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Executives

Chris Jakubik - Vice President Investor Relations

Irene Rosenfeld - Chairman and CEO

Tim McLevish - Chief Financial Officer

Analysts

Chris Growe - Stifel Nicolaus

Christine Mccracken – Cleveland Research

Todd Duvick - Bank of America

Eric Serotta - Merrill Lynch

Pablo Zuanic - J. P. Morgan

Alexia Howard - Sanford Bernstein

Jonathan Feeney - Wachovia

David Palmer – UBS

Robert Moscow - Credit Suisse

Terry Bivens - Bear Stearns

Andrew Lazar - Lehman Brothers

Eric Katzman - Deutsche Bank

David Driscoll – Citi Investment Research

Kraft Foods Inc. (KFT) Q1 2008 Earnings Call April 30, 2008 8:00 AM ET

Operator

Good day and welcome to the Kraft Foods First Quarter 2008 Earnings Conference Call. (Operator Instructions) I’d now like to turn the call over to Mr. Chris Jakubik, Vice President Investor Relations for Kraft.

Chris Jakubik

Good morning, and thanks for joining us on our conference call. I'm Chris Jakubik, Vice President of Investor Relations. With me are Irene Rosenfeld, our Chairman and CEO, and Tim McLevish, our Chief Financial Officer.

Our earnings release was sent our earlier today and is available on our web site, Kraft.com. Also available on our web site are slides that we will refer to during our opening comments. As you know, during this call we may make forward looking statements about the company's performance. These statements are based on how we see things today so they contain an element of uncertainty. Actual results may differ materially due to risks and uncertainties. Please refer to the cautionary statements and risk factors contained in the company's 10-K and 10-Q filings for a more detailed explanation of the inherent limitations in such forward looking statements.

Some of today's prepared remarks will exclude those items that affect comparability. These excluded items are captured in our GAAP to non-GAAP reconciliation within our news release, and they are also available on our web site. Also, please refer to the Form 8-K that we filed on April 11th for a discussion of the changes we’ve made to our reportable business segment.

We’ll begin the call with Irene providing her perspective on our first quarter and outlook for 2008. Then Tim will highlight our financials and review the results for each of our business segments. After that we'll take your questions. With that, I'll hand it off to Irene.

Irene Rosenfeld

Good morning everyone. In February, at CAGNY I said that our turnaround plan would allow us to deal with the near term input costs environment while continuing to lay the foundation for reliable long term growth. Our first quarter results represent further tangible evidence that we’re on track. Our brands got stronger, our market share increased, our investments continue to pay off, and our margins improved sequentially from the fourth quarter. As a result, I’m even more confident that we will deliver our 2008 EPS commitments.

In terms of brand strength we said that in 2008 our growing brand equity would enable greater pricing power and it has. In the first quarter pricing contributed more than four points of revenue growth versus only two points in the fourth quarter and one point six points for all of 2007. As the year unfolds we expect the pricing component of our organic growth to increase further as we take additional pricing actions across our categories to cover rising input costs.

As a result, we’ve raised our guidance for 2008 organic revenue growth to at least 5% from at least 4%. More importantly we continue to gain market share in categories where we have increased prices which is a testament to the improved strength of our brands. On a 13 week basis we saw continued progress with 56% of our business growing or holding share. That’s up from 50% in Q4. Indeed our ability to increase prices and gain market share is proof positive that our investments are paying off.

In the past I’ve talked about the impact of our investments in quality, innovation, and marketing on the improved share performance of key products. These include Oscar Mayer Deli Fresh Cold Cuts, DiGiorno Pizza, Kraft Mac & Cheese, Jell-O, Oreo, Milka Chocolate, and Jacobs Coffee. I’m delighted to add some new businesses to that list. In Q1 our quality and marketing investments to restage Maxwell House led to our first quarterly market share gains in mainstream coffee in more than two years.

In Process Cheese the introduction of Single Select helped to turn around our market share. Planters gained share in Snack Nuts fueled by more effective marketing and a higher level of support. Going forward we’ll continue to invest behind key brands and as the year progresses we expect to add two other large US businesses Pourable Salad Dressings and Crackers to our list of categories gaining share. When this happens we will have invested to improve the performance of our largest North American businesses and set the stage for the portfolio to deliver reliable, profitable growth.

In addition to our strong share performance our Biscuit acquisition from Danone is paying off as well. The integration is on track, financial performance is on plan. We’re successfully launching new better for you products like Petit Dejuener with active yogurt cultures and we’ve expanded Oreo distribution into Greece and the UK which will act as a spring board to launch our broader biscuit portfolio in those markets later in the year.

As a result we are even more confident that Biscuits will be a significant platform for the future growth and profitability of our international business. Overall our top line and market share trends are strong and getting stronger and that brings me to margin. In January we told you that our margins would improve sequentially from Q4 and they have. In Q1 we did a much better job of covering higher input costs through pricing and productivity.

Gross margin improved sequentially from Q4 from 31.2% to 33.7%. Operating margin improved sequentially as well highlighted by a solid rebound in our US Cheese margin which was up 6 percentage points to 13%. We also said that our first half margin and earnings comparisons with the prior year would be difficult and they were. That’s because the full effect of our price increases lagged higher input costs particularly in the EU and in our Cheese and our Snacks businesses in the US.

Going forward while year over year comparisons will remain difficult in Q2 we expect further sequential improvement in both gross and operating income margins. That’s because price increases and productivity improvements will fully cover commodity costs. We’ll drive further gains from a more efficient cost structure. Most importantly we expect improved margins to be driven by sequential gains in the hardest hit businesses, the EU, US Cheese and US Snacks.

In sum, I’m encouraged that in the first quarter we saw further evidence that our turn around plan is working. It’s offsetting near term input cost increases while continuing to lay the foundation for reliable long term growth. As we enter Q2 we have taken and will be taking additional pricing actions to offset continued increases in input costs. Consequently volume comparisons will remain difficult and possibly worsen but we expect to see continued strong revenue growth.

The combination of four things; improved price realization, better manufacturing productivity, increased investments in marketing and innovation, and overhead cost leverage will ensure delivery of our 2008 financial targets. Now I’ll turn the call over to Tim.

Tim McLevish

Before I begin please keep in mind that unless otherwise noted my comments will exclude items affecting comparability that were highlighted in our press release. I’ll start by picking up on Irene’s comments that our business fundamentals are strengthening despite this challenging input cost environment. We’re getting better price realization and will improve further. Our investments are paying off and while our near term volumes may soften in a number of businesses we have seen and expect to see further sequential improvement in our profit margin.

Now let’s look at Q1 results starting with revenues. Our Q1 net revenues increased 8% on an organic basis. Net pricing made a larger contribution as we began to recover a greater portion of input cost increases. It was up 4.3 percentage points versus 2% in Q4 last year, as the impact of pricing taken over the past six months is realized. Despite significant pricing we are encouraged by our overall volume performance as it reflects our investments in quality, innovation, and marketing.

In Q1 this is particularly true in key businesses like Convenient Meals, Mainstream Coffee, and Mac & Cheese. However, as anticipated our first quarter volume comparisons were difficult. This is particularly evident in Ready to Drive Beverages, Cheese, and our Dressings and Enhancers businesses, as we significantly raised prices to offset cost inflation.

Looking forward, in the near term price increases will continue to drive revenue growth and volume comparison will remain difficult. However, we have a strong pipeline of innovations and investments that should translate into improving volume performance in the second half of the year.

Turning to margin performance, our gross margin was down 190 basis points versus Q1 last year, however it was up 250 basis points over Q4 as the effects of improved pricing realization began to show. As our price realization improves further and productivity gains continue we expect to see sequential improvement in our gross margin in Q2. Below gross margin our cost reduction programs drove lower overhead as a percentage of sales.

Looking forward we anticipate that operating income margins will improve from first quarter levels. We will continue to invest in our growth; we expect A&C will be up double digits in 2008. As a result, while Q2 operating margin and earnings comparisons versus the prior year will again be under pressure they will continue to improve sequentially.

Now I’d like to spend a few minutes on input costs and the magnitude of increases we’re facing in 2008. This chart shows commodity prices in each year versus the 10 year average for each of our 11 largest commodity inputs. Comparison numbers as recently as January you can see that the prices of many commodities have increased further.

To put this in context for Kraft, for the quarter our input costs were up about $460 million over last year. We now expect them to be up almost $1.7 billion or about 12% for the year. That’s higher than we anticipated in January and greater than the $1.3 billion increase we saw in 2007. Because of this we have taken and are taking additional pricing actions.

This pricing together with further overhead leverage will deliver operating margin expansion in 2008 although more modestly than we had originally anticipated. Said another way, we expect our actions to deliver our expected earnings dollars but there will be greater pressure on margins as we take additional pricing actions to cover these costs.

Turning to Q1 earnings per share, having discussed the contribution from operations already just a few comments on what happened below the line. Higher interest expense was a $0.06 headwind versus the prior year. This is partially offset by $0.03 from lower shares outstanding and $0.01 from a lower tax rate. Our effective tax rate excluding items was 30.4% in the quarter. This is lower than our full year rate due to the timing of several discrete items. We continue to expect an average rate of 33.5% for all of 2008 with some variation quarter to quarter depending upon when the anticipated discrete items fall.

I’ll now take a few minutes to share some highlights of our business segments. I’ll start with US Beverages where organic net revenues grew 2.4%. Two factors drove revenue results in the quarter. The first is coffee where investments to restage the business are paying off nicely. Maxwell House volume grew double digits and we gained share in the mainstream segment for the first time in many years. Also our new Starbucks branded tea disk drove strong double digit revenue growth of our Tassimo platform.

The second big factor in the quarter was our Ready to Drink Beverage business. In Q1 we significantly reduced trade spending on Capri Sun to cover higher input costs. We accomplished our goal and profitability improved while revenue declined in the mid single digit range as we had anticipated. However, I would note that the effect of this action on our volume and product mix was amplified. Amplified because our volume metric is pound based and the fact that a Ready to Drink product is six times heavier per revenue dollar than the rest of our US portfolio.

As a result our Ready to Drink Beverages literally weighed in the volume performance of the entire US Beverage business due to the tune of about 17 percentage points. Excluding Ready to Drink our Beverage volume was up more than 4%. At the same time the volume impact was largely offset by an upgrade to product mix for the Beverage segment. While this will remain a feature in our second quarter results we expect the impact to be less pronounced. That’s because we back stopped the pricing with a reformulated product containing 25% less sugar and a new advertising campaign.

At the profit line Beverages operating income grew 7% and margin increased 140 basis points. Here the benefits from our improved price realization particularly in Ready to Drink Beverages more than offset higher input costs.

In US Cheese organic net revenues were up 8.8% due entirely to price increases in response to higher dairy costs. Compared to a year ago these prices are up 6% to 25% across our Cheese segments with the largest in Natural Cheese. Overall volume mix in Cheese was flat versus the prior year. Innovations such as LiveActive and Single Select continue to drive solid mix improvement however this was offset by volume weakness particularly in Natural Cheese as consumers adjust to higher absolute price points.

Going forward solid revenue growth will continue. In February and March we announced further pricing actions covering two thirds of the business. We expect this pricing will continue to pressure volume comparisons in the near term. However, our innovation activity will accelerate. We’ll see the full roll out of Bagel-fuls cream cheese filled bagels, the launch of our 2% RBSP Free Cheese products and in June the national expansion of our Deli Fresh Natural Cheese Slices.

Turning to operating income margin it was down 5.5 percentage points versus Q1 2007. Price increases were more than offset by record high commodity costs and the strong double digit increase in marketing. However, consistent with our guidance in January our Cheese margin was up significantly 6 percentage points versus Q4 of 2007. As gains from innovation and price realization continue we expect further sequential improvement in operating margins and market share as the year unfolds.

Moving on to US Convenient Meals, our team delivered another quarter of strong performance. Our investments in quality, base marketing support and new products drove 7.5% organic revenue growth with 5.6 points due to volume and mix gains. In Oscar Mayer the strength of our Deli Fresh Cold Cuts platform continued with strong double digit revenue growth and about 2 points of share gain in the overall Cold Cuts category.

In late Q1 we built on our success by rolling out the new Deli Shaved Singles, Deli Carved and Family Size Packs. Revenue from our Deli Creations Sandwiches more than doubled from Q1 2007. This was driven by our new Flat Breads line which is proving to be highly incremental to our base business. Finally, Pizza continued its double digit organic growth not only from our premium DiGiorno Ultimate and California Pizza Kitchen offerings but also from our base DiGiorno and Tombstone brands as we’ve invested to improve quality.

This drove more than 2 points of market share gain in frozen pizza during the quarter. At the operating income line margin was down 60 basis points versus prior year but up 250 basis points from Q4. As we move forward we expect our year over year margin performance to improve as well.

On to US Grocery where organic net revenues were up 1.4% and operating income margin grew 30 basis points. Here our investments to contemporize the portfolio are beginning to pay off. For instance, two of our early investments, Jell-O and Mac & Cheese delivered a combination of pricing, market share gains and higher operating income margins in the quarter. More specifically despite significant price increases our Mac & Cheese cups are driving meaningful volume growth and mix gains.

These gains were partially offset by declines in other parts of the business including Ready to Eat Deserts, Barbeque Sauce and Pourable Salad Dressings. It will take time to turn the entire Grocery portfolio but the high margins and strong cash flow of these businesses will lead a substantial benefit. In particular, we’ve begun the process of restaging our Pourable Salad Dressings business. By the end of March we were fully national with our new line of Kraft Pure Salad Dressings with no additional artificial preservatives supported by incremental marketing.

While it’s too early to claim victory we’re encouraged by the fact that our March market share grew for the first time in a very long time. In the second quarter more of our investments will hit the market. As these gain traction we expect to see improved year over year performance in the second half of the year.

Looking at US Snack & Cereals, performance was very much a mixed bag. Organic net revenues were up 2.7% in Q1. Biscuits showed solid build mid single digit gains but these were partially offset by a decline in Snack Bars. In Biscuits 100 calorie packs were up strong double digits again as the momentum of that platform continues. Our Oreo franchise demonstrated solid growth behind improved marketing, the roll out of our proprietary snack and seal packaging and the continued success of the Cakesters platform.

Ritz delivered strong growth resulting from investments in product quality and marketing. On the other hand our Snacks Bars business was down in the quarter this is mainly due to a lack of new product news as well as our decision to rationalize SKUs. At the operating income line margin eroded 4 percentage points this was due to escalating commodity costs particularly wheat that were only partially offset by price realization and productivity during the quarter.

Coming into the year we expected soft margins in the first quarter that’s because we made a conscious decision to reduce trade activity in Biscuits instead of increasing list prices to improve the long term health of that business. The benefits of this change in trade strategy are more back end weighted and will unfold over the course of the year. At the same time during the quarter commodity costs particularly wheat increased more than anticipated.

Since then we’ve announced an 8% list price increase effective this week. Going forward the benefits of this latest price increase will combine with the impact of our trade efficiency efforts. We’ll continue to invest in innovation and base brand support. As a result we expect sequentially improving operating margins for the remainder of the year.

Finally I would note that our Cereal business grew both at its top line and operating margins in the quarter. This reflected continued improvement in the kid’s cereal business as well as February price increase. As grain costs have risen further we recently noticed another price increase that takes effect in May. We remain on track to complete the transaction to exit our Post Cereal business in mid 2008.

Turning to Canada & North America Foodservice, organic revenue growth was up strongly 6.4% versus last year. In Canada solid Q1 organic growth was driven by strong category and share growth, increased investment in marketing innovation across all categories, and the implementation of improved customer plans as we leveraged our scale with the reestablishment of Canada as a stand alone business.

In North America Foodservice, high single digit growth came from a combination of strong customer response to quality improvements and innovation, and to a lesser extent customer buy ins ahead of price increases. At the operating income line margins were up 200 basis points as pricing, manufacturing efficiencies, and overhead costs leverage more than offset higher input costs.

Going forward both Canada and Foodservice will be executing price increases to cover significant commodity cost increases. While volumes may soften in the near term given the base business gains from marketing and innovation we expect further margin improvement in the second quarter.

Now I’ll turn to our International business which now represents 40% of our total. We continue to post solid organic growth as we focus our investments on our core brands. In the EU this resulted in 9.5% organic revenue growth marking the third consecutive quarter of solid volume and mix gains. We delivered double digit growth in Chocolate from investments in Milka, Toblerone, and Cote d’Or. Cheese also grew double digits from improved marketing behind Philadelphia. Coffee demonstrated solid organic growth again behind gains from Jacobs and Tassimo.

At the profit line, as we anticipated EU operating margins declined 50 basis points as pricing lagged input cost increases with only a partial offset from overhead leverage. As our price realization improves in Q2 we expect sequential improvement in our EU margins from Q1 levels. As I already mentioned the integration of the LU Biscuit business is on track and it will enhance our EU margins over the course of 2008.

In Developing Markets organic growth of more than 21% was driven by volume and mix gains of more than 12%. Our focus on investments in core categories, brands and markets has continued to pay off. Q1 growth was driven by Jacobs Coffee, Milka Chocolate and Kraft Cheese in our EEMA region. Further gains in biscuit and confectionary in Latin America, as well as consumption and distribution gains in our Asia/Pacific region particularly in China.

At the operating income line margin was up 90 basis points, this resulted from a combination of strong top line growth and the acquisition of the biscuit business and it more than offset higher input costs and investments in marketing and distribution infrastructure. Looking forward, while organic revenue growth may not remain as high as consumer adjust to higher prices our profit margins should remain stable.

Finally, before we take your questions, a few notes on cash flow. Capital expenditures were $271 million in Q1 up from $180 million in Q1 last year but on a pace to spend just over 3% of net revenues for the year. I would also note that we continue to make solid progress in our working capital program despite the rise in input costs. Our numbers on Cash Conversion Cycle were further enhanced by our newly acquired international biscuit business.

To summarize, we’ve had an excellent start to 2008. We remain confident that our strengthening brand equity, our investment and costs reductions will maintain our operating momentum, increase margins and deliver at least $1.90 of EPS (ex items) in 2008. That’s all for opening remarks, now we’ll be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Chris Growe - Stifel Nicolaus.

Chris Growe - Stifel Nicolaus

I just had a couple questions for you. The first one I wanted to maybe get into a little bit perhaps for Irene is in this quarter you had a very strong product mix benefit coming through and obviously some very strong pricing as well. Obviously I guess because the margins were a little weaker particularly in North America that did not fully overcome the input cost pressures. I thought the mix benefit would have been more beneficial to your earnings. Do you have a broad statement about that? Can we expect this level of mix improvement throughout the year?

Irene Rosenfeld

Overall Q1 was generally in line with our expectations. As we had said in January we knew that the first half was going to be difficult because of the timing of a number of our pricing actions as well as the fact that costs continue to escalate on a couple of core items. I would tell you that we needed to price protect a number of key franchises that were relevant to the Super Bowl like Pizza, Biscuits and Easter, Coffee and Cheese for example. As a result that’s part of why we didn’t see as much of the flow through of our pricing actions in Q1.

We will see, as we’ve said sequential improvement as the year progresses. For the full year we expect to fully recover input cost or a combination of pricing and productivity.

Chris Growe - Stifel Nicolaus

Was there much of an Easter benefit to sales or volume in the quarter? Is that something you can quantify?

Irene Rosenfeld

It’s not significant enough for us to quantify.

Chris Growe - Stifel Nicolaus

The last question, relative to your volumes in the US they were weaker than I expected. I know there is that one business really dragging it down. As we look through the year especially this first quarter, I expected that to be a little better given your promotional programs were a little heavier. You talked about cutting back on promotion throughout 2008, I think it was $200 million the number you gave. Is that still something you expect to do, could we see that adjust a little bit based on some weakness in volume we saw like in North America?

Irene Rosenfeld

Let me clarify the issue on volume. As Tim mentioned the Ready to Drink business where we made a very concerted decision to reduce our trade spending and get our feature prices higher on that business in response to the escalating input costs. That business weighed quite dramatically not only on Beverages but on North America and in turn on total Kraft. The organic volume that we reported was essentially flat, ex Ready to Drink it would have been up about 2.5%.

Net net we actually felt reasonably good with the volume performance in the first quarter. We are through, as part of our effort to increase prices we will see higher promotional price points throughout the year. Most importantly I feel much more confident given the investments that we have made in brand strength that we will be able to deliver volume mix improvement sequentially over time despite the fact that we’ve taken these increases.

Operator

Your next question comes from Christine Mccracken – Cleveland Research.

Christine Mccracken – Cleveland Research

When I look at your commodity costs obviously you’re facing a very inflationary environment and you’re taking pricing to offset that. When you have very volatile commodity there’s swings in commodity prices like you’ve seen in cheese and a number of other areas how do you constantly readjust pricing and how does the retailer react to that? Is it that you stick pricing or is it that you’re forced to go back and reevaluate the pricing strategy?

Irene Rosenfeld

The first thing we are doing is getting our merchandising pricing closer to the market place and so that takes a lot of pressure off of us forecasting and over time we’ve talked a lot, particularly in Cheese about our desire to move in that direction and I think you will see that play out in the course of the year. The reality is the world is changing. I think we’re all learning how to forecast better in the current environment.

We’re pretty good on the supply side but even there we see more of the food crop being diverted to biofuel use. We are seeing some unanticipated consequences which I think is impacting pricing. In the face of it though I feel very good about the fact that we have been pricing quite aggressively to recover those costs and once again I feel good that the investments that we have made are increasing our brand strength and our ability to price. As a result we expect that we will continue to improve our margins sequentially despite the input cost situation.

Christine Mccracken – Cleveland Research

Are you seeing any demand impact as you raise prices? It seems like your portfolio is actually fairly well positioned in this environment.

Irene Rosenfeld

Our first quarter came in essentially the way we thought. We will continue to see some of these pricing actions play through in the second quarter which is why we’ve been somewhat cautionary with respect to our volume forecast for the second quarter. As the consumers adjust to these higher prices we believe that the strength of our brands and our marketing efforts will be able to allow us to continue to improve volume mix despite the pricing.

Operator

Your next question comes from Todd Duvick - Bank of America.

Todd Duvick - Bank of America

I had a couple questions for you on the International front. Specifically with respect to your Chocolate segment. Obviously the Mars and Wrigley transaction made a lot of news on Monday and I just want to know from your standpoint if you continue to consider the Chocolate business in Europe to be core to your overall business?

Irene Rosenfeld

As we said we’re continuing to evaluate our portfolio and determine the long term prospects for each of our businesses. The reality is that Mars is already a significant competitor and I feel that the strategies that we’ve got in place will enable us to compete quite effectively in the face of that new combination.

Todd Duvick - Bank of America

One follow up question. With respect to your acquisition you’ve talked a lot about the operations that you have today. Can you talk a little bit about your acquisition appetite? I think you’ve said in the past that one of the things you might consider doing were you to make a sizeable acquisition is that you’d be willing to use equity to help fund a portion of an acquisition. Can you comment on that?

Irene Rosenfeld

Let me underscore again, our plan is predicated on organic growth and with the continued improvement in our businesses, our turnaround is clearly gaining momentum and therefore I continue to be confident that we will deliver the commitments that we’ve made. We have said that we would acquire, in particular to build scale in International geographies and that will continue to be very much on our plate.

Todd Duvick - Bank of America

Can you comment about your appetite for willingness to use equity should you come up with a large acquisition opportunity?

Irene Rosenfeld

I’m not going to comment on that obviously any decisions that we would make have everything to do with circumstances.

Operator

Your next question comes from Eric Serotta - Merrill Lynch.

Eric Serotta - Merrill Lynch

I’m wondering whether you could comment on what impact the deliberate changes in your merchandising and promotional strategies for Ready to Drink beverages had on the overall Kraft consolidated mix contribution and how sustainable you expect the first quarter level of mix contribution to be for the remainder of the year.

Tim McLevish

Ready to Drink as I pointed out in my comments had a significant impact on the volume as we measure it. Ready to Drink is six times the impact for every dollar of revenue due to the weight of the product. Overall the volume in the mix impact in the Beverage business was relatively small net impact, about 2% and had a much lesser impact on the entirety of the company.

We do expect to see some of the same in Q2 although as I pointed out that will be mitigated because we have reformulated the product with 25% less sugar and we’re putting some marketing behind promoting that product and think that will mitigate some of the volume impact. We’re encouraged as we look into the second quarter.

Eric Serotta - Merrill Lynch

Do you think that a 3% to 3.5% mix contribution is sustainable for the remainder of the year or are there other factors that we’re not talking about that should cause that to either accelerate or decelerate?

Tim McLevish

We don’t want to go into the specifics. Q1 was in line with our expectations and we’ve given guidance for the full of the year. We expect to see sequential improvement in our brand strength and therefore in our pricing and out ability to pass through the cost increases and we expect to see margin increases.

Eric Serotta - Merrill Lynch

Finally, was the 4.3% total contribution from price largely in line with your expectations considering that you protected price points on some key items as mentioned? It seems like a pretty strong price number considering you were protecting price points on cheese and pizza?

Tim McLevish

Remember we saw significant price increase in the latter half of last year and into the fourth quarter and so some of the price increases we put in effect during that time as we mentioned in our fourth quarter call. The full effect of that benefited us in the quarter. That contributed to some of the pricing improvement we saw in this quarter. As commodities continue to escalate and perhaps beyond our expectation in some of the categories we put during the quarter additional pricing. Some of it we protected as Irene mentioned but overall it was generally in line with expectations.

Operator

Your next question comes from Pablo Zuanic - J. P. Morgan.

Pablo Zuanic - J. P. Morgan

A couple of questions, in the current environment with a weaker consumer do you find that it’s more difficult for people to trade up? I say that because in some of your products people are paying a premium because of the obviously increased brand equity or you are moving them to a branded premium product or in other cases they are paying extra for convenience or for better quality product. I understand that the strategy and that’s where you want to move but do you find that that strategy is more difficult to implement in the current economic environment?

Irene Rosenfeld

No, actually in fact I think we will continue to do just fine in the current environment. There will be some puts and takes but I am confident that the investments that we’ve made to strengthen our brands will help us to continue to make progress despite the higher pricing and I think although it varies by category the numbers I referred to earlier are quite encouraging to us. For the past 13 weeks 56% of our US revenue is growing share up from 50% in the fourth quarter. I think its really proof positive that we’re able to continue to grow share in the face of very aggressive pricing.

The key remains our ability to differentiate our products in the consumers eyes and to make sure that we’ve adequate support behind those businesses and as we’ve told you we are planning to invest at a double digit increase in A&C this year and that together with a very strong innovation pipeline and our base marketing efforts I’m confident will continue to allow us to grow share.

Pablo Zuanic - J. P. Morgan

Related to that would you say that compared to the past you are being now more assertive in terms of price increases compared to say private label competition. In the past I think you had lagged on Cheese, would you say across the portfolio now you’re moving quicker than the competition and if so has the competition begun catch up with your price increases or are they lagging now? Can you comment on that?

Irene Rosenfeld

I can’t speak specifically to the competition. I would say as we look across our categories the entire market has responded to the higher input costs but there is no question that we are more aggressive in pricing today as a result of the stronger brand strength that we have been able to develop because of the investments that we’ve made in quality, marketing, and innovation.

Pablo Zuanic - J. P. Morgan

Just a quick follow up. When I see a 4% price increase on your revenue base last year of $37 billion that’s about $1.4 billion just from pricing which is pretty much the number you are giving us on commodity. If you maintain a 4% increase obviously you should be able to cover the higher dollar cost increase. Is that the right way to think about that or am I missing something there?

Tim McLevish

I think that’s right. That was what we said that the additional pricing we expect will cover our commodities generally on a dollar for dollar basis. That, as you know if you think through the math of it will put some pressure on the margin improvements although we still can expect that we’re going to continue to drive and deliver margin improvement over the course of the year. It may be a little bit less than we had originally anticipated as the result of the denominator effect from that equation.

Pablo Zuanic - J. P. Morgan

I understand you can’t comment too much on M&A but just remind us Chocolate in the past you have mentioned and highlighted as a core category in your international business and I want to ask a question is that still the case. Given that your chocolate platform is mostly what I would call center the aisle overseas do you see a need to grow in the front end of the store with your chocolate platform? If that’s the case I guess we can make our own assumptions about how you could pursue that through acquisitions.

The same question would apply to the US, you Snack business is not doing well but I could make the argument that all your snacks can be sold in single serve format but your distribution in C stores at the front end of the store is more limited. I’m wondering if an acquisition would make sense in that regard to help you grow in that part of the store or that’s not a priority in terms of growing in that part of the store.

Irene Rosenfeld

A lot of hypothetical in that question. What I will tell you is that we had a very strong quarter on our Chocolate in the EU; we have been very focused on rebuilding the core equities of some of our iconic brands like Milka, Toblerone, and Cote d’Or. We are seeing progressive margin improvement on that business and as long as it continues to contribute it will be an important part of our portfolio.

Operator

Your next question comes from Alexia Howard - Sanford Bernstein.

Alexia Howard - Sanford Bernstein

A question on Europe margins in general it seems to me you’ve just bought the Danone cookies and from memory I think in 2006 the margins in that business were about 16%. Margins in Europe have been stuck in very low double digit now high single digits for quite some time. Historically there were up in the mid teens level. As I look at your peer group many of the other companies have much higher margins mid to high teen levels in Europe. Is there something structural around the portfolio that just makes it very hard to get the margins up over there? How do you see those developing over time?

Irene Rosenfeld

I don’t want to make any excuses for our performance. We are not happy with our margin performance in the EU. We had a very strong top line performance, another very strong quarter of strong volume mix gains and we are expecting to see sequential improvement in margins over the course of the year particularly as the price increases start to flow through. We needed to price protect a number of our core businesses in the first quarter.

That said we have a fairly significant business in Germany which does weigh somewhat on our overall margin performance. We are committed to increasing our EU margins over time and there’s no question that the acquisition of the LU biscuit business will be very much an enabler to that end.

Alexia Howard - Sanford Bernstein

One other as follow up on the restructuring that you implemented during the reorganization into the new independent business units to improve accountability. I guess that’s now complete, could you speak a little bit to what changes you’re seeing? What is that enabling you to do now that that new structure is put in place?

Tim McLevish

The new structure came in place beginning of this year. We have invented business units responsible for the full P&L and balance sheet as opposed to the past where we tended to be much more functionally oriented and we’re seeing that the businesses are stepping up and they’re making decisions much closer to the consumer. They have full responsibility for their brands and as I said the P&L and balance sheet we’re seeing much better decision making and we’re seeing much improvement in the decisions that are being made.

Operator

Your next question comes from Jonathan Feeney – Wachovia.

Jonathan Feeney - Wachovia

You mentioned buy in on the Foodservice side of the business having an impact. Could you possibly quantify that with a little bit more granularity?

Tim McLevish

It’s hard to say specifically how much impact there really was. There was some impact; we don’t think it’s a material amount. That’s as much specificity as I can give you.

Jonathan Feeney - Wachovia

When you look more broadly across your business, most food service and retail particularly in the United States where it seems like the commodity prices and therefore retail pricing has been much more aggressive. Has there been a change in strategy on the retailer standpoint to try to anticipate price increases by buying in and maybe seeing a little bit more carrying a little bit higher levels within inventory.

Irene Rosenfeld

We don’t allow that. We have some fairly strict policies with respect to buy in against price increases. The loading behavior of the past is really not a factor here. One of the reasons we called out the impact on our Foodservice business other pricing actions was just because we had a very strong quarter in Foodservice. I’m not sure that’s entirely indicative of the market.

I think we’re all feeling that although we haven’t been able to fully quantify the impact of the economic conditions on food away from home we’re all feeling that there is some impact and its one of the reasons we feel comfortable that as consumers eat home more often they will come home to Kraft. We purposely call that out because we do believe some of our strength in Foodservice in the first quarter was in response to the pricing actions.

Jonathan Feeney - Wachovia

You talked very consistently about your acquisition strategy for a while and I guess I just wondered now that Master Foods and Warren Buffet sort of broken the ice here does it make it more likely in your view that yourself and others will look more aggressively towards filing those deal acquisition needs maybe just because financing is good and other folks are likely to follow?

Irene Rosenfeld

I won’t speculate on any industry trends or what others may do. What I will tell you is that we are not changing how we go to market. I feel very good about the strategic direction that we’ve laid out. It is clearly our turnaround is gaining momentum, its serving us well and we’re going to stick to our game plan.

Operator

Your next question comes from David Palmer – UBS.

David Palmer – UBS

I was looking at some data recently about the number of new Kraft products that are being introduced under Kraft in general not the brand. It appears like the pace of innovation is not really accelerating. Is that something that you see too? Perhaps you can describe how you’re seeing the pace and incrementality of your innovation how has that played out and relatedly when you look at the pipeline over the next few quarters how do you see the pace and the effect in this of your innovation progressing?

Irene Rosenfeld

I feel terrific about our innovation pipeline. It’s quite full, it’s fuller than it’s been in a long time and actually we have more ideas than we are actually able to fund at the moment. What we have tried to do is to stage those innovations and make sure that they are big enough. For example Cakesters we launched the soft cake idea last year under the Oreo trademark, we just came out with a Nilla version. It’s been a tremendous item for us, in fact it’s contributed to over 3.5 point swing in the growth of the category.

We’re seeing a lot more incrementality to the ideas that we’re doing. We are working to expand them and make them bigger. For example, a number of our innovations this year are behind our 100 calorie packs which just continue to be a stand out performer. Many of the ideas when you see Deli Creations Flat Bread that may not look as innovative to you because you’ve already seen Deli Creations Sandwiches but frankly that’s the point. We have a terrific opportunity to build on the equities that we’re creating and to be able to amortize them in the marketing attachments.

David Palmer – UBS

Just to clarify, when you get more decentralized as you are, one byproduct perhaps you could get little ideas up to the top better and I would expect it to be manifest in more ideas being introduced, more products. Do you literally see more products coming to market from Kraft in the coming quarters?

Irene Rosenfeld

No, once again the value of the decentralization is to enable speed and to make sure that each of our managers is fully focused on the market place and on their competition. What I expect as a result of that is higher quality ideas, bigger ideas; I’m actually not looking for more ideas. Our whole focus over the last two years has been to narrow focus on those areas of opportunity across the company that we think had the greatest promise.

Most of our innovation is focused on health and wellness, on premium products, convenient products, and snacks. Each of our businesses is focused in those areas. Where possible we are looking for synergies on platforms that cut across. For example, we’re building our Deli Fresh Cheese launch is building on our learning and Deli Fresh Meat. Our LiveActive sticks and bars are building on the experience that we had in LiveActive Cheese. We’re trying to take some of those platforms; obviously 100 calorie packs have had an impact across a number of our categories.

Mac & Cheese crackers build on the equities that we have in our base Mac & Cheese business. We don’t expect to see a larger number of items. We do expect to see a larger contribution from a smaller set of items and I feel very comfortable that the pipeline that we’ve got can deliver on the ambitious goals that we’ve set.

David Palmer – UBS

On the wall to wall sales structure initiative how is that helping you as you get to the final stages in that roll out. How is that helping you whether it is the top line or maybe in store marketing, out of stocks or maybe it’s a cost benefit? Any specifics there and if there’s been any negatives that have come out whether it be short term from the roll out itself could you perhaps discuss that.

Irene Rosenfeld

We feel terrific about wall to wall. The roll out is now complete as we had told you it would be. Our focus continues to be on execution and training. We truly believe that better execution on wall to wall is going to help us to improve our display support, help us to reduce out of stock, get our new items to market faster. The proof of that is that we’re seeing about, since we’ve begun the initiative we’ve seen about a 1 point incremental revenue contribution. In fact its almost 180 basis points for the last eight weeks.

As our organization continues to understand what their new responsibilities are and we set the agenda in a way that is easy for them to execute we are very comfortable that this will continue to make an important contribution and give us a source of competitive advantage.

Operator

Your next question comes from Robert Moscow - Credit Suisse.

Robert Moscow - Credit Suisse

We get a lot of questions on the demand side for food and whether food at home is rising or falling and how people are reacting to higher prices. I’m curious if you have any visibility on the supply side. In this high cost environment have you seen any signs that smaller competitors or private label manufacturers co-packing manufacturers are closing up shop or feeling such an impact from the cost pressure that maybe they have to re-look at how they do their business model? Would that have a positive impact for you?

Irene Rosenfeld

I don’t think I can comment specifically on what impact this might have on smaller companies. There’s no question that we are continuing to learn, to forecast in the wake of the current environment. We believe that our scale will continue to be a competitive advantage for us both in procurement and in sales execution and one again the good news is that as a result of the investments that we’ve made in our brand we feel much more confident that we have the ability to price. As a result we will continue to expand margin.

Robert Moscow - Credit Suisse

What about on the consumer side. Have you gone to any consumer testing facilities just to hear consumers and what they’re saying about price inflation in food? There’s a journal article today that says that 5% price inflation for food is annoying but not necessarily something that causes alarm and panic. Would you characterize it that way?

Irene Rosenfeld

I think it’s fair to say that we’re certainly not seeing alarm and panic. We are definitely, as I said its not exactly quantifier we’re certainly seeing a trend in people eating away from home less and eating at home more which we believe is a positive for our business. Don’t forget the reality is there has been essentially little to no inflation in food prices for 10 years and so the reality is we’ve now introduced some pricing into the market place.

We do believe that there is going to be some short term dislocation as consumers adjust to those higher price points. Frankly I’m pleased to see at the early days on a number of our core categories we’re seeing that we’re able to continue to perform. I think our share performance in the face of some very aggressive pricing is good evidence of that reality.

Operator

Your next question comes from Terry Bivens - Bear Stearns.

Terry Bivens - Bear Stearns

A question on your Cheese business, I know there are various ways to forecast the pricing but from where we sit it looks like your Cheese cost ought to be somewhat flat in the second quarter and then be down maybe in the high single digits as we go through the remainder of the second half. My question is this, I was a little bit surprised that you took further pricing in Cheese then it occurs to me have you done what you think is calibrating your spreads to private label to ensure maximum profitability as we go through the back half in Cheese? I should ask first of all do you agree that it should be down on that order.

Irene Rosenfeld

No, we’re not providing a forecast here but what we will tell you we are feeling much better about our ability to take pricing in Cheese than we had in the past. The investments that we’ve made in innovation and marketing support are clearly playing through. As we’ve also said we are committed to improving our Cheese margins over time. We’re going to stay pretty close to the market to ensure that we are adequately getting the right relationship between pricing and costs.

Tim McLevish

We think that our gaps relative to private label are in pretty good shape. We’re finding that the private label players are following our lead in pricing.

Terry Bivens - Bear Stearns

The pricing in your mind is more response to what you see is ongoing pretty high pricing in Cheese there?

Irene Rosenfeld

That’s correct.

Operator

Your next question comes from Andrew Lazar - Lehman Brothers.

Andrew Lazar - Lehman Brothers

I know you’ve mentioned a couple times you’re trying to price closer to the cost curve in Cheese and kind of change the pricing algorithm in that business. Two follow ups there. One, how is that thought process being received by your retail partners, as it is a pretty big departure from what you’ve done as a company in the past. While that might reduce a lot of the volatility going forward that you’ve seen in the business more recently. Does it change at all the structural return of that business? Is it lower just because now you don’t have the ability to price the way you might have previously?

Irene Rosenfeld

I would tell you that the work we’re doing on Cheese is somewhat a work in process. We are looking at a number of different ideas in concert with our customers. I will tell you that they are quite receptive to the notion of there being greater transparency. One of the challenges in the category historically has been that there hasn’t been very clear transparency and I think what we’re talking about doing as we move forward will make a big different.

I think if anything what we’re talking about executing will actually help the structural returns and most importantly reduce the volatility. We see a number of positives of getting our merchandising pricing closer to the market place. I believe our customers are receptive to the idea but working through the details of exactly how we want to execute that is something that we will be doing in the course of the coming weeks and months.

Tim McLevish

We think that the new pricing strategy as we roll it out being much closer to input costs will benefit us, will enable us to get back to respectable margins and maintain them. Our customers in many respects are also our competitors in the private label arena and I think they will welcome the lead we’re taking on that. If you think about where we had been in the past we lost something on the way up and we probably gave a little on the down side. With increased volatility that’s not a good place to be.

Andrew Lazar - Lehman Brothers

In thinking about your 2008 earnings base obviously we know there will be an adjustment of magnitude once the post transaction is completed and you’ve given ranges around that. I want to make sure I’m clear, as you look to absorb your up front costs going forward starting in 2009, do you think they’ll need to be some form of adjustment to the ’08 earnings base beyond the post adjustment as you move into that new model of absorbing these costs? If so, is there any way to gauge what that might be at this stage?

Tim McLevish

I’m going to actually wait until after we announce the post divestiture and recalibrate 2008 before we give guidance. I know that’s a question that is on many people’s minds. The large majority of the heavy investment in restructuring will be behind us by the end of 2008. We do expect to continue over time to continue to drive costs out and there will be some further investment.

We’ve given an indication probably $700 million in 2008 that number should drop by probably $500 million in subsequent years on a $200 to $300 million annual spend. A fair amount of that we think we can absorb it and still deliver the 7% to 9% but we’re not at this point going to commit to exactly how we’re going to recalibrate that.

Operator

Your next question comes from Eric Katzman - Deutsche Bank.

Eric Katzman - Deutsche Bank

I’m not exactly clear as to why the EU is all of a sudden performing so much better. The fourth quarter was a real mess. You’ve said it was going to take while. Is the consumer recovering over there because it doesn’t sound like it’s necessarily that your products are where you want them to be in that region?

Irene Rosenfeld

I would say a lot of what’s happening over there is very much a result of our own efforts on our Coffee business. It’s the redeployment of some of the money that we’re spending that we had siphoned off from our base Coffee business and we’re spending on Tassimo the redeployment and the reinvestment in our core Jacobs and Carte Noir franchises. It’s the focus on our core brands Milka, Toblerone and Cote d’Or and the combination on chocolate and coffee has had some tremendous results and dramatic improvement in our top line performance.

This issue in the EU is to continue to maintain top line momentum but start to make progress on the margin front. As I’ve said we’re committed to doing that. We have a number of programs in place. We should start to see sequential improvement in our EU margins as the year progresses and again the addition of the LU Biscuit business will also enable us to improve our margins overall in that region.

Eric Katzman - Deutsche Bank

A point I missed earlier, what was the new inflation number that you gave all in for ’08?

Tim McLevish

Input cost inflation we’re look at probably as we view the market place today we’re probably talking about a 12% increase. In the first quarter we were up $460 million and we’re looking at perhaps somewhere $1.5 to $1.7 billion expected for the full year.

Eric Katzman - Deutsche Bank

As a bit of a follow up to Andrew’s question I understand that you focus on the organic revenue growth and then earnings number pre the post split or spin off but I don’t think that’s really accurate. Sales this year are going to be in total including the acquisition and currency and everything we have to factor in is that a $41 billion number, $42 billion. I guess I’d like a little bit more clarity as to what you’re thinking in terms of the other drivers for the top line that are having a significant influence on that.

Also, why not, given that you know you’re going to either split or spin that business why not give us a better picture on the bottom line as to what that means and then we can really gauge your margins as to really where it looks like its going to fall out for the year.

Tim McLevish

Our expectation is we’re coming up towards mid year when we expect to complete the transaction. At that time we’ll give a better update when we know the specific of the timing. At this point we still don’t know specifically what the timing is which would have an impact on how we report the year. Within the next couple months we should be at a point where we’ll give you better guidance on that.

Eric Katzman - Deutsche Bank

The top line?

Tim McLevish

The top line as well.

Irene Rosenfeld

We’ve been working pretty hard over the course of the last two years or so to make the necessary investments in quality, marketing support and in innovation to create sustainable growth on our top line. I think as you’re seeing from our results each of our businesses, we’ve chosen to focus on the businesses that can have the greatest impact. The businesses that we’ve invested in are in fact responding. We’re seeing it in revenue growth; we’re seeing it in market share improvement.

Clearly these investments are paying off and so we have great confidence that we will continue to deliver the kind of top line growth that we have committed to. We have taken our guidance up somewhat from at least 4 to at least 5 as we said simply because in this extraordinary pricing year without a doubt we are seeing some extraordinary impact of pricing.

Eric Katzman - Deutsche Bank

Why shouldn’t we view the new pricing mechanism so the market as opposed to an average in something like Cheese as kind of recognizing that that’s more of a commodity type of strategy. If the brand has equity shouldn’t you be able to pretty much price as you want as opposed to more or less having to react to the underlying commodity?

Irene Rosenfeld

I don’t want to react as if we’re reacting to the underlying commodity. I simply want to make sure that we are not getting left behind. You are well aware the issue that we had on our Cheese business is that we have been left behind. Our pricing strategy is designed to stay ahead of that curve and ensure that that is not a contributor to a margin decline. We are confident that as we continue to innovate, launch ideas like LiveActive, ideas like Single Select, ideas like Bagel-fuls. These products are going to continue to help us to drive both our revenue performance as well as our mix contribution.

Eric Katzman - Deutsche Bank

Is it fair to say that there’s a part of the Cheese business that is a little bit more commodity oriented and that’s going to be priced to the market as opposed to as you layer in these new value add products that you hope not to have to price those to market and more to the old way of doing it which was pricing to average?

Irene Rosenfeld

I think the key is to find those areas where we believe we can have differentiation and our focus within Cheese to your point will be on the highest margin segments. Our expectation going forward is that we can significantly improve our mix performance in Cheese by focusing on the higher margin products as well as pricing aggressively enough to recover any of the cost increases.

Operator

Your last question comes from David Driscoll – Citi Investment Research.

David Driscoll – Citi Investment Research

US Snacks and Cereal I’m surprised no one has asked any questions about this because it seems to be the most important data point in the quarter, the most surprising one to me. This division has been very consistent for many many years with very high margins. Can you comment on absolutely massive margin degradation here how does the split work between snack and cereal. Was it all cereal and so we can just forget about it because this thing is going to get sold off or was the bulk of the degradation related to the snacks portfolio.

Irene Rosenfeld

Clearly we are no pleased with the Q1 performance of our Snacks and Cereals business. There’s no two ways about it and in particular the margin performance. The profits this convention were impacted by two factors that we do expect will reverse themselves over the course of the year. The first was our conscious decision to take our initial pricing action by reducing trade. We believe that is very definitely in the long term health of the business but it does take longer to see that play through and as I mentioned we did price protect some of the Snacks businesses at Super Bowl time.

The second is we did have a very unexpected run up in wheat cost in particular which caused us some dislocation in the first quarter. We announced a pricing action on Monday, a second pricing action, and so we are confident that as we continue to invest in those franchises and we have a significant investment in A&C planned.

We’ve got a very strong innovation pipeline as I look at some of the items coming behind in terms 100 calorie packs, the Oreo Cakesters extension, some of the stuff we’re doing on Ritz all of which should lead to a sequential improvement in both the top line and the bottom line performance of our Snacks business. Let me also say quite honestly the Cereals business was not the drag on the overall performance.

We had a very strong Biscuits business performance, we felt good about our Planters business, and we saw some inventory de-loading which impacted shipments but did not hurt our share. Our Cereal business we actually were able to hold market share and we grew both top line and operating margins. That was not a drag. The biggest impact was the dislocation on the pricing front and that will correct as we move to the other quarters.

Tim McLevish

Probably half the degradation was attributable to the taking it in trade as opposed to pricing. The other half was the run up in some of the wheat cost particularly. With the pricing action and as the course of the year rolls out the benefits of the trade change will also improve our margins.

David Driscoll – Citi Investment Research

This is a surprising result and I can’t imagine that folks are going to be happy to see this particular business have these troubles. We all know the problems in Cheese and Coffee and understand the commodity side. A very branded business for you, you have number one brands all over the place, this is a tough one to swallow but I do appreciate the comments and good luck with that business.

Operator

I would like to turn the call over to Mr. Chris Jakubik for any further or closing remarks.

Chris Jakubik

Thanks everybody for joining us on the conference all. For those of you from the media who have follow up question please contact Mike Mitchell. For analysts who have follow up questions I will be around all day. Thank you and have a good day.

Operator

This concludes today’s Kraft Foods First Quarter 2008 Earnings Conference Call.

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Source: Kraft Foods Inc. Q12008 Earnings Call Transcript
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