks. We expect to see less of a negative impact from Russia in the back half. And while we were disappointed in the performance of our Russia Snacks business, our Cereal business in Russia had strong growth during the quarter.

Latin America's internal net sales rose 5% in the second quarter, on top of last year's healthy 8% growth. Internal net sales were driven by price increases in Venezuela and strong cereal growth, particularly in Mexico. Double-digit consumption growth in Mexico was not fully reflected in our net sales performance as retail has reduced inventory in the quarter and we lacked an inventory build last year due to the H1N1 virus scare. We continue to expect Latin America to deliver mid-single digit internal net sales growth for 2010.

Asia-Pacific delivered internal net sales growth of 3%, driven by strong top line performance in Australia, South Korea and India. Both Australia and South Korea saw strong second quarter Cereal category growth. We are currently launching a new Sultana Bran product, which will increase our healthy offerings in Australia and Heart to Heart oat cereal in India. For the year, we continue to expect mid-single digit internal net sales growth from our Asia-Pacific businesses.

Now let me turn it back over to David.

A. D. MacKay

Thank you, John. We're committed to continuing our track record of sustainable and dependable performance. And while we believe that our second quarter is not indicative of the potential of our company, it is never positive to have such weak quarter performance. We feel it is essential to face the issues that created this weakness and reflect them as accurately as possible, hence the lower guidance.

Our view, and we believe the view of the shareholders and investors has always been to be open and transparent and to ensure we do what is right for our business over the long term. While we expect a tough environment to persist, we continue to invest in our business to drive future results. We have confidence in the long-term health of our business and remain focused on managing the business towards sustainable and dependable performance. I'd like to thank all the Kellogg employees for their dedication and hard work.

And before I conclude, I'd like to congratulate John on his election to our Board of Directors. Those of you had the pleasure of interacting with John now that he has a great depth of knowledge about our financial and business operations, and we're pleased to have him join the board.

And now, I'd like to open it up to your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Eric Katzman of Deutsche Bank.

Eric Katzman - Deutsche Bank AG

I guess my question has to do with, we've talked a lot in the past about the advertising efficacy, and it looks like excluding the recall and maybe in the Eggo waffle problems, your volume on the business is still I guess about flat. And yet you continue to raise advertising, you're one of the highest percentage of sales. So I guess, I'll follow up, but what do you think is the issue? Is it just the new products, is it just the macro environment? Maybe you could touch on that, David.

A. D. MacKay

I think, Eric, when you look at it because really when you look at the quarter, the U.S. Cereal category and our performance within it, to a lesser extent the U.K. Cereal category and the recall are the major issues that we've try to lay out as we went through the Q2 results. And you look at the category as John said, when he went through deflation existing in the category, we sort, we talked about it in Q1. It's actually a little bit worse than what's expected. But as we reflected on, did the analysis, no question that Post and the fact that their year-on-year comps, when they're out of the market last year and have come back in this year, have had an impact. I think retailers pushing and using the category to draw traffic in has exacerbated in the short term the situation, and no doubt consumers are continuing to look for and buying a deal. So I think all manufacturers in the short term are seeing some of the costs come down, which has probably meant their activities are going up a little bit. Our view and our outlook as we look to the back half and going forward is, Cereal category is a great category. We think once Post lapsed Q3, that the level of investment tactically should moderate as cost go up. For us, as we look at the performance of Kellogg's specifically and take the 5% decline in U.S., we had a small impact from the SKU calculus, it was probably one or two. So if you look at that relative to the category, while we're not happy with the performance, we can understand it. John mentioned our innovation in the back half is much stronger. We're seeing very good performance at the FiberPlus and a couple of other innovations we've launched. And on your question specifically on advertising investment. Our belief is that while we are one of the highest spenders, if you look specifically in the category, it tends to be a fairly high investment category and we have real opportunities to build stronger capabilities in digital. We have real opportunities to increase the level of communication with Hispanics and those plus other opportunities on new products and investments around the world, we'll see our advertising grow. I think mid-single digits is a very good level for us. And we feel very comfortable that over the medium to long term, we'll get a good investment return for that.

Eric Katzman - Deutsche Bank AG

And if I could just follow up on the recall specifically. I think it was probably a lot greater than most people were expecting. And I'm just kind of worried to the extent that the recall has a brand equity impact. I mean sometimes these things are short term and the consumer comes right back. But are you seeing -- you mentioned some new products performing well, but are you seeing any lingering impact in terms of consumption on some of the core brands where the recall was greatest?

John Bryant

Our view would be that while in Q3 for the first sort of three or four weeks of the quarter, mainly through July, we'll see an impact because in some retailers, we pulled all of the stock and it's going back in, they're just working the availabilities. So we've seen that in the first week of data through July on those affected brands. But because we acted so responsibly I believe and voluntarily withdrawing all of the product, I don't believe there will be a long-term impact on those very strong equities.

Operator

And our next question comes Chris Growe with Stifel, Nicolaus.

Christopher Growe - Stifel, Nicolaus & Co., Inc.

I just had two questions for you. The first was, if you -- just to make clear by some of your competitors in the category. But how would you characterize the return for your promotional investments? Was the nature of the competition in the quarter that made it to where you're promoting more heavily but not seeing a return? Or is it the consumer, and I was curious, if you're thinking they kind of lingers into the second half of the year?

A. D. MacKay

I think if you look at the return on promotions with everyone being a little bit more active, there is a sort of offsetting effect with -- no one's promotions are really working as well because there's just too many offers in the market. So I think that reduces the benefit and return from promotional activity. And our view would be, as we look at our back half, certainly, we're going to be watching our level of promotions very carefully. And I think at some point in time, we'll see the level of deflation in the category abate and go away, particularly as cost pressures start to increase.

Christopher Growe - Stifel, Nicolaus & Co., Inc.

Is that this year you think or more of next year in '11?

A. D. MacKay

I would say it's probably going be towards the end of this year and going into next year.

Christopher Growe - Stifel, Nicolaus & Co., Inc.

And just one follow-up and I guess a question for Ron or for John. In relation to your earnings growth, your EPS growth guidance, we know the clear effect from the recall, that seems to account for the majority of the decline. And even if you take into account up front cost being down, your guidance really hasn't changed much for the year. So is there a degree of real improvement in the second half of the year that you see, it's going to require that would seem like in 3Q and 4Q to really make that full year guidance or am I looking at that the wrong way?

John Bryant

We do expect as we said a bit better performance in the back part of the year. And you can see that our sales are down 1% in the first half, and we're calling our sales flat to 1% for the second half. So there's a bit of business performance improvement, as well as a better benefit from lower average shares outstanding as well.

Operator

Our next question comes from Robert Moskow of Crédit Suisse.

Robert Moskow - Crédit Suisse AG

I guess my question is about the innovation that you do have for the second half, David and John. FiberPlus feels a little bit like a me-too kind of product. I was kind of hoping that you would talk a little bit about the pipeline for 2011 and maybe some -- start getting us excited about things like that. I know Post is planning a lot of new products for January and they've already showed it to the trade. Is there anything that you can kind of hint to in case the second half and FiberPlus doesn't quite achieve what you thought?

A. D. MacKay

Well, we do get out at our innovation here in the back half, I think we're doing very well, with FiberPlus and with Cinnabon. And I get some 0.4 and 0.3 share respectively in the latest 12 weekend. In fact the latest couple of weeks, FiberPlus has been over half a share point in terms of its performance. So I think we're getting good momentum behind that innovation. We have a stronger innovation line up for the first half of 2011 than we had in first half of 2010. We've not shared that with our retail partners yet, so we can't talk about that on this call. But we are excited about the upcoming innovation pipeline in U.S. Cereal.

Robert Moskow - Crédit Suisse AG

Do you feel though that FiberPlus and Cinnabon, did they, have you done any kind of work on whether it cannibalize your existing lines because those shares were up but others must have been down. Do you know where those products took share from?

A. D. MacKay

No, we look at the switching analysis, the turf analysis for all new products, and actually we're quite comfortable with the incrementality to our portfolio. The thing about Cinnabon, we don't have a heavy cinnamon portfolio and then FiberPlus, good, tasty fiber is quite helpful for our portfolio.

Robert Moskow - Crédit Suisse AG

A lot of people have raised some questions here about product quality and the recalls, it seems to be two separate incidents. Are you doubling up your efforts though, when you talk to your suppliers to make sure that they're not cutting corners to achieve your cost-reduction goals?

John Bryant

Robert, absolutely. Particularly in an environment where a lot of businesses are under pressure. There is an increased focus and diligence in working with our suppliers to ensure that they understand that they must meet the high quality standards that Kellogg Company has set and expects of them.

Operator

And our next question comes from David Palmer of UBS.

David Palmer - UBS Investment Bank

The revenue guidance of flat to up 1%, we estimate it, it implies something like a 3% currency neutral revenue growth in the second half, including maybe a one- to two-point gain from currency, it will be less than that. But 3% currency neutral revenue growth in the second half versus about a 1% currency neutral decline in the first half. I guess my question is, does that sound about right? And your North America Cereal business, I'm assuming that's going to lead the sequential improvement in your view, do you see Cereal revenue going back to growth in the second half?

A. D. MacKay

I think, David, the way I look at it is more one to two in the back half to get to zero to one for the year. And when you look at Cereal, as we said in the third quarter, we're going to see the impact of the recalls. So our Cereal is going still be under pressure, and while we expected to have a bit at fourth quarter, our view would be that for the back half, it's going to be more flat or flattish. So that's not going to be the key driver and that's why when we gave the forecast, we did call down net sales to zero to one for the year.

David Palmer - UBS Investment Bank

I know we're going to talk a lot about Cereal. But could you perhaps zero in on the state of that category today? A year ago or so, it seem like this was the epitome of rational, profitable growth as a category. Obviously, there's been some issues with category profitability, folks point at consumers, the retail customers and their actions and then the competition notably, promotional activity from Post. But could you perhaps go back and take another crack at it in terms of what's going on with this category?

A. D. MacKay

I think all of the things you mentioned play into what we're seeing in the category this year. I think when you think about the category in the first half of 2009, the four major developed markets in the world, the category grew anywhere between 4% and 8%. I think with hindsight, we probably underestimated the difficult challenge that would create for 2010. We knew it would be a challenge, that's why when we came into the year, our expectations for top line were probably more moderate than people were expecting. When you look specifically on what's unfolded this year, Post really, as we dug into the data was out and has come back in and are probably back to more historical levels. I think all manufacturers because of lower cost are probably putting a little bit more money back into the market to reflect the concern of our consumers being under pressure. Consumers clearly across all categories, I think, are buying more diligently and deal where they can get it and using coupons. And then retailers themselves see the Cereal category as a great traffic build up, so are actually using it in ways that may help with traffic but may not help with the overall strength in the category. So you put all of those things into combination and what you see is a very stark difference this year to last year partly because of the comps and partly because of those competitive dynamic. But our view would be, this is a great category. We'll see that dissipate as we move through the back half of the year and as cost increases invariably they will as we go forward, we would expect to see the category start to perform in a more normal basis.

Operator

And our next question comes from Jonathan Feeney of Janney Montgomery Scott.

Jonathan Feeney - Janney Montgomery Scott LLC

I want to follow up a little bit on Eric's question, just specifically, forgetting about the customer's reaction to the recall, managing changeovers in this industry as some others have recently taught us is logistically pretty difficult, and are there still places like right now as we speak where there's out of stocks, supply chain interruption and also like problems with getting back on promotional calendars type of thing?

A. D. MacKay

When you go through something like this, it disrupts the organization and our retail partners. We're fortunate that we're able to get back into production very quickly and start to refill the pipeline. I think most of our customers now are back with some of that trade activity, which was obviously disrupted in July and even into August. So it has had an adverse impact on us, it does become a large focus to the organization and so that is distracting.

Jonathan Feeney - Janney Montgomery Scott LLC

But I guess I was asking, at the retail level you feel pretty good about where you are?

A. D. MacKay

I think we feel good about where we are in the retail level. Obviously, this is something that we don't have to go through.

Jonathan Feeney - Janney Montgomery Scott LLC

I'm trying to understand as you restore capacity to Eggo here and presumably there's going to be some cost to get back on the shelves, as you kind of walk capacity back up. Shouldn't there be a period of time though that the contribution margin should be very impressive from Eggo as you sort of releverage, not only the brand investments you've made, but just capacity distribution, et cetera over the next 12 months.

A. D. MacKay

We do expect to continue to grow the Eggo business. And as you said, we are in the process of resetting some freezers in the third quarter, getting back up to a fuller distribution level in Eggo and incremental volume is highly profitable for us. Obviously, we're turning back on advertising and brand building support, so that's going to mitigate the operating profit benefit from getting back into the Eggo business. But it's a big opportunity for us in the back half of the year. And it's early days, we'll see more of the benefit of this I think in Q4, when we'll have an easier comp. Q3 is still a more difficult comp for us.

Operator

And our next question comes from David Driscoll of Citigroup.

David Driscoll - Citigroup Inc

David, can you talk about your Cereal promotional calendar for the second half of '10? And specifically, what I'm worried about is Post and their continued promotional environment. Are they taking events that you otherwise would have had, what's your confidence in second half '10 promotional calendar for Kellogg's Cereal?

A. D. MacKay

All I can really say on that, David, is we are taking the appropriate response and attitude as the category leader in the category to manage what we do going forward, to try and drive the category in that business.

David Driscoll - Citigroup Inc

Don't you have or maybe you could say that you do have visibility, maybe you can't tell us or you don't want to tell us. But you do have visibility on that promotional calendar for six months that's correct, right?

A. D. MacKay

That's correct, yes. Well, certainly three or four months out.

David Driscoll - Citigroup Inc

On the Eggo business. John, I believe that you said that Eggo sales would be up just modestly in the back half of the year Q3 and four. One thing I don't understand about that is, given how weak it was in the year ago period, if you restored the capacities and are now achieving much higher levels now, why wouldn't the expectation be for significantly better numbers just given the weak compares?

John Bryant

Well, I think you will see a significant growth in the fourth quarter when there is quite a weak comparison. In the third quarter though, I doubt it will be much, hopefully, we'll see growth in the third quarter but it will be very modest growth. And a part of that is we do need to get back improved distribution across our key customers. We do need to get some of these SKUs more on the shelf and turn on our advertising and our promotional activities. So there is a need to bring the consumer back into the business.

Operator

And our next question comes from Terry Bivens of JPMorgan.

Terry Bivens - JP Morgan Chase & Co

Two things this morning. First of all, if you look at it, and I know sometimes our figures vary a little bit from what you guys are looking at. But on a brand analysis, one thing that concerns me a bit is some of your more profitable, pricier cereals. I'm looking at Smart Start, for example, Raisin Bran Crunch, Special K, had what I would call pretty disappointing performances, certainly in the ACNielsen data. What worries me there, David, is do you think there is an internal trade down going on in the Cereal category from some of those -- you guys are famous for volume to value, make sure I get that right. But, I guess, I would look at the data and start to worry that maybe there is trade out of some of the pricier, higher profitability cereals.

A. D. MacKay

There's a couple of things going on there. I think with Smart Start, I always wanted to use it as an example. We've actually reduced our investment in Smart Start and moved it elsewhere in the portfolio, and that's one of the reasons why that business is down. I think also what you're seeing a little bit in the Cereal category is the drive towards utility. All family products are doing well. Our highly focused brands against [indiscernible] in this state, in general not doing as well in this current environment, I think that's a reflection of the consumer. Having said that, I think you can point to a couple of businesses, where you are getting some good growth and a reasonably high price. So for example, we're seeing double-digit growth in BearNaked and we're seeing good growth in Kashi. So it's hard to generalize. I think what you're seeing is a movement of money around the brands, and you're seeing a general consumer drive towards utility.

Terry Bivens - JP Morgan Chase & Co

Obviously, the trade inventories were an issue here a little bit more than I felt they would. Where do we stand now going forward, are you satisfied with inventories at the trade level?

A. D. MacKay

I think in U.S. Cereal, we're in very good shape from a trade inventory perspective, as well as in the U.K. Cereal business.

Operator

Our next question comes from Judy Hong of Goldman Sachs.

Judy Hong - Goldman Sachs Group Inc.

I guess I just wanted to go back to Cereal in the U.S. and just really want to understand. It seems like there's a couple of issues. One, at the category level, you've kind of talk about the tough comp and a lot of that was really driven by pricing being pretty robust last year and obviously now you're seeing pricing down, but it doesn't seem to be driving volume pick up as much as the pricing down or the promotional activity being pretty intense. So I just want to understand why that is the case? And why that should get better in the back half, so that even if pricing doesn't necessarily get better, should we expect to see actually volume get better in the back half? And then secondly, at the competitive level, it just seems like you've got even players like Quaker talking about spending more money in the category. Obviously, you're raising investments both from the brand side and some of the promotional activity. Does the competitive environment get worse before it really gets better? Can you just help us understand how that kind of plays out in the path to getting better, I guess, in the next six to 12 months.

A. D. MacKay

Judy, if you step back and look at the Cereal category, one reason that it's such a great category is it's highly responsive to brand-building innovation, that's what drive the category over the long term. The category from a pricing perspective is actually not all that elastic and that the volume didn't go down significantly last year, when some of the pricing came up and didn't go up this year when the pricing came down a little bit. So it's not the category, which you can win in long term through the pricing, maybe get there through brand building and through innovation. I think some of the deflation we're seeing in the category this year is actually a bit of an anomaly. If you look at 2009, let's look at Post, they had some integration issues last year and their price per pound last year was up about $0.25 year-on-year in the second quarter. This year, their price per pound in the major channels are down around $0.25. So a lot of which you're seeing actually is a disruption in one particular competitor coming back to, I guess, what is more normal levels and they'll be there for the second quarter and the third quarter. I think as you go into the back half of this year and into next year, as you get cost inflation coming through, you would expect to see less deflation, potentially return to an inflationary environment in the Cereal category.

Judy Hong - Goldman Sachs Group Inc.

And then if you think about then just in terms of the promotional activity across the category amongst the major players, is the level of spending now pretty comparable across all players at this point? I mean, I guess, your point is last year just Post just under spent and now they're getting back to kind of the normalized level and then as that happens, you really shouldn't see one player kind of disrupt the category dynamics.

A. D. MacKay

It's always an intensely competitive category, there's always some gives and takes across manufacturers. I think this share of incremental has brought in a lot of share base with most players. There's always movements from one quarter to one year to the next.

Judy Hong - Goldman Sachs Group Inc.

And then can you just help us understand how you envision European sales kind of playing out in the back half? It sounds like the U.K. maybe continue to be challenging there. So do you expect sales to also get better in the back half, if you just exclude the inventory movement that hurt you in the second quarter?

A. D. MacKay

Within our guidance, it's fairly flat type sales for Europe in the back half and there's a couple of reasons for that. Certainly the U.K. had a great year last year and that continued even to the back half of the year, so they get some pretty tough comps for that. We are gaining share, certainly in the U.K. but it's a tough marketplace. In Continental Europe, in general, the economy is pretty tough in Continental Europe. Consumers are under pressure. We're actually gaining some share in some big markets in Continental Europe. Hopefully, we'll see some improvement there in the back half of the year, but it certainly is a tough environment. And as we see it in Russia, the bulk sales within Snacks is a transition from a Bulk business to more of the Packaged business. We've seen some of the Bulk sales slipped a bit more, I mean one or two in the Package sales take a bit longer. Hopefully, we can get a better balance in the back half of the year. The great thing on Russia is that we bought that business to drive the Cereal or the credit grade Cereal platform, and our Cereal business in Russia, which is about a third of our business in Russia is up 40%. So we are seeing some good long-term potential there.

Operator

Our next question comes from Vincent Andrews of Morgan Stanley.

Vincent Andrews - Morgan Stanley

Maybe on the share repurchase, just wondering given what your stock is doing today and sort of the outlook for the balance of the year, why you're not being more aggressive with the existing program?

Ronald Dissinger

As we indicated, we did buy more shares in the second quarter. And we're essentially using the available cash that we have after dividends to repurchase shares. We think now our average diluted shares outstanding will be 1% to 2% better depending upon the timing and price that we can purchase the shares at. We believe we'll end up purchasing probably somewhere between $600 million and $1 billion worth of shares in total for the year. And if you think about it, that's roughly a third of a $2.5 billion authorization that we have outstanding.

Vincent Andrews - Morgan Stanley

That third would account for what you should have done last year and then sort of the run rate of this year. So I'm just wondering why not be a little more aggressive?

John Bryant

I think, Vincent, in summing, we will certainly look at and be considering as we go forward and we'll give you an update in Q3. I think the other thing that says, what we've built into the guidance we gave you is what Ron went through. But the point you make is a very valid one.

Vincent Andrews - Morgan Stanley

And then maybe if you could just help me understand, you said the upfront costs are coming down, but the number of projects is flat. So what change has allowed the cost of these projects to come down?

Ronald Dissinger

It's just the estimates that we had in previously for the year on some of those initiatives. We're able to execute those at a lower cost. So it has nothing to do with the actual execution of the initiative and driving our cost-saving initiatives going forward.

Vincent Andrews - Morgan Stanley

And then lastly, you increased your input cost inflation for the year. Could you just give us a sense of what items you're driving that?

Ronald Dissinger

Yes, the primary driver there and I alluded to this briefly in the communication is higher commodity cost, particularly sugar and packaging cost. Since sugar primarily in the U.S. and Mexico and then packaging in North America.

Kathryn Koessel

Christina, we're pressing 10:30, so we can take one more question.

Operator

Our last question comes from Alexia Howard of Sanford Bernstein.

Alexia Howard - Bernstein Research

Just coming back to the cost saving programs, I guess, we're now about half way through time wise in terms of $1 billion challenge. I think it was a three-year program ending the end of next year. Could you talk a little bit about how far through in terms of the cost savings you are? And whether you expect that will -- you talk about a reduction and the cost of actually getting off of these initiatives this time around, is that why you're so persistent to next year? So really, how do you see the benefit from cost playing out as we run through the end of the program next year?

Ronald Dissinger

We actually have a very good visibility to our $1 billion challenge savings. We estimate roughly $400 million, perhaps a little bit more in 2010. And we have good visibility into 2011 to achieve those cost savings as well. So the fact that our cost for some of the initiatives have come down has not impacted our visibility to the savings.

Alexia Howard - Bernstein Research

So you're a little more than halfway right now in terms of the savings from the overall program?

Ronald Dissinger

We are a little bit more than halfway in terms of the savings.

Kathryn Koessel

Thank you very much for joining us today. If you have any additional question, please feel free to call me.

Operator

Thank you. Again, ladies and gentlemen, 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.

Operator

Good morning. Welcome to the Kellogg Company 2010 Second Quarter Earnings Call. [Operator Instructions] At this time, I will turn the call over to Kathryn Koessel, Kellogg Company Vice President of Investor Relations. Ms. Koessel, you may begin your conference.

Kathryn Koessel

[Audio Gap]

w.kelloggcompany.com. As you are aware, certain statements made today such as projections for Kellogg Company's future performance, including earnings per share, net sales, margin, operating profit, interest expense, tax rate, cash flow, brand building, upfront 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.

As a reminder, a replay of today's conference call will be available by phone through Monday, August 3. The call will also be available via webcast, which will be archived for at least 90 days.

Now let me turn it over to David.

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