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Kellogg Company (NYSE:K)

Q3 2007 Earnings Call

October 29, 2007 9:30 am ET

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

Operator

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

Thank you. At this time I will turn theconference over to Mr. Joel Wittenberg, Kellogg Company Vice President ofInvestor Relations. Mr. Wittenberg, please begin.

JoelWittenberg

Thanks Andrea and good morning everyone.And thank you for joining us for a review of our third quarter results and forsome discussion regarding our strategy and outlook. With me here in Battle Creek are DavidMackay, President and CEO; John Bryant, CFO; and Gary Pilnick, General Counsel.

We must point out that certain statementsmade today, such as projections for Kellogg Company's future performanceincluding earnings per share, net sales, margin, operating profit, interestexpense, tax rate, cash flow, brand building, upfront cost and inflation, areforward-looking statements. Actual results could be materially different fromthose projected. For further information concerning factors that could causethese results to differ, please refer to the third slide of this presentationas well as our public SEC filings.

A replay of today's conference call willbe 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 numbersis 3113843. The call will also be available via webcast, which will be archivedfor 90 days.

Now, let me turn it over to David.

DavidMackay

Thank you Joel and good morning everyone.Just as a reminder, Simon Burton has moved into the business and JoelWittenberg has stepped into take on this role as Vice President of Treasury andInvestor Relations. We are pleased to report a solid Q3 even with two to threediscrete items slightly impacting top line growth. With strong EPS growth fromQ3 and year-to-date, and with Q4 off to a strong start, we have increasedconfidence that we will deliver another year of sustainable growth.

Through Q3, we benefited from somediscrete tax items, which have allowed us to make further investments in ourbusiness to support our goal of sustainable, dependable performance. Themomentum year-to-date has allowed us to invest more against cost savinginitiatives, to continue our strong advertising investments through Q4, toabsorb higher cost inflation than anticipated, while raising our full year EPSguidance to $2.72 to $2.75 per share.

During Q3, we reinvested back into thebusiness with double digit increases in advertising, and funding of a majorefficiency project within our DSD system. We are confident that our consistentoperating performance will continue into the fourth quarter, providing a strongfoundation for another year of sustainable and dependable performance in 2008.

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

JohnBryant

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

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

Earnings per share grew by 9% versus lastyear, helped in part by a lower tax rate due to several discrete items in thequarter. And cash flow in the first three quarters was $961 million, exceedinglast 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% higherdue to the price increases we put into place over the past year as well asimproved mix. Tonnage added 0.7% and currency contributed 2.6%. This solidinternal sales growth came despite a couple of items, which dampens the quartersales.

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

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

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

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

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

Third quarter gross profit margin declined40 basis points and year-to-date has declined by 20 basis points. For bothperiods this decrease was driven primarily by higher commodities inflation.

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

We indicated last quarter that commoditycost pressures are more concentrated in the second half of the year and thatwas certainly the case in Q3 and will be even more so in Q4. In North America, operating profit declined 4% due to higherupfront and advertising investments. Most of the Q3 upfront charges occurred inNorth America and reduced operating profit byabout 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%. Hereagain, we continue to make higher investments in advertising. Results were alsobe impacted by a voluntary product recall in the UK. Year-to-date, operating profitis up a strong 11%.

In Latin America,quarterly internal operating profit rose by 1%, reflecting increased investmentin advertising as well as high commodity inflation. And finally in AsiaPacific, internal operating profit decreased by 26%, or $6 million, dueprimarily to the continued challenges in the Australian market. Part of thedecline was due to a challenge in Australia for additional efficiencyinitiatives.

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

On slide 9, you can see a summary of our2007 year-to-date performance. I won't review each point of the sustainablegrowth wheel, but the net takeaway is that we expect 2007 will be our sixthconsecutive year dependable, sustainable growth.

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

For the full year, we now have evengreater confidence that our cash flow will be approximately $1 billion. As youknow, the fourth quarter tends to generate the seasonally lowest cash flow ofthe year, and we are also considering voluntary retirement plan contributionsin Q4.

Let's turn to slide 11, to look at ourfull year 2007 guidance. Our guidance from mid single-digit internal net salesgrowth for the full year hasn't changed. But we now forecast earnings to comein 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 inputcosts in both periods.

We now expect total incremental commodity,fuel, energy and benefit costs of approximately $0.32 per share or $0.04 above themid point of our most recent guidance and $0.16 to $0.19 more than our initialguidance 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 $0.05more than our original estimate.

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

Given the significant inflation costs andincreased investments, we continue to expect that full year gross margin willdecline by approximately 50 basis points. As we discussed previously, ourcommodity inflation is heavily weighted for the second half of the year withthe large impact in the fourth quarter. We continue to get good leverage belowthe operating profit line. We expect essentially flat, full year net interestand the tax rate will be about 29%.

In summary, we are very pleased that wehave the ability to absorb high input costs, while raising guidance in adifficult environment. The fact that we can also increase investment in futuregrowth at the same time demonstrates the flexibility of our business model, thestrength of our current momentum, and our desire to drive sustainable anddependable results.

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

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

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

As we go into next year, we would expectour upfront costs to return to approximately $0.14. However, we have thebenefit 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 intoeither, additional upfront costs and our investments to accelerate our growthin emerging markets.

We will provide more clarity on how wewill reinvest the 53rd week in future conference calls. Either way, it is allabout driving sustainability. In addition, we expect essentially flat netinterest expense and our tax rate will move back to approximately 31%. Some ofthe tax benefits we saw in 2007 were one-time in nature, which obviously willnot be repeated next year.

Also we plan to complete our $650 million2007 share repurchase in the fourth quarter and we are pleased to announce theboard has approved an additional $650 million share buyback for 2008.

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

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

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

DavidMackay

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

Third quarter cereal sales were flatversus last year, as we lapped last year's heightened Q3 credit inventorylevels driven by our September 2006 price increase. We are pleased to achievevery strong underlying consumption growth in Q3 of 3% to 4% across all channelsand we are expecting a stronger fourth quarter shipment performance.

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

Once again, Kashi posted another greatquarter with double digit sales growth. Innovation was strong with two newvarieties of Kashi Granola as well as continued momentum from GOLEAN HoneyAlmond Flax cereal. And our Canadian business also posted a solid quarter. We continueto benefit from this year's innovation with Mini-Wheats Strawberry, Special KFruit and Yogurt, and Vanilla Rice Krispies among others.

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

DSD is a great asset for the KelloggCompany and we are going to further leverage to the asset by taking Kashi Snacksand Fruit Snacks into DSD at the end of this year. While this will providefurther growth opportunities in 2008, we expect modest disruption in Q4 and Q1as we reduce inventory in the warehouse system. Both of these moves are theright steps for the future retail snacks.

Overall year-to-date sales are up a strong8% and you can see more detail on slide 16, which shows our PopTarts businessposted solid sales growth in the third quarter, while lapping last year'sintroduction of Go Tarts. The crackers business also posted solid quarterlygrowth versus a difficult double-digit comparison as Cheez-It and All Brancrackers both performed well.

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

Our cookie innovation and brand buildinghave been strong and we are seeing the benefits, we feel solid sales growth andmeasured channel share gains in our cookie business, and we were again lappinggood growth in the third quarter of last year. New Right Bites Grasshoppers andDipping Delights innovations, were ahead of expectations and Famous Amos postedstrong growth for the quarter.

Our Wholesome Snack business continued todo 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 Kelloggsnacks was recently rated the number one DSD manufacturer among all consumergoods companies by Advantage Groups Performance Monitor. This awarded a greatrecognition for the entire DSD team.

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

And our Kashi All-Natural frozen entreesand pizzas continue to perform ahead of our expectations. We are finding thatfor many consumers Kashi frozen entrées are their first experience with thebrand and are now purchasing additional Kashi items.

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

Side 18, shows that Kellogg Internationalposted another solid quarter with 5% internal sales growth in Q3 lapping lastyear's 5% comparison. Our international growth has been broad based with solidresults in both Europe and Latin America asyou can see on slide 19.

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

Sales were strong in Ireland, Spain,Italy and Benelux and the UKachieved 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 Snacksacross the region. Venezuela,Colombia, Brazil, and the Caribbean all posted goodinternal sales growth in the quarter and Mexico achieved double digit growthwith strong performances from Zucaritas and Special K Control and our market sharealso rose during the third quarter.

Asia Pacific sales declined by 1% or lessthan $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 conditionscontinued in the snacks category. We expect that the situation will shake outin 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 instrengthening our company.

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

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

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

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

Question-and-AnswerSession

Operator

Thank you. (OperatorInstructions). 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 alittle bit more clarity on the Cereal business to make sure, I understand it. Ithink, 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 youthought 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 rememberlast year that we had a price increase in September and as we finished thequarter we said we thought we'd got about 1% incremental shipments in thatquarter.

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 shipmentswere down, even though consumption during the two quarters was relatively evenup 2%, 3% I believe.

Terry Bivens - Bear Stearns

Okay.

John Bryant

This year consumption wasvery 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 themdown so that shipments were flat, but I can't tell you as you would expect isthat through October, ourshipments have been strong, because last year in October we are actually goingthrough 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 thatinventory movement, our consumption remained very strong. We gained share andwe are off to a strong start to Q4.

Terry Bivens - Bear Stearns

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

David Mackay

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

Terry Bivens - Bear Stearns

Okay. Thanks very much.

David Mackay

Thanks.

Operator

We will take our nextquestion from Mariann Montagne with Thrivent.

Mariann Montagne - Thrivent

Good morning. A couple ofdetailed questions here, on the UKrecall, how much are you attributing to that in dollar terms?

David Mackay

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

Mariann Montagne - Thrivent

Okay, and the snackrealignment?

David Mackay

For snacks it was less than acouple of percent, but probably 1% to 2% for the quarter, for that would affectshipments.

Mariann Montagne - Thrivent

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

John Bryant

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

Mariann Montagne - Thrivent

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

David Mackay

Yeah that's right. I thinkthat portfolio was very corn based. So, the commodity issue from corn hasreally hit them very hard this year. Also in the quarter, advertising was updouble digits. But we're very, very happy with the strong growth, we saw in themarket during the quarter. And we are going to continue to invest there becauseit 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 questionfrom Robert Moskow with Credit Suisse.

Robert Moskow - Credit Suisse

Thank you. Can you just tellme, you say that you increased your investment in advertising this year. Didyou give us a sense of how much you're increasing it? And then also, I don'tthink, I quite got you are increasing your upfront charge by another $0.02 forthe 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, Robertwe actually execute the DSD buyback ahead of schedule. And main thing is thetotal 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'venot as yet announced.

Robert Moskow - Credit Suisse

Okay. And you say theadvertising is up double-digit, but is that a stronger double-digit than youthought 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 comefrom David Palmer with UBS.

David Palmer - UBS

Hey, guys. With regard toGeneral Mills' moves with Right Size, Right Price initiative, has that becomemore of a competitive intrusion in the EDLP accounts, where perhaps their lowershelf price has provided a bit of a boost to them and perhaps at the expense toKellogg?

David Mackay

David, you will be bestposing that question to them. I think from our perspective, as you saw in thequarter we did expect, we could have some disturbance there, but ourconsumption was strong. We gained share. Very happy with our business andreally the key for us in the third quarter was the fixed year-on-year inventoryissue that we had last year, which is now behind us and we have started Q4strongly.

David Palmer - UBS

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

I'm wondering to what degreedo you think that some of the growth that we've seen in the last couple ofyears having to do with some of this increase in demand for these attributesmay wane or perhaps do you see some of these concerns in the immediate futurebeing addressed better by the industry in the Cereal category perhaps, pickingup momentum as some of the Cereal category players get better at addressingthese concerns?

David Mackay

I think, David our believe asthe Cereal is on trend, certainly if you look at the demographics in the marketand 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 thinkthat 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 willdo anything on the packaging side in Cereal. It seems, like if anything fromthe consumer standpoint the industry has not done anything in packaging exceptperhaps go backwards with pillow packs for decades. Is that something thatcould be in the horizon for the cereal category?

David Mackay

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

David Palmer - UBS

Alright, thank you very much.

David Mackay

Thanks.

Operator

We'll take our next questionfrom 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.Scereal, 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 moredue to, more just tactical items that you had to do promotionally in thequarter, as supposed to anything structural that pricing isn't coming throughfor some reason?

David Mackay

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

Andrew Lazar - Lehman Brothers

Okay. And the last thing is juston, you have always leaned heavily on reinvestment, so nothing overly new thereand I certainly understand the cost environment. But I know you guys trying tobe anticipatory in your business as well. Is it fair to say that some of thereinvestments for '08 that you're making about, that you're doing now, perhaps arenot only about maybe future growth.

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

David Mackay

Yeah, we are really focusingon our own game. And I think most of these investments to ensure we've gotstrong brands with supporting and driving innovation hard. We are trying tomaintain momentum and top of mind awareness with consumers. And on the costside clearly, we are looking good do as much as we can, whatever possible toreduce cost, so that we can offset some of the inflation. As we mentioned inthe call, clearly with the sort of inflation environment we are seeing, broadbased and global pricing is likely.

Andrew Lazar - Lehman Brothers

Thank you.

John Bryant

And just add a little bit ofcommentary to that as well. When we look at these upfront costs, we do look forsort of a 4, 5 year payback and where those costs occurred depends on, wherethe projects are. So this year it was an SG&A lastly because of the DSDabout 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 Europeanmanufacturing 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 fromVincent 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 meunderstand the 53rd week, is that essentially, is it smaller or the same sizesthan the other week and I assume it's in the fourth quarter?

John Bryant

53rd week is the last week ofthe year. Its bit of a strange week and that is some of our internationalmarkets don't even ship in that week. So, it's a little bit smaller from thesales perspective. But also, it tends to be a smaller brand building week. So, tosit 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 alsoask the decline of gross margin of 40 basis points, that included upfront coststo some extent, correct?

John Bryant

That's correct, that's thereported gross margin.

Vincent Andrew - Morgan Stanley

Okay, all right. And then Iguess my last question is just why is this year, the share repurchase thereseems to be a little more skew towards the back half of the year inparticularly the fourth quarter, any reasoning behind that?

John Bryant

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

Vincent Andrew - Morgan Stanley

Okay. Thank you.

John Bryant

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

Vincent Andrew - Morgan Stanley

Thank you very much. That'svery helpful.

David Mackay

Thanks.

Operator

Our next question comes fromKen 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 askquestion about North American retail snacks. Your business has been hitting aboutdouble-digit top line growth or net sales growth for almost two years. You hada little slowdown to 5%. Is there competitive dynamic that's changing, is ittough comparisons, is it a timing of our products? Can you just give us is theresomething that we should start to see more of this lower mid-single digitgrowth in the net sales growth for North American retail snacks?

John Bryant

Yeah Ken, if you go throughwhat I mean, we gained shares in cookies. We gained share in crackers and they bothgrew about mid-single digits. We grew our Wholesome Snacks high-single digits, eventhough 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 intoDSD. The DSD route buyback impacted snacks just short of a couple of percent inthe quarter.

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

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

Ken Zaslow - BMO Capital Markets

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

John Bryant

Thanks.

Operator

Our next question will comefrom Bill Leach with Neuberger Berman.

Bill Leach - Neuberger Berman

Good morning.

David Mackay

Hi, Bill.

Bill Leach - Neuberger Berman

I just had a question aboutyour implied fourth quarter guidance. If I back out all the numbers that seemsto 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 thatreally 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 fullyear commodity inflations actually hitting us in Q4, so it's abnormally heavyquarter. 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 onthe fourth quarter one in particular I would call out as a tax line. We arelooking at a tax rate within the mid 30s much higher than what we've seenyear-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 JonathanFeeney 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 coupleof mixed sort of a trends here. And I guess, I want to get a feeling, you get pricingacross the portfolio, but Snacks growing a little bit faster than Cereal. Couldyou give us an update as to what may be directional roughly the negative mixbetween Snacks and Cereal is doing to your gross margin line, right now?

John Bryant

Well, in fact the in thequarter, there was no negative mix from snacks and cereal. It was pretty much awash.

Jonathan Feeney - Wachovia Securities

Is that just because the Snacksmargin is up so much or?

John Bryant

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

Jonathan Feeney - Wachovia Securities

Oh, I see. Okay. Thanks verymuch for that. If I could just follow up on the comment you made at very end ofyour prepared commentary David about it being a tough environment out there. AndI guess if you could maybe, you've achieved 310 basis points it looks like aprice mix across the portfolio to offset these commodity costs. You have notbeen doing very well on this high commodity costs environment.

It seems like the supplychain in North America anyway is prettyinflationary. Would you say that's a fair characterization and so when you sayits tough environment out there, do you feel like, retailers and wholesalers arestarting to pushback on the kind of pricing they've been letting through or isthere something new there or is that just kind of tough environment on the costside and lets continue to hope for the best on the pricing side?

David Mackay

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

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

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

Jonathan Feeney - Wachovia Securities

Okay. Thanks very much.

John Bryant

Thank you.

Operator

Our next question is fromEric 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, firston the DSD change. I mean, I don't recall a company in the industry kind ofmessing with their DSD and not having a problem. So, have you kind of built insome kind of let's say conservatism in terms of your guidance for next year asto 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 Q3we thought would be Q3, Q4. They executed it so well that they actually got itcompleted 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 andthey're actually up and running effective October 1.

And while you have short-termimpacts, that actually will be positive for the long term. And then the onlyother things on Kashi Snacks and Fruit Snacks going into DSD, as I mentionedthrough Q4 and Q1, you'll have the inventory levels coming down, a little bitof disruption, but we see those as very positive moves for us. So we arelooking very, at 2008 with a very positive view on our DSD system.

Eric Katzman - Deutsche Bank

Okay. And then if I couldfollow up on 2008 guidance, just a few clarifications here. One I assume thatyou are not including any of those acquisitions in your guidance in terms oftop line or EBIT.

John Bryant

No.

Eric Katzman - Deutsche Bank

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

John Bryant

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

Eric Katzman - Deutsche Bank

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

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

David Mackay

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

Eric Katzman - Deutsche Bank

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

David Mackay

All right, thanks.

Operator

Your next question comes fromPablo 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 accountingquestions first and then one strategic question. John, on the corporate expenseline, the number was unusually low this quarter, $35 million, anythingparticular going on there?

John Bryant

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

Pablo Zuanic - JP Morgan

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

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

David Mackay

Well, I don't think we canget into any specifics on the call. And we haven't actually, we have justtalked 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 verycomfortable 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 giveyou a sense of pricing globally for the company, we have about 3.1% I think itis 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 dataas 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 alot going on there. Lots of innovation around Club and Town House, and nowAll-Bran going to whole grain, just give us a little more color there? It lookslike -- I look at Cheez-It, you have Sticks Cheez-It; then on Club, you haveSticks Club; I mean what's the idea there? How are you segmenting thatportfolio? How should we think of that going forward?

David Mackay

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

And then with Club, thebuttery taste of Club and some of the derivatives we've had there, we've seennice performance particularly well. So it's just looking and segmenting themarket and finding ways to actually bring new consumers in by differentpictures 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 quitesuccessfully going into frozen pizza and frozen dinners, do you see room forKellogg to do another transaction on the organic front like; I don't want togive names, but there is a) Mills, there's many other brands out there. Or isKellogg just interested to Kashi as its organic platform?

David Mackay

Well, we don't want tospeculate on what we might or might not do going forward, but Kashi continuesto grow at a strong double digit. We believe it can continue to perform well inall the categories it's in. Consistent with what you are probably seeing innatural and organic, that area does continue to grow strongly, probably arounddouble digit. So we are looking at how we can continue to participate in thatand 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 comefrom 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 threequestions but they are all related on the same topic, if I can. The firstquestion, I had for you guys is, when is the last time Kellogg experiencedcommodity 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 talksabout as well, is all inflation and not just commodity benefit, it's fuel. Sothere's other elements of inflation that gets into that sort of metric. In thelast three years we've been tracking in that broad ballpark.

David Driscoll - Citi Investment Research

But this should be thehighest number would it not?

John Bryant

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

David Mackay

It would be, I am guessing tobe 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 thatwhen I look at the price mix, its 3.1 percentage points in the quarter, but it'sdecelerated from the year-to-date number at 3.6. Can you guys just talk alittle bit about why it would be decelerating when it looks like the commodityside is accelerating?

John Bryant

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

David Driscoll - Citi Investment Research

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

John Bryant

I don't want to give too muchguidance on that. But clearly with the environment we're operating in price mixwill 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 willcome from Eric Serotta with Merrill Lynch.

Eric Serotta - Merrill Lynch

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

David Mackay

Yeah, I think we spoke aboutthis a long time ago, but basically through the course of 2007 and probablyeven in Q4 '06 we benefited from a global exercise where we looked at ourconsumer promotion spend, tried to drive for efficiencies, purchasing insertson a global basis versus area to area, cutting out some of the least impactfulspend. So that has helped us on a one-time basis through the end of '06 andthrough '07.

Accounts, I don't knowwhether we have actually dimensionalized that, but it was a positive. And that'swhy, certainly for this year we have been focusing more on the advertising soit didn't distort the number.

Eric Serotta - Merrill Lynch

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

John Bryant

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

Eric Serotta - Merrill Lynch

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

John Bryant

I think the bulk of it, Eric,was that latter point, that last year we finished Q3 with a higher inventorylevel than was appropriate. We pulled it down in Q4. So this year we actuallymade that change in Q3 and that's why consumption is 3%, 4% up and shipmentswere flat. So we will see a slight benefit in Q4 on the shipment side. Itshould 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 yourtime. That concludes the call.

Operator

Thank you. And that doesconclude our conference for today. We thank you for your participation. Andhave a great day.

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Source: Kellogg Q3 2007 Earnings Call Transcript
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