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Kellogg Company (K)

Q1 2007 Earnings Call

April 30, 2007 9:30 am ET

Executives

Simon D. Burton - Vice President, Investor Relations

David Mackay - President, Chief Executive Officer

John A. Bryant - Chief Financial Officer

Gary H. Pilnick - General Counsel

Analysts

Andrew Lazar - Lehman Brothers

John McMillin - Prudential Equity Group

Eric Serotta - Merrill Lynch

David Driscoll - Citigroup

Chris Growe - A.G. Edwards

Steven Kron - Goldman Sachs

Alexia Howard - Sanford Bernstein

David Adelman - Morgan Stanley

David Palmer - UBS

Terry Bivens - Bear Stearns

Jonathan Feeney - Wachovia Securities

Robert Moskow - Credit Suisse

Eric Katzman - Deutsche Banc

Pablo Zuanic - J.P. Morgan

Presentation

Operator

Good morning and welcome to the Kellogg Company first quarter 2007 earnings call. (Operator Instructions)

At this time, I would like to turn the call over to Simon Burton, Kellogg Vice President of Investor Relations. Mr. Burton, you may begin your conference.

Simon D. Burton

Thank you, Sarah, and good morning, everyone, and thanks for joining us for a review of our first quarter results and for some discussion regarding our strategy and outlook. With me here in Battle Creek are David Mackay, President and CEO; John Bryant, CFO; and Gary Pilnick, General Counsel.

We must point out that certain statements made today, such as projections for Kellogg Company’s future performance, including earnings per share, net sales, margin, operating profit, interest expense, tax rate, cash flow and debt reduction are forward-looking statements. Actual results could be materially different from those projected. For further information concerning factors that could cause these results to differ, please refer to the second slide of this presentation as well as to our public SEC filings.

A replay of today’s conference call will be available by phone through Thursday evening by dialing 888-203-1112 in the U.S. and 719-457-0820 from international locations. The passcode for both numbers is 6714942. The call will also be available via webcast, which will be archived for 90 days.

Now, let me turn it over to David.

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David Mackay

Thank you, Simon, and good morning, everyone. We are obviously pleased to announce our first quarter results and an increased level of confidence for the year that comes from such a strong start in Q1. As you can see, last year’s momentum continued into the first quarter and sales growth increased faster than our target.

We exceeded our expectations for operating profit growth and we did this while absorbing significant cost inflation and while making investment in the business to drive growth. Both our net sales and operating profit results were achieved against tough year-ago comps, and reported earnings per share growth was greater than our high single digit target.

Results across the P&L were strong and we delivered sales and operating profit growth across most of our global businesses. This shows the strength of our operating principals and the benefit of our commitment to invest in future growth through brand building and innovation.

We are entering the second quarter with greater confidence that we will meet our long-term targets in 2007. Given this great start to the year and our continued business momentum, we are raising our guidance to mid-single digit revenue growth, and we are also raising earnings guidance again to a range between $2.70 and $2.74 per share.

Slide 4 highlights our financial performance this quarter. Reported net sales increased by 9%, building on 6% growth in the first quarter of last year. Internal sales growth, which excludes the effect of foreign exchange, was 7% and builds on 7% internal growth last year. Reported operating profit increased by 6% and internal growth was 3%. As you will remember, we budgeted for internal operating profit to be down in the first quarter, so we are pleased with this better-than-expected performance.

Earnings per share increased by 18% due to the strong sales and operating profit growth, a lower interest expense, and a lower tax rate. This was timing related, which John will discuss later. Note too that EPS included up-front costs of $0.01, in line with last year’s first quarter, and finally cash flow in the first quarter was $289 million, an increase of $188 million from the first quarter of last year.

Let’s look at each of these results in more detail. Slide 5 shows our net sales growth. Internal net sales growth in the first quarter was 7% and, as with previous quarters, this was driven by a relatively balanced contribution from price mix and tonnage growth. Clearly the sales momentum we carried through 2006 continued into the first quarter, which is why we have raised our guidance for full-year internal net sales to mid-single digit growth.

Tonnage and price mix were both driven by strong innovation and excellent brand-building programs. In fact, I’m sure you’ve all seen the strong pricing benefits that are showing through at a recent U.S. measured channel category data, and finally as you can see, the effect of foreign currency translation had an impact of less than 2% on the first quarter’s reported results. We remain committed to our realistic targets and believe they provide us with the basis for our strong performance.

We want to provide you, our shareowners, with consistent, dependable rates of growth. We know that constant reinvestment and strong execution are essential to our continued success.

Now let’s turn to slide 6, which provides detail regarding our increase in investment and advertising. The slides shows the significant increase we made in this investment during the first quarter of 2007 and for the full year 2006, and the double-digit growth posted in the first quarter built on mid-single digit growth in the first quarter of last year. Remember that we said previously that we expected brand-building support to be strong in the first quarter as we continue to invest in the growth of our current brands and support our new introductions.

We had a significant amount of new product activity in the first quarter and as you can see, we certainly invested as we had planned behind these initiatives. We remain committed to both advertising and consumer promotion as a means of building our brands and driving profitable sales growth. We will continue to leverage our scale across our different regions and businesses throughout 2007, with programs such as Shrek 3, Pirates of the Caribbean 3, and X-Box.

Now I would like to turn it over to John for an overview of our financial performance.

John A. Bryant

Thanks, David and good morning, everyone. Slide 7 shows our first quarter gross margin performance. Gross margin was lower in the first quarter, in line with our budget and the guidance we gave you. The decrease resulted from the impact of incremental commodity cost inflation, which accounted for the majority of the decline.

As you know, we have seen a lot of volatility from commodity, fuel, benefits and energy costs over the last few years. As we told you last quarter, 2007 is forecast to be no exception. In fact, we continue to expect that these incremental costs be between $0.18 and $0.22 of EPS in 2007, which could lead to a gross margin decline of approximately 50 basis points for the full year.

The year-on-year increase is somewhat front-loaded, as we lap higher costs in the back-half of 2006. In Q1, we incurred approximately $0.06 of additional commodity, fuel, benefits and energy inflation versus the first quarter of 2006.

We also had some discrete items in cost of goods which negatively impacted gross margin by 40 basis points. This included items such as a $5 million lease termination charge. As I mentioned at CAGNY, however, we bank dollars, not margin and we generated almost $70 million of incremental gross profit in the first quarter. This in turn helped fund our increased investment in the business.

If you look at slide 8, you will see a slide we showed you at CAGNY. This shows the effect that the introduction of higher-priced products can sometimes have. For example, in our international business, our snacks have a sales price per kilo that is 152% of international average, gross dollars about 141% of the average, but gross margin is 92% of the average, so margin is down while the absolute gross dollars generated are up dramatically. Obviously gross margin is important to us but as I said, dollars are what we invest in future growth.

Now let’s turn to slide 9, the discussion of operating profit. The slide shows a growth in internal operating profit in each of our geographic reporting areas. In North America, first quarter internal operating profit growth increased by 3%, despite a significant increase in investment in advertising.

In Europe, 6% internal net sales growth drove 18% profit growth. We do not have the same kind of commodity issues in Europe. We have the benefit of significant cost-saving programs and you can see the leverage in our P&L when we do not face unusual inflation pressure.

In Latin America, quarterly internal operating profit declined by 15%, resulting from cost inflation and the timing of expenses, including investment in brand building. Obviously we will continue to invest heavily in this excellent business throughout the year and we expect that the inflation will remain high. Consequently, we expect approximately flat operating profit from our Latin America business for the full year.

Finally, in Asia-Pacific, internal operating profit increased by 4%, in line with our long-term targets.

For the quarter, consolidated internal operating profit growth was 3%, which as David said earlier was greater than our expectations. This resulted from relatively broad-based sales growth across our businesses and was achieved despite strong investment and continued cost pressures.

Below the operating profit line, interest expense increased for the quarter by $3 million and the tax rate was lower at 24%. While the timing was uncertain, you will remember that we said previously that our expectations for the full year tax rate would include the effect of certain discrete items. As you can see, these flowed through in the first quarter. This effect was simply one of timing.

Let’s turn to slide 10 and a more detailed discussion of cash flow. You can see that we posted strong cash flow of $289 million in the first quarter of 2007, which was largely driven by better working capital management. Both inventories and payables made significant contributions to cash flow in the quarter and obviously we will remain very focused on this important metric in the future.

We continue to expect that full year cash flow will be between $950 million and $1.025 billion.

Finally, I would like to discuss guidance for the remainder of the year on slide 11. You can see that we now expect mid-single digit internal revenue growth, an increase from the guidance we gave you last quarter and at CAGNY. We still expect that operating profit will increase at a mid-single digit rate but we now expect that earnings will be in a range between $2.70 to $2.74 per share. Remember too that our previous guidance was an increase of $0.01 from our initial guidance.

New guidance includes our estimate for total incremental fuel, energy, benefits and commodity costs of between $0.18 and $0.22 per share, unchanged from last quarter. This inflation remains a considerable headwind, so we are very pleased to be able to absorb these costs and still increase our earnings guidance.

We continue to expect that up-front costs for the full year will total $0.14 of EPS, approximately equal to last year’s level of investment. Obviously we expect some leverage below the operating profit line in 2007. For the year, we expect approximately flat net interest expense and we expect that the tax rate could be between 30% and 31%, slightly lower than our recent guidance.

I am sure that many of you are wondering why, given our stronger than expected first quarter performance, we have not raised our EPS guidance even more for the full year. While we significantly increased investment in advertising in the first quarter, there was a benefit to operating income from the timing of programs and in addition, we will continue to invest in the business given our increased flexibility.

So you can see we have momentum and our goals have not changed, so we should post another year of dependable results in 2007 while following our operating principles and investing in long-term sustainable growth.

I will turn it back over to David for a review of our business.

David Mackay

Thanks, John. Some of the themes you’ll be seeing throughout the remainder of the presentation are outlined on slide 12. We continue to invest aggressively behind innovation. We have a balance between line extensions, such as Special K Chocolate, usage occasions such as Right Bites Cookies, and new platforms such as Special K Beverages.

We will also continue to reinvest behind our brand to drive long-term sustainable growth. We leveraged our global scale to quickly share ideas around the world and it is our strong execution that allows us to fully leverage our innovation programs, brand-building initiatives, and price mix gains to help us deliver dependable sales growth.

Now let’s turn to slide 13 which shows the internal growth posted by our North American businesses in the first quarter. We are pleased with the performance as sales growth continued to be strong across these businesses. Let’s look at each of them in a bit more detail, and if you look at slide 14, it shows the sales growth we posted in North American cereal in recent quarters. As you can see, the first quarter’s strong 4% growth builds on 6% growth posted in the first quarter of 2006, the year’s most difficult comp.

Our base sales increased by 4% in measured channels in the quarter and price per pound increased by 5%, and both were driven by successful innovation and strong brand-building programs. Special K Chocolate, Rice Krispies with Strawberries, and Kashi Go-Lean Honey Almond Flecks, all of which were introduced within the last year, are doing very well and all contributed to our strong results.

We are constantly looking for creative ways to bring innovative foods to consumers and as you would imagine, we have more introductions planned, including our cereal straws product and Mini-Wheat Cinnamon Streusel.

Kashi posted strong sales and share growth in the quarter, as GOLEAN and Organic Promise did well, and we are launching two versions of Kashi Granola, which are great-tasting additions to the Kashi franchise.

Our Canadian business posted mid-single digit sales growth as a result of All Bran Guardian and Buds, Mini-Wheat Strawberry and Special K Chocolate, all performing well.

Slide 15 shows our snacks business and the strong 11% growth posted in the first quarter. This continues the strong momentum that these businesses built up in 2006 and builds on a 12% comp. Let’s look at more detail on slide 16. Our Pop-Tarts toasted pastries business posted essentially flat sales on a difficult comp from the introduction of Go-Tarts last year. Despite this, category share in measured channels was 86% in the quarter and we continue to expect another solid year from this great brand.

Our cracker business posted high-single digit sales growth and strong consumption growth in measured channel. Cheez-It, Club, and Townhouse all had a good quarter and portable snacks continued to do well and we’ve got great new innovation about to launch with Club Puffed Crackers.

We also saw a high single digit sales growth in the cookies business and posted increased consumption gains and share gains. Our portable products, such as Right Bites and Gripz had a great quarter. We are about to introduce a new variety of Sandies in the second-half after a strong line-up of innovation in the first-half.

Our wholesome snack business also had an excellent quarter, posting double-digit sales growth behind innovation and continued growth in Special K bars, Rice Krispies Treats, Nutrigrain and Sweet and Salty bars. Our fruit snacks business continued to post excellent sales growth, consumption growth and share gains. Yogos is doing well and we’ve got more products planned for introduction in the month to come.

Finally, in Canada, we also saw high single digit sales growth as a result of innovation, including All Bran Snack Bites, Nutrigrain Sweet and Salty bars, Munch’ems, and Fruit Loop Yogos.

If you will turn to slide 17, you will see that our frozen and specialty channels businesses posted 5% growth on 5% growth last year. Our two frozen brands, Eggo and Morningstar, both contributed and both gained share in the quarter.

The Eggo business saw continued growth from innovation. Pancakes continued to do well and we’ve got new Blueberry Eggo Pancakes launching in a couple of months. Morningstar posted high single digit sales growth, also as a result of good innovation. Products such as Veggie Bites posted significant growth.

Our Kashi frozen entrees have six of the top 10 natural and organic entrees ranked by sales. Kashi entrees have also grown in the category and are doing very well to date, and as you may know, we are introducing three versions of Kashi Frozen Pizza in the second-half.

Finally, our specialty channels businesses had another good quarter. Our execution in these channels has been excellent and we expect another strong year from this very important business.

Now if you will turn to slide 18, you can see some of the innovation planned by the North American businesses in the second-half of the year. As you would expect, this is a lot of activity and we are excited about the continued strong quality of the ideas. Importantly though, the innovation is broad-based across categories, as cereal, cookies, crackers, toaster pastries, fruit snacks, frozen foods, and specialty channels are all represented. Most of these products will be shipping in the next couple of months.

You can see on slide 19 that we posted very strong internal sales growth in Kellogg International in 2006 and we began 2007 well, also with strong growth of 5%. This growth was relatively widespread.

Now if you will turn to slide 20, you will see internal growth highlighted by area. In Europe, we posted quarterly internal sales growth of 6% as a result of strong growth in both our cereal and snacks business. The U.K. posted mid-single digit growth, also as a result of both growing the cereal and snacks businesses. Both Special K and Rice Krispies did very well, as did Nutrigrain Outback Bars and Special K Bars, and we’ve got more innovation planned, including two varieties of Crunchy Nut Bars.

Our businesses in Spain, Italy, and France all posted high single-digit or low double-digit internal sales growth, and we have Special K Two Week Challenges and Shrek-themed promotions planned across Europe in Q2.

We also had good, pan-European innovation planned, including Special K Sustain with fiber and protein, Corn Flakes Multigrain, and Special K Snacks.

In Latin America, we posted growth in both cereal and snacks. In Mexico, our largest business in the region, cereal posted strong growth and we continued to gain shares. We ran a number of promotions in the first quarter which were well-received and innovation continued to contribute. In the second quarter, we have a Shrek 3 promotion and we will introduce Guardian cereal.

Outside Mexico, we also saw double-digit growth from our businesses in Venezuela, Ecuador, Columbia, and Brazil.

Finally, in Asia-Pacific, we posted internal sales primarily as a result of continued weakness in the Australian Snacks business and category. However, in Asia we saw growth in our cereal business and in our snacks business. We introduced snacks in Japan, which are off to a good start. We also posted good results in Korea, Thailand, Taiwan, and double-digit growth in India as a result of innovation and brand-building programs.

We are anticipating that the Asia-Pacific business as a whole will return to growth in the remaining three quarters of the year and that full-year growth will be in line with our long-term target.

In summary, our message for 2007 remains unchanged. Our strong start to the year simply enhances our confidence and gives us more opportunities to build momentum for the future. 2007 will be another year in which we meet our long-term realistic growth targets in a difficult competitive environment. More importantly though, we plan to achieve these goals while continuing our investment in sustainability and future growth.

We recognize that this investment will build stronger momentum and visibility into 2008 and 2009. We will continue to focus on executing well and pursuing continuous improvements in all that we do. Our commitment to our business model, operating principles and our strategy remain strong and our confidence in the future has only been enhanced by our positive start to 2007.

With that, I would like to open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions)

We’ll go first to Andrew Lazar of Lehman Brothers.

Andrew Lazar - Lehman Brothers

Good morning. I am thinking about the operating leverage that you saw in Europe versus North America on the margin line. I think you had mentioned you are not facing the same inflationary pressures I guess there that you are here. Perhaps you could provide a little bit more color on that, and I guess in the context of would it be a fair characterization to say that all of your projects and up-front costs over the last couple of years, are they generating per activity savings ongoing that are as of now equal to what you spend let’s say this year, $0.14 or so, in costs? Or have we not reached the inflection point yet?

David Mackay

I think, Andrew, firstly on Europe as you are aware, the EU has fairly tight controls on the cost of many commodities and imports, and therefore we do not see the levels of volatility in Europe that we will see in other markets that may be a little more open to immediate shifts. So that is certainly true.

As far as our investment in up-front costs, I think the reason why we continue to be able to invest in the business and drive growth and succeed in driving the top and the bottom line has been that ongoing process of constantly looking for ways to improve our cost space to try and offset these movements in commodities and other cost volatility. Hopefully we will continue to do that as we go forward and we will continue to see strong results.

John, anything you want to add?

John A. Bryant

To Andrew’s question on whether we have seen an inflection point, as David said we invest in up-front costs to offset inflation and so if you want to take a multiple-year look at the savings program, multiple year look at the inflation as well and the two have been offsetting each other. That’s why you don’t see a net benefit in our P&L. Although in Europe, as we said in this quarter, we had both operating leverage as well as the benefits of prior up-front cost programs coming through because we don’t see the peak commodity cost increases in Europe.

Andrew Lazar - Lehman Brothers

Thanks very much.

Operator

We’ll go next to John McMillin of Prudential Equity Group.

John McMillin - Prudential Equity Group

Good morning, everybody. Congratulations on the quarter. The tax rate guidance for the year is now 30, 31, and prior it was what?

John A. Bryant

Prior guidance was 31% even.

John McMillin - Prudential Equity Group

Okay, so -- and obviously the first quarter rate was well below that. You just simply are going to spend this back? Is that the message you are getting across today? I see the tax rate coming down a little bit. I did not see that in the press release or anywhere else. Just in terms of not passing that on, it’s just your decision to spend it offensively?

David Mackay

I think when you look at the tax in the first quarter, that was really in our full-year guidance. It is just really timing and nature, John. We do believe there could be a slight benefit in tax for the year but it is nothing that significant at this point. It is early and clearly taxes are in the forecast but we feel pretty good about the latest call of 30 to 31.

John McMillin - Prudential Equity Group

Thank you.

Operator

Moving on, we’ll hear from Eric Serotta of Merrill Lynch.

Eric Serotta - Merrill Lynch

Good morning. Following up on Andrew’s question on operating leverage, it looks like your volume growth in U.S. cereal was pretty flat, or perhaps negative. Was an absence of volume growth in cereal -- I know you are focused on value over volume, but was perhaps a lack of volume growth a factor in the lack of operating leverage in North America?

David Mackay

I think, Eric, if you look at our U.S. cereal business, it was a great performance in the quarter. We grew 4%. The category was actually quite strong as well. We actually gained a tenth of a share. It was driven by base sales and also our price per pound being up about 5%, and also our price on deal being up even higher than that.

I think that is specific to the way we are driving the business, innovating, but I would not draw any conclusions apart from a very strong first quarter in U.S. cereal. What was the other part of the question?

Eric Serotta - Merrill Lynch

Basically I realize it was a very strong quarter from a dollar perspective in cereal. Was an absence of volume growth a factor in the absence of operating leverage in the quarter?

John A. Bryant

I think the primary issue in North America on operating leverage is really the increase in commodity benefits and fuel costs year on year. That is really more of a North American or an Americas-driven issue, between North America and Latin America. That is affecting both of those businesses predominantly within our portfolio.

Eric Serotta - Merrill Lynch

Thank you very much.

Operator

We’ll move next to David Driscoll of Citigroup.

David Driscoll - Citigroup

Good morning, everyone. Certainly congratulations on the quarter and a good start for the year. Just a follow-up on the tax rate question; am I right to assume that in ’05 and ’06, you had similar “discrete” events? The difference being is that those events were more evenly spread throughout the years, hence I don’t remember seeing a tax rate this low in any one particular quarter.

First off, is that correct, that we are just seeing a lower tax rate because you guys have had a number of these discrete events for the last couple of years?

John A. Bryant

There have been discrete items in the past and they have fallen across the years. In the first quarter of this year, the discrete item was particularly large and it is the main discrete item that we expect in the year. So as we look at full-year guidance of 30% to 31%, we do have roughly 24% in the first quarter and then more like a 32%, 33% in the back three quarters of the year.

David Driscoll - Citigroup

John, I believe that I’m correct in remembering that the K, the 10-K indicates a 33% number in the absence of the discrete events. So really I come up with the question then is how long of a sustainability do you really see out there for these discrete events, which I don’t know that any of us can have any real clarity on? How much further, how many years forward would you see the tax rate remaining at the 31% level? Can you give us any guidance here?

John A. Bryant

You are right, David, that our sustainable rate in the 10-K is about 33%. We do have a variety of initiatives underway to try to drive that sustainable rate over time down to 31%.

David Driscoll - Citigroup

So then you would give guidance of 31% for the foreseeable future?

John A. Bryant

It is a bit early to be giving guidance for 2008, 2009 but that is certainly where we are trying to drive the rate to.

David Driscoll - Citigroup

Thank you.

Operator

Moving on, we’ll hear from Chris Growe of A.G. Edwards.

Chris Growe - A.G. Edwards

Good morning. I just wanted to ask a couple of quick questions here, just a bit of a follow-up on North American cereal. Were there any inventory adjustments that occurred at retail this quarter or are we pretty much in the clear there, if you will?

David Mackay

I think basically our inventories were broadly in line with where they were last year. I think what we saw was the fourth quarter of ’06 was a bit of a hiccup and the performance in the first quarter at around 4% growth was very strong, and the category itself actually grew probably if you add in non-measured channels, probably grew 3.5% to 4%, so it performed strongly as well. We are very pleased with that, don’t see any real issues on inventory.

Chris Growe - A.G. Edwards

And then just a quick question on the SG&A and advertising side. You had talked about some savings coming through from kind of the consumer marketing side. Were those in effect just reinvested back into advertising this quarter, or was there some kind of benefit there to SG&A in the quarter?

David Mackay

No, we reinvested back. On the consumer promotions line, that was a little less than last year but our advertising was up, so we reinvested those benefits back into advertising.

Chris Growe - A.G. Edwards

Thanks a lot.

Operator

(Operator Instructions)

We’ll go next to David Driscoll of Citigroup.

David Driscoll - Citigroup

I appreciate being able to get back in so quickly. Just a question; you guys had launched, and I forget the name of it, I think you just simply called it your Wholesome Snacks or really you were trying to open up a division that was going to be your big push into getting healthier snacks out there. Again, forgive me, I don’t remember the name -- it was Wholesome Snacks I think you called it.

Bottom line, David; can you give us an update as to where this is going and how do you see future product innovations coming out? Should we be expecting a lot more innovation this year or is this something that really stages rather slowly over the course of the next few years?

David Mackay

I think you are talking about Wholesome Portable Breakfast Snacks, WPBS, which is part of our snacks business unit. I think that area has always been a very high innovation segment for us. It is doing well. It is growing probably mid-single digits over the longer term. We saw a lot more growth certainly in the first quarter and we were up double-digits.

I would hate to give any predictions on the future except we have a strong pipeline and we feel very good about our approach to innovation and advertising.

Operator

We’ll go next to Steven Kron of Goldman Sachs.

Steven Kron - Goldman Sachs

Great, thanks. Good morning. Two questions, if I might; on the cost reduction programs, the up-front spending, $0.01 this quarter. Do you have any color as to the pacing of that as we move through the year?

David Mackay

I think you are going to see it back-loaded as it has been certainly in the last couple of years, with a fair amount in the fourth quarter and a little bit in the third. But that’s been consistent over the last couple of years I think.

Steven Kron - Goldman Sachs

David, can you give us an update on some of your health and wellness initiatives, kind of the Special K expansion, if you will? Also, whether the organic Kellogg cereals, what kind of traction you are seeing there?

David Mackay

I think the Special K Protein beverage and the meal replacement bars, it is relatively early. We launched the advertising in January, so probably another three to six months before we get a very clear read, but we do now have the number one selling meal replacement bar in the market. This [inaudible] promising and I think the protein beverage is doing well. But like all of these things, it is a relatively new concept. It will be a while before we see whether we’ve got the level of trial and repeat that we need to make it a long-term success but the initial indications are positive.

Steven Kron - Goldman Sachs

And on the organic Kellogg cereals?

David Mackay

Sorry, the organic cereals, tracking probably around a tenth of a point. Probably not doing as well as we would like. It is very much dependent on the area in which it sells. We’ve got some pockets of strength but the overall market reaction at around a tenth of those SKUs has been okay but probably slightly below what people thought it might have been.

Steven Kron - Goldman Sachs

Thanks.

Operator

Moving on to Alexia Howard of Sanford Bernstein.

Alexia Howard - Sanford Bernstein

A question on the SG&A as a percent of sales. It seems as though you have very deep and elaborate share this time around, despite the in media spending. Could you give us a little bit more color on what that was, whether it’s the retention expenditures or some other ongoing cut-back? Is that likely to be sustainable for the rest of the year?

John A. Bryant

I think the key reason our SG&A as a percentage of sales went down is because the sales growth was so high, so we spent the money we expected to spend. We had good increases, a double-digit increase in advertising at the company and there was nothing unusual on the cost line so much as such a high level of growth at the top line.

Alexia Howard - Sanford Bernstein

Thank you very much.

Operator

We’ll go next to David Adelman of Morgan Stanley.

David Adelman - Morgan Stanley

Good morning, everyone. David, is there any major business unit or major geography you flagged where you are increasingly anxious about the competitive dynamics?

David Mackay

No, I don’t think so. From time to time, we have more intense competitive activity but generally, most of the markets in which we compete are highly competitive and that remains the case. There is not one that stands out. We feel pretty good about our business approach. It seems to be working so we are going to stay focused on driving the business through innovation and brand building.

David Adelman - Morgan Stanley

Also, a question on the capital structure. What is your response to the reaction that the company’s balance sheet is becoming increasingly lazy, that you could increase returns to shareholders and returns on capital and accelerate growth going forward by taking on more debt, like in the post Keebler environment, whether it is through a buy-back or a one-off dividend and so forth?

David Mackay

I will let John add a little bit of color to that but you know we have an authorization for share buy-back of $650 million and we think we are actually managing our balance sheet pretty well. John, any thoughts?

John A. Bryant

I think our debt level, given the size of the company, is about in line with the food industry peer group, if not slightly higher, so I think we have a pretty good position there. It gives us flexibility as a company to operate and what we started to do is to continue to try to improve our ratings position by growing into the ratings rather than say paying down additional debt, so we are, as David said, we have a large share buy-back this year. We also have the dividend increase we recently announced of 6.5%.

I think we have a pretty good balance there amongst so many uses of cash.

David Adelman - Morgan Stanley

Thank you.

Operator

We’ll go next to David Palmer.

David Palmer - UBS

Just one big picture question on cereal; clearly there is that growing 55 and over population in the U.S. You have been doing some nice things with Kashi and recently some weight management innovation under Special K, but I can’t help but think that internally you think you could be doing more, and maybe you are working on doing more to appeal to this age group, which could be kind of a long curve of demand growth in the future, particularly in the cereal category. Could you perhaps give us a sense of how you view what you have done to date with this age group and the remaining opportunity?

David Mackay

I think you have seen a number of initiatives over time. Special K continues to do very well. Smart Start, Healthy Heart and [Optive] in the U.K., very much targeting the over-40, 50s -- Kashi continues to really appeal to all of these people. All Bran around the world is doing extremely well. A tougher challenge in the U.S. but nevertheless starting to get some traction.

We have I think a fairly broad array of products that appeal to a number of the needs of the demographic population that is going to continue to probably be a bigger part of that business, which is the over 40s, over 50s. That is true not only in the U.S. but around many of the markets globally for us.

We feel very good about it. There is more going on and when and if we are ready to go to market, we will let you know.

David Palmer - UBS

Okay. I’ll leave it at that. Thanks.

Operator

We’ll go next to Terry Bivens of Bear Stearns.

Terry Bivens - Bear Stearns

Good morning, everyone. Going back to the cereal category, clearly you guys have been successful in getting some price mix in there and I am referring to North America. Your chief rival has been going the other way in some of the recent data. The question would be as you look forward, what would you expect Mills to do in terms of pricing on the cereal line? They seem to be signaling that it is coming but have you seen anything or what would your expectation be?

David Mackay

We don’t like to make any conjecture on what other competitors in the market will or won’t do. We manage the business to ensure that we believe we are driving it in the right way. We have taken pricing as coming through. Our price per pound is up, even higher than our base consumption growth. Even our sales price on deal, those prices are rising. So we are managing the category we think in the right way, given the cost pressures that we are under and continuing to drive the category through innovation and brand building we believe is absolutely right for the long term.

I really would not like to get into any discussion about what someone else in the category might or might not do.

Terry Bivens - Bear Stearns

Just on visible evidence though, has there been anything you have noticed over the short term of late that would suggest they are more likely to try to get some pricing?

David Mackay

You could probably refer to the IRI data and they do stand out in a couple of regards, but rather than comment on that, I would suggest you go back and look at the data.

Terry Bivens - Bear Stearns

Okay, thanks very much.

Operator

We’ll go next to Jonathan Feeney from Wachovia.

Jonathan Feeney - Wachovia Securities

Good morning. Congratulations. I wanted to -- I jumped on the call a little bit late. I apologize if this has been asked but one area of confusion I think for investors has been to gross margin and the impact on it. You are down 120 basis points but it occurs to me that you guys have a snacks business that is growing 11%, a cereal business that is growing 4% and there is a huge gross margin differential there. Is there any way you could quantify how much of an impact those different gross margin products might have had on your gross margin?

John A. Bryant

There is an impact as we said at CAGNY, that we are selling more products with a higher price per kilo realization, whether they be wholesome snacks or other similar products. That has had a positive impact on our sales growth and a positive impact on our gross profit growth in dollars but it does have a slight negative impact on gross margin as a percentage of sales.

While we haven’t historically quantified that, it was about a negative 30 basis points in the first quarter.

Jonathan Feeney - Wachovia Securities

Thanks very much.

Operator

We’ll go next to Robert Moskow of Credit Suisse.

Robert Moskow - Credit Suisse

Good morning. I have a question about the snacks business being up as high as it is. I know it is a combination of better distribution and better innovation but it seems like a lot of these items are things that might be kind of fattish in nature. I am wondering; can you give me a sense of what percentage of these do you think are platforms that can last for a long period of time and what percentage of them would you consider new flavor variations that are just trying to keep the news flow up?

David Mackay

I think if you look at the growth in our snacks business, one of the biggest drivers in there has been the single-serve 100 calorie packs. I think that is true not only for ourselves but for our competitors. I think that growth is sustainable and something that we will see going forward because it is something consumers are looking for. On other occasions for people to snack when they can do so with controlled calories or a controlled portion size, I think will continue to be a growth area for us and for all in the category.

We don’t actually look at our growth and believe we are launching stuff that is going to disappear. A little of innovation in snacks is probably slightly higher than the average for the company but that really relates to the nature of that type of category and those types of products.

The fortunate thing is when you have a DFD system as we do in the U.S. we are able to deliver a lot of innovation cost-effectively to the marketplace and manage it extremely well. If it doesn’t succeed, we will de-list it. If it is working, we will push it hard.

We feel very good about what is going on in snacks.

Robert Moskow - Credit Suisse

Another question; Kashi, it seems like whenever I turn on the TV, I see another Kashi ad, so you are clearly investing heavily this year. Can you give us a sense about how big that brand is currently, and then what do you think it could be five years down the road?

David Mackay

If you took Kashi in totality, it is in excess of $300 million, but we would not give any more flavor than that. It is doing very, very well. It is clearly on trend and I think that it is the brand that will continue to grow very, very strongly for us.

Robert Moskow - Credit Suisse

Great. Thanks, David.

Operator

We’ll go next to Eric Katzman of Deutsche Banc.

Eric Katzman - Deutsche Banc

Good morning, everybody. A few questions. One is just more of a specific follow-up on the tax issue. John, is this a FIN-42 or whatever that number was in terms of then should we just expect more volatility from quarter to quarter from here on out?

John A. Bryant

FIN-48 does -- will drive a little bit more volatility. Obviously what happened in Q1 has nothing to do with our implementation of FIN-48 because that was for us an immaterial implementation, in fact. It just had to do with this particular discrete item coming through in the quarter.

Eric Katzman - Deutsche Banc

Okay, and then, on the cookies and crackers, I think Kraft mentioned the price increase in Oreo. I don’t know if that was broader but have you taken pricing up in cookies and crackers at Keebler?

David Mackay

Yes, we took it up I think effective January. It might have been December. December, January -- effective first quarter.

Eric Katzman - Deutsche Banc

And then last more of a comment than a question; I talked with Simon about this but I just don’t understand why, for example, in your slides, I think you gave two slides on international and yet the vast part of the growth of operating profit and arguably a big part of the growth on the top line longer term is going to come from international and yet, I don’t know, you’ve continued to guide us to focus in on the domestic business when it looks like the year-to-year strength is actually and should continue to come out of international and yet that’s -- we get less detail on that.

David Mackay

I think if you look at our business currently, it is around two-thirds, a third 65, 35 North America, two international. I think the growth expectations for the company currently are that we will grow in most markets around the world. I think when and if we find opportunities to potentially get into some of the developing markets then over the longer term, that may have an impact but over the short term, I don’t see it being dramatic.

We do try and give broad flavor on every part of that business, so maybe you could talk to Simon if you would like us to do more.

Eric Katzman - Deutsche Banc

I just think -- I’ll let it go but I just think you are under-selling yourself because obviously the developing markets in South America, you have very high share. The markets there are quite strong and you are doing well. Europe is finally recovering for you after a decade or so of weakness in some respects, and I don’t know. It just seems to me that rather than getting us to focus in on the difficult or more competitive U.S. cereal market every single quarter, it would just be better to kind of focus in on these developing markets and the recovery in Europe to a greater extent than you kind of show us through the slides. I’ll leave it there.

David Mackay

Thanks, Eric, and we’ll have a look at that.

Operator

Moving on, from Franklin Management Group, we’ll hear from Linda Donnelly.

Linda Donnelly - Franklin Management Group

I believe before you gave us guidance on CapEx for this year of 454. Is that still approximately what you plan?

John A. Bryant

Our guidance is about 4% of sales for the year.

Linda Donnelly - Franklin Management Group

All right, and could you give us a little guidance on depreciation and amortization?

John A. Bryant

Depreciation expense should be around $330 million for the year.

Linda Donnelly - Franklin Management Group

Thank you very much.

Operator

(Operator Instructions) We’ll go next to Pablo Zuanic of J.P. Morgan.

Pablo Zuanic - J.P. Morgan

Good morning, everyone. I have two questions, if you don’t mind, but I want to follow-up on the last question on international. I actually look at it from a different angle. I could make the argument when other companies talk about selling soup in China and Russia that those countries have the daily habit in their diet, but in the case of cereal obviously it is not part of those countries’ dietary habit, so I’m just wondering, when I look at international, why are you not being more aggressive in sending some of your biscuits, your cookies, crackers overseas? Should I assume that most of the growth is going to come from cereal bars? It is hard for me to picture, to be bullish on the Kellogg International growth when I believe that some countries, the people that would eat cereal are limited to well-to-do families or people that have had exposure or lived in the U.S. Can you walk me through that rationale? I have a hard time getting comfortable with your long-term growth story of your international piece.

David Mackay

It’s interesting. Cereal is still the biggest part of our business. You go to the biggest, the highest per capita consumption market in the world is Ireland. I think it is about 8 kilos per head, and the first quarter of this year, Ireland grew 10%, the category was up 10%. The category in many of our bigger developed markets is growing four, five, six, but Ireland 10%. It seems there is no limit to how far you can push and grow these categories.

We are looking at the international markets and looking at our overall portfolio products and saying okay, if we want to expand on these, what products best fit and you are absolutely right. A market like China for cereal is quite small, so we will see how we pursue that over time and we will give you more color when we get there.

Pablo Zuanic - J.P. Morgan

One last one; when I look at operating margins in North America, I see roughly around 18% for Kellogg, and then I look at General Mills and Heinz, 23%, 24% if I’m not wrong. Do you guys benchmark with them? Why would your margins be lower? How should we think about your profit margins in North America evolving over time?

David Mackay

I think Pablo all I’d say is we had a great first quarter, our business is strong, our business model strategy and operating principles continue to work. We are investing heavily back against innovation and brand-building, which is driving we believe long-term, sustainable growth. We think our margins are very strong. We think our model is working so we are very comfortable with where we are at.

Pablo Zuanic - J.P. Morgan

Thank you.

Operator

We’ll go next to Chris Growe of A.G. Edwards.

Chris Growe - A.G. Edwards

Thank you. I just have a quick follow-up; you had talked about I believe it was at CAGNY about having a good chunk of your commodity costs hedged for the year. Is there any way you could update us on where you stand on the input costs that you can hedge?

David Mackay

We’re about probably 80%-ish for this year.

Chris Growe - A.G. Edwards

Okay, and just one other quick follow-up as well; you had mentioned we know about pricing in cereal, we know about pricing in cookie and cracker. Are there any other price increases that have hit, that have already been announced that are hitting maybe in international markets, for example, where you are taking pricing up?

David Mackay

We’ve taken pricing in probably every market over the last six months. We took pricing in frozen, we took pricing in specialty channels, cereal, snacks, the U.K. through Europe, Australia, Latin America, Canada -- I can’t think of a market, to be quite frank, where we haven’t in the last six odd months taken pricing.

Chris Growe - A.G. Edwards

Okay, that’s all I wanted to be clear on. Thanks so much.

Simon D. Burton

If we could just take one last question.

Operator

Thank you. That will come from David Palmer of UBS. Mr. Palmer, your line is open. Hearing no response, we will move on to John McMillin of Prudential Equity Group.

John McMillin - Prudential Equity Group

I got in there in the nick of time. I will only ask one question. First of all, thank you for putting the up-front charge number in the actual press release. I assume this lease termination is in North America, is that right?

David Mackay

It is.

John McMillin - Prudential Equity Group

Okay. I am just trying to back it out of my numbers. Thanks a lot.

John A. Bryant

Sorry, John, just to clarify -- the lease termination charge is not for the up-front cost. The up-front cost, $0.01 in this quarter, is actually in Europe. The lease termination charge is just a discrete item that does not qualify by our standards as an up-front cost.

John McMillin - Prudential Equity Group

Okay, so you have that charge plus the up-front charge.

John A. Bryant

True.

John McMillin - Prudential Equity Group

Thanks a lot.

Operator

Gentlemen, I will turn the conference back over to you for closing remarks.

David Mackay

Thank you very much for your time and we are looking forward to hopefully a very strong year. Thank you.

Operator

That concludes today’s conference. We thank you all for joining us.

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Source: Kellogg Q1 2007 Earnings Call Transcript
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