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Executives

Joel Wittenberg - VP and IR

David Mackay - President and CEO

John Bryant - CFO

Gary Pilnick - General Counsel

Analysts

Terry Bivens - Bear Stearns

Mariann Montagne - Thrivent

Robert Moskow - Credit Suisse

David Palmer - UBS

Andrew Lazar - Lehman Brothers

Vincent Andrew - Morgan Stanley

Ken Zaslow - BMO Capital Markets

Bill Leach - Neuberger Berman

Jonathan Feeney - Wachovia Securities

Eric Katzman - Deutsche Bank

Pablo Zuanic - JP Morgan

David Driscoll - Citi Investment Research

Eric Serotta - Merrill Lynch

Kellogg Company (K) Q3 2007 Earnings Call October 29, 2007 9:30 AM ET

Operator

Good day and welcome to the Kellogg Company 2007 Third Quarter Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question and answer period. (Operator Instructions)

Thank you. At this time I will turn the conference over to Mr. Joel Wittenberg, Kellogg Company Vice President of Investor Relations. Mr. Wittenberg, please begin.

Joel Wittenberg

Thanks Andrea and good morning everyone. And thank you for joining us for a review of our third 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, brand building, upfront cost and inflation, are forward-looking statements. Actual results could be materially different from those projected. For further information concerning factors that could cause these results to differ, please refer to the third slide of this presentation as well as 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 pass code for both numbers is 3113843. The call will also be available via webcast, which will be archived for 90 days.

Now, let me turn it over to David.

David Mackay

Thank you Joel and good morning everyone. Just as a reminder, Simon Burton has moved into the business and Joel Wittenberg has stepped into take on this role as Vice President of Treasury and Investor Relations. We are pleased to report a solid Q3 even with two to three discrete items slightly impacting top line growth. With strong EPS growth from Q3 and year-to-date, and with Q4 off to a strong start, we have increased confidence that we will deliver another year of sustainable growth.

Through Q3, we benefited from some discrete tax items, which have allowed us to make further investments in our business to support our goal of sustainable, dependable performance. The momentum year-to-date has allowed us to invest more against cost saving initiatives, to continue our strong advertising investments through Q4, to absorb higher cost inflation than anticipated, while raising our full year EPS guidance to $2.72 to $2.75 per share.

During Q3, we reinvested back into the business with double digit increases in advertising, and funding of a major efficiency project within our DSD system. We are confident that our consistent operating performance will continue into the fourth quarter, providing a strong foundation for another year of sustainable and dependable performance in 2008.

Now, I would like to turn it over to John to take you through the financials.

John Bryant

Thanks, David and good morning everyone. Reported net sales increased by 6%, lapping a strong 8% sales growth in the third quarter of last year. Internal sales growth, which excludes the effect of foreign exchange, was 4%, building on a 6% comparison last year.

Reported operating profit rose by 1%, and internal declined by 2%. This was primarily the result of high investment and year-on-year upfront costs savings initiatives, which reduced operating profit growth by 5 percentage points in the quarter. These results also reflect double digit growth in advertising investment as well as higher commodity inflation.

Earnings per share grew by 9% versus last year, helped in part by a lower tax rate due to several discrete items in the quarter. And cash flow in the first three quarters was $961 million, exceeding last year by $111 million. Let's look at each of these results in more detail.

Slide 5, shows our net sales growth. Reported net sales growth in the quarter was 6.4%. Price mix was 3.1% higher due to the price increases we put into place over the past year as well as improved mix. Tonnage added 0.7% and currency contributed 2.6%. This solid internal sales growth came despite a couple of items, which dampens the quarter sales.

First, in U.S. cereal, elevated levels of customer inventories in last year's third quarter resulted in a difficult inventory comparison, and our U.S. cereal shipments were flat in this year's Q3.

The good news is that we continue to deliver strong consumption growth and we continue to gain share demonstrating strong underlying momentum.

Second, our snacks DSD reorganization, including the repurchase of third party owned routes resulted in some inventory repurchases that reduced sales in the quarter. Despite these issues, we were still able to report a solid sales performance giving us continued confidence as we go into Q4.

Now let's turn to advertising spending on slide 6. We increased our advertising investment at a double-digit rate for the third quarter as well as year-to-date. Brand building investment is an essential part of our business model and we had significantly increased spending in the fourth quarter to support both new and existing products.

Let's turn to slide 7, to review our gross profit performance. Third quarter gross profit was $1.3 billion, a 5% increase over last year. For the year-to-date period gross profit is almost $280 million above last year, an increase of 7%. This increased gross profit funds our advertising and innovation growth.

Third quarter gross profit margin declined 40 basis points and year-to-date has declined by 20 basis points. For both periods this decrease was driven primarily by higher commodities inflation.

Now let's turn to slide 8 and a discussion of operating profit by region. Operating profit declined by 2%, as a result of strong ongoing investments in advertising and additional up-front costs. In fact the year-over-year increase in up-front costs adversely impacted operating profit by 5%.

We indicated last quarter that commodity cost pressures are more concentrated in the second half of the year and that was certainly the case in Q3 and will be even more so in Q4. In North America, operating profit declined 4% due to higher upfront and advertising investments. Most of the Q3 upfront charges occurred in North America and reduced operating profit by about 7%. Even with these higher upfront costs and advertising investments, year-to-date operating profit is up 3% in North America.

In Europe, operating profit declined 2%, versus a tough year ago comparable of 20%. Here again, we continue to make higher investments in advertising. Results were also be impacted by a voluntary product recall in the UK. Year-to-date, operating profit is up a strong 11%.

In Latin America, quarterly internal operating profit rose by 1%, reflecting increased investment in advertising as well as high commodity inflation. And finally in Asia Pacific, internal operating profit decreased by 26%, or $6 million, due primarily to the continued challenges in the Australian market. Part of the decline was due to a challenge in Australia for additional efficiency initiatives.

In Asia, our Cereal and Snacks businesses are performing well. Below the operating profit line, net interest was approximately unchanged and our tax rate was about 27%. Meanwhile, our average shares outstanding continue to decline because of share buybacks. We repurchased $153 million of shares for the quarter bringing our year-to-date repurchases to $417 million.

On slide 9, you can see a summary of our 2007 year-to-date performance. I won't review each point of the sustainable growth wheel, but the net takeaway is that we expect 2007 will be our sixth consecutive year dependable, sustainable growth.

Let's turn to slide 10, for a review our cash flow. Year-to-date, we have generated $961 million of cash. This growth has been achieved through our strong earnings growth. The cash flow metric is very important for us and we will remain focused on further improvement in the future.

For the full year, we now have even greater confidence that our cash flow will be approximately $1 billion. As you know, the fourth quarter tends to generate the seasonally lowest cash flow of the year, and we are also considering voluntary retirement plan contributions in Q4.

Let's turn to slide 11, to look at our full year 2007 guidance. Our guidance from mid single-digit internal net sales growth for the full year hasn't changed. But we now forecast earnings to come in between $2.72 and $2.75 per share, a penny higher than our earlier guidance. Remember this includes the extra investment we have discussed for Q3, additional investment plan for Q4, as well as significantly increased input costs in both periods.

We now expect total incremental commodity, fuel, energy and benefit costs of approximately $0.32 per share or $0.04 above the mid point of our most recent guidance and $0.16 to $0.19 more than our initial guidance for the year. And we've increased our estimates for upfront investments. We now expect this investment will total approximately $0.19 of EPS or $0.05 more than our original estimate.

Obviously this will reduce our internal operating profit growth. In fact, excluding upfront costs, operating profit would rise at mid single digits. These projects provide greater visibility for 2008 and beyond.

Given the significant inflation costs and increased investments, we continue to expect that full year gross margin will decline by approximately 50 basis points. As we discussed previously, our commodity inflation is heavily weighted for the second half of the year with the large impact in the fourth quarter. We continue to get good leverage below the operating profit line. We expect essentially flat, full year net interest and the tax rate will be about 29%.

In summary, we are very pleased that we have the ability to absorb high input costs, while raising guidance in a difficult environment. The fact that we can also increase investment in future growth at the same time demonstrates the flexibility of our business model, the strength of our current momentum, and our desire to drive sustainable and dependable results.

Now, let's turn to slide 12 and a preliminary guidance for next year. For 2008, we expect to deliver another year of sustainable growth. Once again, we are forecasting and planning for high single digit earnings per share growth. Our forecast calls for mid single digit revenue growth, reflecting our momentum into 2008 and broad pricing actions across our portfolio that help offset significantly higher cost inflation.

We anticipate advertising will once again rise at or ahead of sales. We currently forecast that incremental commodity, fuel, energy and benefits cost inflation to increase by more than $0.40 per share in 2008. This builds on the 2007 increase estimated at $0.32 and 2006 inflation of $0.28. We expect mid single digit operating profit growth and high single digit earnings per share growth.

As you can see, we are anticipating earnings of between $2.92 and $2.97 per share in 2008. We also expect to see continued investments in upfront costs in 2008. Over recent years our upfront costs have been running at about $0.14. However in 2007, we had the benefit of a lower tax rate, which enabled us to increase our upfront investments to about $0.19.

As we go into next year, we would expect our upfront costs to return to approximately $0.14. However, we have the benefit of a 53rd week in 2008, which adds roughly $0.05 to EPS. At this stage, we are reviewing our ability to invest the benefit of the 53rd week into either, additional upfront costs and our investments to accelerate our growth in emerging markets.

We will provide more clarity on how we will reinvest the 53rd week in future conference calls. Either way, it is all about driving sustainability. In addition, we expect essentially flat net interest expense and our tax rate will move back to approximately 31%. Some of the tax benefits we saw in 2007 were one-time in nature, which obviously will not be repeated next year.

Also we plan to complete our $650 million 2007 share repurchase in the fourth quarter and we are pleased to announce the board has approved an additional $650 million share buyback for 2008.

While we do not give quarterly guidance, the shape of the year might be a little bit different from 2007 due to some unique circumstances. We will have significant commodity inflation particularly in the first half of the year and tough tax comparisons in Q1 and Q3. Because of all these factors and the timing of the 53rd week in Q4, we expect EPS growth to be back-end loaded.

As you can see, I am always working. We have been and will continue to invest back into the business for long-term sustainable and dependable results, which will enable us to offset this unprecedented cost environment, while investing in innovation and brand building.

And now, I would like to turn it back over to David for the business review.

David Mackay

Thanks, John. If you can turn to slide 13 and the internal sales growth posted by our North American businesses in the quarter, North American sales were 3% higher versus last year's 7% growth, and slide 14 looks at each business in more detail.

Third quarter cereal sales were flat versus last year, as we lapped last year's heightened Q3 credit inventory levels driven by our September 2006 price increase. We are pleased to achieve very strong underlying consumption growth in Q3 of 3% to 4% across all channels and we are expecting a stronger fourth quarter shipment performance.

In addition, our price per pound rose by more than 4% during the quarter. Innovation was strong with the launch of Froot Loops Smoothies and Cinnamon Streusel Mini-Wheat. We also saw a strong performance from Rice Krispies, Raisin Bran Crunch and Smart Start in the quarter behind good advertising campaigns.

Once again, Kashi posted another great quarter with double digit sales growth. Innovation was strong with two new varieties of Kashi Granola as well as continued momentum from GOLEAN Honey Almond Flax cereal. And our Canadian business also posted a solid quarter. We continue to benefit from this year's innovation with Mini-Wheats Strawberry, Special K Fruit and Yogurt, and Vanilla Rice Krispies among others.

Slide 15, shows our snacks sales were up a strong 5% for the third quarter. This exceeded our long-term target despite last year's 11% comparable. The DSD route reorganization had an adverse impact on sales growth as we realigned the system and bought back inventory from the equity route owners.

DSD is a great asset for the Kellogg Company and we are going to further leverage to the asset by taking Kashi Snacks and Fruit Snacks into DSD at the end of this year. While this will provide further growth opportunities in 2008, we expect modest disruption in Q4 and Q1 as we reduce inventory in the warehouse system. Both of these moves are the right steps for the future retail snacks.

Overall year-to-date sales are up a strong 8% and you can see more detail on slide 16, which shows our PopTarts business posted solid sales growth in the third quarter, while lapping last year's introduction of Go Tarts. The crackers business also posted solid quarterly growth versus a difficult double-digit comparison as Cheez-It and All Bran crackers both performed well.

In addition, we also saw double-digit growth from Club and Wheatables. We gained Crackers share in the category, in the quarter and new innovation including Club Puffed, Cheez-It Sticks and Carr's Cheese Melts give us confidence we will finish the year well.

Our cookie innovation and brand building have been strong and we are seeing the benefits, we feel solid sales growth and measured channel share gains in our cookie business, and we were again lapping good growth in the third quarter of last year. New Right Bites Grasshoppers and Dipping Delights innovations, were ahead of expectations and Famous Amos posted strong growth for the quarter.

Our Wholesome Snack business continued to do well in the quarter. We saw a solid growth from Rice Krispies Squares, Special K Bars and Nutri-Grain Fruit and Nut Bars.

And finally we are delighted that Kellogg snacks was recently rated the number one DSD manufacturer among all consumer goods companies by Advantage Groups Performance Monitor. This awarded a great recognition for the entire DSD team.

Now let's turn to our frozen and specialty channels business on slide 17. Frozen and Specialty sales were up 6% for the quarter. We achieved solid growth for Eggo Pancakes, French Toast Sticks and our new special K Waffles.

And our Kashi All-Natural frozen entrees and pizzas continue to perform ahead of our expectations. We are finding that for many consumers Kashi frozen entrées are their first experience with the brand and are now purchasing additional Kashi items.

Specialty channels contributed solid growth again with good performance across club, convenience and drug channels.

Side 18, shows that Kellogg International posted another solid quarter with 5% internal sales growth in Q3 lapping last year's 5% comparison. Our international growth has been broad based with solid results in both Europe and Latin America as you can see on slide 19.

In Europe, we have posted 3% internal sales growth with good growth in both cereal and snacks. In Cereals, Special K, Cocoa Pops and Rice Krispies all performed well. We saw solid performance with recent cereal innovations from Optivita and Chocos.'

Sales were strong in Ireland, Spain, Italy and Benelux and the UK achieved Cereal growth even with the adverse impact of a product recall in Q3.

In Latin America, we posted 12% internal sales growth, as a result of growth in both Cereal and Snacks across the region. Venezuela, Colombia, Brazil, and the Caribbean all posted good internal sales growth in the quarter and Mexico achieved double digit growth with strong performances from Zucaritas and Special K Control and our market share also rose during the third quarter.

Asia Pacific sales declined by 1% or less than $2 million. We saw solid Ready-To-Eat Cereal sales growth in Japan, South Korea, India and South Africa. As we have discussed, the Australian business posted lower sales, as difficult category conditions continued in the snacks category. We expect that the situation will shake out in the next 12 months much as it has in other parts of the world. And finally, a thank you to all 26,000 Kellogg employees for their great work in strengthening our company.

As we look towards 2008, it is clear that cost inflation is likely to remain high and volatile. Accordingly, we will be looking to employee all the leavers to help offset these costs including mix, trade efficiencies, cost savings initiatives and pricing. Our focus on strong innovation and increased advertising support remain highly relevant, and our operating principles remain in place.

Finally, we've talk frequently about our intention to explore small bolt-on acquisitions and opportunities for geographic expansions that support our focus strategy. We are pleased to share that over the next few months; we expect to close several small acquisitions in several areas around the world. These transactions are subject to regulatory approval and standard closing condition, so we are not in a position to share any additional details at this time.

As John mentioned earlier, in our 2008 guidance, we have the flexibility to invest in new geographic market expansion. We remain confident that with strong investments in Q4, we will maintain our momentum into 2008, and deliver another year of sustainable, dependable performance and what is shaping up to be a challenging environment.

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

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And we'll hear first from Terry Bivens with Bear Stearns.

Terry Bivens - Bear Stearns

Good morning everyone.

David Mackay

Good morning, Terry.

Terry Bivens - Bear Stearns

Dave, I wanted to get just a little bit more clarity on the Cereal business to make sure, I understand it. I think, last year in Q3, you mentioned the base business in RTE was pretty good, North America was the incremental that didn't quite get the takeaway you thought inventories build up a little bit. As we move now into this quarter, where do you think your inventory levels are first of all?

David Mackay

Yeah, Terry, you remember last year that we had a price increase in September and as we finished the quarter we said we thought we'd got about 1% incremental shipments in that quarter.

Terry Bivens - Bear Stearns

Okay.

David Mackay

The inventories were higher. We pulled them down and that's why you saw in Q4 last year actual shipments were down, even though consumption during the two quarters was relatively even up 2%, 3% I believe.

Terry Bivens - Bear Stearns

Okay.

John Bryant

This year consumption was very strong. We are up 3% or 4% across all channels. We actually gained share, but our inventory levels clearly on last year had to come down. I'd pull them down so that shipments were flat, but I can't tell you as you would expect is that through October, our shipments have been strong, because last year in October we are actually going through the process of pulling them down. So it's all about comps year-on-year, that issue is now behind us. The great news is that through all of that inventory movement, our consumption remained very strong. We gained share and we are off to a strong start to Q4.

Terry Bivens - Bear Stearns

Do you have to take trades spending up that all in the third quarter perhaps to in reaction to some of the things Mills is doing?

David Mackay

Really I think as we look at our position, our consumption was strong. We gained share. We are very happy with the business. We continue to play our own game and focus on strong innovation and brand building.

Terry Bivens - Bear Stearns

Okay. Thanks very much.

David Mackay

Thanks.

Operator

We will take our next question from Mariann Montagne with Thrivent.

Mariann Montagne - Thrivent

Good morning. A couple of detailed questions here, on the UK recall, how much are you attributing to that in dollar terms?

David Mackay

Well, it's probably about $5 million-ish.

Mariann Montagne - Thrivent

Okay, and the snack realignment?

David Mackay

For snacks it was less than a couple of percent, but probably 1% to 2% for the quarter, for that would affect shipments.

Mariann Montagne - Thrivent

And Australia, what kind of a write-down is that in dollar terms?

John Bryant

It was just a couple of million dollars -- $2 million.

Mariann Montagne - Thrivent

Okay, it's small. And then on the Latin American side the 12% internal sales growth 1% profit growth that's due to your mix toward the corn products is that right?

David Mackay

Yeah that's right. I think that portfolio was very corn based. So, the commodity issue from corn has really hit them very hard this year. Also in the quarter, advertising was up double digits. But we're very, very happy with the strong growth, we saw in the market during the quarter. And we are going to continue to invest there because it remains one of our strongest growth region.

Mariann Montagne - Thrivent

And, is that also an area, you're targeting for greater snack growth?

David Mackay

It is, yes.

Mariann Montagne - Thrivent

Okay. Thank you.

David Mackay

Thank you.

Operator

We'll take our next question from Robert Moskow with Credit Suisse.

Robert Moskow - Credit Suisse

Thank you. Can you just tell me, you say that you increased your investment in advertising this year. Did you give us a sense of how much you're increasing it? And then also, I don't think, I quite got you are increasing your upfront charge by another $0.02 for the year. Is that a new project or is the exiting DSD project just costing one. And that's it?

David Mackay

Robert, on the advertising, we are up double digit. John, you want to take this.

John Bryant

On the upfront cost, Robert we actually execute the DSD buyback ahead of schedule. And main thing is the total cost of that program was a little bit less than what we had anticipated. The additional $0.02 is for another project in the fourth quarter that we've not as yet announced.

Robert Moskow - Credit Suisse

Okay. And you say the advertising is up double-digit, but is that a stronger double-digit than you thought at the end of second quarter?

John Bryant

Yes, it is. Yep.

Robert Moskow - Credit Suisse

Okay. Thank you very much.

John Bryant

Thank you.

Operator

Our next question will come from David Palmer with UBS.

David Palmer - UBS

Hey, guys. With regard to General Mills' moves with Right Size, Right Price initiative, has that become more of a competitive intrusion in the EDLP accounts, where perhaps their lower shelf price has provided a bit of a boost to them and perhaps at the expense to Kellogg?

David Mackay

David, you will be best posing that question to them. I think from our perspective, as you saw in the quarter we did expect, we could have some disturbance there, but our consumption was strong. We gained share. Very happy with our business and really the key for us in the third quarter was the fixed year-on-year inventory issue that we had last year, which is now behind us and we have started Q4 strongly.

David Palmer - UBS

Okay and then just a second question having to do with the health news benefit in the Cereal category. The Americans want to maintain their health obviously and they're saying they want to add things like dietary fiber, whole grain, antioxidants, probiotics, and alike.

I'm wondering to what degree do you think that some of the growth that we've seen in the last couple of years having to do with some of this increase in demand for these attributes may wane or perhaps do you see some of these concerns in the immediate future being addressed better by the industry in the Cereal category perhaps, picking up momentum as some of the Cereal category players get better at addressing these concerns?

David Mackay

I think, David our believe as the Cereal is on trend, certainly if you look at the demographics in the market and a number of including Kellogg's playing towards the, slightly older demographic, where there is a greater propensity to look for health benefits. We would think that will be a positive for the category for many years to come.

David Palmer - UBS

Okay. And last question, just, I know this is out there, but is there any possibility that you guys will do anything on the packaging side in Cereal. It seems, like if anything from the consumer standpoint the industry has not done anything in packaging except perhaps go backwards with pillow packs for decades. Is that something that could be in the horizon for the cereal category?

David Mackay

We're constantly looking at how we can improve, our environmental footprint, and we've taken a lot of packaging out. It may not be obviously, but there is a huge amount of work gone into that and continues to go into it, not only by us, but I think by the whole industry. And it's an area, we will continue to focus on given how fragile Cereal is; it's not as easy as you think to make a dramatic move. But there is constant work going on trying to reduce the amount of cotton and use recycled board et cetera. So, and you will probably see more of that in the years to come.

David Palmer - UBS

Alright, thank you very much.

David Mackay

Thanks.

Operator

We'll take our next question from Andrew Lazar with Lehman Brothers.

Andrew Lazar - Lehman Brothers

Good morning.

David Mackay

Good morning Andrew.

Andrew Lazar - Lehman Brothers

Just one quick one, on U.S cereal, I think, you said that sales were flat and shipments were flat as well. Was, if I have that right, the fact that not a lot of pricing came through more due to, more just tactical items that you had to do promotionally in the quarter, as supposed to anything structural that pricing isn't coming through for some reason?

David Mackay

Our shipments were flat, because of the inventory reduction year-on-year comparison to last year. Our consumption was up 3% to 4% across all channels. Actually, price per pound was up 4% in the quarter. So, it's a very strong quarter and really the shipment issue is now behind us and as I mentioned earlier, October is off to a strong start as you would expect.

Andrew Lazar - Lehman Brothers

Okay. And the last thing is just on, you have always leaned heavily on reinvestment, so nothing overly new there and I certainly understand the cost environment. But I know you guys trying to be anticipatory in your business as well. Is it fair to say that some of the reinvestments for '08 that you're making about, that you're doing now, perhaps are not only about maybe future growth.

But also an anticipation of maybe some structural shifts in, whether it be in the North American Cereal category or whether would be whatever your box size changes from competitors or even potential shifting around of brands ultimately to new owners. I'm trying to guess how you think about that, looking forward?

David Mackay

Yeah, we are really focusing on our own game. And I think most of these investments to ensure we've got strong brands with supporting and driving innovation hard. We are trying to maintain momentum and top of mind awareness with consumers. And on the cost side clearly, we are looking good do as much as we can, whatever possible to reduce cost, so that we can offset some of the inflation. As we mentioned in the call, clearly with the sort of inflation environment we are seeing, broad based and global pricing is likely.

Andrew Lazar - Lehman Brothers

Thank you.

John Bryant

And just add a little bit of commentary to that as well. When we look at these upfront costs, we do look for sort of a 4, 5 year payback and where those costs occurred depends on, where the projects are. So this year it was an SG&A lastly because of the DSD about buyback. To give you a bit color on color on 2008, we've given guidance of $0.14 about half of that we've already committed to an ongoing an European manufacturing project the other half we will announce as we sum up the project.

Andrew Lazar - Lehman Brothers

Got it. Thank you.

David Mackay

Thanks.

Operator

Our next question comes from Vincent Andrew of Morgan Stanley.

Vincent Andrew - Morgan Stanley

Hi, good morning everyone.

John Bryant

Good morning.

David Mackay

Good morning.

Vincent Andrew - Morgan Stanley

Could you just help me understand the 53rd week, is that essentially, is it smaller or the same sizes than the other week and I assume it's in the fourth quarter?

John Bryant

53rd week is the last week of the year. Its bit of a strange week and that is some of our international markets don't even ship in that week. So, it's a little bit smaller from the sales perspective. But also, it tends to be a smaller brand building week. So, to sit back and look at it, we estimate that it's worth about $0.05 of EPS.

Vincent Andrew - Morgan Stanley

Okay. Thank you. And can I also ask the decline of gross margin of 40 basis points, that included upfront costs to some extent, correct?

John Bryant

That's correct, that's the reported gross margin.

Vincent Andrew - Morgan Stanley

Okay, all right. And then I guess my last question is just why is this year, the share repurchase there seems to be a little more skew towards the back half of the year in particularly the fourth quarter, any reasoning behind that?

John Bryant

No. I think, if you look at the third quarter, it's pretty proportional from a share buyback perspective. I think we've got off to a slow start to the year we're $417million and $650 year-to-date. So, we're tracking reasonably well.

Vincent Andrew - Morgan Stanley

Okay. Thank you.

John Bryant

Just going back to clarify one piece on the 53rd week, one thing, I want to keep sort of reinforce is that we're not using that 53rd week to hit our guidance for next year. The guidance we've given is effectively a 52 week guidance, what we are saying is the 53rd week that's $0.05 will be reinvented back into the business either in additional upfront costs going above the $0.14 that we've given guidance on or into selected emerging market investments, which we'll give you more commentary on when we get there.

Vincent Andrew - Morgan Stanley

Thank you very much. That's very helpful.

David Mackay

Thanks.

Operator

Our next question comes from Ken Zaslow with BMO Capital Markets.

Ken Zaslow - BMO Capital Markets

Good morning, everyone.

David Mackay

Good morning, Ken.

Ken Zaslow - BMO Capital Markets

I'm actually going to ask question about North American retail snacks. Your business has been hitting about double-digit top line growth or net sales growth for almost two years. You had a little slowdown to 5%. Is there competitive dynamic that's changing, is it tough comparisons, is it a timing of our products? Can you just give us is there something that we should start to see more of this lower mid-single digit growth in the net sales growth for North American retail snacks?

John Bryant

Yeah Ken, if you go through what I mean, we gained shares in cookies. We gained share in crackers and they both grew about mid-single digits. We grew our Wholesome Snacks high-single digits, even though the category grew slightly faster than that. Our Fruit Snacks was down, part of that was as we discontinued items in preparation to move those into DSD. The DSD route buyback impacted snacks just short of a couple of percent in the quarter.

So net, we had a strong quarter. It was nothing from a competitive or slowdown perspective. We have continually said that the prior quarters are greater than 10% and our view weren't sustainable. What we would expect is roughly mid-single digit Q4 and through 2008. And the only thing that could impact that is we've got to allow that in Q4, end of Q1 next year there will be some disruption as we move Kashi Snacks and Fruit Snacks into our DSD system.

But I think as we talk about DSD you've got to remember that, our DSD snacks group was recognized by the Advantage Group as the best DSD organization in the USA. So, this is a great asset for us, they're performing fantastically well. We continue to want to drive it hard.

Ken Zaslow - BMO Capital Markets

Okay, thanks. I am going to limit my question to one. Thanks.

John Bryant

Thanks.

Operator

Our next question will come from Bill Leach with Neuberger Berman.

Bill Leach - Neuberger Berman

Good morning.

David Mackay

Hi, Bill.

Bill Leach - Neuberger Berman

I just had a question about your implied fourth quarter guidance. If I back out all the numbers that seems to me you are implying EPS in the fourth quarter before upfront cost of about $0.48 down from $0.53 lat year, so it's down 9%. I was just wondering is that really what you are trying to say and what you are assuming for the tax rate, in the fourth quarter?

John Bryant

It's a good question Bill. There is a few things going on in the fourth quarter. We do have 40% about full year commodity inflations actually hitting us in Q4, so it's abnormally heavy quarter. We also had a significant investment in advertising in the quarter. And if you go below the line, there are several items, which will be a drag on the fourth quarter one in particular I would call out as a tax line. We are looking at a tax rate within the mid 30s much higher than what we've seen year-to-date. So, that is certainly impacting the outlook for Q4.

Bill Leach - Neuberger Berman

Okay. Thanks a lot.

John Bryant

Thank you.

Operator

And we'll hear from Jonathan Feeney with Wachovia Securities.

Jonathan Feeney - Wachovia Securities

Good morning, thank you.

John Bryant

Hi, John.

David Mackay

Good morning

Jonathan Feeney - Wachovia Securities

John, I know, we've got a couple of mixed sort of a trends here. And I guess, I want to get a feeling, you get pricing across the portfolio, but Snacks growing a little bit faster than Cereal. Could you give us an update as to what may be directional roughly the negative mix between Snacks and Cereal is doing to your gross margin line, right now?

John Bryant

Well, in fact the in the quarter, there was no negative mix from snacks and cereal. It was pretty much a wash.

Jonathan Feeney - Wachovia Securities

Is that just because the Snacks margin is up so much or?

John Bryant

Well, I think you would be looking say, we have pointed out before there is a lower gross margin in some markets Snacks relative to Cereal. We're referring say the Cracker business very strong, that's a very good gross margin business.

Jonathan Feeney - Wachovia Securities

Oh, I see. Okay. Thanks very much for that. If I could just follow up on the comment you made at very end of your prepared commentary David about it being a tough environment out there. And I guess if you could maybe, you've achieved 310 basis points it looks like a price mix across the portfolio to offset these commodity costs. You have not been doing very well on this high commodity costs environment.

It seems like the supply chain in North America anyway is pretty inflationary. Would you say that's a fair characterization and so when you say its tough environment out there, do you feel like, retailers and wholesalers are starting to pushback on the kind of pricing they've been letting through or is there something new there or is that just kind of tough environment on the cost side and lets continue to hope for the best on the pricing side?

David Mackay

Yeah, I think Jonathan, when you are look at the current forecasts that I have seen on food inflation for next year is 4% to 5%. That's not our forecast, that's the forecast that's out there. And I think with the volatility in commodities that exists today, our view is that that moves to a higher level, and while they could stabilize over the next few years for a year or so, they do appear to be on an upward trend and that's what I am talking about.

It's a tough business environment, when costs are going up, we are taking a lot of moves to try and reduce our own costs and drive mix and trade efficiency. But we also are looking at broad based and global pricing. I think if you look at our track record over the last two, three years, we've demonstrated our ability to offset inflation, and I think we go into next year with a high degree of confidence.

We are reinvesting this year to make sure that we have momentum going into next year. So we think we are pretty well positioned, but there are unknowns out there. Even for us today as we are giving 2008, we feel pretty good that we have captured everything. We'll update it in Q4, but at this point we certainly do appear to be in a relatively high inflationary food environment.

Jonathan Feeney - Wachovia Securities

Okay. Thanks very much.

John Bryant

Thank you.

Operator

Our next question is from Eric Katzman with Deutsche Bank.

Eric Katzman - Deutsche Bank

Hi, good morning everybody.

David Mackay

Good morning, Eric.

Eric Katzman - Deutsche Bank

Few questions, I guess, first on the DSD change. I mean, I don't recall a company in the industry kind of messing with their DSD and not having a problem. So, have you kind of built in some kind of let's say conservatism in terms of your guidance for next year as to how, if something messes up with the DSD that you can kind of cover that?

David Mackay

I think what we are saying is, I mean, our DSD is performing incredibly well. The DSD route buyback back in Q3 we thought would be Q3, Q4. They executed it so well that they actually got it completed almost in its entirety in Q3. That was buying back over 500 routes, putting in, products into our current DSD system, hiring a lot of people and they're actually up and running effective October 1.

And while you have short-term impacts, that actually will be positive for the long term. And then the only other things on Kashi Snacks and Fruit Snacks going into DSD, as I mentioned through Q4 and Q1, you'll have the inventory levels coming down, a little bit of disruption, but we see those as very positive moves for us. So we are looking very, at 2008 with a very positive view on our DSD system.

Eric Katzman - Deutsche Bank

Okay. And then if I could follow up on 2008 guidance, just a few clarifications here. One I assume that you are not including any of those acquisitions in your guidance in terms of top line or EBIT.

John Bryant

No.

Eric Katzman - Deutsche Bank

Okay. And then currency what are you assuming for currencies since that's been the pretty big tail win for everybody in the industry?

John Bryant

We are expecting about five to six penny is a good news on FX next year.

Eric Katzman - Deutsche Bank

Okay, and then, when I just look at some the swing factors with currency being a benefit and lower shares being a benefit, the tax rate being a negative, up-front costs year-over-year change being positive, I guess we'll just leave the 53rd week kind of up in the air at the moment. So, I guess we are kind of left with the input costs being just this huge negative.

The $0.40, most of the other companies in the industry kind of look at it from a percentage basis, so like ConAgra is talking about 7% increase, I guess Mills has been talking about five and Campbell's has been talking about five. What's the percentage increase or are you way out of line with others? And should that make us question kind of how you've hedged or haven't hedged successfully?

David Mackay

No, I can say we'd be around the five. The $0.40, $0.42 we are saying, about 0.40 is the current view. I mean, as you know there are a lot of things moving around still but we'll be around the five, so relatively consistent with most in the industry. It does vary of course depending on what's going on at the time, but we are pretty close to most other companies.

Eric Katzman - Deutsche Bank

Okay. All right, that's helpful. Okay, I will pass it on. Thank you.

David Mackay

All right, thanks.

Operator

Your next question comes from Pablo Zuanic with JP Morgan.

Pablo Zuanic - JP Morgan

Good morning everyone.

David Mackey

Good morning, Pablo.

John Bryant

Good morning.

Pablo Zuanic - JP Morgan

Just a couple of, I guess accounting questions first and then one strategic question. John, on the corporate expense line, the number was unusually low this quarter, $35 million, anything particular going on there?

John Bryant

Pablo, if you look at a year-to-date basis, it's actually pretty similar to last year, so just timing from one quarter to the next.

Pablo Zuanic - JP Morgan

Thank you, but year-on-year corporate expense should be relatively flat then you are saying for the full year?

John Bryan

That's right.

Pablo Zuanic - JP Morgan

Okay, and this guidance of $0.40 in cost inflation for '08, that assumes that you are what, 50% hedged already? You've given that ratio before, just to have a sense?

David Mackay

Probably around 50%.

Pablo Zuanic - JP Morgan

Okay. And then just on the Cereal side in terms of the ability to increase prices, I know we've touched on this before, but the concern I have is that when I look at your major price increases, September '06. If I am not wrong that was mostly resizing of Frosted Flakes, Mini-Wheats and Rice Krispies. And since then okay, you have a $0.04 price per pound increase, but I think that's mostly milk. I am just trying to get a sense of what's been the real price increase on what I would call a like-for-like basis? And aren't you having an issue with price points on a per box basis now, particularly when Mills is resizing?

David Mackay

Well, I don't think we can get into any specifics on the call. And we haven't actually, we have just talked about pricing more holistically on a broad based perspective until we, we are not going to discuss exactly what we are doing. But we feel very comfortable going forward with what our plans are and when they hit the market, we'll let you know. John, anything you want to add?

John Bryant

I'd just, Pablo, just to give you a sense of pricing globally for the company, we have about 3.1% I think it is price mix benefit, about a third of that is price, and two-thirds is mix. And you can see in IRI data, we get some good price mix coming through the data as well.

Pablo Zuanic - JP Morgan

Yeah, and just to follow up, David, if you can talk about the Crackers business, I mean that seems there's a lot going on there. Lots of innovation around Club and Town House, and now All-Bran going to whole grain, just give us a little more color there? It looks like -- I look at Cheez-It, you have Sticks Cheez-It; then on Club, you have Sticks Club; I mean what's the idea there? How are you segmenting that portfolio? How should we think of that going forward?

David Mackay

Yeah, I think well when you look at the Crackers market, I mean it continues to do relatively well, even in IRI it is up. And then when you take all channels you'll probably add another 2 or 3% so it's doing pretty well and has for the last two or three years. We are looking at Cheez-It, the big cheesy taste and looking at other ways to bring new food forms, to bring other consumers in that may be on the outskirts of the brand.

And then with Club, the buttery taste of Club and some of the derivatives we've had there, we've seen nice performance particularly well. So it's just looking and segmenting the market and finding ways to actually bring new consumers in by different pictures and different flavors, Pablo, and it's working.

Pablo Zuanic - JP Morgan

And just one last one, David, if I may. When I look at the organic business, Kashi apparently quite successfully going into frozen pizza and frozen dinners, do you see room for Kellogg to do another transaction on the organic front like; I don't want to give names, but there is a) Mills, there's many other brands out there. Or is Kellogg just interested to Kashi as its organic platform?

David Mackay

Well, we don't want to speculate on what we might or might not do going forward, but Kashi continues to grow at a strong double digit. We believe it can continue to perform well in all the categories it's in. Consistent with what you are probably seeing in natural and organic, that area does continue to grow strongly, probably around double digit. So we are looking at how we can continue to participate in that and if we find new opportunities then we'll let you know at that time.

Pablo Zuanic - JP Morgan

Okay, thank you.

Operator

Our next question will come from David Driscoll with Citi Investment Research.

David Driscoll - Citi Investment Research

Good morning, everyone.

David Mackay

Good morning, David.

John Bryant

Hi David.

David Driscoll - Citi Investment Research

I apologize, I've got three questions but they are all related on the same topic, if I can. The first question, I had for you guys is, when is the last time Kellogg experienced commodity inflation at a 5% level?

John Bryant

Well, let me just clarify, the 5% inflation that we mentioned before, which I think our peer group talks about as well, is all inflation and not just commodity benefit, it's fuel. So there's other elements of inflation that gets into that sort of metric. In the last three years we've been tracking in that broad ballpark.

David Driscoll - Citi Investment Research

But this should be the highest number would it not?

John Bryant

In certainly the commodity component, this is the highest number we'd seen. I think if you go back quite a while since the company's seen this sort of inflation.

David Mackay

It would be, I am guessing to be frank, probably seven or eight years before getting it even close to this, apart from '06 and '07 which has also been quite high.

David Driscoll - Citi Investment Research

My related question is, is that when I look at the price mix, its 3.1 percentage points in the quarter, but it's decelerated from the year-to-date number at 3.6. Can you guys just talk a little bit about why it would be decelerating when it looks like the commodity side is accelerating?

John Bryant

I am not sure I would really call it decelerating, David. It's really a lower number, but I would say we are still driving price mix very hard and it's our intention to continue to drive that into next year. That's the big reason why we have a goal of mid single-digit sales growth next year.

David Driscoll - Citi Investment Research

Would you say, and that's the final question, I had is what is the assumption for price mix for 2008 is it more than the half of your expected sales growth?

John Bryant

I don't want to give too much guidance on that. But clearly with the environment we're operating in price mix will be an important part of delivering next year's numbers.

David Driscoll - Citi Investment Research

Very good. Thanks very much.

David Mackay

Take one more question, Andrea.

Operator

Okay. Our next question will come from Eric Serotta with Merrill Lynch.

Eric Serotta - Merrill Lynch

Hi, thanks for taking the question. First of all could you comment on brand building in aggregate for the quarter? I know you spoke about advertising, but previously I think you'd mentioned that consumer promotion expense might be down somewhat given the efficiencies you are realizing. And what kind of benefit did you get in the quarter and year-to-date from some of those efficiencies?

David Mackay

Yeah, I think we spoke about this a long time ago, but basically through the course of 2007 and probably even in Q4 '06 we benefited from a global exercise where we looked at our consumer promotion spend, tried to drive for efficiencies, purchasing inserts on a global basis versus area to area, cutting out some of the least impactful spend. So that has helped us on a one-time basis through the end of '06 and through '07.

Accounts, I don't know whether we have actually dimensionalized that, but it was a positive. And that's why, certainly for this year we have been focusing more on the advertising so it didn't distort the number.

Eric Serotta - Merrill Lynch

Okay, and just a couple of just final housekeeping items, I know that you don't want to talk about specifics of acquisitions, but every company defines bolt-on acquisitions differently. Can you give us a sense as to what we should expect for contribution from acquisitions in aggregate? You mentioned you had, I think you said several on the front burner for the next quarter or so. What kind of contribution in terms of percent of total sales do you think in aggregate these acquisitions could add?

John Bryant

It's a difficult question and a good opportunity to clarify. We are looking at several acquisitions but in aggregate the several acquisitions will cost us between $200 million and $300 million. So these are relatively small acquisitions. Again, all of them combined are only $200 million to $300 million from a purchase price perspective, relatively small acquisitions. They are strategic around the portfolio, whether it be interesting parts of the world for us or pulling out our portfolio in the U.S. So these are not acquisitions which are going to dramatically drive our P&L or our balance sheet.

Eric Serotta - Merrill Lynch

Okay, and then just lastly to finally clarify just once again on the North American Cereal inventory situation. I just want to clarify, did you see any customer inventory de-stocking on a sequential basis 2Q to 3Q? Or was this all attributable to the year-over-year impact of customers carrying some high inventories in the third quarter of last year and then drawing them down in the fourth quarter of last year?

John Bryant

I think the bulk of it, Eric, was that latter point, that last year we finished Q3 with a higher inventory level than was appropriate. We pulled it down in Q4. So this year we actually made that change in Q3 and that's why consumption is 3%, 4% up and shipments were flat. So we will see a slight benefit in Q4 on the shipment side. It should be stronger shipments in Cereal in Q4.

Eric Serotta - Merrill Lynch

Okay, thanks a lot.

David Mackay

Thank you.

John Bryant

Okay, thanks very much. Andrea, we are all set.

David Mackay

Thank you very much for your time. That concludes the call.

Operator

Thank you. And that does conclude our conference for today. We thank you for your participation. And have a great day.

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Source: Kellogg Q3 2007 Earnings Call Transcript
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