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Kraft Foods Inc. (KFT)

Q3 2007 Earnings Call

October 31, 2007 8:00 am ET

Executives

Chris Jakubik – IR

Irene Rosenfeld - Chairman and CEO

Tim McLevish - Chief Financial Officer

Analysts

Alexia Howard - SanfordBernstein

Terry Bivens - Bear Stearns

Steven Kron - Goldman Sachs

Eric Serotta - Merrill Lynch

David Palmer – UBS

Eric Katzman - Deutsche Bank

Andrew Lazar - Lehman Brothers

David Driscoll - Citi Investment Research

Pablo Zuanic - JP Morgan

Kenneth Zaslow - BMO Capital Markets

Vincent Andrews - Morgan Stanley

Jonathan Feeney – Wachovia

Robert Moscow - Credit Suisse

Edgar Roesch - Banc of AmericaSecurities

Presentation

Operator

Good morning and welcome to the Kraft Foods third quarter2007 earnings conference call. Today's call is scheduled to last about onehour, including remarks by Kraft Foods management and the question-and-answersession. (Operator Instructions)

I will now turn the call over to Mr. Chris Jakubik, VicePresident of Investor Relations for Kraft. Please go ahead, sir.

Chris Jakubik

Thank you and good morning. Thanks for joining us on ourconference call. I'm Chris Jakubik, Vice President of Investor Relations. Withme are Irene Rosenfeld, our Chairman and CEO; and Tim McLevish, our ChiefFinancial Officer.

Our earnings release was sent out earlier today and isavailable on our website, Kraft.com.

As you know, during this call, we may make forward-lookingstatements about the company’s performance. These statements are based on howwe see things today so they contain an element of uncertainty. Actual resultsmay differ materially due to risks and uncertainties. Please refer to thecautionary statements and risk factors contained in the company’s 10-K and 10-Qfilings for a more detailed explanation of the inherent limitations in suchforward-looking statements.

Some of today's prepared remarks will exclude those itemsthat affect comparability. These excluded items are captured in our GAAP tonon-GAAP reconciliations within our news release and they are also available onour website.

We'll begin today's call with Irene’s perspective on ourthird quarter. Then Tim will provide an overview of our financials and resultsof operations. After that, we'll take your questions.

With that, I'll hand it to Irene.

Irene Rosenfeld

Thanks, Chris. Good morning. As we reported in thismorning’s press release, we posted organic revenue growth of just over 6% inQ3, and EPS ex items that were $0.02 lower than the prior year.

Broadly speaking, our top line growth is stronger than Iwould have expected at this point in our transformation plan. At the same time,higher input costs and the impact on our margins are a bigger challenge than Iwould have anticipated.

To be more specific, I am encouraged that our top linemomentum continues to build and that our businesses are responding to thegrowth initiatives we launched earlier this year. We have had three consecutivequarters of improved organic net revenue growth; and in Q3, revenue growthaccelerated in every geography.

I am especially pleased that we also had solid volume gains,despite significant price increases. That is a clear sign that our brand equityis strengthening.

In businesses where our investments in quality, marketingand new products have had time to gain traction, we generated solid volume mixgains and capture market share, despite price increases. Prime examples are Mac ‘n Cheese, cold cutsand cookies. A number of the newproducts we’ve launched this year promise to be sizeable businesses and highlyincremental to our base. These include Oreo Cakesters, Live Active Cheeses,Easy Mac cups, Ultimate Pizza and Deli Creation sandwiches. In fact, we expectthe revenue contribution from new products in 2007 to be more than 30% higherthan 2006.

Our growth initiatives in our focus categories are alsobeginning to generate share gains. In Q3, we gained share in 47% of our NorthAmerican business, versus only 38% for the trailing 52 weeks. That is not yetwhere we need to be; we expect to have over 50% of our revenues growing sharein the near term, and at least two-thirds longer term.

We are moving in the right direction, and you should seefurther improvements as more programs hit the market in the fourth quarter.Highlights include new campaigns for Maxwell House behind our Advantage productand package; and Planters, capitalizing on the natural goodness of this iconicsnack brand. We will also have a furtherstep-up in spending on our international growth initiatives.

As our wave 1 investments gain traction in the marketplace,I remain confident that this will set the stage for continued top line momentumand share gains into 2008 and beyond.

Despite our progress on the top line and in market share, westill have some significant challenges. The biggest is our margin performance.We are in a much tougher input cost environment that we had expected. In thequarter, gross margins declined 240 basis points, even after pricing actionsand manufacturing productivity. Frankly, we haven’t yet rebuilt the brandequity of our portfolio to the point where we can fully recover input costinflation through a combination of pricing and productivity.

This has been particularly true in our North American cheesebusiness, where dairy costs in the third quarter were up 40% versus prior year,and current spot prices are not reflecting their historical seasonal decline,leading to record high average barrel cheese costs for 2007.

The easy thing to do would be to cut our investments ingrowth to improve our near-term profit margins; but as I said last quarter, theinput cost environment will not change our plans to make the necessaryinvestments to improve the quality of our products and to rebuild the equity ofour brands.

These investments are essential to adding value to ourproducts, and therefore to our ability to manage input cost inflation over thelong term.

Our investments are also key to driving the acceleratedvolume growth and stronger product mix that will leverage our overhead costs,lead to higher operating margins, and restore Kraft to reliable growth.

In the face of these extraordinary cost increases, we arealso taking more aggressive actions to reduce our overhead costs. To date, wehave been able to achieve savings at a faster rate while incurring lessexpense. Cumulative savings under ourrestructuring program are now expected to reach $775 million this year, versusour expectation of $700 million at the start of the year; and there is more tocome. Looking at our total restructuring program, we expect to come in at thesame cost and reach higher savings than the $1 billion originally expected.

If you recall in September, as part of our strategy torewire the organization for growth, I announced a new organizational structureto place key resources closer to the market, increase accountability, speeddecisionmaking and streamline headquarters. We have now defined the structure,identified the accountable business units and named the leaders of those units.

Based on the work to-date, I am even more convinced that ournew structure and new leadership team will simplify our operations and increaseour agility and competitiveness in the marketplace.

As you might have seen on Monday, we named Mary Beth West asour new Chief Marketing Officer. As Headof North America Beverages, Mary Beth helped develop our successful go tomarket strategy for Tassimo in the U.S.and engineered the reawakening of our Maxwell House brand that has just hit themarket. She brings a strong, consumer-centric approach to business challengesand will play a key role in helping to upgrade the capabilities of ourmarketing teams and improve the effectiveness of our programs.

We still have a few more personnel holes to fill, includinga new leader for our North American cheese business and we'll be in a betterposition to quantify the incremental savings from these actions as we exit theyear and put the new structure in place in early 2008.

Finally, we continue to take the necessary steps tostrengthen our portfolio; to exit businesses where we do not have a clearcompetitive advantage, so that we may allocate our capital and managementresources to those businesses that can grow and generate attractive returns forour shareholders. Specifically, we justclosed the sale of our Fruit 2.0 and Veryfine bottled beverage assets, andwe're on track to close the acquisition of Danone biscuits by year end.

In sum, I am encouraged by the continued progress in theearly stages of our transformation plan. We're doing what we said we would doand we are seeing signs that our efforts and investments are paying off. Westill have a number of challenges, but we are addressing them and I remainconfident that we are on track to restore Kraft to reliable growth.

Now I will turn the call over to Tim.

Tim McLevish

Thanks, Irene and good morning. Before I begin, please keepin mind that unless otherwise noted, my comments will exclude the itemsaffecting comparability that were highlighted in our press release.

In the third quarter, our organic net revenues increased astrong 6.2%. That's up from 3.9% organic growth in the first six months of theyear. Volume and mix accounted for about two-thirds of the Q3 growth, as manyof our wave 1 investments in quality, new products and marketing began to hitthe market.

Net pricing was up 2.3 percentage points versus 1% in thefirst six months of the year, as we have begun to see the realization of priceincreases taken earlier this year. Overall, we had a great improvement on thetop line.

Turning to the drivers of profit and earnings, there arethree factors to highlight. First, our lower price realization improved in Q3;our gross margin was down 240 basis points versus Q3 last year. Higher inputcosts and our investments in product quality more than offset pricing andproductivity gains. For the year, we expect our input costs will be up about 9%versus 2006. We expect gross margin pressures to continue in Q4 and into 2008as well.

Second, because of the decline in gross margin, ouroperating income margin was down 210 basis points. On the positive side, Iwould note that our overhead cost declined as a percentage of sales, meaningour cost savings are coming through, and we began to generate some operatingleverage due to a combination of volume mix, growth from our investments andrestructuring savings.

Looking forward, we expect operating income margins tocontinue to be pressured over the next several months, due to higher inputcosts. However, in 2008 we will leverage improved price realization, volumegrowth and improved product mix while driving down our overhead cost to achievehigher operating margins versus 2007.

Third, below the line we benefited by approximately $0.02from a combination of a lower effective tax rate and our share repurchaseactivity. In the quarter, our effective tax rate was 31.3%, reflecting one-timeadjustments from the impact of various foreign tax law changes. As a result ourguidance for the year is now 32.5% versus our earlier forecast of 33.5%.

On the share repurchase front, during the quarter werepurchased another $1 billion of our stock. In the first six months since thespin-off, we have repurchased $3 billion or 5.6% of our shares outstanding atan average price of $33.02.

If you recall, in September we raised our guidance to $1.80to $1.82, reflecting strong revenue growth, lower taxes and further sharerepurchase. Our Q3 results came in very much as we had expected and thereforewe remain confident in our guidance, despite continued cost pressures.

I'll take a few minutes now to share some highlights of ourbusiness segment results. We'll start with North America,where Q3 results reflected the launch of most of our wave 1 growth investments.In North America beverages, organic net revenues grew5.3%. Our focus on health and wellness and premium offerings is paying off.

Capri Sun ready-to-drink pouches wereup strongly from the addition of antioxidants and functional benefits, as wellas from teaming up with Nabisco for a back-to-school promotion.

In coffee, Starbucks premium coffees continued to growstrongly, combined with another quarter of 70% growth from Tassimo, as ourrevised go-to-market strategy continues to gain traction. Our market share incoffee was still down in the quarter, as gains in the premium segment wereoffset by mainstream weakness. However, October 1st marked the beginning of ourMaxwell House Reawakening ad campaign in support of our improved offering.Customer and consumer reaction to both the package and the new 100% Arabicablend has been enthusiastic and we expect positive results from the program tobegin in Q4 and to continue into 2008.

At the profit line, beverages operating income marginincreased 260 basis points. Volume growth, favorable product mix, pricing andthe benefits of our new Tassimo strategy more than offset higher input costs.We expect a similar profile in the fourth quarter.

In North America cheese and foodservice, results were impacted by unprecedented barrel cheese prices. Organicnet revenues were up 5.6%, mainly due to price increases reflecting higherdairy costs but operating income margins fell over 6 percentage points as wechose not to price to peak input costs and continued to fund our growthinitiatives to lay the necessary foundation for long-term growth of thisbusiness.

Dairy prices have remained uncharacteristically highthroughout 2007, likely leading to record high average barrel cheese prices.Three major factors have combined to break the historical cyclicality of thecheese curve. Australiacontinues to suffer from a second year of severe drought. A weak U.S. dollar ismaking U.S.dairy exports attractive, and demand for milk powders has grown globally,particularly in Asia and North Africa.

In the face of this, we've taken significant action. About80% of our cheese portfolio has been priced at least once in 2007 and pricingactions have ranged from 2% to 13% for an average 7% increase overall. However,absolute price levels are causing weak category volumes and driving moreconsumers to trade down to private label versus historical norms. As a result,both our volumes and market share of total cheese are down year-to-date.

Clearly our pricing and innovation have not been enough tomanage this input cost volatility. However, our new initiatives are beginningto move us in the right action. Live Active prebiotic and probiotic cheeses areoff to a good start. To date, Live Active cottage cheese has captured a 1.6%share of cottage cheese and is more than 85% incremental. Live Active naturalcheese has a 2.6% share of the natural cheese snacking category.

Also, Kraft Singles Select has already gained 1 share pointof the processed slices category, one month after introduction. Fixing ourcheese business will take time and continued investment. As a result, we expectoperating income margins in this business to be under pressure for the balanceof 2007 and into the beginning of 2008.

Moving on to North America convenientmeals, revenue momentum has been building with each successive quarter in 2007.The investments we have been making in marketing, quality and new productsdrove strong volume and mix gains while we've increased pricing across most ofthe business.

The introduction of Ultimate Pizza is helping to turn aroundour share of frozen pizza. Ultimate’s share of the category was about 3% in Q3and all four Ultimate SKUs are in the top 5% of category dollar sales in Q3.

Mac ‘n Cheese is also gaining share, up over half a point inthe latest 52 weeks, driven by our investments in quality and new products. EasyMac cups have been more than 50% incremental to our business year-to-date, andhave been a key driver of the double-digit growth of our Mac ‘n Cheesebusiness.

Finally, Oscar Meyer continued to post strong growth behindboth Deli Creation Sandwiches and Deli Shaved Meats. In fact, Deli Shaved Meatsnow have nearly a 10% share of the total cold cuts category. The result: 8%organic net revenue growth for convenient meals in the third quarter.

However, operating income margins fell in the quarter,negatively impacted by three factors: the impact of divested operations; higherinput costs, including investments in quality and new capacity; and incrementalmarketing investments. Going forward, we expect profit margins in convenientmeals to improve as we see continued momentum from our growth initiatives.

On to North American grocery, where organic net revenueswere essentially flat. We are at the early stages of contemporizing thesehighly profitable brands. Jell-O is the first and earliest of our efforts. Thetotal Jell-O franchise is up about 5% year-to-date, and it was up 7% in Q3behind strong momentum from new, better-for-you products. We will be launchingan integrated marketing campaign to rejuvenate dry packaged Jell-O in Q4.

Pourable salad dressings will be next as we look to reversemany years of weakness in this franchise. We're upgrading the quality of thepackaging and product and we'll be fully national with incremental marketingsupport in the first quarter of 2008. Some of the costs associated with theseactivities will weigh in our grocery margins in the fourth quarter.

Looking at North American snacks and cereals, organic netrevenues were up 4.6%, led by growth of 5.5% in snacks. Several successful platformsare driving our snacks growth and serve as good examples of the impact ofreframing our categories. For instance, revenue growth of our higher marginNabisco 100-calorie packs was up 51% in Q3.

Second, during the third quarter, the introduction of Oreo Cakesterscaptured a 6 share of the billion-dollar snack cake segment with two of thecategory's top 10 SKUs and a 3 share of total cookies. Considering that we onlylaunched the product in late July, we're expecting even better things to come.

Third, our toasted chips platform grew 18% in Q3 versus theprior year and is now over a 3 share of the cracker category. Our new Garden HarvestChips have captured 1 share point since being introduced with velocities wellahead of competitive products. But despite some promising success, our marketshare performance in snacks remains mixed. While our cookie share is up, westill have areas that need to be fixed, namely Planters and our broader crackerbusiness. Going forward, we expect our strong new product line up, and bettermarketing support across the snacks business, to accelerate organic growth andimprove market share trends.

Operating income margins in the quarter fell 230 basispoints as solid volume and product mix gains were offset by higher input costs,spending behind our growth initiatives, and dilution from the sale of Cream ofWheat. Clearly, given the high cost of grains, our input costs are on the risein our snacks business, placing increased emphasis on improving net pricerealization.

As a result, we're considering a combination of list priceincreases, targeted reductions in trade spending and productivity in order tomanage these costs going forward. Nonetheless, we will continue to invest inthe growth of this business and in 2007 we'll have a solid base from which todrive growth.

Now I'll turn to our international business which continuedto post solid organic growth as we focus on our investments in our core brands.The EU continued its return to moderate growth, increasing organic net revenuesby 4.9 percentage points. In fact, EU organic revenue is up 3.3% year-to-date,its best performance in the last three years. Our two largest growthcategories, chocolate and coffee, have been the main drivers.

Chocolate delivered double-digit growth this quarter. Thereare two key reasons: a combination of new product launches and a double-digitincrease in marketing behind core brands like Milka and Toblerone. Secondly,cooler weather across the EU.

Coffee growth was driven by two factors also. Categorygrowth and market share gains from the successful restaging of our Tassimo on-demandcoffees and new product activity under our core Jacobs brand.

EU operating margins declined 220 basis points. There aretwo major reasons: First, 2007 is a year of investment to revitalize our corebrand equities through market and promotion; in fact, A&C spendingex-Tassimo will be at its highest level in three years.

The second is higher input costs. Coffee and dairy costshave been on the rise and as mentioned earlier, these businesses -- especiallyin Germany --are not yet strong enough to enable us to fully recover these costs. In fact, withdairy costs now on the rise in Europe, input cost pressureis likely to get worse in the EU before it gets better.

Looking ahead, although we'll continue to make the necessaryinvestments to strengthen our core equities in coffee, chocolate and biscuits,we are actively pursuing additional ways to reduce costs and improve margins.

Moving on to developing markets, where we delivered anotherquarter of solid growth with organic net revenues up double-digits. All regionsposted better growth in the third quarter than in the first half of the year.Our focus on key brands and key products is paying off in each region. Thisincluded Jacobs coffee as well as Milka and Alpen Gold chocolate in our EMEAregion; Oreo and Club Social biscuits, Lacta chocolate and Tang beverages in Latin America; and Oreo and Tang in Asia Pacific.

At theoperating income line, margins were up slightly. The benefits of higher pricingand volume growth were offset by higher input costs and higher investments inmarketing and distribution. Going forward, we expect continued strong top lineperformance from developing markets. However, we expect continued marginpressures as we step up our investment and marketing support and expandeddistribution.

Finally, I would like to comment on our restructuringprogram. Annualized savings from the program are up to $720 million and we nowexpect them to reach $775 million by year end, up from the $700 million levelwe expected at the start of the year.

On the cost side, we have incurred $326 million year-to-dateand we now expect total cost of $500 million for the year, down from anexpectation of $625 million at the beginning of the year.

As Irene mentioned earlier, we do expect to generate bettersavings than originally planned over the life of the program and we'll closeout the program by the end of 2008. Obviously, the actions we will take toimplement our new organization structure are part of our restructuring program,so we would be in a better position to update you as we exit the year.

From 2009 onward, we expect to maintain a normalized levelof spending and cost savings initiatives each year, which will be part of ourongoing results.

Irene Rosenfeld

Thanks, Tim. In sum,from an overall perspective I feel good about our business momentum and theearly returns from our growth initiatives. We can see that our investments inquality, marketing and new products are driving improved organic growth. We'regenerating solid volume and mix gains, despite significant price increases andwe're beginning to leverage our cost savings.

We still have challenges, particularly in the face of higherinput costs, but we're making the necessary investments for long-term growthand have maintained our full year EPS guidance of $1.80 to $1.82. I remainconfident that our transformation plan will maintain our top line momentum anddeliver improved margins in 2008.

We would now be happy to take your questions.

Question-and-AnswerSession

Operator

Your first question comes from Alexia Howard - SanfordBernstein.

Alexia Howard - Sanford Bernstein

A couple of quick ones. Marketing spending. I know thatwe've got this incremental $300 million to $400 million this year that coversmarketing, SAP, R&D and better ingredients. Could you tell us how much ofthat went into the third quarter and how much is left for the rest of the year?

Irene Rosenfeld

We haven't actually quantified the pieces that went intoeach of the quarters, Alexia, but as I said, our spending is back half loadedand it will be a combination of Q3/Q4 with more of it skewing to Q4, which iswhy we're anticipating continued progress on our share growth in Q4.

Alexia Howard - Sanford Bernstein

Another quick one about the differential between pricing andinput costs, obviously very negative this quarter. I'm not sure whether you canquantify that. Going forward, do you see that differential closing in Q4 or arewe likely to have to wait until next year for that gap to start to close?

Irene Rosenfeld

Well, as we said, we're covering only about half of ourcosts at this point. It's primarily an issue related to dairy and it has a lotto do with the strength of our brand equity and that's why we continue to makethe necessary investments.

As we look forward to the fourth quarter, I think it's goingto look a lot like the third quarter. We should continue to see strong top linemomentum and continued pressure on margins. But as we exit this year, as we'vediscussed, I believe we have programs in place that will allow us to make thekind of gains in our operating margins that we had given in our guidance.

Operator

Your next question comes from Terry Bivens - Bear Stearns.

Terry Bivens - BearStearns

Just a couple of things, I know you probably won't get intoguidance until the fourth quarter but Tim, is there any way we can get anadvanced look at what you are thinking about in terms of the tax rate? That isa pretty big swing factor here. You've given us one for this year, obviously;but any comment there, looking into '08?

Tim McLevish

First of all, as you saw, our rates have progressively comedown over the course of the year as we identify opportunities that fall withinthe discrete category in the year. We're now anticipating the 32.5% for fullyear as opposed to previous guidance of 33.5%.

Clearly, as we think about the tax rate and as I get moreengaged in better understanding where we've been and what the opportunitiesare, we'll be more thoughtful about how we plan the rate rather than start outthe year with a high rate and progressively bring it down.

Secondly, as I engage in looking at opportunities, I amconfident that we will find ways to overall better manage the tax rates, but atthis point I'm not prepared to commit to a number.

Terry Bivens - BearStearns

On commodities, Kellogg I am sure you're aware talked aboutsome pretty significant input inflation going into next year, be it energy orfood ingredients. What is your preliminary view on where that might go, '08over '07?

Tim McLevish

Again, we're not going to get into specific guidance on 2008but certainly commodity costs are putting pressure across many of ourcategories in our businesses. It is particularly exacerbating the dairysituation, where dairy costs are at unprecedented levels. Despite fundamentalmarkets in the U.S.,we're seeing the prices are holding up there more so than we would anticipate.No question, this is going to provide headwind in 2008 and certainly in theearlier part of the year.

Operator

Your next question comes from Steven Kron - Goldman Sachs.

Steven Kron - GoldmanSachs

Following up on the marketing initiatives, the $300 millionto $400 million. I was a littlesurprised that the marketing and administration line was a little bit favorableon the year-over-year basis, so clearly the trade-off of some of the costbenefits that you're seeing, whether it be overhead or other initiatives, isoffsetting the incremental spending. Can you maybe talk a little bit about howyou expect that line to trend going forward?

Irene Rosenfeld

Well again, Steven, as we said our focus is going to be tocontinue to make the necessary investments in the business and you're seeingplay through. We are continuing to work though to offset some of the otherinput costs with continued focus on overhead. What you're beginning to see inthis quarter is indicative of what we're going to continue to push on goingforward.

If you remember our fundamental growth formula, it is forpricing and productivity over time to offset input costs and to use volumegrowth and mix together with a continued focus on overhead cost savings toincrease operating margins. So we're seeing some of the early benefit of that,we expect that we'll continue to benefit more from the overhead opportunity in2008.

Tim McLevish

We continue to drive opportunities to manage the overheadpiece of it. We want to continue to invest in the advertising and consumer andas Irene mentioned, we want to continue investing in building our brand. Rightnow, we're not able to offset the commodity increase costs with pricing but aswe build our brands we'll be even better positioned to do that.

Steven Kron - GoldmanSachs

I think this is the first time I think in four or five yearswhere cost to the consumer on products that are eaten at home, food at homeproducts is outpacing that of food away from home. I was just wondering, givenyour size and diversity of product and customer, whether you could provide somecomments? Clearly the cheese category is feeling the price sensitivity; tradedown to private label, as you indicated. What about across your othercategories, your other brands? Are you seeing the price realization a lot moredifficult to achieve? Maybe you could talk little bit about how you're thinkingabout pricing in some of those other categories going forward.

Irene Rosenfeld

I would argue that we're actually seeing better pricingrealization as we have come out of the third quarter than we've seen in quitesome time and I've been particularly pleased by the fact that our volume andmix have held up in the face of that.

As we exit the year, we will continue to see the impact ofpricing as it plays through on a number of our categories. But there is noquestion that we are in somewhat uncharted water in a number of thesecategories as we reflect the impact of input costs to the P&L.

Operator

Your next question comes from Eric Serotta - Merrill Lynch.

Eric Serotta -Merrill Lynch

I just wanted to circle back on Alexia's question regardingthe marketing and other quality investments and investment spending in thethird quarter. Last quarter, Irene, you made the comment that about 75% of the in-marketactivity would occur in the second half. I realize you don't want to get intospecifics of dollars spent, but could you give us some sort of feeling as topercentage left to go for the fourth quarter?

Irene Rosenfeld

No,we're not prepared to provide that number at this time, Eric. Again, I'll tellyou that particularly as we look at some of the launches that are pending, our MaxwellHouse Reawakening program, our Planters campaign launch, a number of otherprograms on both cheese and biscuits, we are looking to see continued increasein our spending in the fourth quarter.

Eric Serotta -Merrill Lynch

Tim, is it fair to say that your accruals for thisinvestment spending is more evenly weighted through the year than the actual in-marketactivity or benefits that you are likely to see?

Tim McLevish

No, I think we are expensing as we incur the cost.

Chris Jakubik

Eric, as we have discussed on some of these programs, someof it is allocated throughout the year based on volume. But when you have newproducts come out that are entirely new to the product, you incur the cost asyou launch.

Eric Serotta -Merrill Lynch

Sure, but things like the Maxwell House restage, have thecosts from that been accrued throughout the year in anticipation of it, or isthat an example of something that you're expensing as incurred?

Tim McLevish

Eric, I think the important takeaway here – I don’t want toget into every individual brand – but the important takeaway, as Irene said, about three-quarters of thespend was going to come in the second half of the year. As we look at the thirdquarter, we certainly had a significant step-up. We're going to have anothersignificant step-up in the fourth quarter as well.

Operator

Your next question comes from David Palmer - UBS.

David Palmer - UBS

Just a question about your product improvements andreformulations. I know you were making some changes there. Are thosesubstantial? Is there any way for you to give us a sense of how much of anexpense this is, versus the other marketing and pure commodity cost inflation?

Irene Rosenfeld

It's a little bit hard to quantify. Certainly, it is a pieceof the impact on our gross margins. It's probably about a quarter of our $400million incremental cost. But the end result here is the fact that as Imentioned, we're seeing considerable step-up in the percent of our productsthat are rated superior to competition. As we go forward, that will continue tobe a key driver of our performance and we're seeing the benefit in selectcategories like Mac ‘n Cheese, where we have made those kinds of investments,we're seeing the impact of that investment in the marketplace.

David Palmer - UBS

So a quarter of the $400 million is really something that'sflows through the COGS line?

Irene Rosenfeld

That's correct.

David Palmer - UBS

The wall-to-wall initiative, I might have missed it in youropening remarks. Could you perhaps give us an update there, how you're feelingabout the progress? I think by mid- '08 you were expecting to have thingslargely rolled out.

Irene Rosenfeld

We continue to feel good about the program. We are learning,continuing to learn about how best to train our sales reps but we expect to benational by mid-2008 and we are on track.

Operator

Your next question comes from Eric Katzman - Deutsche Bank.

Eric Katzman -Deutsche Bank

A few questions. The first one, the charge within beveragesof $120 million, that seems like a lot. I just don't remember Fruit 2.0 and Veryfinebeing that big of a business. Why is that such a high charge?

Tim McLevish

It all has to do with the sales price and the valuevis-à-vis when we bought it. Unlike a lot of our other brands, it was rathernew, it wasn't terribly depreciated in terms of the assets as well as the brandvalue. You can you do the math. That's pretty much the end result.

Eric Katzman -Deutsche Bank

Irene, you mentioned that we're kind of at unprecedentedlevels vis-à-vis pricing and potential demand elasticity but you've been therefor 20 years or so. There were periods of inflation back in the late '80s,early '90s. What kind of experience did the company have at that point vis-à-vistrade down by the consumer and is that applicable to today?

Irene Rosenfeld

I think certainly, Eric, some of the past history is applicable and we areseeing in select categories again, particularly cheese where the costs are mostextreme, we are seeing some trade down and it comes back to our need tocontinue to make the necessary investments in brand equity to be able to addenough value to be able to justify our price premium.

But having said that, there are a number of factors, despitethe fact that as we look at the dairy market, we see some of the traditionalmetrics all going in the right direction -- number of cows, milk production,milk per cow -- all of those traditional metrics that we look at that wouldlead to declining dairy prices at this time of year; we're not seeing thathappening.

That reflects the fact that there really are some secular changeshappening in the marketplace, as Tim mentioned. As we move forward here, someof the impacts are somewhat uncharted and we just need to continue to beprepared to address them, which is why we are so focused on continuing to buildbrand equity, while driving down costs.

Eric Katzman -Deutsche Bank

I think you mentioned that you expect EBIT margins to be upin 2008. But can you quantify how much incremental savings you expect from therestructuring efforts? Because if you have a continuation of input costs up,and you are also expecting advertising to be up -- I assume at a greaterpercentage than sales -- that means that the savings have got to be prettysignificant. Can you quantify what dollar amount that should be?

Irene Rosenfeld

Well as you might expect, it's a little early for us to giveyou a firm number on 2008. we obviously will do that in our fourth quartercall. But as Tim said, we expect to grow margins in 2008 as we committed inFebruary, despite the input costs and it's really going to come from the factthat we're going to see the benefits of our wave 1 investments, plus some ofthe beginning of the wave 2 investments that we're now making as well as theimpact of the accelerated restructuring savings. So that's what will contributeto our operating leverage in 2008.

Eric Katzman -Deutsche Bank

So the restructuring savings, do they really start rampingup in '08? In terms of incremental, is it much more significant in '08 versuswhat you got in '07 versus '06?

Tim McLevish

If you think about it, we're anticipating being at anannualized level of $775 million at the end of 2007, so there will beincremental. We said that the overall savings will exceed $1 billion, so therewill clearly be incremental year on year. The $775 million is a run rate levelso clearly, 2008 will see more benefits from restructuring savings.

Operator

Your next question comes from Andrew Lazar - LehmanBrothers.

Andrew Lazar - LehmanBrothers

In looking at the volume gain that you had, that's certainlya better organic volume number than we've seen in a couple years, maybe since’05 or so. I am just trying to get a sense of with all the new products thatyou're launching, is there a way to quantify perhaps how much of that wasimpacted by shipping out a whole bunch of the new products that hopefully willstart moving off the shelf in the fourth quarter versus just ongoing volumeimprovements?

Irene Rosenfeld

We haven’t quantified that, Andrew, but I would tell you thisis not about pipeline. This is about takeaway and contribution of some of thesecore businesses that I mentioned in my earlier remarks to our overallperformance. I feel very comfortable that the volume gains that we are seeingare sustainable and real and in fact will continue to build into 2008.

Andrew Lazar - LehmanBrothers

Mix has been, for a couple years now, a really great driveron the top line. It was again in this quarter. It accelerated a little bit fromwhere we've seen, but obviously the comparisons are tough. I know that issomething you are expecting to help out again from a contribution standpoint in'08.

Does the way you get that mix start to become more difficult?In other words, it now seems like it has to come from a lot of the highervalue-added new products that you're putting out versus maybe before where itwas one-off SKU reductions, selling less, heavy beverage versus light powder.Things that you shifted by perhaps changing compensation of the sales force,things like that. Does it get harder to do now or is the visibility around themix part still pretty high in your view?

Irene Rosenfeld

I think the visibility is still pretty high. I feel goodabout the progress that we've made. As you rightly say, over the last couple ofyears we have benefited from cleaning out some of the less profitable parts ofthe portfolio. We've got most of that behind us though at this point and so themix that we're looking at is about the higher margin that comes fromcompetitively advantaged concepts like Cakesters, like Live Active cheeses, forexample, that will allow us to realize higher margins in our snacks business,these 100-calorie packs and our toasted chips have very attractive margins.

Andrew Lazar - LehmanBrothers

Tim, I know you said you started to see perhaps some signsof operating leverage in the business, even though we don't see it comingthrough in totality, given costs and such. Could you just expand on that alittle bit? That becomes I think obviously a lot more critical as we go into'08 and it's tougher for us to see underneath, given the impact on margins forcosts and investment spending.

Tim McLevish

Well clearly we are providing some leverage from the increasedvolume. It's our cost savings initiatives, it's the restructuring program andthe benefits associated with that, that is helping to contain those costs.

You may recall that at the gross margin line, we're down 240basis points but on the operating line we're down 210 basis points; so that 30 deltais a result of that volume leverage and the savings initiatives.

Operator

Your next question comes from David Driscoll - Citi InvestmentResearch.

David Driscoll - CitiInvestment Research

Gross profit margin was down 240 basis points. Can you giveus the split between the raw material inflation and the product qualityimprovements? I kind of think of this as the so-called self-inflicted hit. Sowhat's the difference between things that are out of your control versus thingsthat were in your control on that 240?

Tim McLevish

I don't mean to be cute here, but 100% of those was drivenby input costs. Another third of it was attributable to the investments we'remaking in new products and so forth. And we made up that one-third back fromother productivity initiatives. So it's all from input costs.

David Driscoll - CitiInvestment Research

On the commodity cost side, somebody else was asking aboutthis, but can I just ask you if you would be kind enough to give us whatpercentage of your commodity costs are hedged for the balance of the year?Other companies are willing to give us that hedge for 2008. Will you give ussome level of guidance on that?

Tim McLevish

I'm sorry, we can't give that kind of guidance. Certainly,we have some of our input costs hedged and that is a dynamic process as we useit over the course of the year and going into 2008, clearly we're hedging someahead but that's not a level of specificity we're prepared to talk about.

David Driscoll - CitiInvestment Research

Irene, one final question. Status on divestitures. You know,there's lots of discussion around Post and Oscar. I think in your preparedcomments I wrote this down that you said that you would exit businesses thatdid not provide a competitive advantage. Can you talk about those two bigbusinesses and whether or not they provide a competitive advantage? How do youthink about them?

Irene Rosenfeld

David, as I laid out the strategies in February, I made itclear that they were not meant to be a Safe Harbor for all of our businessesand we've given each of our businesses the charge in the go-forward strategy totake a look at what the long-term growth prospects look like.

We've been very clear to say that the three criteria we arelooking at in terms of the potential divestiture is growth potential, relativemarket share and overall profitability. We will continue to use those as ourscreens. Certain of our categories are better positioned with this newframework to be able to make progress and be accretive over the long-term.Obviously, as we have news to announce on that front, we will give it to you.

Operator

Your next question comes from Pablo Zuanic - JP Morgan.

Pablo Zuanic - JPMorgan

I'm just trying to understand, Irene, the cheese strategy. At the recent investorconference you talked about five products that you want to focus on, and one ofthem was cheese. Why would the industry leader, with all these marketinginnovations in probiotic cheese want to lag in terms of price increases?

It seems that there is opportunity here, all of theinnovation and brand support that you are putting through, of leading. That'sone question. I have a hard time understanding that, this persistent focus onmarket share where perhaps profitability would be more important in thisenvironment, you would think private label is being more squeezed.

Related to that, when I think of the cheese business, Iwould assume that given your scale, you have to have some cost advantages overyour competitors, so you also should have room there to increase prices in thisenvironment.

Could you comment on that, please?

Irene Rosenfeld

As we mentioned, Pablo, we've been quite aggressive in ourprice increases on our cheese business. We've priced over 80% of the portfolioanywhere between 2% and 13%. We continue to have a premium on virtually everyform that we make. So it's not about our shyness as the market leader in termsof willingness to take pricing.

Having said that, we're also well aware of the fact that weneed to make sure that we are justifying the prices that we're charging and wehaven't across the portfolio yet added enough value to be able to be even moreaggressive in those price increases.

I think we're beginning to see some of the impact in thekinds of items that we have launched, the Live Active cheeses, our Singles Selectproduct, and some of the marketing actions that we've taken on our basebusinesses.

Bottom line, quite frankly, we need some new thinking on ourcheese business and we've been making some key leadership changes over thecourse of these last few months in an effort to help that business realize thepotential that I know it has.

Pablo Zuanic - JPMorgan

Just to follow up on that, can you walk us through brieflyin terms of your five North American divisions, in terms of what are theleadership changes? [Inaudible] you are looking for someone for cheese. Justbriefly, if you can give us some color, please.

Irene Rosenfeld

Basically, as Mary Beth West moved into our CMO role, wehave back filled Mary Beth with Bob Levi, who is a beverage veteran, been withthe company over 20 years, and has made some significant contributions. He willpick up that business as we move forward.

Chris Baldwin has joined us on our snacks business and I amquite confident that he will help us to access what we believe to be terrificopportunity on the snacks front. Our cheese leadership is open right now. Wehave been public in terms of looking on the outside. I really do want to getsome new thinking on that business and in the meantime, Nick Meriggioli, whohas been running our convenient meals business, has stepped in to serve as theinterim leader there.

Cheese is really at this moment the only one of ourbusinesses that is open. Rhonda Jordan is still managing our grocery businessquite effectively and we are beginning to see good progress as we improve therelevance and the contemporariness of that business.

Pablo Zuanic - JPMorgan

One last one, if I may. Going back to the back-to-schoolconference, you told us about the five products you want to focus on and then youalso mentioned I believe snacks, salad dressings and convenient meals, OscarMeyer meat. That was about 70% of sales. How should we think about the other30%? The experience with other companies is that where there are not enoughinvestments on those other products, they begin to fall off a cliff in terms ofsales. Should we think that other 30% will eventually be sold? How do we thinkabout that, Irene?

Irene Rosenfeld

Pablo, the way we should think about it is that we aresequencing our investments. As I said at back-to-school, we have chosen tofocus on the categories that matter most. The five categories that I have laidout there were about 50% of our revenue and as we continue to make improvementsthat will further add to our overall investment. But the reality is, we cansequence these investments and start to get the impact while we then make thenext phase of investment.

So with investments in these five core categories, we haveseen a significant step-up in our revenue growth. Our organic revenue, as wesaid, is up over 6% in this quarter. Iam confident that by focusing our investments on the areas that can have thegreatest leverage, we will be able to make progress but we will eventually getto all of the businesses in the portfolio that need support.

Pablo Zuanic - JPMorgan

One last one. I understand that by November 14th, if youwant to make changes to the board of directors, that has to be proposed beforeNovember 14th. Is that true and are there plans for new directors to beproposed?

Irene Rosenfeld

It is true that November 14th is the filing date. Wecontinue to look at the opportunity to add directors, qualified directors toour board and that will be an ongoing process independent of the November date.

Operator

Your next question is from Kenneth Zaslow - BMO CapitalMarkets.

Kenneth Zaslow - BMOCapital Markets

I just had some follow-up questions from the previousquestion. Commodities for the quarter I think you said were up 9%. What is yourexpectation for the full year? I don’t know if you said that.

Irene Rosenfeld

9% is the number for the full year.

Kenneth Zaslow - BMOCapital Markets

On the cheese side, can you discuss Kraft's premium relativeto private label and is the premium relative to private label one of thereasons that you're having a more challenging time pricing through?

Irene Rosenfeld

No, we've been very diligent in managing our price gaps andI feel very comfortable that we're in a much stronger position with respect toour gaps than we have been historically and we are not going to allow ourselvesto get out of the proper range, which is why we need to continue to ensure thatwe've added enough value to the portfolio and that is the focus of theinvestments that we're making.

Kenneth Zaslow - BMOCapital Markets

You said something very interesting, you said you're lookingfor new thinking on the cheese. What are you looking for in terms of thethinking? Are you talking about new product innovation? Are you talking abouthow to execute? What would you be looking for in that division when you'relooking for a person to head that up?

Irene Rosenfeld

I think it's the opportunity to approach the category from aconsumer perspective as I laid out in February. I continue to feel verystrongly that cheese is a growth opportunity for Kraft. As we look around theworld, consumers are eating cheese. It's growing at a very healthy rate. Ouropportunity is to ensure that our offerings within the category are preferred. Ithink the key to that is to take a more consumer centric approach to thecategory and both through our marketing effort as well as our new productinnovation.

Kenneth Zaslow - BMOCapital Markets

My last question is, you didn't discuss cereal at all in thediscussion. Is there something we should interpret from that? Is theresomething wrong with the business? Was it just an oversight? How do we look atthat? There was no commentary on the cereal business?

Irene Rosenfeld

You should interpret nothing, it simply was not a significantcontributor to the overall results of our snacks segment and that's why wedidn't mention it.

Operator

Your next question comes from Vincent Andrews - MorganStanley.

Vincent Andrews -Morgan Stanley

I had to step off the call for a moment so if this hasalready been asked, please let me know. Irene, I'm just wondering if you couldgive your view of what businesses are operating at an acceptable level ofperformance right now?

Irene Rosenfeld

Well a number of our businesses, frankly, on the top lineare performing at an acceptable level. As we look across the portfolio I am quitepleased by the performance of most of our categories, both in North America and around the world. As we mentioned, we have seenaccelerated revenue growth in the all geographies. So I feel very good aboutthat.

I would say within North America, our convenient mealsbusiness was up 8% and if you look under the covers and look at thecontributors to that growth it's about quality, it's about marketinginvestment, it's about new product innovation and that is the formula for ourfuture. So I believe that is our model and as we move through the various partsof the portfolio, that is the formula that we're looking for.

Vincent Andrews -Morgan Stanley

Would you still stand by the idea that in 2009 you're goingto hit your stride and you'll fully realize the financial benefits of yourinvestments and you will deliver your long-term targets?

Irene Rosenfeld

Absolutely.

Operator

Your next question is from Jonathan Feeney - Wachovia.

Jonathan Feeney -Wachovia

I'm sorry to beat a dead horse here, but on private labeltrade down, what is it about the cheese category that it seems like you heldthe line a little bit more there, absorbed a little more of those commoditycosts, yet it seems like that's the only place you called out where you arelosing to private label. Is that a fair characterization? What is it specificallyabout this category that made it such that private label won't raise price?

Irene Rosenfeld

Without a doubt, of all the categories in which we compete,private label is a bigger factor in cheese than it is in other categories, soyou start there. The reality is that to the extent that some of our offeringswithin the category are not well-differentiated, it puts pressure on ourability to price at a very significant premium. We're still at considerablepremiums within each of our forms today but the issue will be, can we commandan even higher premium?

I come back to the fact that products like Live Active haveabout a 13% margin advantage to our base product. It's the opportunity toleverage some proprietary technology that goes into the making of that product,together with our marketing opportunities, that then allow us to be able tocommand higher prices going forward.

The reality is absolute price points do matter as well. Partof the challenge in cheese is that the entire category is down as the consumerabsorbs some of the extraordinary impact of these input costs.

Tim McLevish

We have an unusual situation also with regard to dairyprices, whereas typically at this time of the year, we would have seen themstarted to come off the seasonal peak and in fact they've held up much morethan we would ever have experienced in the past. Usually with the spike in theseason, the industry typically doesn't price to that peak. As we're seeing itbehave a bit differently, we're going to have to rethink that.

Jonathan Feeney -Wachovia

To ask a converse implication of the squeezed, cash-strappedconsumer, if we go back to the late '80s, early ‘90s the last consumerrecession, are there any parts of your portfolio that you would expect toreceive some of those consumers who are maybe eating out a little bit less? Areyou seeing any of that lift today, do you feel like?

Irene Rosenfeld

I think one of the benefits of the breadth of our portfoliois that we expect that can benefit virtually all of our products as we continueto think about a consumer centric approach to them and what we need to do tohelp to make them more relevant to today's consumer. Virtually every one of oursegments can benefit from that move from away from home to at-home consumption.

Operator

Your next question comes from Robert Moscow - Credit Suisse.

Robert Moscow -Credit Suisse

My question has to do with the guidance for '07. If I lookat the implication for fourth quarter, maybe it is just my model, but it lookslike it's something like a 12% to 13% EBIT decline and you've been tracking arounda 5% for the year. Am I looking at that correctly, Tim?

Tim McLevish

We've given our full year guidance and I'll let you sort outthe analysis in between it.

Robert Moscow -Credit Suisse

Is there anything about fourth quarter that's exceptionallyworse than the first three quarters of the year?

Tim McLevish

I'd say the fourth quarter, you see what's happening comingout of the third quarter, I would expect it to probably look a lot like thethird quarter. We continue to expect to have top line momentum. As we talkedabout with the input costs, we continue to expect pressure there.

Robert Moscow -Credit Suisse

Secondly for 2008, the Danone acquisition is hanging outthere. You've said to expect, I think it was about $0.01. Commodity costs are alot higher than they were when you first negotiated the deal. Do you have anyvisibility as to whether margins in that business have held up and when do youthink you'll be able to update us on your guidance for how accretive ordilutive that business could be?

Irene Rosenfeld

We'll update you as part of our 2008 guidance but we are ontrack for our year end closing. They continue to report strong performance ontheir biscuit business. As you know, their Q3 growth was almost 7%, so it's ahealthy business. Clearly the impact of grains will have some impact. But thereare some very strong productivity programs in place and I'm pretty confidentthat we will be able to continue to benefit from the accretion that we havelaid out for you.

Robert Moscow -Credit Suisse

To help us think about that a little bit more, is thereanything you can tell us about your snacks business in Europein the quarter and how much of a commodity hit it took and maybe we couldextrapolate that into the Danone business?

Irene Rosenfeld

I think the better indication is what happened to our snackbusiness domestically. Without a doubt it did take a hit in margin. As wementioned, though, we are looking at a variety of actions, including pricing,trade spending and productivity to help to manage that going forward and I'mconfident that we will be able to do that.

Robert Moscow -Credit Suisse

Lastly, has the transition to wall-to-wall in the U.S., hasthat at all compromised your ability to get baked goods distribution like youhad been the crackers business or do you think that it's more a function of themarketing program that's causing the weakness in crackers?

Irene Rosenfeld

I feel very confident that it is about the marketingprograms. One of the key metrics that we look at as we are rolling out wall-to-wallis the performance of our base biscuit program versus the performance of thewarehouse products. We continue to see strong incremental growth in thewall-to-wall markets and as we look at the base businesses, I'm confident thatthis has not had an adverse impact on the biscuit business. That's one of ourmost important criteria as we roll this thing out.

Operator

Your final question comes from Edgar Roesch - Banc ofAmerica Securities

.

Edgar Roesch - Bancof America Securities

Irene, when you talked about '08 costs being up, is that justa continuation of what we're seeing on the ag side or has the increase inenergy started to factor into your outlook as well, and maybe spill over intopackaging?

Irene Rosenfeld

When we talk about input costs, it is not just the rawmaterial input cost. It's the knock-on effect on resins and packaging costs asa consequence of the high energy prices. So it's an aggregate assessment.

Edgar Roesch - Bancof America Securities

Could you just give us the changes to the Tassimo program,what kind of benefit that provided the beverage segment?

Irene Rosenfeld

Well as you are aware, one of the most significant changeswe made this year was to focus our Tassimo marketing efforts to a more targetedaudience and to look at more targeted marketing approaches to that audience. Weare seeing the benefits of that. Our Tassimo business is up almost 70% and at aconsiderably lower cost than we had a year ago.

Edgar Roesch - Bancof America Securities

'07 is clearly a year of investment. I would just like toknow if you expect to exit the year with a lot of that heavy lifting done andthe reinvestment is largely behind you or whether there is further investmentin into 2008 as well.

Irene Rosenfeld

As we said when we laid out the plan in February, this is athree-year plan. Our target in terms of our overall A&C investment is toget to us the competitive levels of 8% to 9% over time and we are committed tomaking progress against that objective. As we exit 2007, we will have madeprogress. We will make continued progress in 2008. We are looking to then driveour other aspects of the P&L, particularly overhead costs, as our meanstogether with volume growth, and mix improvement to drive our overall operatingmargins.

So you will see continued investment in the business in 2008but we are committed to making margin improvement as we said.

Operator

I would now like to turn the floor over to Mr. Chris Jakubikfor any further or closing remarks.

Chris Jakubik

Thanks everybody for joining us this morning. If any of theanalysts have further follow-up questions we'll be around all day. Thanks verymuch.

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Source: Kraft Foods Q3 2007 Earnings Call Transcript

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