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Kellogg Company (K)

Q2 2007 Earnings Call

July 26, 2007 9:30 am ET

Executives

Simon Burton - Vice President, Investor Relations

David Mackay - President, Chief Executive Officer

John Bryant - Chief Financial Officer

Gary Pilnick - General Counsel

Analysts

Ken Goldman - Bear Stearns

Pablo Zuanic - JP Morgan

Chris Growe - AG Edwards

Terry Bivens - Bear Stearns

Eric Katzman - Deutsche Bank

John Feeney - Wachovia Securities

Tim Ramey - D.A. Davidson

David Driscoll - Citigroup

Eric Serotta - Merrill Lynch

Steven Kron - Goldman Sachs

Alexia Howard - Sanford Bernstein

David Adelman - Morgan Stanley

David Palmer - UBS

Presentation

Operator

Good morning. Welcome to the Kellogg's Company 2007 second quarter earnings conference call. (Operator Instructions) I would like to turn the call over to Mr. Simon Burton, Kellogg Company Vice President of Investor Relations. Mr. Burton, you may now begin your conference.

Simon Burton

Thanks, Lisa. Good morning, everyone. Thanks for joining us for a review of our second 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 Monday evening by dialing 888-203-1112 in the U.S. and 719-457-0820 from international locations. Pass code for both numbers is 6714942. The call will also be available by a webcast which will be archived for 90 days.

I will now turn it over to Dave.

Dave Mackay

Thank you, Simon and good morning, everyone. As you can see from this morning's press release, the quarter was a strong one. The double-digit earnings growth was higher than expected and was of very good quality. The mid single-digit internal revenue growth we posted exceeded our long-term targets, as momentum continued behind excellent innovation and brand building that resonated with consumers.

Importantly, we capitalized on this strong growth with leverage throughout the P&L. Gross margin exceeded our internal expectations and we saw margin expansion in the quarter and we achieved this result despite continued cost of goods inflation. We delivered very strong operating profit growth and operating margin expansion and we achieved this while increasing investment in brand building and while making significantly greater investment in upfront costs than we originally anticipated. These results combined with below the line leverage to provide another quarter of excellent EPS growth.

All this was a result of continued reinvestment and strong execution. We have launched some great innovation over the past year and we have had the brand building to support it. We've also executed well across categories and regions and we gained share in many of them.

Many of you know that our business model is designed to provide confidence in the company's ability to deliver dependable and sustainable rates of growth in future years. The strength of the business in the first half of the year has provided us additional flexibility to invest even more heavily in future visibility. So we have increased our estimate for upfront costs for the year from $0.14 to approximately $0.17 per share. We've increased our estimate for commodity inflation and still tightened our fully earnings guidance to $2.71 to $2.74 per share.

Slide 4 highlights our financial performance in the second quarter. Reported net sales increased by 9%, lapping a difficult 7% sales growth in the second quarter of last year. Internal sales growth, which excludes the effect of foreign exchange, was 6%, also building on 7% internal growth last year. Reported operating profit increased by 12%. Internal growth was 9% and operating margin increased by 60 basis points.

As I said, we achieved these results despite significant investment in brand building and more investment in upfront costs than we had anticipated. In fact, we invested approximately $0.08 of EPS into upfront costs this quarter. The year-over-year impact lowered the internal operating profit growth rate by almost 5% so we have invested half of the amount we expect to invest during the year in the first half.

Earnings per share increased by 12% due to the excellent operating results. Cash flow in the first half was $569 million which is $229 million more than in the first half of last year. Let's look at each of these in a little bit more detail.

If you look at slide 5, it shows our net sales growth. Reported net sales growth in the quarter was 8.7%. The effect of currency translation added 2.5%, leaving a very strong internal sales growth of 6.2%. As you can see, we again had a good balance between tonnage growth and price mix benefits. Much of the measured channel data is showing this here in the U.S. and in other regions of the world.

Despite exceeding our growth goals, we remain committed to further investment in our business. This will drive visibility into future growth and will help us achieve our long-term goal of dependable, sustainable rates of growth.

Now let's turn to slide 6 and a discussion of our investment in advertising. We increased this investment at a double-digit rate in both the second quarter and in the first half. In the second quarter, we ran a number of strong ad campaigns around the world including our successful two-week challenge event. We also ran Shrek and Pirates of the Caribbean promotions in many of our businesses around the world and we've got an Xbox themed promotion to come later in the year. We recognize that this investment is essential to achieve our targets and we have a significant amount of spending planned in the back half of the year to support both new and existing products.

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

John Bryant

Thanks, David and good morning, everyone. Slide 7 shows our second quarter gross margin performance. As David said earlier, gross margin increased in the second quarter. This 120 basis point improvement was ahead of internal expectations and was achieved despite the impact of continued cost inflation. The margin expansion was driven by good operating leverage, savings from cost reduction initiatives and favorable price mix. In addition, we benefited from a difference in the amount of upfront costs recognized in cost of goods this quarter and from last year's consumer promotion cost savings initiative.

As we told you last quarter, commodity, fuel, energy and benefit costs continue to be volatile. It now appears that some costs in the second half of the year will be even greater than our original estimates. So we now expect that these incremental costs will account for approximately $0.26 to $0.30 of EPS in 2007 or approximately $0.08 more than our previous guidance. We expect that full year gross margin will decline by approximately 50 basis points as we told you last quarter.

This inflation will be back half loaded, as we saw approximately one-third of the inflation we expect for the full year in the first half of the year. So while we are very happy with this margin performance, as we said before, we bank dollars, not improved margin and in the second quarter we generated $142 million of additional gross profit or 11% growth from the second quarter of last year. In the first half of the year, we've generated $209 million of incremental gross profit and increased gross profit that will fund our visibility into growth in future periods.

Now let's turn to slide 8 and a discussion of operating profit by region. This slide shows the growth in internal operating profit in each of our geographic reporting areas. In North America, second quarter internal operating profit growth increased by 11% as a result of net sales growth and operating leverage and some timing benefits from brand building activities. Increased upfront costs in North America in the quarter lowered internal operating profit growth by more than 4% and we also faced significant cost inflation.

In Europe, 7% internal net sales growth drove 19% profit growth as we again saw the benefits from operating leverage and less volatile commodity costs. The European business achieved this growth despite a double digit increase in investment in advertising and the year-over-year increase in upfront costs.

In Latin America, quarterly internal operating profit declined by 8%, lapping difficult comparisons and driven by high commodity costs and double-digit increases in investment, in brand building and in R&D.

Finally, in Asia Pacific, internal operating profit decreased by 26% or $6 million. This decline was largely the result of asset write-offs and efficiency initiatives in Australia. In addition, we increased brand building in Asia and South Africa and saw continued weakness in the Australian snacks business.

For the quarter, consolidated internal operating profit growth was 9%, including the impact of increased investment in advertising and significant cost inflation. Increased investment in upfront costs in the quarter lowered consolidated internal operating profit growth by almost 5%. Below the operating profit line, interest expense was approximately unchanged and the tax rate was 32%. Now, let's turn to slide 9 and a more detailed discussion of cash flow.

Good cash flow growth continued in the second quarter and in the first half we generated $569 million of cash. This is significantly greater than the $340 million generated to this point last year. This growth has been driven in part by strong net earnings growth, excellent performance in trade payables and timing of brand building. Obviously, the cash flow metric is very important for us and we will remain focused on improvement in the future.

Our estimate for depreciation is now $350 million, up from the $330 million I mentioned last quarter. This increase is due to the impact of upfront and higher asset write-offs. For the full year we now have even greater confidence that we can meet our guidance for cash flow of between $950 million and $1.025 billion.

Turning to slide 10. In Q2, we saw sales growth driven by the success of new products, great advertising and promotions and excellent in-store execution. We made significantly greater than anticipated investment in future growth and still saw operating leverage, which led to gross margin expansion and ultimately significant operating profit growth and operating margin expansion. We saw very strong EPS and cash flow growth. All of which should give you confidence that we can achieve another year of dependable, sustainable rates of growth in 2007.

Now let's turn to slide 11 and look at upfront costs of the year. The upfront cost initiative that we announced last week in our snacks business will account for approximately $0.13 to $0.15 of EPS or most of the investment we will make in 2007. As you remember, this initiative involves exiting franchise agreements and reorganizing our DSD network in the southeast. The initiative includes the cost of buying out franchisees and streamlining activities and should drive future cost savings and sales growth.

The European initiative that we began last year will add approximately another $0.03 to the total for the year and makes up the remainder of the total. As you remember, this amount is less than the approximately $30 million for 2007 that we expected previously. As we said, these projects provide essential cost savings that will help us to offset inflation in future periods, so we are pleased to be increasing this year's investment.

If you will turn to slide 12, we'll look at guidance for the remainder of the year. We continue to expect that full year revenues will grow at a mid single-digit rate, greater than our low single-digit long-term target. You can see that we now expect earnings to be between $2.71 and $2.74 per share. Notably, this guidance also includes an increased estimate for total incremental commodity, fuel, energy and benefit costs of approximately $0.26 to $0.30 per share; an $0.08 increase from our previous estimate.

As we mentioned earlier, we also expect to absorb upfront costs for the full year of approximately $0.17 of EPS or $0.03 more than we expected previously. These projects provide added visibility for future periods, so we are pleased to be able to make this additional investment this year.

We continue to expect some leverage below the operating profit line for the year. We expect essentially flat net interest expense, but we now expect the tax rate will be approximately 30%. The benefits from this lower rate will be more than off set by the increased cost inflation and higher investment in upfront costs and brand building that we mentioned earlier.

So to wrap up, we are pleased with the quarter's strong performance, our current momentum and our ability to increase our investment in future growth even while absorbing increased cost pressures. Most important though, is our model has the flexibility to allow us to absorb all of this and maintain our strong earnings guidance.

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

Dave Mackay

Thanks, John. If we could turn to slide 13 and the internal sales growth posted by our North American businesses in the quarter. We are happy with the 6% growth overall and this growth is lapping a strong 8% growth in Q2 of last year. As you can see, we posted growth in each of the businesses in the quarter. We had good results from product and packaging innovation, and our execution and both traditional retail and specialty channels remained strong.

We will look at each of these business in more detail, turning to slide 14, which shows our North American cereal sales growth. We posted 3% internal growth this quarter, building on a strong 4% growth in the second quarter of last year. Much like last quarter, our base sales increased in the latest measured channel data and our price per pound increased by more than 3%. We also have higher promoted prices for the 13-week and year-to-date periods. So our sales force has really been executing well and the results have shown in this quarter's data.

We recently launched Mini Wheats Cinnamon Streusel, Corn Pops Peanut Butter and Chocolate, a new version of Fruit Loops and the Straws products we told you about last quarter. These and other products including All Bran, Rice Krispies, Smart Start and Special K contributed to the quarter's strong results.

Kashi posted another strong quarter. In fact, you can see double-digit sales growth in share gains in the measured channel data, which was driven by Heart To Heart and Go Lean and Organic Promise. Our Canadian business posted internal sales growth, as we continued to benefit from good innovation earlier this year and the category continued to grow. Special K Chocolate, All Bran Guardian and Strawberry Mini Wheats all contributed and all held good share positions. For the second half, we recently introduced both Special K Fruit and Yogurt and Rice Krispies Vanilla.

Slide 15 details the strong 9% growth posted by our snacks business in the second quarter. As you can see, this excellent growth built on double-digit growth in the second quarter of 2006. As we look for more detail on slide 16, our PopTarts business posted mid single-digits sales growth in the second quarter, despite the fact that we were lapping the introduction of Go Tarts in the first half of last year. In addition, measured channel category share for the quarter was 86.5%.

The cracker business also posted quarterly growth on very difficult double-digit comparison as Club and Townhouse both did well. In addition, we also saw growth from Cracker Packs, Right Bites and the new All Bran crackers. We also gained cracker category share in the quarter and recently introduced some great new products including Club Puffs. It's early with these, but we're encouraged by the initial success. We also introduced Carr's Cheese Melts and Right Bites variety pack in the second half.

We saw excellent sales growth in category share gains in our cookie business and we are again lapping good growth in the second quarter of last year. Sandies, Grips, On The Go, and Famous Amos all added to the growth. Our innovation and brand building has been strong and we are seeing the benefits. We have got more activity planned, including a new version of Grips and we just launched Dipping Delights. Again it's early, but they appear to be starting well.

The wholesome snack business also did well in the quarter. Special K bars have been posting excellent double-digit growth for a number of quarters. We also saw great results from Rice Krispies Squares, Nutrigrain bars and Crunchy Nut bars. Finally in Canada, we saw double-digit internal sales growth, also the result of innovation and category growth. Sweet and Salty bars continue to do well, as did All Bran bars, as the result of strong media support.

If we can now turn to our frozen and specialty channels business on slide 17, our Eggo business posted high single-digit revenue growth from good gains and price mix and this was lapping high single-digit growth in the second quarter of last year. Eggo Pancakes posted another quarter of strong growth, as did French Toast Sticks and Kashi Waffles.

Our veggie food business posted growth, also off a difficult double-digit comp from last year. We are seeing good growth driven by innovation and we are also seeing strong results from our Kashi frozen entree business. We shipped three new varieties earlier this year and, as you know, we just launched Kashi frozen pizzas.

Finally, our specialty channels business also had a good quarter with the food service and vending and the convenience and drug businesses both contributing. Specialty channels continue to drive excellent results through a combination of effective innovation and great execution in the second quarter.

If we turn to slide 18, you can see some recent innovation. While this is only a sample of the new products, you can see the activity spans both geographic regions and categories. Our long-term goal is for innovation introduced in the prior three years to account for about 15% of the current year sales. As you know, we have exceeded this goal in recent years and it is the contribution from this innovation that has helped drive much of the benefit we are seeing in price mix.

Slide 19 shows specific detail on our International businesses. You can see on the slide that Kellogg International posted 6% internal sales growth in the second quarter, lapping a strong 5% comparison in the second quarter of last year. This growth was led by excellent results in both Europe and Latin America.

Now, if you will turn to slide 20, you will see internal growth highlighted by area. In Europe, we posted 7% internal sales growth and saw good growth in both cereal and snacks. In cereal, Special K Sustain and Multigrain Corn Flakes are being introduced in a number of countries in the region and we are investing behind the Optivita Heart Health brand we launched last year. In the U.K., our biggest business in the region, we saw very strong high single-digit cereal category growth in the quarter and we gained share. Innovation introduced in recent months, including Special K Bliss, Optivita and a new version of Coco Puffs contributed to the performance. We also saw strong sales performance in other key European markets, including Spain, France, Ireland, Italy and Benelux.

In Latin America we posted 8% internal sales growth, also as a result of growth in both cereal and snacks. In Mexico, growth was driven by the cereal business and by our ready-to-drink All Bran and Special K shelf stable milk products. New products and promotions such as the Special K Summer Challenge contributed and we just introduced Special K Mini Snacks and have Special K Bliss cereal planned for introduction in the third quarter. Venezuela, Colombia and Ecuador all posted good internal sales growth in the quarter.

Finally, in the Asia Pacific region, we saw cereal sales growth in Asia, as both our South Korean and Indian businesses did well. We also saw good results in our new Japanese snacks business behind the All Bran, Special K and Genmai brands. We've gained solid share positions in this business and category growth rates have been high. Our Australian business posted large sales, as difficult category conditions continued in the snacks business in the second quarter. We continue to expect that this situation will shake out over time, much as it has in other parts of the world.

So in summary, we are very pleased with the results we posted in the first half of 2007. In fact, it is this strong start to the year that gives us even more confidence for the remainder of the year and beyond. We are seeing better momentum this year than we expected. Our strong brand-building programs and innovation continue to drive these results and we have continued to execute well around the world.

With increased investment in future growth, we've significantly increased our investment in upfront costs, which will help drive efficiency gains and help offset commodity and energy inflation in future periods. We have also planned to increase investment brand building in the balance of the year. So, both of these things will build on the year's already excellent earnings quality.

We have done all of this while maintaining our earnings guidance, which all hopefully increases your confidence that we can deliver our targeted rates of growth again in 2007 and shows our commitment to manage the business for long-term, sustainable, dependable performance.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Ken Goldman - Bear Stearns.

Ken Goldman - Bear Stearns

A question on cash. You have a lot of cash on the balance sheet right now, the most it seems to me this decade. How comfortable, John, are you holding that amount of cash against the possibility of returning it to shareholders? And if you do plan to return it, can you talk about which forms of returning cash you are considering?

John Bryant

If you look at the cash we have on the balance sheet, first recognize that our cash flow performance is very strong through the first half of the year. I think it is actually not that far out of line from what we had in the past. We've had cash on the balance sheet around the $500 million mark in the past. So it's a little bit higher than what we would normally have but not out of line.

As I look at returning cash to shareholders, that has obviously been the primary use of cash over the last few years and will continue to be the primary use of cash this year. We have the dividend. We've increased that by 6.5% this year and we have the authorization for a share buy back of up to $650 million, which we still intend to fully execute and we are slightly less than halfway through that.

Operator

We will take our next question from Pablo Zuanic - JP Morgan.

Pablo Zuanic - JP Morgan

Good morning, everyone. More of a strategic question, all this growth that you have in snacks is quite remarkable and also you've been able to sustain it. How are you going to be effected by what you are doing with these DSD changes? Is what is driving the DSD changes [inaudible] or is this an initiative to take more control and give you more access to what we call the single serve channels? How should we think about that? I'll have a follow-up if you don't mind.

Dave Mackay

The initiative you are referring to involves us buying back distributor wraps, in the southeast principally. When we bought the Keebler business, we had about 517 of these independent equity distributors there. The key drive for this is really to enable us to further streamline our systems for distribution, to enhance that DSD system and to continue to improve service in that part of the geography. We think it as very strong initiative for us. We think it will actually improve our performance in that part of the U.S., and hopefully, the bulk of that work will be behind us at the end of Q3, Pablo.

Pablo Zuanic - JP Morgan

Just to follow up, if I may. When I look at this recent management change and Jeff moving to International and Brian moving to North America, I have to say that in Europe, very encouraging, right? Sales up, profit margins up now for a couple of quarters. North American sales continue to go up and we had margin expansion this quarter after you make all the adjustments. Why mess with that? Since Jeff is running North America so well. John was doing a good job in International, how should we think of that. I mean, I assume it's succession planning here, but isn't it taking a big risk here?

Dave Mackay

We have a very strong senior management bench at the Kellogg Company. We are taking an opportunity to develop a number of them with these moves, not only John and Jeff, but Paul, Brad, Mark, a number of other people further down the organization. So really what this is about is developing our management bench and retaining our key talent, Pablo.

Operator

We will take our next question from Chris Growe - AG Edwards.

Chris Growe - AG Edwards

I just had a quick question for you here. If you look at the Asian Pacific division, were there upfront costs associated with that in the quarter? There was a mention of write-offs. Would it take more restructuring of that business to help improve the profit performance there?

John Bryant

I will take the first half of that question. In terms of upfront costs, we didn't classify those items, upfront costs in the quarter. There was about $4 million of items between asset write-offs and severance costs, but it was below our normal materiality threshold to classify as upfront costs.

Dave Mackay

I think, Chris, for the second part, wherever we an opportunity to improve the business, we have been taking it. We don't see significantly more activity going forward, but until we identify it, we really don't comment on it.

Chris Growe - AG Edwards

Relative to the cereal category, is there a suggestion that Kellogg may be a little more offensive in the second half of the year? You have your big competitor making quite a bit of change in their package sizes and pricing. Will that require more promotional than you've announced in the short run here?

Dave Mackay

As we have said before, we will continue to play our game. We will focus on the fundamentals, driving strong innovation and brand building. We have seen late in the second quarter and we do anticipate seeing through the third quarter probably a heightened level of promotional activity and that level of discounting and coupon usage we believe will dissipate as we finish Q3.

Operator

We will take our next question from Terry Bivens - Bear Stearns.

Terry Bivens - Bear Stearns

Dave, we talked about this before. Clearly Mills has to clear some stuff off the shelves before the resizing comes in. What can you tell us so far about how they are moving the old stuff off the shelf, what you are seeing in terms of the new? It seems like that might be disruptive, but I would like to hear your thought on it.

Dave Mackay

I think probably you are better to ask them. I think if you look at the measured channel data through the second quarter. I think what you can see there is that, as far as the base prices and promoted prices, Kellogg and all competitors, apart from one, actually saw the base price up and the promoted prices up and one competitor actually saw them go down. So I think you saw the start of that, as I said in responding to Chris' question, we do expect in Q3 a heightened level of promotional activity, but that level of discounting and coupon usage will dissipate, we believe, as we finish Q3.

Operator

We will take our next question from Eric Katzman - Deutsche Bank.

Eric Katzman - Deutsche Bank

John, did you provide the breakdown between cost of goods and SG&A in terms of the $0.08 in one-time costs, could you do that?

John Bryant

In the second quarter was $0.07 in SG&A in North America and $0.01 in cost of goods in Europe.

Eric Katzman - Deutsche Bank

For the bigger picture question, inflation cost has been rising. Everybody in the industry has recognized that. In fact, as the quarter ended, it actually accelerated. I am wondering if Dave, you could talk about the challenges of having to rely on upon discreet pricing actions, as opposed to some parts of the industry where it is just a contracted pass through? And how that works if costs are rising like they are and are just that much more volatile.

Do you think that given your brand building and new products that you have the ability, let's say, to go back to the major retailers and ask for pricing three months or six months after one was initiated? Or do you think you kind of have to wait in what has historically been a once a year process?

Dave Mackay

We actually in U.S. cereal took about a 1% weighted increase a month or so ago. If we are going to talk about future pricing, the level of commodity and energy inflation certainly, you can see it as we have taken our expectations up for the year and we were pretty well hedged when we talked on the first quarter call. We had wheat covered through July but were open thereafter. That has been a big part of that increase. Dairy which isn't a big component for us, still has risen so fast that even though we don't use a lot, it's hurt us. I think going forward it is really up to everyone. Our business model is very clear. The way we are going to run the business is clear. We will make the right decision so we can keep driving the business as we go forward.

Eric Katzman - Deutsche Bank

But is it your sense, just to speak more broadly as a company that is obviously doing well in a tough environment, is it your sense that the retailers out there are willing to consider a more aggressive pricing as opposed to one time per year? I assume that by mentioning the 1% weighted price increase that you put through a month ago, that was successful and that you do think it is possible to be more timely in terms of pricing when necessary.

Dave Mackay

I think you have to talk to retailers. Specifically, when we talk to them, they're seeing many of the same costs we are seeing, so there is an absolute awareness of what is going on in FMCG and the food and beverage industry, but I really can't comment more than that.

Eric Katzman - Deutsche Bank

You guys only allow me to ask one question. They won't even answer one. So, what can I tell you. Thank you.

Operator

(Operator Instructions) We will take the next question from John Feeney - Wachovia.

John Feeney - Wachovia Securities

Congratulations. On the Asia Pacific side, could you give us a sense as to how the business is outside Australia? New Zealand grew in some the faster population growth markets. Maybe in that, comment about you long-term strategy to maybe try to increase your exposure to these fast growing global markets?

Dave Mackay

The way we now report Asia Pacific also includes South Africa, Asia and Australia. South Africa and Asia were up I think high single-digits for the quarter. Really the only weakness in that area was with Australia and it was principally focused on the snacks business.

As far as our long-term view for South Africa and Asia, we do believe there are significant opportunities for us there. There are some markets across that geography where we really don't have a presence. We've been doing a lot of work looking at it and when we get to a point where we have got something that we believe can be accretive to the shareholders, then we'll come forward and talk specifically about it. But it remains a potentially opportunity for us, but not an easy one.

John Feeney - Wachovia Securities

You use the term accretive. Can I read into that you are maybe thinking of acquiring in that region?

Dave Mackay

We have said before that our thrust, as far as some of these developing markets to go, would be either joint ventures or acquisitions. That's really still our major thrust, is where can we partner with someone who gets a common benefit with us or is there a business there that we could buy? Most of those we're talking a small bolt-on type acquisitions market- to-market.

Operator

We will take our next question from Tim Ramey - D.A. Davidson.

Tim Ramey - D.A. Davidson

Just trying to better understand the gross margin performance, which was a pleasant surprise and how that might play out sequentially for the second half of the year. You mentioned earlier that $0.07 of the upfront costs were in SG&A, which explains part of the surprise. Can you mention what the breakdown was last year? Did that discontinuity account for part of the upside in gross margin.

John Bryant

It's a good question and you're right. Part of the benefit in gross margin in the quarter is lower upfront costs going to cost to goods. The other one is cost of goods promotion. Just to give you an sense of what is going on there, we were up about 120 basis points in gross margin. About 50 basis points is because of upfront costs being in SG&A rather than cost of goods year on year. About 60 basis points is our cost promotion challenge. Those are things like toys in the box and so on, that would really be increased advertising. That was about 60 basis points.

If you look year-to-date, we are basically flat on gross margin year on year as a percent of sales. We're still indicating that we are going to be down approximately 50 basis points for the year so we are saying that increased inflation in the back half of the year will put some pressure on gross margin as a percent of sales in the back half.

Operator

Our next question comes from David Palmer - UBS.

David Palmer - UBS

Just a clarification question. Before when you mentioned competitors' couponing and promotional activity that you believe will dissipate, is that because presumably that they will get the inventory of the old boxes sold through and they will get to what you believe is a more benign strategy with the new sizes and price point on those sizes? Thanks.

Dave Mackay

I think, David, they are currently working through the inventory liquidation and it as big undertaking, I am sure. Once they get that behind them, then we would expect to see things to return more to normal.

Operator

Our next question comes from David Driscoll - Citigroup.

David Driscoll - Citigroup

Good job on the quarter. A question on the guidance. Last year I believe the commodity cost was back half weighted. You are saying that again year it is going to be back half weighted. In the second half of '06, I believe EPS was up about 3% year on year and you have EPS up 3% year on year again with the guidance today back half. However, you have been growing that first half of the year is up 14%.

Can you reconcile this for me? It feels very uneven, in terms of what's happening. It would seem more logical to expect the year-on-year variances in commodity costs to be easier, given how difficult it was in 2H06. So John, can you start to reconcile some of these facts here?

Dave Mackay

Let me have a crack at that. I think that what I would say overarching all of that is our business model is working and we've had a great first half. I think as a result of that, we have increased confidence as we look at the back half of the year, so we are investing heavily in brand building and taking that up. We are investing heavily in cost reduction and efficiency gains. When we talk about absorbing higher commodities and energy, if you look at the year when we are in first quarter, the midpoint of our 18 to 22, that $0.20, we fell $0.10 in the first half so the other $0.10 is still there, but we have now seen another $0.08, all of which will fall in the second half of the year.

So that's a big headwind for us in the back half. We think we are taking a realistic view on the second half, given the factors we see. Certainly North American cereal in the third quarter, that is going to be a bit choppy. But, net-net, we are on track for another strong year of sustainable, dependable performance.

Operator

Our next question comes from Eric Serotta - Merrill Lynch.

Eric Serotta - Merrill Lynch

You guys had a nice balance between price mix and tonnage growth in the second quarter, as you have for the past few quarters. I'm wondering how you see that balance playing out over the second half, as you face some tougher comps I think it was some earlier than expected benefit from pricing in U.S. cereal last year and pricing across the board in the second half of last year.

Dave Mackay

Eric , I think broadly we'd anticipate that trend to continue. It might move a little bit, but broadly speaking, roughly equivalent. I think we got 60%, two-thirds in price mix and one-third or 40% in volume. Somewhere in that broad metrics we'd see the balance of the

Eric Serotta - Merrill Lynch

U.S. retail cereal, you're volumes were down slightly this quarter and I realize you're not managing the company for volumes and certainly not managing the cereal business for it, but how comfortable are you with that kind of a trend continuing over the rest of the year into next year, where growth in North American cereal being driven largely by price mix than volume.

Dave Mackay

If you look at volume, all channels -- because remember you are looking only at IRI data, which doesn't give as clear a picture. Volume was actually up about 1%. You look at the category, it grew about 3%, we are about the same, so we broadly held share. So that price is a pretty good performance given what was going on in the second quarter. We broadly anticipate that for the balance of the year with a little bit of an unknown in third quarter given some of the inventory liquidation going on.

Operator

Our next question comes from Steven Kron - Goldman Sachs.

Steven Kron - Goldman Sachs

One quick follow-up on the commodity cost guidance. Given last quarter that you talked about being 80% locked in for the year, seems like a pretty big increase notwithstanding the inflation we're seeing. Can you comment on whether you are approaching the contracting any different? Are you going out longer to try to minimize this volatility on a quarter-to-quarter basis?

Dave Mackay

Steven, firstly, you are right in your observation. It was a bit of a surprise. We were about 70%, 80% covered in Q1. We had wheat covered through July. And as that opens up, you can see wheat stayed at a 20-year high. That is probably made up 25% to 40% of that $0.08. Dairy, as I mentioned earlier, we are not a big user of dairy, but the increases are such that even that has had an impact. And some of the packaging costs, like things like resin, are way up. Aluminum is also up and fuel and diesel in the back half has gone up significantly versus the first half, when you saw the price of oil at whatever, $66 going to $76. The balance was just miscellaneous raft of items that really are too small to cover.

But we have said that we think these moves in commodity prices are a structural change. We are going to run the business to absorb them and continue to deliver sustainable, dependable results as we go forward and it is just the environment in which we live and compete today and we've just got to move on. So it was a big increase, but it is what it is.

Steven Kron - Goldman Sachs

The other question I had is kind of a two-part question on Kashi. First, you continue to see great growth out of that brand. Could you first comment on what, if any, impact you might be feeling in the Kashi brand from some of the larger brands coming out with their own organic varieties in mainstream, even your Kellogg brands? Secondly, just an update on how the frozen rollout is going.

Dave Mackay

Kashi continues to do extremely well, up strong double-digits. It's gaining share in the cereal category and the natural organic products and the competition has intensified, but Kashi continues to grow at a very positive pace so we don't see any issues there. We see more opportunities, to be quite frank. As far as the Kashi entrees go, they are doing very well in that subsegment that we are targeting, which is more the natural and organic segment. That category is growing very fast and we are now number 2 in that category and gaining share. So a very strong performance thus far.

Operator

Our next question comes from Alexia Howard - Sanford Bernstein.

Alexia Howard - Sanford Bernstein

Quick question on the advertising. I think when we last spoke the plan was to do mid single-digit increases in advertising for the full year. I guess it's been up much higher than that in the first half. Is the intention to take it up higher than that for the full year?

Dave Mackay

We have actually said that we expected advertising to rise at a mid to high single-digit. We're actually doing double-digits through the first half. We anticipate even a higher level in the back half of this year, as we look for opportunities to invest behind new innovation and brands and build momentum as we go into 2008.

We also had mentioned Alexia, that part of that increased investment in advertising has been funded by the consumer promotions work we did last year, where we've looked to optimize globally and drive efficiencies in our consumer promotions. John mentioned, in the gross margin the COGs promotion was down in the quarter. That's a direct result of that activity where we've cut costs and streamlined and that investment is going back into advertising. So a strong year to go, a strong year on supporting brands and innovation.

Operator

Your next question comes from David Adelman - Morgan Stanley.

David Adelman - Morgan Stanley

David, I was curious in this higher cost input environment, whether you think you are broadly seeing an alteration in the competitive behavior? In other words, do you think there is less share renting broadly, less deep promotional spending and so forth?

Dave Mackay

We will see how it pans out. I just think if people are looking to run their business for the long term versus getting too concerned in a given quarter, then there is going to be a granted disposition towards innovation and brand building and potentially less ability to on an ongoing basis to deep discount. But that varies in almost all categories you look at quarter to quarter. But that is certainly going to be our approach. It has been for the last five years and we think that will stand us in good stead as we look at this year and going into 2008.

David Adelman - Morgan Stanley

On the gross margin line, could you quantify what the improvement would be in basis points or the change year over year in the second quarter excluding the upfront influences in both periods?

Dave Mackay

I think the upfront in COGs came down and gave us 50 basis point benefit in gross margin in Q2.

Operator

Your next question comes from Pablo Zuanic – JP Morgan.

Pablo Zuanic - JP Morgan

David when I look at the Kraft [inaudible] deal and that Kellogg would have been involved also on the biscuit side. I mean, overseas it is cereal and your wholesome snacks. But you always say there is an opportunity there on the biscuit side. How should we think of the biscuit business on an international basis? It seems like you are just focusing on the U.S.

Dave Mackay

While we don't comment on major deals like that that we are not involved in, we have said as we are looking at some of these geographies around the world, that we will consider all parts of our portfolio, wholesome snacks, biscuits and cereal and look from a consumer perspective at some of these developing markets, which is the best entry vehicle for us. So, that's as far as we have commented on that.

Pablo Zuanic - JP Morgan

To my knowledge there is no other market where you introduce biscuit. Is that correct?

Dave Mackay

At that point, it is correct. Yes.

Pablo Zuanic - JP Morgan

Just one last one regarding Europe. Comment on the competition you are seeing from CPW in the major markets. If there is any market where you actually have lost shares to CPW in Western Europe?

Dave Mackay

Europe overall remains a highly competitive market. Not only with branded but also, hard discounters. And as far as CPW in particular, I wouldn't want to single any one out. It as competitive market but the great thing about our European business is I think the heightened cycles there on innovation and brand building is actually coming through not only in overall category growth in the categories in which we compete, but our strong performance.

Operator

Our last question comes from David Palmer - UBS.

David Palmer - UBS

Longer term, is there an impact to margins from either of these two potential factors -- and I really mean over a long term basis. First, the mass channel potentially slowing down in its growth with perhaps a little bit better performance in supermarkets. I would imagine this has already happened to some degree. Second, ongoing faster growth in the non-cereal categories in the U.S. or internationally. Thanks.

Dave Mackay

I think the way that we deal with all of the trading partners is pretty consistent across the board. So it really doesn't matter which channel you look at. So, I don't see that as being a factor.

Then the only factor is on a percentage basis or a margin points basis, I think John went through what happens when our snacks business internationally grows as does cereal, we have a lower gross profit percent, but we actually have higher gross profit dollar generation and that's why you have seen in the last couple of quarters we are also giving people clarity on how much our gross profit dollar improves. Because at the end of the day it is the dollars you spend to drive the business. As you saw in Q2, we actually generated $142 million of incremental gross profit dollars. So I don't think that is going to be a significant factor for us.

David Palmer - UBS

Longer term, if you were projecting out gross margins over time, is this the kind of thing, that I mean, is there any way to quantify this mix drag? Maybe you can talk in terms of what we have seen thus far just in terms of the mix drag.

Dave Mackay

I don't think so. If we drive out developing markets business, if we could get to a point where it is having impact we will explain it to you at that point in time.

Operator

Now, I would like to turn the conference back over to our speakers for any additional or closing remarks.

Dave Mackay

I wanted to say thank you to everyone for their questions. It was a strong quarter and we are very much focused on driving our business model and delivering sustainable, dependable performances as we go forward. Thank you.

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Source: Kellogg Q2 2007 Earnings Call Transcript
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