2005 3rd Quarter Earnings Release
October 31, 2005
Speaking on behalf of Kellogg:
Jim Jenness, Chairman and CEO
David Mackay, President and COO
Jeff Boromisa, CFO
Simon Burton, Director, Investor Relations
Good morning and welcome to the Kellogg Company 2005 Third Quarter Earnings Call. This call is being recorded. All lines have been placed on mute to prevent background noise. After the speaker’s remarks there will be a question and answer period. If you would like to ask a question during this time, simply press * and the number 1 on your telephone keypad. If you would like to withdraw your question, please press the # key. Also, please limit yourself to one question during the Q&A session. Thank you. At this time I would like to turn the conference over to Mr. Simon Burton, Kellogg Company Director of Investor Relations. Mr. Burton you may begin your conference.
Good morning everyone. Thanks for joining us for a review of our third quarter results and for some discussion regarding our strategy and outlook. With me here in Battle Creek are Jim Jenness, our chairman and CEO, David Mackay, president and COO; Jeff Boromisa, CFO; and Gary Pilnick, general counsel. We must point out that certain statements made today, such as projections for Kellogg Company’s future performance, including earnings per share, net sales, margin, brand building, operating profit, innovation, costs, interest expense, tax rate, cash flow, working capital, share repurchases, and debt reduction are forward-looking statements. Actual results could be materially different from those projected. For further information concerning factors that could cause these results to differ, please refer to the second slide of this presentation, as well as to our public SEC filings. A replay of today’s conference call will be available by ‘phone through Thursday evening, by dialing 888-203-1112 in the U.S. and 719-457-0820 from international locations; the passcode for both numbers is #3783244. The call will also be available via webcast, which will be archived for 90 days. Now let me turn it over to Jim Jenness, chairman and chief executive officer.
Thank you, Simon, and good morning, everyone. We are pleased to report our third quarter and year-to-date results. As we anticipated, our strong business momentum and excellent execution continued in the third quarter… and as we discussed last quarter, we took advantage of this performance and dramatically increased our investment in future growth.
Reported net sales growth was 7.3%, which built on the very strong 7.2% growth we posted in the third quarter of last year. Internal net sales growth, which excludes the impact of foreign exchange, acquisitions, and divestitures, was 6.6 percent. This was growth on growth, as internal growth in last year’s third quarter was an impressive 4.8 percent.
Our goal remains sustainable growth, and we can achieve this only by continued reinvestment. In fact, we again made significant investment in future margin improvement through both brand building and cost-reduction projects in the third quarter… and as always, the up-front costs are embedded right in our earnings.
We intend to increase our investment in brand building again in the final quarter of the year to drive sustainability. However, despite this increase, our continued momentum gives us the confidence to raise our earnings guidance for the year to a range between $2.32 and $2.34 per share.
We have realistic targets and clear operating principles that guide how we run our business every day. Our goals haven’t changed and we intend to make significant investment in future growth in 2006, as we remain committed to our long-term strategy of growing cereal, expanding snacks, and pursuing selected growth opportunities.
Slide 4 details some of the quarter’s financial highlights.
Net sales increased by 7% due to strong sales growth and a contribution from foreign currency exchange of less than 1 percent. Internal sales growth, which excludes the effect of foreign exchange, was also nearly 7 percent.
Operating profit increased by 2%, and internal growth was 1 percent. This growth was generated despite a significant, double-digit increase in brand-building investment. Up-front costs related to cost-reduction initiatives were approximately 4¢ a share. Our year-to-date operating profit growth is 7 percent; year-to-date internal operating profit growth is 6%, right in line with our long-term target of mid single-digit growth.
Earnings per share increased by 12% due to operating income growth, lower interest expense, and a lower tax rate and year-to-date cash flow of $915 million exceeded last year’s total of $860 million. Let’s look at each of these results in more detail.
Slide 5 shows the components of the third quarter’s sales growth. Reported sales growth was 7.3%; internal sales growth was 6.6% driven by gains in price, mix and tonnage. Keep in mind that this growth adds to very strong internal growth of 4.8% posted in the third quarter of last year. In addition, growth was balanced and both mix and price contributed.
You’ll remember that, at the end of the second quarter, we indicated that we intended to make significant investment in brand building in the second half of the year. Well, slide six details this growth for the third quarter and the progress we’ve made year-to-date. While we haven’t changed our long-term strategy to increase investment in brand building at a rate greater than sales growth, we far exceeded it in the third quarter.
We had the ideas. We had strong innovation around the world. And we took advantage of our current business momentum and strong results. In fact, brand-building investment, which includes advertising and consumer promotion, but not trade spending, increased at strong double-digit rate in the third quarter. We recognise that this investment, not spending on trade, is the way to build brands and support innovation.
And of course, we are committed to continuing this strategy in the fourth quarter of 2005 and in 2006, we expect to again increase our investment in brand building at a rate greater than sales growth.
In a moment, David will review each of our businesses in more detail. But first, let me turn it over to Jeff Boromisa, who will walk you through our financial results.
Thanks, Jim. Good morning. Gross profit margin decreased by 90 basis points to 45.2% during the third quarter… but note that, year-to-date, our gross profit margin has expanded by 30 basis points, slightly less than our long-term target of 50 basis points a year.
Much of the decrease in the third quarter resulted from absorbing all of the 4¢ of up-front costs in COGS. This was more than 1¢ greater than in the third quarter of last year. We also faced competitive conditions in a couple of our businesses, which impacted our gross margin. In addition, we were also affected by the same higher energy, fuel, and benefit costs faced by much of the industry. However, due to our cost saving initiatives, we were able to offset these increases during the quarter.
Now let’s turn to operating profit growth by business. Slide 8 shows the growth in internal operating profit in each of our geographic reporting areas in the third quarter; this growth excludes the impact of currency translation.
In North America, internal operating profit growth was 2.2 percent. This was mostly a result of a very significant, double-digit increase in investment in brand building.
In Europe, operating profit growth declined by 10.3 percent due to increased competitive activity and continued investment in brand building. This investment has also increased at a double-digit rate so far this year.
In Latin America, internal operating profit growth was 5.4%, even including a mid double-digit increase in brand building.
And in Asia/Pacific we posted internal operating profit growth of 7.9 percent. While brand-building investment decreased in the quarter due to the timing of programs, for the year-to-date period, brand-building investment has increased at a double-digit rate.
This quarter’s growth was strong and we invested heavily in the business. Remember, too, that total up-front costs in the quarter added to approximately 4¢ per share.
Interest expense in the third quarter was lower than last year, partially as a result of the retirement of debt earlier in the year. The tax rate in the third quarter was 30%; the year-to-date tax rate of 31.7% is broadly in-line with our new expectation for the full-year rate to be approximately 32 percent. The lower tax rate was attributable to several discrete items which were recorded during the third quarter.
In 2006, we expect full-year interest expense to be slightly lower than this year’s level and we expect the full-year tax rate to be between 31 and 32 percent.
Slide 9 shows the excellent improvement we’ve made over the years in core working capital measured as a percentage of sales. Getting to this industry-leading level has been a significant driver of cash flow over the years and we are very pleased with this performance.
Let’s now turn to slide 10 and a discussion of cash flow. Year-to-date cash flow through the third quarter was 915 million dollars versus 860 million dollars in 2004. The increase was a result of strong earnings growth and a year-over-year reduction in benefit plan contributions.
This is very strong year-to-date performance and we continue to expect that we will meet full-year guidance for cash flow between $950 million and $1.025 billion in 2005; this does not take into account the impact of additional benefit plan contributions that are planned for the fourth quarter; these contributions will reduce cash flow by up to $240 million.
Separately, the Board of Directors has increased 2005’s share repurchase authorization to $675 million. This increase will allow us to repurchase approximately $400 million more of our shares by the end of the year; we had repurchased approximately $260 million of our stock through the end of the third quarter.
Turning now to slide 11 and our debt level in recent years; year-to-date, we have reduced debt by approximately $450 million. While debt will increase over the next few months, primarily as a result of share repurchases and benefit plan contributions, we remain committed to the continued long-term repayment of net debt, or reducing total debt less cash.
Slide twelve shows our return on invested capital over the past four years. We are very pleased with this progress, as focus on return is very important to us. It is an integral part of our broader operating principles and we are confident that we are concentrated on the right drivers of ROIC.
Now, let’s turn to slide thirteen and our financial outlook for the remainder of the year. Slide 13 shows our outlook for the full-year 2005. The financial flexibility we saw at the end of the first half allowed us to invest more heavily in brand building and innovation in the third quarter and we will continue this in the fourth quarter; this is what drives sustainability. In addition, we expect the business momentum that we’ve seen through the first three quarters to continue and expect mid single-digit internal sales growth in the fourth quarter… which is higher than our long-term target.
As Jim mentioned, we continued to execute cost-reduction projects in the third quarter that we expect to complete in 2006. Almost all of the costs that we’ve absorbed thus far this year, and that we’ve identified for next year, are associated with the closure of two snacks bakeries. We still expect these costs to total approximately 15¢ for the full year, or approximately 3¢ in the fourth quarter.
And as we discussed in last quarter’s conference call, we dramatically increased the amount of investment in brand building and future growth in the third quarter and you should be anticipating a significant increased investment in the fourth quarter, as well as possible investment in financial and operational initiatives.
As you all know, the price of fuel, energy, and energy related supply costs continue to increase or remain high. To put it into perspective, we anticipate that fuel and energy costs for the full year will be an incremental 12-13¢. We have seen some commodity deflation, but it was our focus on cost-reduction initiatives that offset most of this unexpectedly large fuel and energy cost inflation. In addition, we continue to expect that increased benefit and healthcare costs will negatively affect EPS by approximately 6¢ for the full year. There is no doubt that our focus on sustainable, consistent performance, and the significant investment we’ve made, has allowed us to weather these headwinds relatively well and despite these headwinds, we do still anticipate that we will post mid single-digit operating profit growth in 2005, right in-line with our long-term target.
And we also feel comfortable raising our earnings guidance to a range between $2.32 and $2.34 per share.
Now let’s turn to slide 14 and a first look at 2006. We expect low single-digit internal net sales growth in 2006, which is right in line with our long-term target and we expect to meet this target despite the very difficult comparisons set throughout 2005.
Our suppliers and fuel and freight providers continue to voice inflationary concerns. However, our long-term target is for an annual improvement in gross margin of 50 basis points and we expect to achieve this goal again in 2006 and, we expect to do this despite our projections for increased energy, fuel, and commodity costs. It’s early and prices have been volatile, but we currently expect these costs to adversely affect EPS by approximately 13¢ to 16¢ for the year. We will be able to give you more clarity about this at the end of the year, but we will work to offset these increases, much as we have in 2005. We also expect that benefit costs will have an additional 3-7¢ negative effect on earnings. This is a significant cost impact after recent commodity inflation. Fortunately, our topline growth and strong execution have positioned us well to absorb the large cost increases and still deliver our goal of high single-digit earnings growth.
Much like in previous years, we will also continue to reinvest in future growth and we have currently identified cost-reduction projects of 5-6¢ per share. As always, we are constantly evaluating new cost-saving projects and, as we highlighted at CAGNY, opportunities for investment in future growth, which will require start-up cost absorption. Consequently, we expect to identify, and execute, more of these projects during the balance of 2006 and we expect the total investment to be approximately equal to 2005’s level; as always, the total funding for these investments is included in our earnings guidance.
Despite this investment, and significant cost pressures, we anticipate that operating leverage, productivity savings, and mix improvement will allow us to meet our long-term target of mid single-digit operating profit growth in 2006.
As you know, we’ve posted tonnage growth for a number of quarters, due largely to the success of our innovation and brand-building programs. We’ve had tremendous success with many new products, but have also seen many of our existing products increasing in popularity as well. Consequently, we have decided that we will add capacity to help us better meet this increasing demand this is a very high return use of our cash and, consequently, we expect that cash flow for 2006 will be in a range between $875 and $975 million and that cap ex will be approximately 4% of sales.
We have continued to reduce debt and expect that interest expense will again decrease next year. In addition, we expect to have a sustainable tax rate of between 31 and 32 percent. Slightly lower interest expense, and fewer shares outstanding, should lead to high single-digit earnings per share growth; also right in-line with our long-term targets. Remember, though, we haven’t included the effect of expensing options in 2006’s guidance; we anticipate this will have an EPS effect of approximately 8 cents.
We are very pleased we can provide an outlook that is again right in line with our long-term targets. Even with the difficult cost environment, we continue to believe that our realistic targets focus our entire organization on the right metrics. With that, let me turn it over to David.
Thanks, Jeff. Let’s now take a look at our results by business segment. Slide fifteen shows the quarterly break-down of internal growth posted by each of our North American businesses. We are very pleased with these results, and they are particularly impressive given the strong growth posted by the Retail Snacks and Frozen and Specialty Channels businesses in 2004.
Now, let’s look at the North American businesses in more detail. Strong sales growth in our North American Retail Cereal business continued in the third quarter and we had excellent base sales growth. Internal sales growth of 11% added to last quarter’s growth of 10% and built on a 1% comp last year. And remember, too, that 2004’s results built on a 10% comp, so three-year growth has been impressive as well. This strong performance puts our quarterly share, through the end of September, at 33.9%, up 0.8 from the same period last year.
Growth in the U.S. during the third quarter was broad-based across brands and we saw excellent growth from new brands such as Smart Start, two new flavours of Crunch and Special K Fruit and Yogurt… and we also saw good growth from existing brands such as Mini Wheats and Kashi. In fact, Kashi brands GoLean Crunch, Organic Promise Autumn Wheat, Heart to Heart, and Kashi 7 Whole Grain Flakes all grew at a double-digit rate in the quarter.
The Canadian business also posted excellent growth on strong innovation launched in 2005, such as Special K Vanilla Almond, Extra, Tony’s Turbos, and All-Bran Strawberry Bites, which added to our already strong All-Bran franchise. These products, combined with strong retail programs and effective brand-building investment led to double-digit growth on a difficult mid single-digit comp.
As we mentioned, we increased our investment in brand building throughout the company and North America was no exception. Total brand-building investment in the third quarter increased at a high rate behind many of the brands I just mentioned including Crunch, Smart Start, Special K, and Mini-Wheats.
And, as we detailed in our presentation at the Prudential conference in September, we have a significant amount of both brand-building investment and innovation planned for 2006, some examples of which are pictured on the slide.
Slide 17 details the very strong growth posted by our North American Retail Snacks business in the third quarter. The quarter’s 6% growth built on a very difficult comp of 9% in the third quarter of last year. In fact, we’ve posted strong broad-based growth across these categories over the past two years. While certain categories are stronger than others at times, we are very pleased with this history of good results and are committed to continuing our success in the future.
Slide 18 details the results posted by each category in the third quarter. Our Pop-Tarts toaster pastries business continues to be strong. In fact, we currently have 85% category share and we have increased this share by about 1.5% so far this year. The lower sales posted in this quarter simply reflects the timing of programs and the strong double-digit growth posted in the third quarter of last year. Innovation has been strong this year and we have more planned for 2006.
We saw strong growth in the crackers business in the third quarter. This was driven by strength in the base businesses such as Cheez-It, Townhouse, and Club and by strong innovation such as Cheez-It Fiesta and Club Sticks.
Our cookie sales decreased in the quarter as the early positive effect of innovation such as Chips Deluxe Right Bites and Gripz, and Fudge Shoppe filled cookies in two varieties, was offset by the effect of the discontinuation of various products including two flavors of low-carb cookies. It is worth noting, though, that our three largest brands, Chips Deluxe, Fudge Shoppe, and Sandies, which account for approximately two-thirds of our cookie sales, all posted strong gross sales growth. So, we saw better results where we are focused and we are effectively managing ongoing SKU rationalizations.
The wholesome snack business was again very strong in the third quarter. New products such as Special K bars and All-Bran bars continued to post very strong, double-digit growth, and even existing products such as Rice Krispies Treats and fruit snacks added to the strong results. It’s interesting that, while Rice Krispies Treats benefited from the recent introduction of Split Stix, the base business is posting good growth as a result of the strong execution of our DSD system.
In Canada, high single-digit sales growth was driven by the introduction of Froot Loops Winders, the Raisin Bran bar that we introduced earlier this year, and the two varieties of All-Bran bars that we introduced last year
So, we remain very pleased with our snacks business and the excellent results posted over the last two years.
Slide 19 shows that the Frozen and Specialty Channels business posted internal sales growth of 8% in the third quarter. This resulted from strong growth from Eggo, Morningstar Farms, and the Specialty Channels business.
Eggo posted strong double-digit sales growth as a result of strength in both base sales and good innovation. Toaster Swirlz and an expansion of our pancakes line are both doing well in the market and we have new innovation coming in the first quarter of 2006.
Morningstar Farms posted mid single-digit growth as a result of strong brand-building programs and category expanding innovation. The Meal Starters products we launched last quarter are doing well, and we have a lot of innovation planned for Morningstar Farms, too, including vegetable snack bites in two varieties, which will be out in the first quarter of 2006.
Our Specialty Channels businesses also did well in the quarter. This group of businesses continues to execute very well and achieved great results despite a difficult mid single-digit comparison.
Slide 20 shows the reported and internal sales growth posted by Kellogg International in the third quarter. Reported sales growth was 4 percent. Internal growth, excluding FX, was 3 percent. You will notice that the strengthening U.S. dollar has significantly narrowed the spread between reported and FX adjusted growth.
Now, let’s take a look at the results by geographic area. Slide 21 details the internal net sales growth posted by each of our international areas in the third quarter.
Europe posted internal sales growth of more than 1% driven by gains in both cereal and snacks. While we have resolved the issue with the retailer we referenced last quarter, we continued to see an effect as we work to return to normalized levels of distribution and promotional activity; this continued effect decreased sales growth across Europe by approximately 1% in the quarter. We gained almost a point of cereal share in the U.K. during the quarter and this came primarily from innovation and brand building. Special K Purple Berries, Coco Pops Rocks, and Crunchy Nut Nutty all contributed to the share gain. The U.K. continues to be a highly competitive market with significant promotional and buy-one-get-one-free activity. In addition, we saw good growth in various other countries across Europe including Italy, the Benelux region, and most others… France posted strong growth as a result of excellent innovation and brand-building programs. These recently introduced new products, and additional programs planned for the fourth quarter, give us confidence about our business across Europe for the remainder of this year.
Latin America posted internal sales growth of 10% on high single-digit cereal growth and double-digit snacks growth. In Mexico, the region’s largest business, we launched a new variety of Extra, new varieties of Choco Krispies and Froot Loops, and a Cartoon network-themed cereal. We invested in brand-building programs for Choco Krispies and Special K with good results. In snacks, we launched Special K Chocolate bars and new Nutri-Grain bar flavors launched in Q2 are doing well. We have new innovation planned for the fourth quarter including snacks and cereals such All-Bran Yoghurt and Kellogg’s Go!... And we have just launched a new Amaranth Bar under a new brand, Nutri Día, in two flavors in Mexico.
The Caribbean, Argentina, Brazil, Venezuela, and Columbia all posted very strong growth in the quarter and in Columbia, we launched All-Bran Flakes with good results.
The Asia Pacific region also posted 1% internal sales growth. A good innovation program drove the recovery of the cereal business in Australia. New products which shipped during the quarter include Be Natural brand Muesli in three flavors, Crunchy Nut Clusters, Just Right Tropical and a new variety of Guardian. The snacks business declined due to the timing of innovation and very difficult, double-digit comps.
In Asia we saw a slight decline in sales in a competitive environment. Japan’s sales declined, but we did see growth from innovation in Japan with Cocoa Flakes, Genmai Sesame, Frosties Plus, and Special K. And we will begin to support Special K with brand-building programs shortly.
And in Korea, after a difficult year last year, a health-oriented advertising campaign and good brand building added to the sales growth of various brands including Black Bean Flakes and Frosties.
We remain encouraged by our performance in Asia Pacific and have good innovation in the markets, although, we would caution you that we face a relatively difficult comp in the fourth quarter driven by growth in Australia last year.
Our strong topline growth, driven by innovation and aggressive brand building, has helped us absorb the significant upturn in energy and fuel related costs faced by most manufacturers. This momentum has given us the flexibility to absorb these costs and continue our approach of focusing on the generation of sustainable growth in the future. Now I’ll turn it back to Jim
In summary, we are pleased to report another quarter of strong results. We are confident that 2005 will be another year of sustainable growth performance where we deliver against our long-term targets, build positive momentum, and invest in our business for sustainability, despite the significant pressures facing us and the industry.
More than ever, as we look to 2006, our confidence in our sustainable business model is strong. We remain committed to running the business with realistic goals in-line with our long-term targets of low single-digit sales growth, mid single-digit operating profit growth, and high single-digit earnings growth. We have a focused business strategy and Volume to Value and Manage for Cash operating principles that drive the right behavior. And we will continue to make significant investments in future growth. We will continue to increase our investment in brand building at rate faster than sales growth. We will continue to drive mix improvement through value-added innovation. We will continue to find cost-saving investment initiatives. And we will continue to pursue selected growth opportunities that are sources of possible, incremental revenue growth.
We recognize that we have to improve. Our success wouldn’t be possible without the dedication of our employees around the world, and their ability to execute. And with that, I’d like to open it up for questions.
Thank you. Once again, if you would like to ask a question please do so by pressing the * key followed by the digit 1 on your touch tone telephone. Also, if you are using a speaker phone please make sure your mute function is off to allow your signal to reach our equipment. Once again please press *1 to ask a question. Additionally, please limit yourself to one question. Our first question comes from Christine McCracken with FTN Midwest.
Clearly you are no exception – fuel and energy are a big deal and it looks like it will continue to be a big deal. But I am a bit surprised with the guidance given some of the other levers that you've had to pull. I am wondering if you are expecting to be able to pass any of this along. Clearly you can't comment on price increases, but are you seeing any reluctance on the part of retailers to increase prices or maybe you can just comment on your ability to pass through some of these cost pressures.
First of all, as you know, we just can't comment on pricing, but I would like to take you back to your question on our guidance. For 2005, at the high end of our guidance there at $2.34, it’s right in line with what we have been basically saying we were going to deliver. And within that, please keep in mind the very strong increase in brand building that we have in place and have been executing against, which is really an investment for us in the future to help our sustainability. Within that, we are also absorbing significant energy and fuel costs which really came and started to hit more in the second half of the year. So we see this and the guidance we are giving as really a confidence-builder for us in our model, how we go about doing it, and that sustainability and what we have been on for the last four years is exactly the right focus ultimately to deliver value to our shareholders over time.
Okay. But with the lower tax rate you are expecting lower interest expense, some of, I guess, these positive factors that you have working for you next year. Is it more about the pricing? Have you not been able to pass that through at this point?
Christine, I want to make one comment and then I'm going to turn it over to Jeff. Keep in mind that our guidance for 2005 here, the $2.34, recall last year we had an extra week. So if you just try to normalize it and go to the high end of our guidance, that $2.34 without the extra week really gives us some strong performance.
Yes, and Christine, for next year what we kind of pointed out, is that we are seeing additional costs for next year in the commodity arena. Probably 2/3 of that is related more to fuel and energy, but that's about a $0.13 to $0.16 on-cost or headwind for us next year. And benefits still remain to be high, benefit costs for us. And looking at where discount rates are and inflation on health care, that's driving up our costs another $0.03 to $0.07 on top of this year. So there's $0.16 to $0.23 of headwinds. Considering that we are right on track with our long-term guidance is really evidence that this model of sustainability is working. We are able to offset a lot of that because of our cost-savings initiatives we have been executing over the years. The other fact is we have also allowed in our guidance for next year the continuation of reinvesting in these cost savings projects. So that $0.15 that we did this year is very similar to next year's thinking, although we haven't identified all of the projects and we are currently working through our list of evaluation of them. But we feel good about the guidance. It is exactly what we have been saying the last four years.
Fair enough. Thanks.
Thank you. Our next question comes from Pablo Zuanic with JP Morgan.
I am just trying to get my hands around these comments about brand building. I mean, on the one hand I see that SG&A over revenues was unchanged year-on-year, so what happened? Maybe G&A was down and brand building was up? But can you just comment on that because the numbers I am looking at seem to indicate that as a percentage of sales brand building was flat. And if you can just explain there. I think most of that goes on the SG&A line except for the inserts that go on the cost of sales line. But please expand on that. I am just trying to understand. And also related to brand building, how much of that would you say is discretionary, and how much is more the market forcing you to spend more on advertising. Some other companies may opt to be more aggressive on pricing. You have a different strategy but that means you have to spend more on advertising. So it's not that we should give you kudos for spending more on brand building and investing for the long term as it's just what the market is demanding you do given your strategy.
I will take the first part of your question. When you look at SG&A, we have a continual focus here on optimizing our overhead area. And as you remember, last year we had a couple large cost savings projects to help on that line item. Those types of savings in our overhead area through SAP implementation, through the restructuring that we did in Europe are basically funding a lot our brand building and that's what we look to do going in the future.
On discretionary spending, it is discretionary. It’s brand building; it is not price-based. So we are talking about support behind innovation. We are talking about incremental advertising either new campaigns, new ideas that we are talking to consumers about it. We are talking about value-added promotions as far as inserts and on-packs. We are not talking about price-based activity. So it isn't driven by so much a competitive demand which typically reflects itself in tactical activity. It is very strategic in nature. We said in the second quarter given the strength of the business, we had a lot of innovation in Q3 and a lot of opportunities to increase our brand building. We took that opportunity, which we believe is absolutely right, to drive our brands to grow our top-line growth, which I think is reflected in the third quarter. And we want to continue doing that forward because in our view it is working.
Great. If you can expand on those two markets. You mentioned you were facing more competitive pressures than expected, I assume one of them was Europe?
One of them was the UK in particular, where there was a lot of buy-one-get-one activity, a lot of tactical activity going on. Which I can also tell you does appear to have calmed down a little bit although it is always relatively aggressive there. And that was probably the key market. I mean all the markets in which we compete around the world are competitive by nature, especially the larger ones but that's ongoing.
Jeff so you are saying $0.05 to $0.06 in charges for '06 but most likely to be increased by $0.15 and pretty similar to what you did in '05 the way you gave guidance. But as you increase those charges does that mean that your GAAP guidance would change or you would just absorb the higher $0.10 in charges?
Yes. We have identified $0.05 to $0.06 going into next year. We have included in our guidance the assumption of using the full $0.15.
I would just like to expand on our confidence in our business model, that included in our guidance is not only the $0.15 of similar upfront cost activity that we had last year included in the guidance of '06, but also brand building at a rate greater than our sales growth. And we are absorbing that into the business. So we see the funding of this as real positive.
Yes. We are working through that process right now, Pablo and evaluating and identifying those projects.
Thank you. Our next question comes from Linda Donnelly with Franklin Management.
I believe you mentioned earlier that you are expecting capital expenditures for '06 of 4 % of sales. What do you anticipate it being for '05?
Right now year-to-date we are about 2.8%, slightly below the 3% target. We do see that increasing in the fourth quarter. We will probably be closer to 3.5% by the end of the year. And for next year, our guidance is, really due to capacity constraints that we have across the businesses across lots of our different businesses, to increase that to 4%. But it's really driven from a capacity standpoint.
Thank you. We will take our next question from Todd Duvick with Banc of America Securities.
I wanted to check and see if you could expound a little bit on your strategy for free cash flow use. You are obviously increasing your share repurchase authorization both for this year and then looking into next year. Also, I guess you said that in the short term, debt is going to increase partly as a function of the share repurchase activity. Can you tell me, going forward, what your priorities for free cash flow are going to be? If you expect debt to continue to decline in 2006? And how that may jibe with your strategy for improving your credit rating.
At the end of the second quarter, as we talked a little bit on the conference call, that we were going through this process of evaluating the different alternatives of our cash flow, and there's certainly the share repurchase and increasing that is part of that result. We think that that's certainly a great avenue for our cash flow. The other one is we are doing some benefit funding here in the fourth quarter, which helps us for next year. And when we talk about the $0.03 to $0.07 of benefit increase next year, that’s with the assumption of doing this funding – so you can see how big those cost increases are.
The other important avenue, when we look at cash flow, is having available debt capacity for the Company. That if there is an acquisition that comes up that is makes a lot of sense and is a good fit for the Company, that we can transact that without any problem. So that's the other third part that we looked at. So going forward, certainly in the short-term, debt will certainly not go down in the fourth quarter. We do see it stabilizing essentially where it is at the end of this year for next year, but our long-term commitment is to continue to look at reducing debt, look at net debt which is debt less cash, and try to bring that down over the long term.
Thank you. Next we will take a question from Terry Bivens with Bear Stearns.
Just on the cereal category, one question I guess with two parts. Could you give us the category growth that you saw in the quarter? And also, it looks as though there is some suggestion that maybe private label is taking their price up a little bit. If you could talk a little bit about the pricing environment in U.S. cereal as well.
Sure. The IRI data said the category was down 0.2. When you reflect non-measured channels, we believe the category grew between 2 and 3% for the quarter. And on your question specifically regarding private label, it does appear in the third quarter that their average price per pound is up about 1.5%. And it was down through the first half. That's in the IRI data.
Okay. And if you could give us a breakdown, if you would, David, on the volume price on that 11% sales increase in North American cereal.
If you look at the IRI data for Kellogg reported was 1.5%. Non-measured channels, Terry, you can use 3% to 5%. It always falls somewhere in that 3 to 5 range. Year-ago we had the price increase. We typically protect price increase promotions. So year-ago trade expenditure, based on the price increase promotions was higher, so this year it was lower by 1% or 2%. And actually in the third quarter of this year our trade and coupon spend was also down 1% or 2% versus year-ago. So that's broadly it. We have reconciled it back as we typically do. The biggest swing clearly is in non-measured channels in the 3% to 5% range. But a very good quarter for us, and we are very, very pleased. Our base sales were up, as you know, and while our incremental was slightly down, we had a very strong quarter in innovation and brand building.
Thank you. Our next question comes from David Adelman with Morgan Stanley.
I would like to get a better understanding of what is happening with your gross margins. If you step back, I think they were up 110 basis points Q2, granted that was particularly strong. Now they are down 90 basis points. How does that break down based on what is happening on the margin between higher fuel and energy costs versus the competitive dynamics in a couple of markets that you had referenced?
Yes, we are down about 90 in the quarter; we are up about 30 basis points year-to- date, so slightly below our target of 50. But energy and fuel has been a component now. The increase in the quarter is quite large. We do have cost savings projects that help mitigate and bring that down, but certainly if we didn't have the energy fuel increases, that would have probably contribute about 1/3 of that 90 basis points. The other thing that you have to see is that on our cost savings initiatives there was about $0.01 more in up-front costs this quarter versus last year. So that has a contributing effect also, that's probably 1/3 of it also. And then the rest is the competitive environment we see in Europe.
And the $0.12 to $0.13 number you flagged for fuel and energy for the year, what would that have been coming into the second quarter? Because that's not a number you've shared with us before. How much has that comp gone up over the last couple of months in your forecasting?
I haven't got the exact number but I would expect, David, it would have been probably half than that, maybe slightly less than that. You look at the price of natural gas today versus where it was six to nine months ago, it's jumped incredibly high, as have packaging and energy-based costs gone up across the board, as well as the price of diesel remaining extremely high. And our forecast is that all those things are starting to come through. So it would have been significantly less than half, I guess. But I can't give you an exact number because we didn't work it out on a quarter-by-quarter basis.
Thank you. Our next question comes from Jon Feeney with Wachovia.
In the spirit of one question here, looking at your decision to expand capacity here, I am not quite sure, David, I understood your response to Terry's question about the split between volume and pricing in cereal. If you could clarify that in the midst of answering this question. You've put that off capacity expansion to a great extent, and a great part of volume-to-value has been over the past few years, taking the pricing to avoid having to break ground on new facilities in a category that is growing between 2 and 3% in the U.S. First, are you expanding capacity in cereal? And secondly, could you just get a little bit more granular about what the current pricing environment is as far as price mix's contribution to the 11% growth in North American cereal?
Yes, we are expanding capacity in cereal. Some of it is driven by mix, where our capacity in certain product lines which have grown extremely fast over the last year or two has meant that we just don't have the capacity to service those and maintain the service levels that our trading partners expect of us. So some of it is forced through that. If you look at volume-to-value, we continue to grow price mix but volume is also up, which we believe is a very positive thing. And across the board, as we look at the categories in the future and our current capacity constraints across some of the products we are seeing grow pretty fast now, it is clear that we need to make this very high return investment in CapEx.
Also, Jon, when you look at capital allocation within the Company, these types of projects have the highest internal rate of return, and it gives us a stronger sustainable cash flow in the future with these types of investments.
David, I am sorry, is that the most granularity you can provide on price mix?
If you look at volume and sales, volume was slightly over half of the sales for the third quarter, about 60% in North America.
Thank you. Our next question comes from David Palmer with UBS.
I want to ask this in a very general way. You highlighted energy and benefit costs this morning. This isn't the first time we've heard of these pressures from different companies. And you broke it out in pennies – it looks like 9 percentage points or so hit EPS growth in both '05 and '06 from these things. And it appears that every major supplier to the grocery channel has been or plans to in the near future retailer customers for a significant price increase, and not just on list, but promoted prices. Because of the significant price pressure and the fact that it has lasted for several years now, do you see price increases as generally being – I am not talking about Kellogg's – generally being more readily accepted in the future?
I think all I will do is respond on what we are seeing affect our business. But, as you have heard already, we don't comment on what pricing activity we may or may not take ourselves. I think most companies are feeling the cost pressures we are feeling. It certainly has come faster and heavier than we predicted, even 3 to 6 months ago. And even though we are doing a projection now for '06, it could swing, because energy and fuel costs are very volatile. We believe the numbers we have given you are a pretty good reflection of where we think '06 is going to end up. And we are seeing a lot of our supplies of raw materials actually come through because of the incremental freight that they are having to bear in their P&Ls as well.
A theme that we have tried to communicate here is that the way the way the Company has been managed over the last several years around sustainability and around realistic goals is really serving us well as we come into this area of some unpredictability relative to these input costs. So our confidence in delivering dependable growth to our shareholders is really what we are feeling very strong and very positive about despite these pressures.
Our next question comes from Chris Growe with AG Edwards.
One point I wanted to clarify and that's on the commodity cost for 2006. I think you said $0.13 to $0.16, something like that. You mentioned that cost savings or efficiencies would overcome that. So should we assume it is mostly from the upfront cost programs, that the savings from those programs are roughly $0.13 to $0.16 for the coming year. Is that a reasonable estimate for next year?
Yes, Chris, when you look at that on-cost, it’s not only commodities but it is also benefits. But, yes, we are getting benefits from those prior cost initiatives, and we are also working on having more cost initiatives for next year. But, yes, that's part of the model that Jim was explaining. We feel good about the guidance because we do have these types of projects that are offsetting those types of costs.
Chris, just to expand on my earlier comments. If you look at the shape of '06 and what we are laying out, our guidance is exactly the same story we've been on and the same performance levels we have been on for four years. Our strategy continues to be around growing the cereal business, expanding snacks business and looking for close-end selected growth opportunities. We are absorbing significant costs both in a benefit area and in the commodity area and while we are doing that we are still funding our brand building at a rate greater than net sales growth. We are funding up-front cost initiatives in that guidance of $0.15. And as Dave and I have gone around our world looking at plans for next year – the quality of the ideas and the investment opportunities – we feel very good about. And as Jeff pointed out, we have got the financial flexibility within this overall package of how we look at 2006 that if something comes up that we are interested in from an acquisition standpoint we have the financial flexibility to get it.
Okay. Along those lines, Jim, as we are looking at 2006 guidance in my model – if you assume that commodity costs are overcome by efficiency initiatives, and we'll hope that to be true, and you have flat up-front costs year-over-year, it does imply more of a reliance on more sort of one-time items like the lower tax rate, the increase in the share repurchase authorization and activity hopefully coming through. Is the missing link then, really, the brand building? I guess it could be substantial, no doubt, but it's been up so substantially now the last four or five years. Is that sort of the missing link for the guidance next year?
I am not sure if it is the missing link, Chris. Our brand-building initiative will continue to go up at a rate greater than sales. But we are always working to cut costs. And that's an ongoing program, not only from those cost savings initiatives we have executed in the past. It is our ongoing programs to help reduce costs.
And, Chris, our ongoing operating profit guidance for next year is consistent with what our long-term target is.
I think the only other thing, Chris, is because we have a lot of cost-saving initiatives we will be able to offset some of those costs. At this stage, we are working to find more, but that is a fairly significant jump in 2006 commodity, energy, and fuel-based costs. I think, to Jim’s point, that even with that we are pretty much on guidance for where we have been the last four years.
Let's take one more question and we will wrap it up, please.
Thank you, we will take our final question from Eric Katzman from Deutsche Bank.
This kind of follows up on some of the questions that have been asked earlier. Maybe this is more of a statement and you will react to it. It seems to me that we are seeing a bit of a change here. Price mix is, since when Carlos took over and put on the Volume to Value strategy and the Manage For Cash, price mix has been a significant contributor every quarter. This quarter it was the lowest it's been in years. capex is moving up as a percentage of sales, and that has historically been kept low along with the working capital. So I guess there are a few things. One is, is ROIC likely to flatten out? And if these capex projects are such high-return projects, why would you – I mean it seems to me if they are such high-end projects because you have such momentum in cereal and snacks, wouldn't you scale back on the lower return projects which I assume are the cost savings projects that you have been tackling over the last few years? It seems to me that there is a bit of a change going on here, and that's what the stock is reacting to today, which is down significantly.
Well, first of all, Eric, I would say that our level of capex, even as you think about it moving up as we have indicated, is still – relative to the industry – a very strong position to be in. And so keep that in mind, and keep in mind that our commitment to running this business against realistic targets for sustainability is what we are going to continue to drive into the business as we move forward, and that's what you are seeing.
Yes. I would also add, if you look at volume-to-value in principle, you have seen the wheel, you know the component parts, nothing has changed. The fact that volume grows, I would have thought that would have been a net positive. We are still driving price mix, the combination of the two has really helped us. And we continue to drive innovation and brand building, which is all part of volume-to-value. So I don't think really much has changed, to be frank.
Yes, but Dave, if you go back in the last few years, you emphasized price mix and not volume, and the idea was that you had such low capacity utilization that that price mix benefit really just fell to the bottom line so strongly. But now it’s kind of more volume-related so you have to add in relatively high cost capex. Unless you're willing to kind of go on record and say, well, the incremental capex has, I don't know, a 30 or 40% ROI versus what would be a typical project like on-cost savings which I think you said has got to be 20.
Yes, I think, Eric, going from around 3% to 4%. I think the industry average is 4 or greater, so it's not a huge move. And we have seen growth in some areas where we had limited capital. And therefore, we have got to add it. Our job is to actually service what consumers want. If they want things where we don't have capacity, we are going to add it. As we look at our mix at the moment that's happening on a couple of brands. Those returns are going to be great for us, and it hasn't taken a capex above the industry norm.
And, Jeff, does that translate into ROIC being kind of flat in '06 or even down if you boost capex by so much?
No, Eric, on the return on invested capital, we still see it moving up because simply on the share repurchase activity that we are doing, we feel we will be in a strong position. Also by reducing some of our cash on the balance sheet, we'll also be helping us in the future on that.
Thank you. That does conclude the question-and-answer session today. Mr. Burton, I would like to turn the conference back over to you for any additional or closing remarks.
We would just like to thank everybody for tuning in and we will talk to you all later.
Thank you. That concludes today’s conference. Thank you for your participation. You may now disconnect.