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McCormick & Co. (NYSE:MKC)

Q3 2011 Earnings Call

September 28, 2011 8:00 am ET

Executives

Alan D. Wilson - Chairman, Chief Executive Officer and President

Gordon M. Stetz - Chief Financial Officer, Executive Vice President, Director and Chairman of Investment Committee

Joyce L. Brooks - Vice President of Investor Relations and Member of Investment Committee

Analysts

Andrew Lazar - Barclays Capital, Research Division

Ann H. Gurkin - Davenport & Company, LLC, Research Division

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

Charles Edward Cerankosky - Northcoast Research

Thilo Wrede - Jefferies & Company, Inc., Research Division

Robert Moskow - Crédit Suisse AG, Research Division

Akshay S. Jagdale - KeyBanc Capital Markets Inc., Research Division

Robert Dickerson - Consumer Edge Research, LLC

Alexia Howard - Sanford C. Bernstein & Co., Inc., Research Division

Erin Swanson Lash - Morningstar Inc., Research Division

Eric R. Katzman - Deutsche Bank AG, Research Division

Mitchell B. Pinheiro - Janney Montgomery Scott LLC, Research Division

Operator

Greetings, and welcome to the McCormick's Third Quarter 2011 Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Joyce Brooks, Vice President, Investor Relations for McCormick. Thank you. Ms. Brooks, you may begin.

Joyce L. Brooks

Good morning, and welcome to our review of McCormick's third quarter financial results and latest 2011 outlook. We've posted a set of slides to accompany today's call at our website, ir.mccormick.com.

With me are Alan Wilson, Chairman, President and CEO; and Gordon Stetz, Executive Vice President, CFO and Treasurer. Alan is going to begin with an update on our business and the current operating environment, and then Gordon will discuss our third quarter financial performance and latest guidance. After that, we look forward to discussing your questions.

As a reminder, our presentation today contains projections and other forward-looking statements. Actual results could differ materially from those projected. The company undertakes no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or other factors.

In addition, certain information that we will present today are non-GAAP measures. This includes certain financial results from 2010 that exclude items affecting comparability. We present this non-GAAP information for comparative purposes alongside the most directly comparable GAAP measures. Reconciliations of GAAP to non-GAAP measures can be found in the presentation slides for our call.

It's now my pleasure to turn the discussion over to Alan.

Alan D. Wilson

Thanks, Joyce. Good morning, everyone, and thanks for joining us. In the third quarter, we delivered strong top line growth and a solid profit result. In local currency, we grew sales 11%, a step up from our 5% sales increase in the first half of 2011. We're driving this growth with product innovation, expanded distribution and increased brand marketing support, along with pricing actions. We reported a double-digit increase in each of our 2 segments and in a number of our operating regions. Of particular note this quarter was a 5% increase in volume and product mix for our consumer business, which was accomplished during a period when pricing also rose 5%. The increase was led by our Americas business and was broad-based with increases in grilling products, dry seasoning mixes, authentic ethnic cuisines, Zatarain's, Simply Asia and Thai Kitchen, as well as our sales of the private label products that we produce for some of our major customers. We also had a favorable impact from customers that purchased product in anticipation of a fourth quarter price increase.

On the industrial side of our business, we grew sales in local currency at a double-digit rate in each of our 3 regions, with sales in China up 30%. In markets around the world, this performance was driven by demand from quick-service restaurants and our supply of seasonings for snacks. Earnings per share was $0.69. Several factors affected profit this quarter, as Gordon will discuss in more detail, but I will share the major drivers.

Positively impacting EPS this quarter were higher sales. Our cost savings for McCormick Comprehensive Continuous Improvement program, CCI, and discrete tax items. Offsetting a portion of these increases were our additional investment in brand marketing support, which was up 27% for the quarter, and a further escalation in our raw and packaging materials costs. For these reasons, as we anticipated, our third quarter profit growth moderated from the double-digit increase in earnings per share that we reported in the first half. For the full year, we remain on track with our 2011 sales and profit outlook.

During my remarks this morning, I'd like to cover 3 topics and will begin with comments about the completion of our investments in Kamis and Kohinoor, as well as a few remarks about a smaller acquisition in the United States. Next, I'd like to go a bit in depth into the current environment, including our input costs and pricing actions as we head into our fourth quarter and look ahead to 2012. Finally, I'll share why I'm pleased with our momentum as we kick off the fourth quarter, McCormick's peak selling period.

Earlier in September, we completed the acquisition of Kamis and our Kohinoor joint ventures. As stated in our June call, these 2 strategic deals give us a leap forward in executing against our emerging markets strategy. The acquisition of Kamis is an excellent complement to McCormick's business in Western Europe and our recent joint venture in Turkey. Kamis is a brand leader in spices, seasonings, mustards and other flavor products in Poland, with distribution subsidiaries in Russia, Romania and the Ukraine. The purchase price for this business was approximately $286 million. Kamis will be managed under Lawrence Kurzius, the President of McCormick International; and by Malcolm Swift, our President in Europe, Middle East and Africa.

We've welcomed the Kamis employees to McCormick and named one of our business leaders in Europe, Fiona McDonnell [ph], as General Manager, and she's now on site. Our integration plans began in the pre-close period, and our integration team is fully engaged. Sales of this business have been increasing at a double-digit rate, and we intend to continue this growth through new product introductions, brand marketing programs and penetration of other markets in Central and Eastern Europe.

The Kohinoor joint venture establishes a new platform for growth in India and demonstrates our commitment to invest and grow in this region. Our investment was approximately $113 million. This gave us an 85% interest in the newly formed joint venture. The Kohinoor brand is one of the top national brands in the basmati rice category in India, with products reaching over 350,000 retailers and sales growing at a double-digit rate. Kohinoor will be managed under Lawrence Kurzius, as well as Paul Beard, President of Asia Pacific, who many of you know. One of McCormick's senior leaders, Satish Rao, has been named Managing Director of the joint venture and has relocated to India.

We've taken steps to achieve a smooth transition for this business, and we have met with all of our distributors to ensure business continuity. We produced new advertising to be launched in the fourth quarter featuring Bollywood stars using Kohinoor products in a family setting. You can access a fact sheet for each of these businesses on our website, which contains more detailed information.

During the third quarter, we acquired the assets of Kitchen Basics for $38 million. Kitchen Basics is a leading brand of ready-to-serve, shelf-stable liquid stock in North America. As a key flavor ingredient, consumers use stocks to add depth and flavor to a variety of dishes such as gravies and soups. Annual sales of Kitchen Basics are approximately $25 million and have increased at a double-digit pace for the past 3 years. We expect to continue to grow the brand with expanded distribution and product innovation. This acquisition is expected to be immediately accretive to earnings.

Acquisitions are a key part of our 3-pronged growth strategy, and we're extremely pleased with what we accomplished in 2011 as a result of our teams' diligence, persistence and financial discipline. We are having success this year not only with acquisitions but with our other growth strategies, launching new products, investing in brand marketing and expanding distribution. However, we're also feeling the impact of the current economic environment. Many consumers are struggling in this economy. They're making tough choices and some are altering their shopping patterns. In the U.S. and the U.K., we've seen a shift in private label sales for basic ingredients like pepper, garlic and cinnamon, and we've seen a shift in our sales towards alternative channels like dollar stores and warehouse clubs. In response, we continue to gain new distribution in all channels. Our latest win is placement of 9 branded items, including extracts and gravy mixes, in Sam's Club locations across the United States.

Another action we're taking is to emphasize the value of our brands. We've added resources to analyze and optimize the effectiveness of promotional price points and the timing of these promotions. Through traditional and digital medium, we're highlighting product differentiation and usage ideas. Secondary placement is an additional way that we separate our brands from private label, as well as our product innovation. Another challenge in this environment is the steep rise in material costs, not only for commodities but for many of our spices and herbs. We began the year expecting 7% to 8% cost inflation, and through the first half, we managed this through pricing actions and our continuous Comprehensive Continuous Improvement, CCI cost savings.

In the third quarter, we began to experience further increases in our raw materials. We're now expecting a double-digit rate of material cost inflation in 2011, and we expect these higher costs to persist through 2012. To illustrate this, let's take a look at one of our top 5 raw materials, black pepper. Black pepper is a crop that has a long history of fluctuation but has hit historic highs. Slide 9 shows that the cost of pepper has more than doubled in the past 1.5 years. Similarly, costs have escalated for red pepper, nutmeg, cinnamon, cloves, cumin, turmeric and many other items. There are several factors influencing the spice and herb markets at this time, which include poor weather conditions in some of our growing regions; farmers’ shift to growing more lucrative crops that are less labor-intensive such as coffee, cassava, rubber and palm oil; increased global demand and a weakening U.S. dollar. Beyond spices and herbs, the costs of packaging, fuel and energy have remained steady but at an elevated level.

So how are we responding to this cost pressure? First, we're leveraging our global procurement team for insights and smart decisions on strategic inventory. As we've reported throughout 2011, our inventory is up due in part to higher strategic inventories. While neither Gordon or I want to see more inventory on the balance sheet, this is one way to effectively manage our purchase of spices and herbs. Second, our CCI cost savings program is a vital means of offsetting a portion of the increase. We've raised our projected savings for 2011 to at least $50 million, which is approaching the level reached in 2010 of $54 million. Third is pricing actions.

For our consumer business, we increased prices as we headed into 2011 to offset a portion of the cost inflation. In response to the latest increase, we've begun to implement additional price increases in both brand and private label items. In North America, the average increase will be about 5%. Depending on the underlying raw materials and price thresholds, the increase will range from a low level on certain items, like extracts, to a double-digit rate on black pepper.

In our industrial business, as I indicated, higher ingredient costs lowered profit in the third quarter. As many of you know, we have a pricing protocol to pass through the higher cost of major commodities to our customers, materials like dairy ingredients, wheat and soybean oil. However, these protocols do not extend to items via a commodity trading market such as spices and herbs. To address this, we are working with our customers to adjust pricing for these items and expect to get pricing in place over the next few months. In the meantime, we expect profit for the industrial business to be under pressure in the fourth quarter and to remain under pressure in the early part of 2012.

To summarize this portion of my remarks, our business is being challenged by a difficult economy, a weaker consumer and escalating material costs. We're addressing these challenges by adapting our marketing efforts and promotional activity and taking prices where we need to. Throughout this period of volatility, the fundamentals of our business remain sound, and we've made good progress with our sales growth initiatives, progress that we're seeing continuing into the fourth quarter. We have a strong lineup of activity as we head into this important selling period. During the fourth quarter, secondary displays are an essential way for retailers to avoid out-of-stocks on key holiday items. We have displays being shipped to complement the merchandising strategy for all of our major U.S. customers. We're planning to increase brand marketing support at least $5 million for the programs behind dry seasoning mixes, Hispanic products, seasoning blends and the Thanksgiving holiday in the United States. In Europe, we have incremental marketing support behind our Vahiné dessert page in France and an integrated digital and PR campaign for Slow Cookers in the United Kingdom. And in China, we have new Grinders advertising that features a chef hosting a cooking class with consumers.

Finally, we expect a lift from new products. In addition to items introduced early in 2011, we've launched Recipe Inspirations in the United Kingdom and, in the U.S., a line of authentic Hispanic dry seasoning mixes, premium-grade Grill Mates barbecue sauces, new Lawry’s dry seasoning mixes and 4 new reduced sodium dry seasoning mixes. Results from our other reduced sodium products indicate that 75% of sales are incremental for the category.

We have good sales momentum heading into the fourth quarter and an incremental impact from Kamis, Kohinoor and Kitchen Basics. A combination of this increased volume, our pricing actions and some favorable foreign currency exchange rates have us on track to achieve strong sales growth in 2011. Before I turn it over to Gordon, I want to recognize and thank McCormick employees in locations around the world who are driving our success with excellent sales growth, above target CCI savings, completion of acquisitions and a joint venture that expand our global portfolio of leading brands. Gordon?

Gordon M. Stetz

Thanks, Alan, and good morning, everyone. We are pleased with our financial performance for the third quarter. At the bottom line, we achieved $0.69 of earnings per share in the face of significant cost increases and with an increase in our investment in brand marketing support. Our earnings per share this quarter included the benefit of favorable discrete tax items. At the top line, we exceeded our projections for sales growth in many parts of our business. In total, sales for the quarter rose 16% with an 11% increase in local currency. Volume and product mix was up 6%, and the pricing actions we've taken in response to higher material costs added 5%.

As seen on Slide 14, we grew consumer business sales 15%, with a 10% increase in local currency. In the Americas region, we grew consumer business sales 12% in local currency, with equal contributions from volume and product mix and from pricing. About half of the increase in volume and product mix, an estimated $10 million, was the result of customer purchases in advance of a fourth quarter price increase. This buy-in is expected to lower fourth quarter consumer sales in the Americas by $10 million.

Another thing to keep in mind when projecting fourth quarter sales for this part of our business was a shift in sales from the first quarter of 2011 into the fourth quarter of 2010 for an estimated $10 million that related to customer purchases in advance of our previous price increase.

Growth in a number of product lines drove the other half of the increase in volume and product mix in the Americas. During the quarter, we increased our marketing support behind core McCormick products and the Zatarain's brand. This investment drove a significant increase in our McCormick brand dry seasoning mixes, products that consumers can use to make an inexpensive meal for their family, dishes like chili, taco, stews and pasta. We achieved double-digit increases in the sales of Grill Mates, featured in a great digital media campaign, and our authentic Asian products under the Simply Asia and Thai Kitchen brands. Sales of these brands were boosted with some great new products that include a line of dipping sauces.

In the third quarter, we also had a pickup in sales of private label, due in part to our distribution gains in 2011. We are monitoring consumption trends closely and, as Alan indicated, are developing new tools to help optimize price and promotions on brand and private label, both of which offer our retail customers an attractive profit. In Europe, the Middle East and Africa, EMEA, we grew consumer sales 22%, with a 7% increase in local currency. Both pricing and favorable volume and product mix contributed to growth this quarter. This increase is a nice improvement from previous quarters. We continued to have a good performance in France, which benefited from brand marketing support, distribution gains and a number of new product introductions. Also contributing to growth this period were export sales into developing markets. We also saw steadier results in some of the smaller markets like Spain and Portugal, which had steep declines in the year-ago period.

In the U.K., we are operating in a competitive retail environment where private label share has increased in many categories. We have redirected a portion of our brand marketing support to emphasize to consumers the value of our products, and we have also accelerated the development of several new products, which are differentiated from our competitors in the marketplace. While the U.K. continues to be a challenging market, our actions led to a modest increase in volume and product mix this period.

In the Asia Pacific region, consumer sales rose 18% and in local currency were up 3%. Both pricing actions and favorable volume and product mix contributed to this increase. This was led by a 7% increase in China in the third quarter where we have a rebranding initiative underway and some new television advertising.

Operating income for our consumer business increased 5% to $101 million with the favorable impact of higher sales and CCI cost savings. These increases were offset in part by the escalation of material costs and a $7 million increase in brand marketing support.

Let's take a look at the sales performance for our industrial business on Slide 15. For this part of our business, we also grew sales at a double-digit rate, up 17% in total and 12% in local currency. This is particularly impressive given overall food service trends. McCormick continues to benefit from its strong global relationships with some of the top quick-service restaurants, which as a group, are faring better than other restaurant formats in today's environment.

Industrial sales in the Americas grew 14% and in local currency rose 12%. Volume and product mix added 7% of the increase. This was driven in part by a double-digit increase in volume and product mix with food manufacturers, including sales of snack seasonings and ingredients. Many of these products featured all-natural ingredients, reduced sodium and other healthy attributes for which we continue to see high demand. We also increased sales of food service products, led by new products and expanded distribution with quick-service restaurants. Sales of branded food service items to the distributor channel were also up in the third quarter.

In EMEA, our industrial business continued a run of strong sales growth. We grew third quarter sales 21% and in local currency 11%. Favorable volume and product mix added 7%, with the remainder coming from pricing actions. As in the prior 2 quarters, the increase in volume and product mix was led by greater demand from quick-service restaurants for products we supply from operations in the U.K., Turkey and South Africa.

In the Asia Pacific region, industrial business sales rose 30% and in local currency grew 17%. Sales in China drove this result with a 30% increase in local currency this period. We are achieving exceptional growth in this market as we support the rapid expansion of quick-service restaurants. This period, we also benefited from the promotional activities of these customers.

Operating income for the industrial business declined 8% to $28 million in the third quarter. While this business had the benefit of higher sales and CCI cost savings, we were significantly impacted by rising material costs. As Alan described, we are going beyond the key commodities and working with our customers to respond to increases in other ingredients such as spices and herbs with increased pricing. This pricing activity will continue through the next quarter, and because our pricing actions are lagging these cost increases, we expect further profit pressure in our industrial business.

Margins for this business are under pressure due in part to higher costs, as well as the effect of higher prices on net sales when calculating percentage margins. Margin was also impacted by the mix of our business during the third quarter, as a result of buying patterns and other customer activity. Our strategy for the industrial segment continues to be to develop and grow the business through value-added higher-margin products.

For the total business, third quarter operating income rose 2% from the year-ago period, and operating income margin was below the prior year period at 14%. Year-to-date, we have grown operating income 7% and operating income margin is down 30 basis points. At the gross profit line, we achieved a 9% increase in gross profit dollars with the strong sales performance and CCI cost savings. However, gross profit as a percentage of net sales declined 250 basis points. This decrease in gross profit margin was the net effect of increased prices, higher costs and our CCI savings, and the decline is expected to continue into the fourth quarter. As a result, we expect gross profit margin to be down for the fiscal year, which is consistent with the outlook we presented back in January.

SG&A rose 13% from the third quarter of 2010, but as a percentage of sales, SG&A was down 60 basis points. This period, SG&A included an $8 million increase in brand marketing support, up 27% and $1 million of transaction costs related to Kamis and Kohinoor. The tax rate came in favorable at 26.8% due to $5 million of discrete tax items. As you analyze third quarter results, keep in mind that we also had significant discrete tax items in our year-ago results. In the third quarter of 2010, discrete tax items added $16 million to net income. Of this prior year amount, $14 million related to the reversal of a significant tax accrual for a closed tax year. This tax accrual was recorded based on uncertainties about the tax aspects of transactions where the company reorganized its European operations and divested certain joint ventures. This reversal increased earnings per share by $0.10 in the third quarter of 2010 and was treated as a non-GAAP adjustment.

As you think about tax expense in the fourth quarter of 2011, let me remind you that we also had a significant tax variance in the fourth quarter of 2010. During this period, the repatriation of cash from foreign subsidiaries resulted in foreign tax credits in the U.S. that added about $0.08 to earnings per share that quarter.

Moving to income from unconsolidated operations, we had a slight increase this quarter, which was impressive given the impact of higher soybean oil on our joint venture in Mexico where mayonnaise is a leading item. Even with the cost pressure, this business grew sales at a double-digit rate and achieved higher income. Our unconsolidated joint venture in India, Eastern Condiments, also contributed to the higher income, while our smaller joint ventures had a small decline in profit this period. We are not yet reporting any profit from the new joint venture in Turkey but have made great progress in the past year and have launched 42 items nationally with a Ducros and [indiscernible] brand. We are beginning to gain distribution and are encouraged by the early results.

At the bottom line, as shown on Slide 19, earnings per share was $0.69 compared to $0.76 in the third quarter of the prior year. Excluding the impact of the significant tax reversal in the year-ago period, this was an increase of $0.03, an amount comprised of $0.01 from operating profit, including an unfavorable $0.01 from transaction costs related to Kamis and Kohinoor, $0.01 from this year's tax rate when compared to the rate in the third quarter of 2010 and $0.01 from the net impact of smaller items, including our share buyback activity in the past 12 months.

I'd like to turn next to the balance sheet and cash flow. We have discussed the effects of the current economic climate on our income statement and our pricing actions, cost inflation and sales trends. McCormick's balance sheet and cash flow have also been impacted, primarily in our management of working capital. As we have moved into this higher cost environment, we increased our strategic inventory positions in several spices and herbs, crops that do not have hedging options other than outright purchase. We also accumulated higher inventory levels of crops sourced from growing regions exposed to political risks, such as North Africa and Egypt. In addition to higher levels of raw material, the cost of our raw material inventory has led to a significant increase in inventory. Foreign exchange rates is a third factor that affected inventory.

Despite these increases, improving working capital remains an important priority for our business. As indicated last quarter, a key initiative currently underway is the implementation of a new inventory management process in North America. Once we fully implement this system and begin to drive reductions in our inventory in North America, we will turn our attention to implementing these new processes in other parts of our business.

For the 3 quarters ended August 2011, net cash flow from operations was $86 million compared to $185 million in the year-ago period -- I'm sorry, $145 million in the year-ago period. Our growth in net income was more than offset by increased working capital. During the third quarter, we issued $250 million of 10-year, 3.9% notes to finance in part our acquisitions. We also entered into a new 5-year, $600 million revolving credit facility, which replaced our existing $500 million facility, which was due to expire in June of 2012. The all-in drawn pricing on this new credit facility is LIBOR plus 0.875%.

Early in September, we completed our acquisition of Kamis and the Kohinoor joint venture for a combined price of $399 million financed with cash and debt. Our share repurchase program remains curtailed while we pay down the borrowings associated with these investments and return to our target debt level. At August 31, 2011, $270 million remains on our $400 million share repurchase authorization. Even with these purchases and increased working capital, our balance sheet remains strong, and we have the capacity to continue to pursue further success with our acquisition activity.

Let's finish up with our latest financial outlook for 2011 on Slide 21. We are reaffirming the full year guidance set forth in our June earnings call. We expect to grow sales 6% to 8% in local currency, which includes 1% of sales from Kamis and Kohinoor as indicated in our previous outlook. We continue to expect favorable currency to add 2% to sales at prevailing exchange rates. As discussed earlier, for the full year, we are projecting a decline in gross profit margin, at least $50 million in CCI cost savings and an increase in brand marketing support that is in line with our sales growth. For the fourth quarter, we plan to increase marketing support by at least $5 million. Our outlook for 2011 earnings per share remains $2.74 to $2.79. Given our year-to-date results, this implies a range of $0.93 to $0.98 in the fourth quarter.

In our June earnings call, we lowered our earnings per share guidance by $0.06 to reflect an estimated $9 million of transaction costs related to the completion of the Kamis and Kohinoor deals. We incurred $2 million of these costs in the first half of 2011, which lowered earnings per share $0.01. At the time of our June call, we expected to complete these deals by the end of the third quarter and to record the remaining $7 million of transaction costs, which would have lowered our third quarter earnings per share by $0.05. We now expect the transaction cost to total $11 million instead of $9 million. We expect the reduction to 2011 earnings per share to be $0.07 rather than $0.06. Because the Kamis and Kohinoor deals were completed in early September rather than in the third quarter, let me provide you with the timing of these costs.

Of the $11 million, we recorded $2 million in the first half, approximately $2 million in the third quarter and expect to record $7 million in the fourth quarter. Likewise, the reduction to earnings per share impact was $0.01 in the first half, $0.01 in the third quarter and an estimated $0.05 to be recorded in the fourth quarter, adding up to the full year impact of $0.07.

To recap, there is a $0.01 increase in the impact of transaction costs for the full year and a shift of $0.05 that had been in our third quarter outlook and is now expected to be recorded in the fourth quarter.

Let me summarize. McCormick is adapting its business to the challenges of today's environment, adjusting our marketing programs, merchandising activities and product innovation to achieve sales growth. We are carefully managing our pricing actions and our working capital and are driving down costs with our CCI program. As a result, we are well-positioned and have good momentum heading into our fourth quarter and look for 2011 to be a year of strong financial performance.

Thank you, and I would like to turn it over to the operator to take the first question.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from the line of Thilo Wrede of Jefferies & Company.

Thilo Wrede - Jefferies & Company, Inc., Research Division

Can you give us a little bit more background, have you already filled the channel there? You talked about, I think, 9 SKUs that you have nationwide now. Is there a chance that, that will grow in the future? Any more color would be appreciated.

Alan D. Wilson

Yes, without getting into too many specifics, what we -- we had a regional distribution at Sam's Club for about 2 years. We expanded that earlier this year nationally with some Grill Mates items, and then what we're talking about on this call is expansion of another 9 SKUs, predominantly in the baking area such as extracts and gravy mixes and things like that. We're real pleased with what we've seen there. We can't speculate on what might happen in the future, but we continue to grow and invest with not only that customer, but customers in a number of channels.

Thilo Wrede - Jefferies & Company, Inc., Research Division

Okay. And then a question about your inventory. Is your inventory still physically increasing? Are you increasing the volume of your inventory, or are the increases now more driven by overall price increases, currency and so on? And if the physical inventory is still growing, when do you expect that to slow down or reverse?

Gordon M. Stetz

The majority of the increase is driven by the cost pressures and the strategic inventory and foreign exchange. So about 45% of the increase is related to cost pressures in the environment we're in. Maybe another quarter of it is related to strategic inventory purchases and maybe another 20% is related to foreign exchange. The volume component is not as big of an issue as the cost pressures. Obviously, the environment we're in, difficult to project cost inflation. It's a volatile environment, but we certainly aren't expecting a retreat in the cost environment anytime soon. So we would expect to start to hopefully see this moderate as we go into 2011 -- I mean, 2012. Our teams are very focused, though. I don't want to say they're not focused on the volume opportunity to try and reduce inventories. So they're looking at their modeling, their safety stock assumptions, their demand planning assumptions. So it's still a big area, but we are feeling it from the cost side.

Thilo Wrede - Jefferies & Company, Inc., Research Division

Okay. And then one last question about the pricing. You talked about more pricing to come. Are you expecting any major pushback from retailers as you go into the holiday season?

Alan D. Wilson

We're expecting absolutely great execution by retailers as we head into the holiday season. And we have announced and implemented pricing in a number of our markets, the U.S. consumer included. So we'll see the impact of that as we go through, but we feel like we're well-positioned with our display activities, an increase in advertising, which is right on with the kinds of things that we want to drive in the holiday period. So we feel like we're well positioned for the fourth quarter.

Operator

Our next question is coming from the line of Alexia Howard of Sanford Bernstein.

Alexia Howard - Sanford C. Bernstein & Co., Inc., Research Division

Just a couple of questions here. A couple of quarters ago, you called out a concern about private label share gains going forward. It seems as though that hasn't played out particularly harshly. Is this less of a concern today? And why -- what do you think’s happened there?

Alan D. Wilson

Well, I think what we have seen is an increase in pricing in private label, which has closed some of those gaps with the brand. Certainly, we're at some pretty high levels in terms of overall pricing points. But as I look at the public data on what's happening with private label, their pricing has increased at a rate that's higher than even the branded on a percentage basis. So I think that's part of what's going on. The other thing is I'd like to think that -- not only like to think, but I'm pretty confident, that our product innovation, our increased advertising is really helping our brands hold up in this environment.

Alexia Howard - Sanford C. Bernstein & Co., Inc., Research Division

That's great. And a quick follow-up on the sales in Africa that you mentioned. Are you able to quantify how much benefit you got out of the European sales growth from those sales into Africa this quarter? And could you tell us a little bit about your strategy there? Is it a strategic move? Is it an explicit investment and deployment of resources in the region, or is a bit more opportunistic and pool-based and led by local distributors?

Alan D. Wilson

The first answer is, it had a very minimal impact on our results in Europe this quarter. And it is more opportunistic at this point. We have a nice business in South Africa. We think there's great opportunities. But we are working with distributors in Northern Africa in places like Morocco and Nigeria to build and grow our business. It's a business that we've had for a long time, but we're seeing some success there.

Operator

The next question is from the line of Chris Growe with Stifel, Nicolaus.

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

Just I wanted to ask you about the -- on the industrial side of the margin in that business, I know obviously there's heavy cost inflation there. But with the volume so strong, I was surprised that the profit declined. I guess one of the things I was thinking about would be how mix played a factor into that. Was that an issue in terms of the profit result in the quarter? Or anything else we could kind of point to for that division?

Alan D. Wilson

Yes, certainly, it was a combination of all other ingredients, those non-major commodities which were a lot higher. Typically, we don't have pricing protocols on those, and so it's more of a negotiation, but they tend to balance each other out. What's happening right now is everything is up and so it's more of a negotiation to be able to implement pricing on those commodities. There absolutely was an impact in our industrial business on the mix of our business and so we sold more of the lower-margin items and less of the higher-margin items in this period, so that was impacting our sales to an extent. Gordon, you want to add on that?

Gordon M. Stetz

No, that's absolutely right. Yes.

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

Did you indicate then that fourth quarter profits would be down? You mentioned there would be pressure still. Does that mean that you think they'll be down on the fourth quarter?

Gordon M. Stetz

Certainly, the -- as we indicated, the pricing protocols are on a lag, so that's going to put pressure on it. But the thing that can shift quarter-to-quarter is the mix. As Alan indicated, we have had some significant wins on some quick-service restaurants. I'll say that some of those are in the lower margin part of it, so whether they're down or flattish, we don't expect a strong performance in the industrial profitability in the fourth quarter.

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

Okay, that's helpful. I just wanted to ask a question about 2012. I know you don't want to give guidance, so my question is I think you discussed or mentioned on the call you expect this heavy inflation to continue into next year. Do you expect double-digit inflation in 2012, or is that going too far at this point?

Alan D. Wilson

We do expect to see higher costs continuing into 2012. We don't see, at least in the commodities that impact us, much that's going to cause it to decline or go down. We're expecting in 2012 we’ll continue to see higher costs.

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

And double-digit, though, may be going too far at this point to say that?

Gordon M. Stetz

Yes, we're not ready to say that yet, but certainly, you've seen it continue to creep up as we've gone through this year, that's for sure.

Operator

Our next question is from the line of Akshay Jagdale with KeyBanc Capital Markets.

Akshay S. Jagdale - KeyBanc Capital Markets Inc., Research Division

My question is more regarding the guidance. So it seems that your guidance for cost is higher than what it was before, you're saying double digits. You had a range before. And acquisition costs are going to be higher, but you didn't change EPS guidance. Is this difference just a lower tax rate, or is there something else in the SG&A line that we should be thinking of, or did I miss something?

Joyce L. Brooks

Actually, this is Joyce, your line is a little unclear, so may I ask you to repeat your question please?

Akshay S. Jagdale - KeyBanc Capital Markets Inc., Research Division

Sure. Can you hear me now, Joyce?

Joyce L. Brooks

Yes.

Akshay S. Jagdale - KeyBanc Capital Markets Inc., Research Division

Okay. Sorry, my question was regarding guidance. It seems as though your cost guidance now, you're saying it's going to be closer to 10%. Before it was just a range. And you increased your cost guidance on the acquisition, but your EPS guidance range didn't change. Does that mean that the offset, what you're expecting in terms of higher cost, is just a lower tax rate? I mean, I know you also increased your CCI guidance, but I'm just wondering if there's anything else in the SG&A that we may be missing, where you think there's an offset to these costs?

Gordon M. Stetz

Well, there's a number of factors. I mean, obviously the strong sales growth is contributing -- has helped to offset some of those as well. We've also been increasing our advertising and promotion as well to help drive sales. So it's really a combination of factors. I guess my takeaway would be that we're absorbing some of these increased costs, and we're still achieving the results that we laid out for you in the beginning of the year, and that's the strength of our underlying business that's doing that.

Akshay S. Jagdale - KeyBanc Capital Markets Inc., Research Division

That's helpful. So is it fair to say that the sales have been better than you had expected so far? And how would you characterize your gross profit performance in third quarter relative to your own expectation?

Gordon M. Stetz

Well, certainly, sales have been stronger, and gross profits, it's probably fair to say, it’s been a little more under more pressure than we had anticipated. I will say we expected it to be under pressure as we proceeded through this year, because we saw the cost increases, as we indicated earlier in the year, with the high-single-digit type numbers. So we expected those to start to occur through the third and fourth quarter. But I will say, it's gotten higher as you can tell, by the increases we've talked about on this call.

Akshay S. Jagdale - KeyBanc Capital Markets Inc., Research Division

Yes, and just one last one, if I may, on marketing spending. I was impressed that even though you've had some margin pressure on the gross profit line, you still continue to invest in your brands. Can you help us understand now with these new acquisitions, should we expect anything different in 2012? I mean, how are you feeling overall about your level of marketing support as a percentage of sales? Are you thinking to continue to move that up, and how much room is there to move it up?

Alan D. Wilson

Well, it's early to call 2012. But our pattern and our expectation is that we'll continue to increase marketing spending either slightly above or pretty much in line with our sales increases. In terms of the new brands that we've acquired, they have good marketing programs. We expect to continue to build on those and bring product innovation to them. So I would expect -- our expectation is to continue to drive our brands with marketing as we have the last several years.

Operator

Our next question is from the line of Rob Moskow with Crédit Suisse Group.

Robert Moskow - Crédit Suisse AG, Research Division

A few details. Gordon, I would like it if you could give us a tax rate estimate for fourth quarter. I know you've given us an EPS range, but it could be anything from 26% to 31%, from what I can tell. Second, did you give any reason for why the transaction costs are higher on these acquisitions? What was the -- most of the time in these estimates, you should be conservative in your estimates, and this time we're running higher than expected. And then lastly, I guess for Alan, on the industrial business. A lot of us remember the restructuring of the industrial business many years ago. I think it made the organization stronger. And I'm just wondering if with your basic customers now and with the way the organization is structured, are you better prepared for this inflationary period on your non-traded commodity costs?

Gordon M. Stetz

Sure. Fourth quarter, the underlying rate has been 31% as we progress through this year. That has been the constant. The more difficult component is sometimes the discrete items. But if you think of about 31% rate for the fourth quarter, and these transaction costs, a lot of them are nondeductible, that’ll push the rate up even higher, so it could be as high as 33%. So the only caveat I have is you sometimes have these discrete items that occur that can impact that. But we would expect it to be closer to a 33%-type rate based on the underlying rate of 31% and the transaction cost impact. In terms of the estimate of the due diligence costs, clearly, it went a little longer. We were anticipating this being done in the third quarter. You have to go through various regulatory filings, due diligence, et cetera with these transactions, so the only answer I can give you is that it took a little longer, it's a little more expensive than we had anticipated. That's really all that had occurred.

Alan D. Wilson

In terms of the industrial question, we do believe that our strategy to focus on major significant strategic customers is the right strategy. I do believe we're well-positioned to deal with the high commodity. We continue to gain business. We continue to grow. What we saw this time, though, is – it’s something that we learned, is we have to continue to adjust our pricing protocols in a different environment. And I think we're very well positioned to do that. I know that's going to take some time and a lot of effort, but I think we're well positioned.

Robert Moskow - Crédit Suisse AG, Research Division

Alan, what kind of a pushback are you getting from these strategic customers on your efforts to take your prices up?

Alan D. Wilson

Well, in most cases, our customers understand the pricing pressure, but it's always a discussion, it's always a difficult conversation because we're not the only ones walking in with increased prices, and they're seeing it across the board. And just like we'd see in our customer business, they're seeing an impact with consumers as they continue to take higher pricing. I would say we're having constructive discussions, and we're working our way through these, but it's always a process and conversation.

Operator

Our next question is from the line of Mitch Pinheiro with Janney Montgomery Scott.

Mitchell B. Pinheiro - Janney Montgomery Scott LLC, Research Division

First, could you give us some idea of what the pricing actions are, the magnitude for consumer and the industrial in the fourth quarter?

Alan D. Wilson

Yes. In general, it's about a 5% increase in consumer as we go into the fourth quarter. Some items are almost nothing, some items are more like double digit, some of the commodities have really surged. Industrial, it's a little harder to pin down the specific pricing as we go into the quarter because a lot of it's commodity, depends on when customers make contract decisions and things like that. Because we'll price it based on the market at the time that we make those decisions. But the overall impact we expect is going to be in that 5% range.

Mitchell B. Pinheiro - Janney Montgomery Scott LLC, Research Division

And 5% for the combined?

Alan D. Wilson

For the combined across the board. And I know that, that kind of translates into an expectation that's about 5% in industrial as well, but that's the way we see it today.

Mitchell B. Pinheiro - Janney Montgomery Scott LLC, Research Division

Okay. How does your cost coverage look, commodity costs? How far out are you bought?

Alan D. Wilson

Well, we don't disclose specifically how far we are, and it varies by commodity. But a good part of that inventory increase are positions that we've taken that will help us into next year that are at rates that are below the current market.

Mitchell B. Pinheiro - Janney Montgomery Scott LLC, Research Division

Roughly, what percentage of your industrial business do you have a relationship where you're having like a direct pass-through, where you're buying for your customers directly?

Alan D. Wilson

That's a tough percentage for me to get to without kind of backing into it. But with most of our major customers on major commodities, we have those protocols. The thing that makes it a little hard to get to is depending on the products, the major commodities will be a big part or a smaller part of the costs that go into it. So it's just hard to quantify that.

Mitchell B. Pinheiro - Janney Montgomery Scott LLC, Research Division

Okay. As far as -- any channel mix dynamics in the consumer side that you can point out to as either different or changing?

Alan D. Wilson

Well, we're certainly seeing consumers shopping in more alternative channels like dollar and in club. That's just been a shift that's been ongoing and accelerated in this environment. That's why we feel good about our strategy to continue to expand our brand presence in those channels.

Mitchell B. Pinheiro - Janney Montgomery Scott LLC, Research Division

Okay, last question. As you look out, you were very positive earlier in the year about the pipeline for innovation, new products with your larger industrial customers. As we're entering the end of the year here, how does it look as you look out for the next 6 months?

Alan D. Wilson

The industrial pipeline’s still pretty good. And we expect that's going to continue just like we've seen. We're positive on our consumer innovation as well. Everybody recognizes, to continue to grow and to continue to deal with some of these cost pressures, we have to innovate. We have to find things that excite consumers because they're willing to spend when the items are right and priced right and really do bring innovation. So we're seeing a pretty good pipeline and continued activity with technical development in -- with our other customers.

Mitchell B. Pinheiro - Janney Montgomery Scott LLC, Research Division

I said last question. I do have one more, sorry. In your marketing spend, where are you seeing your greatest success, your best ROI?

Alan D. Wilson

Without question, it's in the digital area. It's a very effective and efficient spend. It lends itself very well to the kinds of products that we sell, the recipe marketing, the word-of-mouth and the excitement that comes with it, and we're going to continue to shift our spend more aggressively in that area.

Joyce L. Brooks

We're coming up on 9:00. We've got a number of folks still in the queue, so we'll go as long as -- we'll try to get through everybody. We'll just ask you to limit your questions, please, going forward.

Operator

Our next question is from the line of Ann Gurkin with Davenport and Company.

Ann H. Gurkin - Davenport & Company, LLC, Research Division

Just want to continue the discussion on the industrial business. You talked about this just briefly a minute ago. But is there any pullback from customers as they see these higher price increases? Are you seeing any change in demand from the industrial customers?

Alan D. Wilson

We're not necessarily seeing a change in industrial customers and pullback, but we are seeing a shift. As a for instance, food service distributors are a big part of our business and an important part of our business because we're selling branded products that carry good margins, and that part of the segment’s under pressure. We're seeing pretty good success with our quick-service restaurants, restaurant customers.

Operator

Our next question is from Eric Katzman of Deutsche Bank.

Eric R. Katzman - Deutsche Bank AG, Research Division

I guess the sales looked quite good broadly across the business, so compliments to that in this environment. But just a couple of quick ones. One, I thought that the pricing in consumer is usually taken early in the year, and you try not to put something through as we kind of get right into the holiday season. So Alan, what gives you confidence that putting through pricing even on some of the basic spice stuff isn't going to be met with consumer elasticity?

Alan D. Wilson

We are in a little bit of a new world because it's been more than a decade since we've taken pricing as we head into the fourth quarter in our, at least our U.S. consumer business, and we are watching those elasticities pretty closely. We felt that we were at a point where we didn't have a choice because of the increased costs, and our customers have understood that. But we're going to continue to drive the investment in brand marketing, the display activity and our promotion plans through the fourth quarter. So we think we're positioned to help deal with that, but we are in a little bit of new territory.

Eric R. Katzman - Deutsche Bank AG, Research Division

Okay. And then just on the industrial side. I guess I'm very surprised at the comments around the protocols because ever since vanilla hit, my impression at least was that these protocols covered pretty much everything. And it seems to me that you can always hedge the major ingredients like soybean oil or wheat or what have you, and it was the items that are more obscure were the ones where you were in protocols and agreements with whatever it is to whichever customer it is to not get this kind of hit or exposure. So I don't really understand what's happened and why, again, why the contracts aren't kind of broadly covering -- or the protocols aren't broadly covering the stuff that's hard to hedge to begin with?

Alan D. Wilson

Well, we’ve -- the biggest thing is those major commodities we've had less control of and the minor commodities have not typically been volatile. They tend to offset each other, they tended to be more consistent and reliable, but what we're seeing is a continued upward pressure now that's forcing us to really change how we do that. And so it's been a challenge to get those kinds of things passed through, that it's just taken some time. So we're working through them, but our protocols really do address those major commodities where we can buy collaboratively with our customers.

Gordon M. Stetz

And the only thing I'll add is it's not all due to that. Again, we talked about a mix component as well. So I don't want to get that lost in the dialogue, either.

Operator

Our next question is from Erin Lash of Morningstar.

Erin Swanson Lash - Morningstar Inc., Research Division

I was wanting to talk about acquisitions. Obviously, you've been quite acquisitive this year and you discussed the fact that you still have an appetite for acquisitions, and I was curious where you felt some of those opportunities might lie, depending on region, category, that sort of thing?

Alan D. Wilson

Sure. The acquisitions that we've made this year are acquisitions that we've worked on for a long time. And we've been very interested and continue to expand in emerging markets, Eastern Europe, India, China and Latin America. We will continue to pursue growth areas in those markets. In our more developed markets like Western Europe and North America, we like to do tuck-in kind of acquisitions where flavor really matters, and that's why we're doing -- we did Kitchen Basics in the past quarter because we believe we can bring innovation and continue to help people in how they cook in a segment that consumers continue to grow in. So we believe that our acquisition strategy does 2 things: it expands the categories we're in, but it expands geographically where we are. And as you've seen through our history, acquisitions are about 1/3 of our growth rate over the last 10 or 12 years.

Erin Swanson Lash - Morningstar Inc., Research Division

That's very helpful. I just had one quick follow-up. You mentioned I think last quarter that retailers were emphasizing or promoting private label products versus branded, and I was wondering what you're seeing now and how you are thinking about that going into the fourth quarter with your planned price increases?

Alan D. Wilson

Well, we're still seeing retailers promote private label, but as we always do in the fourth quarter, we expect to see consumers buy the brands because they trust the products for their holiday meals, and our display activity ramps up so aggressively in the fourth quarter that we always see our shares go up in the fourth quarter. So we expect to see that continue.

Operator

Our next question is from the line of Robert Dickerson with Consumer Edge.

Robert Dickerson - Consumer Edge Research, LLC

Just 2 very short ones. I know we're short on time. Just one was your FX guidance of the 2% for the year. Is there any risk do you think to that as we go into Q4, just considering the appreciation we've seen in the dollar over the past month?

Gordon M. Stetz

There's always risk in a volatile world with currency, but we got 3/4 of the year behind us. I know, obviously, this is the biggest quarter we're entering into, but FX, as you saw in the results, was 4.6% favorability. So it's our best guess at the moment given the rate environment.

Robert Dickerson - Consumer Edge Research, LLC

Okay, fine. And I think you stated early on in your prepared remarks that you were tracking along to still meet your profit target or operating profit target. And correct me if I'm wrong, but I thought, I haven't checked this recently, but I thought your top line guidance originally for the year was 5%, 7% growth and then EPS was 5%, 7% growth. I thought you were guiding to like the 0 to negative 2% operating profit growth for the year. Is that what you were referring to? And either way, is that a reasonable profit target for the year, or just any comments on that?

Gordon M. Stetz

Our guidance have always been mostly around the top line and the earnings per share, which has been consistent all year long. The only change to the guidance that we've made that we’ve tried to make clear here is, obviously, the impact of all these acquisitions. Other than the acquisition impact, we’ve really been consistent since the beginning of the year on EPS and top line guidance, as well as the gross profit margin, where we've been indicating all along that we expect to see it down versus prior year.

Operator

Our next question is from Andrew Lazar, Barclays Capital.

Andrew Lazar - Barclays Capital, Research Division

Just one quick follow-up on inflation. Of the, I guess, double-digit inflation that you're looking for in input cost this year, can you give us a little bit of a sense of kind of how that tracked? So maybe directionally what it was in the first half, maybe what you saw in terms of year-over-year inflation in the third quarter, so we can get a sense of how that flows into the fourth? Does it ramp up dramatically into the fourth from here? Just trying to get a better read on that.

Gordon M. Stetz

Obviously, as we started the year, as we indicated, we had gross profit margin improvement in the first quarter. People recall, and we were making sure people are aware that we did not expect that to continue as we saw the increases start to occur as we progressed through the year. We obviously knew the third and fourth quarters, we’d experience it the most, so I would suggest that what you just saw in the third quarter is probably what we could potentially expect going into the fourth quarter. You do have a shift of business mix in the fourth quarter as the consumer part of our business ends up being a much bigger part of the portfolio, but I'd say the types of increases that we expected are starting to occur – they occurred in Q3 and will occur in Q4.

Andrew Lazar - Barclays Capital, Research Division

Okay. And my last, is it fair to say that the lag that you saw and expect a little bit more in terms of pricing versus cost is more due to really trying to -- seeing where costs kind of went more recently and then thinking obviously out into 2012 versus having tried to get pricing through a little earlier but running into roadblocks or delays from a, whatever, retailer or consumer standpoint?

Alan D. Wilson

Yes, we really haven't seen an impact in any delays. It's more accelerating costs that are driving the need for pricing, and so it's less of -- certainly, we have to negotiate pricing, but we haven't seen any delays in getting it implemented. It's more the costs have gone quicker. And I will say that part of our culture is that pricing is one of the last levers we want to pull as a company. And so our teams try to do everything they can to manage costs and work with customers before we pull that pricing lever. But we're just in an environment where we have to pull it faster.

Operator

Ladies and gentlemen, we are almost out of time for questions. We have time for one final question from the line of Chuck Cerankosky with Northcoast Research.

Charles Edward Cerankosky - Northcoast Research

Wanted to ask about the acquisition environment. With the pressure on raw material cost increases, working capital pressures, capital availability in general, what are you seeing that doing to the people you've been talking to?

Alan D. Wilson

Well, certainly, the environment is impacting everyone, and different companies are in a different position with being able to take pricing, again depending on the market that they’re in and the strength of their business. We don't think that's going to either cause people to be more aggressive at selling their businesses or less willing to sell their business. I think it's less of an impact, but it certainly will impact how we value businesses as we go forward. Go ahead, Chuck. I'm sorry.

Charles Edward Cerankosky - Northcoast Research

I was just going to say about their working capital investments, just carrying inventories going up for them, is that hastening their decision to sell at all?

Alan D. Wilson

I don't know that it's hastening their decision, but we certainly see it impact the balance sheet. I’m going to…

Charles Edward Cerankosky - Northcoast Research

All right. Then what do you expect retailers to be doing over the next couple quarters as you try to push through additional pricing?

Alan D. Wilson

Well, I think retailers are responding the way that they typically have, and we saw that as we headed into the fourth quarter where retailers did -- there was some amount of buy-in, in advance of the price increase. But I expect that retailers are doing the same things in our category that they are in others, and those are finding -- those prices are finding their way to the shelves.

I want to thank everybody for participating. I know it's been a long call, but I did want to quickly wrap up. And several factors impacted our results this period, things like discrete tax items and the timing of our acquisition costs. And while those make the job of analyzing results and projecting our outlook a little tougher, we hope that we provided you what you need. We do want to leave you with a couple of key takeaways.

First, we demonstrated our ability to implement pricing actions while achieving higher volume and product mix in our year-to-date results. Secondly, we're adapting our business to the economic environment and today's consumer, our product innovation and additional brand marketing support and are vigorously pursuing distribution opportunities. And third, we're investing for growth with accretive acquisitions and joint ventures while we exercise financial discipline and maintaining a strong balance sheet. I appreciate your attention, and I'll turn it over to Joyce to wrap up.

Joyce L. Brooks

Thanks, Alan. I’ll leave my thanks to those listening on today's call. Through October 5, you may access a telephone replay of the call by dialing (877) 660-6853. The account number for this replay is 309, and the ID number is 377603. You can also listen to a replay on our website later today. If anyone has additional questions regarding today's information, I'd welcome a call at my number (410) 771-7244. This concludes our call.

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