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Kellogg (NYSE:K)

Q2 2012 Earnings Call

August 02, 2012 9:30 am ET

Executives

Simon Burton - Executive Officer of Snacks business unit

John A. Bryant - Chief Executive Officer, President, Director and Member of Executive Committee

Ronald L. Dissinger - Chief Financial Officer and Senior Vice President

Todd Penegor

Analysts

Gregory Hessler - BofA Merrill Lynch, Research Division

Jason English - Goldman Sachs Group Inc., Research Division

Robert Moskow - Crédit Suisse AG, Research Division

Eric R. Katzman - Deutsche Bank AG, Research Division

Kenneth Goldman - JP Morgan Chase & Co, Research Division

David Palmer - UBS Investment Bank, Research Division

Matthew C. Grainger - Morgan Stanley, Research Division

Edward Aaron - RBC Capital Markets, LLC, Research Division

Jonathan P. Feeney - Janney Montgomery Scott LLC, Research Division

Kenneth B. Zaslow - BMO Capital Markets U.S.

Christopher Growe - Stifel, Nicolaus & Co., Inc., Research Division

Alexia Howard - Sanford C. Bernstein & Co., LLC., Research Division

Operator

Good morning. Welcome to the Kellogg Company Second Quarter 2012 Earnings Call. [Operator Instructions] At this time, I will turn the call over to Simon Burton, Kellogg Company Vice President of Investor Relations. Mr. Burton, you may begin your conference.

Simon Burton

Thanks, Karen. Good morning, and thank you for joining us today for a review of our second quarter 2012 results. I'm joined here by John Bryant, our President and CEO; Ron Dissinger, our Chief Financial Officer; and Todd Penegor, President of our U.S. Snacks business. As we move from being a global cereal company to being a global cereal and snacks company, our intention is to highlight different business units periodically. Todd's here to discuss our U.S. Snacks business in more detail.

The press release and slides that support our remarks this morning are posted on our website, www.kelloggcompany.com. And as you're aware, certain statements made today, such as projections for Kellogg company's future performance, including earnings per share, net sales, margin, operating profit, interest expense, tax rate, cash flow, brand building, upfront costs, investments and inflation, are forward-looking statements. Actual results could be materially different from those projected. So 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.

As a reminder, a replay of today's conference call will be available by phone through Monday, August 6. The call will also be available via webcast, which will be archived for at least 90 days. And with that, I'll turn it over to John.

John A. Bryant

Thanks, Simon, and good morning, everyone. We're pleased that the results we announced this morning are in line with our expectations and the guidance we gave last quarter. In fact, total internal revenue growth for the quarter was in the middle of the 2% to 3% range we expect for the full year and represented an improvement from the results we posted in the first quarter.

Importantly, we saw improvement in overall revenue trends in both the North American and international businesses, with the North American business posting both good revenue and operating profit growth. So we do feel much better about this performance and some of the traction we've achieved from actions taken in recent months. I'll speak more about this later.

The operating profit results also improved in the second quarter, although less dramatically than sales. As we told you last quarter, we expected that Europe's profit would decline at about the same rate in the second quarter as it did in the first quarter. This turned out to be the case. As you know, economic conditions in Europe continue to be difficult, but we're optimistic that we've begun to take the right actions across the region and that we will see further improvement.

So we have additional visibility because of the results we posted in the second quarter, and we are maintaining our outlook for the full year across the P&L. We're actively executing the strategy we outlined to you earlier this year. We are a global cereal and a U.S. snack company. We're building a global snack business, and the addition of Pringles is an important part of that.

So let me talk a bit more about Pringles and Slide 4. The integration is progressing well. Just as a reminder, this was a carve-out, not a straight acquisition, and was far more complicated as a result. So we're pleased that the transition is going so smoothly. Our Pringles team and the existing Kellogg teams are working very well together, and we anticipate that we will be able to discontinue our transition services with Procter & Gamble on schedule. We now have improved visibility into both the company's operations and the annual synergies that we expect to realize. We remain very comfortable that ongoing annual synergies will be in the $50 million to $75 million range we discussed with you previously. And finally, we're seeing good sales early in the third quarter and are starting to leverage Pringles through cross display and marketing activities. It is also important to note that our customers around the world have a lot of confidence in the brand, and just like us, are optimistic regarding its potential.

And with that, I'll turn it over to Ron.

Ronald L. Dissinger

Thanks, John, and good morning, everyone. If you will turn to Slide 5, you will see our quarterly and year-to-date financial summary. We posted reported revenue growth of 2.6% in the quarter and internal sales, excluding the impact of Pringles, divestitures and foreign exchange, increased by 2.3%. And that's on top of a very strong 6% internal growth in the second quarter of last year.

Year-to-date internal revenue growth was 1.1%, driven by the improved trends we saw in both North America and Europe in the second quarter. Internal operating profit decreased by 5% in the quarter against a difficult comparison of 8% last year. The timing of our planned investment in supply chain lowered overall operating profit by 5 points. So operating profit would have been flat without this impact.

You’ll remember that our investment in 2012 will be at the same level as in 2011. However, shape is different given that last year's investment was skewed much more to the back half. Also, as John mentioned, Europe results contributed to the decline as did continued high commodity costs. Reported earnings per share were $0.84 in the second quarter, in line with our expectations, including $0.07 of transaction and integration costs associated with the acquisition of Pringles. We also saw below-the-line favorability of $0.02 per share, which I'll talk about in more detail later.

Slide 6 shows the details of second quarter sales growth. Reported sales increased by 2.6%, and internal sales increased by 2.3%. While volumes declined by 0.6 points, we continued to see favorable results in price and mix at almost 3 points. Importantly, sales increased in the quarter across all 3 categories: cereal, snacks and our other category, which is primarily Frozen Foods and some Specialty Channels business. Pringles added 3.5 points to overall reported sales growth as a result of the sales we picked up in June. And finally, currency decreased overall growth by 3 points.

Now if you'll turn to Slide 7. We'll look at our gross profit performance. Gross profit was $1.4 billion in the second quarter, and gross margin declined by 190 basis points. Commodity costs increased in the quarter, but productivity savings and pricing helped offset the impact. The key drivers of the margin decline were the timing of investment in our supply chain and lower production as we reduced levels of inventory. These 2 items accounted for more than half the decline we saw in gross margin. And the addition of the Pringles business also reduced our reported gross margin. As we've said in the past, however, we intend to improve the margins at

Pringles over time. It's worth noting that gross profit dollars would have been flat if we exclude the timing for the supply chain investments.

Finally, as you are aware, some commodity prices have increased significantly over the past couple of months due to weather conditions. We are now essentially fully covered on food and packaging inputs for the year, and we have included the impact of recent inflation in our outlook for the year.

Slide 8 shows details of our investment in brand building over the last 18 months. Investment was lower in the quarter, although this was the result of comparisons to strong investment the first half of last year, which supported our innovation and marketing programs. This year, we have a lot of activity planned in the second half to support commercial activities and innovation. In addition, we are a proud sponsor of the Olympics. So you can appreciate that our investment will be skewed to the second half of the year.

As you know, investment in brand building is one of the cornerstones of our operating principles. We're committed to this investment, which includes effective programs and more efficient spending, specifically through increased use of digital media. Importantly, even including these efficiencies, we still expect to increase brand building for the whole company at a rate equal to or greater than sales growth for the full year.

Slide 9 shows the internal operating performance for each of the regions. Total company internal operating profit decreased by 5% in the quarter. As I mentioned earlier, the year-over-year impact of our investment in supply chain accounted for all of the decline. As a reminder, we stepped up our investment in supply chain by $100 million last year and held this investment in 2012. We're getting a good return from this investment, and our supply chain is stabilized. So while the timing of the investment has been a significant headwind in the first half of the year, it will be a tailwind in the second half.

North America's internal operating profit increased by more than 3% in the quarter. This was due to strong sales growth, including volume, price and mix improvements. It's also worth noting that we achieved this growth despite the headwind from the timing of the supply chain investments I mentioned earlier.

As we expected, Europe's internal operating profit declined by 20% in the quarter. Half of this decline was the result of lower production to reduce inventory levels. The remainder was due to lower sales and consumer pressures across the region. Europe has been a very difficult operating environment for us.

Internal operating profit in Latin America decreased by approximately 15% in the second quarter. While sales growth was strong, operating profit declined due to a one-time benefit from an asset sale last year and a very strong double-digit increase in brand building in the quarter this year. In fact, these 2 items accounted for all of the decline in operating profit.

And finally, internal operating profit in Asia Pacific decreased by almost 32%, although this was only $8 million. This was primarily the result of a continued difficult operating environment in Australia, including reductions in retailer inventories. However, we did see very early signs of improvement in the category and in our performance in Australia late in the quarter.

Now let's turn to Slide 10 and a discussion of cash flow. Year-to-date cash flow was approximately $525 million, an increase of more than $120 million versus last year. As we said in the first quarter, this includes much of the working capital benefit we expected from Pringles, and we remain focused on managing working capital and made progress in reducing our inventories during the second quarter. Year-to-date capital spending was $155 million or 2.2% of sales. Full year capital spending is still expected to be in the range of 4% to 5% of sales, but it is more second half weighted and includes investment in Pringles. And we purchased no shares during the quarter. As we have said, we intend to pay down debt to strengthen our balance sheet.

Slide 11 shows details of our full year guidance for 2012. As we've said previously, internal sales and operating profit exclude the impact of Pringles, but our earnings per share guidance includes the expected accretion and one-time costs related to the acquisition. So as you can see on the chart, we've maintained our guidance for the year. As a result, we continue to expect internal net sales growth to be between 2% and 3%. This includes the impact of good price and mix growth, partially offset by decline in volume.

We also expect that reported gross margin will be down more than 100 basis points for the year, including the impact of a lower margin structure for Pringles. Internal gross margin will decline less than 100 basis points, consistent with our previous expectations. Our expectations for total cost of goods inflation, including commodity inflation, remain at approximately 7%. And again, we continue to expect that our supply chain will deliver good productivity savings of slightly greater than 3%, in line with our long-term expectations. Our estimate is that full year internal operating profit will be lower by 2% to 4%, including the increase in investment in brand building, equal to or greater than sales growth. And our guidance for earnings per share remains consistent, although some of the puts and takes have changed.

Let's turn to Slide 12 to discuss changes to some of the components of our guidance. Remember that last quarter, we had a one-time $0.05 benefit from transaction-related hedging. This quarter, we had a couple of one-time items also, including that benefit reversing itself, that combined to a $0.02 negative impact. But this was more than offset by a lower tax rate that added approximately $0.04 of benefit. So we netted a positive $0.02 impact from these one-time items in the quarter. All of these items are related to the Pringles acquisition.

As a result of the tax benefit this quarter, we now expect our full year effective tax rate to be approximately 29%. Expectations for currency translation got $0.02 worse and now stand at approximately $0.06 of negative impact for the year. We've outlined all of this information on this slide. So as a result, our estimate for full year earnings per share remains in the $3.18 to $3.30 range. This includes a net $0.07 to $0.10 headwind of one-time items and the $0.06 headwind from currency. And cash flow is still expected to be in the $1.1 billion to $1.2 billion range.

Finally, you can see from the full year guidance that we're expecting continued improvement and much better results in the second half of the year. This should be a gradual improvement, though, as we progress through the remainder of the year.

And with that, I'll turn it back to John.

John A. Bryant

Thanks, Ron. Slide 13 shows the internal revenue growth posted by Kellogg North America and Kellogg International in the quarter. Both results represent a significant improvement from their performance in the first quarter. Revenue growth in North America was 4%. That was declined by 1% in our International business, mostly due to the results we expected in Europe.

Slide 14 shows the U.S. business broken out by segment. As you can see, each of the segments posted growth in the quarter. U.S. Morning Foods and Kashi posted growth of 1.2%. Cereal sales and share declined slightly, as we were lapping a double-digit sales growth at almost 1.5 of share gains in the second quarter of last year. So the performance was good, considering that we proactively chose to lower incremental spending during the period and we've all seen that we posted good share growth in more recent data.

The contribution from innovation has also been good, with Krave cereal continuing to do very well at 1 share point. The Pop-Tarts business had a great quarter, posting a strong sales growth, and we had a very favorable response to the reintroduction of the Crazy Good advertising campaign. And the Kashi business posted good sales growth, including the Bear Naked brand, which contributed -- which continued to post very strong growth as a result of innovation and increased levels of distribution.

U.S. Specialty segment posted internal revenue growth of 6.3%. This was a result of strong innovation, particularly Special K Cracker Chips, which are off to a great start in these channels. Also, we saw double-digit growth and good share performance in the Convenience channel and increased sales of Frozen Foods.

The North America Other segment, which is comprised of the Frozen Food and Canadian businesses, also had a great quarter. Frozen Foods had another strong quarter, posting high single-digit revenue growth off a difficult comparison. In fact, our Frozen Foods business is the fastest-growing, large Frozen Foods business in the U.S. over the last 52-week period, as measured by Nielsen. The innovation we've launched is doing well in all the categories, and Eggo Thick & Fluffy waffles posted strong double-digit growth in their second year. And we've got Special K flatbread breakfast sandwiches and vanilla Eggo waffles planned for introduction. Veggie Foods is responding to activity that started late in the quarter, and we're seeing strong growth in recent measured channel data.

And the Canadian business also posted strong revenue growth. Innovations are doing well in Canada, especially Special K Cracker Chips, which are off to a very strong start.

Now if you'll turn to Slide 15, you'll see just some of the innovation that has either been launched this year or that will be launched in the second half. The purpose of this is to give you some idea of the magnitude of the activity and look at some of the great new products that we've launched. Remember that corporate-wide, we've launched approximately $600 million of innovation in 2010. This grew to approximately $800 million in 2011, and are on course to introduced innovation of $900 million in 2012. That's sort of activity, but we know that this is essential to our future growth.

Now, I'm pleased to introduce Todd Penegor, the President of our U.S. Snacks business. As Simon said at the beginning of the call, we intend to highlight one business on these calls from time to time. Given the acquisition of Pringles and the importance of snacks to our plans for future growth, we want to take this opportunity to have Todd talk more about our single largest business unit, U.S. Snacks.

Todd Penegor

Thanks, John. First of all, let's take a look at Slide 17 and a discussion of the Snacks business performance in the second quarter. As you can see, we posted very good internal sales growth of 4.1% and this was building on strong mid-single-digit growth in the second quarter of last year. The cracker category increased at a mid-single-digit rate in all channel data, and we increased category share. As in previous quarters, both Cheez-It and Special K crackers did very well in the quarter, and we're very excited about the introduction of Special K popcorn chips in August. These new SKUs will build on the current Special K franchise, and we're confident this off-cycle innovation will continue to drive our business.

The cookie business posted low single-digit growth on good performance from the focus on the core Keebler brands. Fudge Shoppe, Chips Deluxe and Sandies all did well and in combination posted sales growth that exceeded the low-single-digit category growth.

Our wholesome snack business also had a very good quarter. Sales of Special K bars, Nutri-Grain bars and Rice Krispies Treats all grew in the quarter. You'll remember that our wholesome snack innovation for the year is much more skewed to the second half of the year, and we're starting to see some of the benefit already. Although it's early, Special K Pastry Crisps are off to a good start, and FiberPlus Nutty Delights are now being activated.

Slide 19 shows the scale of and our share in the 4 main categories in which we compete in the U.S. As you can see, these are big categories which add almost $20 billion a year in sales, and they're growing, too. So although we're strong #2 in wholesome snack and cracker categories and a more distant #2 in cookies and savory snacks, we see a lot of potential in all these businesses. This means that we have to embrace our position and act as a hungry #2. And it also means that we have to drive our execution and innovation that much harder, and we have. We've done a very good job with both over the years. I'll talk about some of these initiatives in a little more detail in a few minutes. So as I mentioned, our categories have been growing more than 4% a year, and I'd like to think that the hard work we put in by the entire team has meant that Kellogg has helped drive part of this growth.

A big part of our success is due to the strength of our brands. And if you turn to Slide 21, you'll see some detail regarding one of the most important of those brands. Cheez-It has been a multiyear success story for us. We've had some great close-in innovation over the years and have worked hard to keep the brand fresh. The purchase rate on Cheez-It is among the highest of our large brands, and you can see on the chart the impressive growth posted as a result over the last 15 years. In fact, this brand increased sales every year over this 15-year period, and the compound annual growth rate was more than 9%, which is really impressive.

Recently, Cheez-It scored highly in a study of popular savory snack brands. This survey focused on a broad array of benefits and product attributes valued by consumers and included some of the largest savory snack brands in the country. Cheez-It is a cracker and is sold in the cracker aisle. However, consumers think of it as a savory snack and they consume it like one.

We have integrated our consumer programs with our sales efforts to really drive incremental sales and build the brand. The successful Choose Your Cheese program is one example that ran over the last couple of years, and we've also got sales partnerships with Coke and MillerCoors, which we're very excited about and that will provide even more opportunities in the future. And so, as a result of these activities, we have some very passionate consumers who have driven this to be one of the largest brands in the company, with almost 3.5 million Facebook fans. Finally though, I would like to say that we don't think we've tapped anywhere near all the potential of this brand despite the past growth you see on the chart. In fact, we expect that sticking to our plan will bring many more years of success.

Now let's turn to Slide 22 and a discussion of another important brand for us, Special K, which has helped to drive our wholesome snack and cracker businesses. The Special K brand in Snacks has benefited from strong innovation, and we've seen increased household penetration and very passionate consumers. As a result, we posted strong growth in each of the last few years, and you can see it all adds to a compound annual growth rate over the period of more than 22%, which is great. In fact, the growth has been accelerated over the last couple of years by the introduction of Special K Cracker Chips, which have increased the brand's reach. And the introduction was one of our most successful in the category. The 2 SKUs we launched this year have done well, on top of a strong base set last year. It is on trend, highly relevant proposition and brand and it's successfully traveling to businesses outside of the U.S. as well. Kellogg Canada and Kellogg Mexico have both launched this product and have also seen great results. Importantly, we're confident that Special K Popcorn Chips and Pastry Crisps, both of which are being introduced in the second half of 2012 with strong support, will help keep this business growing.

Slide 23 shows some detail regarding the Keebler cookie brand, which is one of our strongest. The Keebler brand, the Keebler Elves and the Hollow Tree are all loved by consumers. Last year, we decided to focus our efforts on the broader Keebler brand and primarily Fudge Shoppe, Chips De and Sandies. And as you can see from the chart, the results have been dramatic. It's important to note that the Keebler brand accounts for $1 billion of sales across the cookie and cracker categories. We changed a lot of things as a part of this refocus: Advertising, pricing, packaging, marketing partnerships, social media activities, and we even rethought our in-store activation. And we're pleased with the performance in the latest 52-week period. As you can see, the core sub-brands under Keebler have posted strong growth, a big change from prior periods. And as with Cheez-It and Special K, we've got increasingly passionate consumers, more activity and good innovation planned, all of which should help us maintain our solid momentum.

And now you'll turn to Slide 24. The final brand I'd like to highlight today is, of course, Pringles. In U.S. Snacks, we're really excited about the opportunities that Pringles brings. This is a big iconic brand and is one that allows us to leverage our strengths: brand building, innovation and strong in-store execution. It also provides us with access to another aisle in the store. As John has mentioned previously, the business has been a little constrained on capacity. But we're doing a lot of work on this as an organization. This means that as we progress, we should be able to focus on driving sales growth, particularly through the introduction of innovation and additional merchandising, leveraging our in-store presence.

The introduction of Pringles with more flavor has helped accelerate the growth of this brand. This was a simple idea, but it's one that highlights the opportunities we have to drive this business. We've also got a lot of really great brand-building ideas, and we've got savory snack brands that complement each other. So as you might imagine, we're already co-promotions with Pringles and Cheez-It. We see a lot more potential to do this kind of thing as we look across the portfolio.

Slide 26 shows some detail on the success of our innovation that I referenced earlier. As you can see, we've done a great job driving innovation in our largest categories, in both absolute terms and versus the competition. It's also important to note that this is a 3-year rolling innovation which highlights the longer-term success of some of these ideas. We've increased the amount of innovation we've launched, measured in dollars, consistently over the last few years. So we're very proud of this track record, and I believe that we have the processes and ideas in place to continue this success into the future.

One final note on innovation. We recently have been recognized by both Nielsen and IRI for some of the successful innovations we've launched. Specifically, these are awards for our Town House Flipsides, Special K Cracker Chips and Special K Pastry Crisps products.

Now let's turn to Slide 27 and the final element of our growth strategy, the DSD delivery network, which is one of the largest in the country. Let's look at some of the impressive statistics on the page. As you can imagine, visiting each store more than 4 times a week on average puts us in regular contact with both our customers and consumers. The number of visits also helps us manage the shelf and minimize out-of-stocks. And we can't wait to build on our in-store presence to drive even more display for our Pringles business.

So in conclusion, on Slide 28, I'd just like to say that we're very motivated by the opportunities we have in the U.S. Snacks business here at Kellogg. There is great potential in all the categories in which we compete. These categories are growing, and we're benefiting from this. We have the right brands. Cheez-It, Special K, Keebler, and now, Pringles, are all great brands, and we've got the opportunity to accelerate their performance as we focus, integrate and expand our efforts. We've got a great innovation plan and, as importantly, a well-run process that's been very successful. And we've executed well in-store and will continue to do so. We are very optimistic regarding our future in Snacks and we're very excited to welcome the U.S. Pringles employees to the Snacks family. And finally, I'd like to thank all the employees of the Snacks business for their hard work. Together, they've built a great organization, and they should all be very proud.

And with that, I'll turn it back over to John.

John A. Bryant

Thank you, Todd. Now if you'll turn to Slide 29, you'll see some detail regarding our International businesses. Sales performance posted by our European business in the second quarter was better than we saw in the first quarter. The U.K. business also declined much less than it did in Q1 as some of our commercial plans and pricing actions started to gain traction. We have new Special K and Crunchy Nut advertising on-air. We have launched new Special K Biscuit Moments, and Nutri-Grain Breakfast Biscuits are going into the market. This is a growing category, and we see potential in this great new product. More broadly, we've got new ads on the air for most of our major brands, and we've relaunched Special K in both Italy and Spain, like we did last year in Mexico, where we saw very good sales growth as a result. We feel better about the second half because of all this activity and because of other innovations we have planned. However, as you've heard from other companies, the continent continues to be a challenge given the economic environment. Southern Europe in particular, is difficult, and we are taking action in the region and we're watching developments closely.

Quarterly net sales results in Asia Pacific were impacted by lower retail inventories and a difficult competitive environment in Australia, as retailers decreased their inventories around their fiscal year end. Australia is a developed market and has issues similar to other developed markets. However, the third quarter is off to a better start, and we have stronger activity planned for the second half.

In addition, we saw good growth in Southeast Asia, China and India, and we expect better growth across the region in the second half of the year as we have more activity planned, including a significant amount of brand building.

Sales in Latin America increased by almost 7% as a result of strong pricing and double-digit growth in certain countries. We increased brand building at a double-digit rate in Q2 and are also planning for a double-digit increase across the balance of the year. So we expect continued good revenue growth in Latin America this year because of this investment and because of innovations such as Special K Crisps and Special K Cracker Chips, which are similar to the ones you are familiar with in the U.S. Like in other places around the world, this launch is off to a very strong start.

In conclusion, I'd like to say that we have increased visibility into our International business for the balance of the year. We're taking actions across the regions, some of them significant, and we're starting to see improvement. We remain very focused, and we are excited about the opportunities we see in the second half of the year and into 2013.

Now let's turn to Slide 30 and the summary. We're pleased that our second quarter performance improved from the first quarter of the year. The North American business posted internal growth in both sales and operating profit. We've done a lot of work in these businesses, and we're encouraged by the improvement. And we're excited about the prospects for the second half.

The International business also posted improved performance, as some of the actions that we have taken have started to make a difference. We expect that this activity will drive performance that continues to improve as we progress through the second half. And because of this, we have additional visibility into our outlook for the year.

We plan to continue investing in our model because we know that it is the right way to run our business. Investment in our brands and strong innovation are what drives our results, and we're excited about both what we have planned for the remainder of this year and the longer-term prospects for the business. We compete in great categories, and we have new strong growth opportunities in our Pringles business.

Finally, I'd just like to thank Kellogg's employees for all their hard work. I'd also like to welcome the new employees coming to the family as a result of the Pringles acquisition.

And with that, I'll open up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Greg Hessler from Bank of America Merrill Lynch.

Gregory Hessler - BofA Merrill Lynch, Research Division

As you guys ended the quarter, I think you had like $750 million in short-term debt, and you've got a couple of notes that are maturing in the next 12 months. So I was wondering, how do you plan to address those? I know you're focused on using near-term free cash flow to reduce debt, but might we see you back in the corporate bond market in the next couple months or in the back half of the year?

Ronald L. Dissinger

Yes, Greg. This is Ron. It is possible that we'll be back in the market. We'll obviously look at all of our options here, including a CP, as well as longer-term debt.

Gregory Hessler - BofA Merrill Lynch, Research Division

Okay. And in conjunction with the debt reduction, is there a particular balance that you're targeting by year end?

Ronald L. Dissinger

We haven't communicated a specific balance that we're targeting by year end. What we have said is that we like our BBB+ credit-rating, and we're working to maintain that rating by paying down our debt and strengthening our balance sheet.

Operator

And our next question comes from the line of Jason English from Goldman Sachs.

Jason English - Goldman Sachs Group Inc., Research Division

Europe, it sounds like you're feeling confident about the progress you're making there. Can you help illuminate some of the issues? So just give us a little more detail of exactly what the challenges have been there.

John A. Bryant

Well, I think as we said back on the first quarter call, we've been disappointed by our start in Europe. I think to your point, Jason, we are seeing much better progress in the second quarter, and our second quarter results were in line with our expectations -- the expectations we gave you coming out of that first quarter call. We have seen improvement in the U.K. and France. Having said that, Southern Europe, particularly Spain and Italy, have been a bit softer than we would like, and that just reflects the tough environment in that part of the world. To give you a sense of some of the actions that we've taken, in the U.K. we have new cereal innovation coming out, with line extensions on All-Bran, Crunchy Nut and Krave. In the U.K. we have Special K Biscuit Moments launching in June. And in Spain and Italy, we're actually relaunching Special K, which is our biggest brand there, similar to what we did in Latin America last year, where we saw a very good response from that program. And across the region, we have new proven copy behind major brands, and we've improved some price points in some critical brands in some major markets. So I think we are making some good progress, and it's coming through in a better result in Q2 than Q1.

Jason English - Goldman Sachs Group Inc., Research Division

That's helpful. And just a housekeeping item. On your guidance bridge here, you've got, it looks like a net $0.02 benefit from one-time costs. And I know FX is an offset. But just on a currency neutral basis, if we were to exclude the one-timers, is it right that you're lowering sort of the constant currency pro forma guidance by $0.02? And if so, where exactly is that coming from?

Ronald L. Dissinger

We're not necessarily lowering the constant currency guidance. Our base or core EPS remains exactly the same. We've got $0.02 of headwind of currency.

Jason English - Goldman Sachs Group Inc., Research Division

But you have $0.02 of a net tailwind from one-time costs, is that right? That weren't included in the guidance before?

Ronald L. Dissinger

Yes. Yes, we do.

Simon Burton

That's right, Jason. Excuse me, it's Simon. Those 2 things offset each other so...

Ronald L. Dissinger

Yes.

Simon Burton

We're still at a $3.18 to $3.30.

Jason English - Goldman Sachs Group Inc., Research Division

But if FX hadn't changed -- okay, I'll follow up offline.

Ronald L. Dissinger

If FX hadn't changed, then the rates would have gone up.

Simon Burton

Yes.

Operator

And our next question comes from the line of Rob Moskow from Crédit Suisse.

Robert Moskow - Crédit Suisse AG, Research Division

I wanted to know if you can give us a little more color on how Pringles is doing. We can see the data in the U.S. but not so clearly in Europe, and this is a heavily European business. Are they having the same kind of geographic kind of slowdown in Southern Europe, and can you help us quantify what it looks like? And then secondly, can you give us an update on how you're thinking about that combination of integrating Pringles in Europe and also, I think, kind of restructuring your headquarter platform in Europe? And I think a lot of people are concerned that this is a lot to take on at this time when Europe, in general, is having recessionary conditions.

John A. Bryant

Let me say a few comments first about Pringles in general and then Europe, and then maybe have Todd say a few things about what's happening in Pringles here in the United States. The integration is going very well with Pringles, very smoothly. We have good visibility into the synergies. We're having good pickup with Pringles employees now becoming Kellogg employees. And I think actually, the company's done an excellent job of executing a very difficult integration with the carve-out and moving forward. And as you say, we are seeing some good response here in the near term in the U.S, and I'll have Todd talk about that in a minute. In terms of Europe, the Pringles business is doing well in Europe. We do have more of an emerging market platform for that business than, say, the Kellogg company would have. But we're continuing to see progress in that business. More broadly, as you said, we are undergoing a major set of changes in our European business. We are organizing ourselves for the future. That means we are looking at the best way to set ourselves up. The beauty of the Pringles acquisition is it creates a snacking capability to add to our International business. It helps transform our International business from largely a cereal business to a cereal and snacks business. The Pringles acquisition or integration within Europe, Pringles will continue to be in Geneva, so there's not a big dislocation there. There is an opportunity though for us to look at how we best organize Europe, given that we have cereal in Dublin and Pringles in Geneva. Asia Pacific, we'll also have Pringles in Singapore and seeing very good progress of that integration as well. And it's a relatively small business in Latin America. So early days in Europe. A lot going on. But we think Pringles actually is an important part of the strategy to help drive the future growth of our European business. And so we feel we're absolutely taking the right long-term actions. Todd, you want to talk a little bit about the U.S. channels?

Todd Penegor

And in the U.S., it's -- the integration is also going very smooth. We haven't skipped a beat. Period 6 came in on expectations, and we're off to a solid start here in Period 7. Really excited about the opportunity to leverage our in-store presence to drive even bigger partnerships and in-store displays. And we're securing the right talent to ensure our success going forward. So feel very, very good at the moment.

Robert Moskow - Crédit Suisse AG, Research Division

And John, just 37% of Pringles sales are in Western Europe. Are those -- is that business down?

John A. Bryant

Coming into the year, Pringles had a strategy in some parts of Western Europe to reduce their reliance on some of those markets. And some of those markets are down; others are up. So it's a bit of a mixed story across the continent.

Operator

Your next question comes from the line of Eric Katzman from Deutsche Bank.

Eric R. Katzman - Deutsche Bank AG, Research Division

Okay. A couple of questions, I guess. First, just more specific you're looking at the tax rate, I guess, as included in the guidance, a large part of that is due to Pringles. But shouldn't Pringles help the overall tax rate long term? And should we then therefore take some comfort in the fact that you're including this benefit in the second quarter as maybe a longer-term benefit to the company?

Ronald L. Dissinger

Pringles will benefit our tax rate over the longer term based on the tax-efficient structures that are in place, Eric. What we recognized in the second quarter was a one-time benefit associated with the liability that we adjusted in relation to International earnings. We previously expected we might repatriate those International earnings. Now as a result of a debt that we have overseas, we'll use that cash to pay down the debt. So we made this one-time adjustment to that liability and picked up $0.04 of earnings per share benefit.

Eric R. Katzman - Deutsche Bank AG, Research Division

So is -- again, just on the one-time items, the $0.07 to $0.10 that you originally -- well, you updated in this -- after the first quarter results, that -- the $0.07 to $0.10, that includes the, I guess, net $0.03 hedging gain, but that also includes a $0.04 tax benefit and then the initial one-time items that you had put out at CAGNY?

Ronald L. Dissinger

That's exactly right, Eric. So it's got the integration costs embedded, which are a headwind. It's got the benefit of this -- it's a transactional foreign exchange item of $0.03. And then it's got $0.04 of benefit related to tax.

Eric R. Katzman - Deutsche Bank AG, Research Division

Okay. And then I guess just last question. Just kind of maybe talking about, John, the cereal business in the U.S. It looks like the category has still been a bit of a struggle. Perhaps you can talk a little bit about that. And as I go around, there are still a lot of questions about the category versus other breakfast items or even versus pretty aggressive QSR movement into breakfast. Perhaps an update there, and then I'll pass it on.

John A. Bryant

We remain excited about the long- term potential of cereal in the U.S. We see it as a low-single-digit growth category, and in the second quarter, it was flat to up 1%. So at the lower end of the range that we'd like to be operating in, but not that far out of that range. And the reason we believe it has long-term potential, obviously, is the aging population, health and wellness considerations, and we know it's a category driven by brand building and innovation. Within the cereal category in the second quarter, we were down about 1% in the U.S. but lapping a 13% growth last year. And so our share did drop down about 50 basis points, but we began lapping a 140-basis-point gain in the year-ago period. And within the category, we're actually seeing very stable base sales performance. And where the category is losing a little bit of volume is on the incremental side. I think that reflects some of the actions taken in the area of pricing through the year. But I think longer term, what's going to drive this category is going to be more innovation and more brand building. And if you look across our back half plans, we have a much heavier brand-building investment in the back half of the year, and we have new innovation like Special K Protein coming out in the back half. And if there's one thing we are seeing in general, it's a little bit of protein seeking going on, whether it be Greek yogurt or eggs or similar sort of items. And so we believe that we can play into that, even through cereal. So we're comfortable with where the cereal business is. It's improving as we go through the year. We see a better back half, and we believe it has good long-term growth prospects.

Operator

And our next question comes from the line of Ken Goldman from JPMorgan.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

When you bought your grains for this year, was that before or after the big corn spike? I'm asking because I think it's reasonable to assume it was before since your guidance for total cost inflation has remained constant even though corn and wheat and oats and so forth have jumped since you last provided an update. And the reason I'm asking is not so much about 2012 but just kind of looking ahead to 2013 and seeing if we can reasonably expect a little bit of a commodity headwind at that point.

Ronald L. Dissinger

So for 2012, we did have some grains purchased or hedges in place. We did see a little bit of exposure in the back part of the year but we've been able to manage that, Ken, and still stay within our guidance and total cost inflation expectations.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

Is it reasonable for us to assume that commodities overall will still be somewhat of a headwind next year?

Ronald L. Dissinger

We do expect inflation in 2013. Keep in mind, we buy $5 billion worth of commodity packaging and energy across our business. The grains are a relatively small portion of that overall purchase. But yes, we do expect some inflation next year.

Operator

And our next question comes from the line of David Palmer from UBS.

David Palmer - UBS Investment Bank, Research Division

I have a question separately on supply chain. You mentioned something about supply chain being a little bit disproportionately high -- investments in supply chain being disproportionately high in the second quarter. Can you give an update about how that's flowing through the year in terms of incremental spending on supply chain first half versus second half? And are you on track for that sort of, I think it was $100 million of incremental spend? And then any specifics about what you're spending that on and what that's supposed to achieve would be great.

Ronald L. Dissinger

It's very consistent with what we've communicated before, Dave. And yes, $100 million is still our expectation for spending in 2012 because we're lapping the investment we made primarily in the back half of last year. We're seeing headwinds in the front half of this year. And then we'll see a benefit in the back half of 2012.

John A. Bryant

Then, David, I'd like to say that the investments are having a tremendous payoff for us. And I really do believe it was absolutely the right thing to do. We've turned the corner with our supply chain. We're having a much, much better 2012. And those investments will enable us to continue to drive our business forward, to continue to grow the business over time. So I really feel like we -- it's been absolutely the right thing and it's made tremendous progress in our supply chain.

David Palmer - UBS Investment Bank, Research Division

Is there any way that you could illustrate with examples about what you mean when that -- improving your ability to execute in supply chain and what sort of increment -- any dollars in terms of what benefit that will provide?

John A. Bryant

I think it has to do with just the stability of the supply chain and the overall performance of the supply chain. If you went back over the last 3 to 4 years, unfortunately we've had a number of events that have adversely affected our company. As we went into the back half of last year, we really took the business apart, making sure we were getting down to the root causes, understanding the issues and resolving them. And as we've gone through this year, we'd have a much, much better performance out of our supply chain as a result.

Operator

And our next question comes from the line of Matthew Grainger from Morgan Stanley.

Matthew C. Grainger - Morgan Stanley, Research Division

Just one follow-up on grain costs. As we think about the impact of the recent increase in costs on discrete categories, as we look forward to next year, and specifically thinking about cereal, as it stands today, do you feel confident in your ability to cover the inflation outlook for next year through productivity? Or are we approaching the point where you think additional pricing might be required in cereal at some point during the next 6 to 12 months?

John A. Bryant

Matthew, we really cannot talk about prospective pricing. I want to get back to what Ron said. We buy a lot of different items, of which grains are just one. So we might have some inflation on that particular item but we have some other items that are not inflationary. We as a company and as an industry, are driving tremendous productivity to try to help offset our need to take pricing as much as possible, and I'm sure that will continue to be the approach of the company and the industry in general. So this is one more thing for us to manage our way through, and we'll talk about our 2013 outlook at the end of the year.

Operator

And our next question comes from the line of Ed Aaron from RBC Capital Markets.

Edward Aaron - RBC Capital Markets, LLC, Research Division

Just following up on David's question on the supply chain. Does turning the corner there give you the confidence that you can begin to manage down that spending in the out years? And then just a follow-up, a separate housekeeping question. Have you finished the inventory adjustment and can you maybe actually give the quarter ending inventory level for the base business, excluding Pringles?

John A. Bryant

Let me answer your question on the supply chain. Our goal is to always be driving productivity to our supply chain. We see that investment of $100 million as a permanent step-up in the base. If we can do anything over time to reduce that spend, obviously we will. But we're looking at it in the context of running the total supply chain, not as $100 million in isolation. So our goal is to keep driving our productivity around 3% to 4%. That's our long-term aspiration. In terms of inventory, Ron?

Ronald L. Dissinger

Yes. In terms of the inventory reductions, we will still see some inventory coming out over the back half of the year. So we'll have some adverse impact there. In terms of getting into the exact inventory for Pringles and what our balance sheet is, I'd rather not go into that level of detail.

Operator

And our next question comes from the line of Jonathan Feeney from Janney Capital Markets.

Jonathan P. Feeney - Janney Montgomery Scott LLC, Research Division

I guess I have a detailed question, and then I have a question for Todd. The detailed question is, just coming back to the guidance. So I guess in a nutshell, the tax rate that’s now 29% for the full year means your second half tax rate is what you anticipated it was going to be when you originally gave guidance earlier this year. It's just part of those Pringles net cost and benefits included a tax element that we weren't counting on before. Is that a fair characterization?

Ronald L. Dissinger

That's exactly right. That's right, Jonathan. That's exactly the way to think about it.

Jonathan P. Feeney - Janney Montgomery Scott LLC, Research Division

As a question for Todd, you've had such success with the Snack program, and I think, yes, even going back to the Keebler acquisition and look at how you've executed against innovations there. What is the -- what were the costs and benefits be, like why is the decision not being made to integrate Pringles into that DSD network? And is that something that's potential for the future? And what I'm -- I guess, what are the aspects of that business versus the rest of your Snack business that make that the appropriate decision? I mean, could that change?

Todd Penegor

Good question, Jonathan. We have a very efficient distribution model already in place for Pringles. So the key is for us to continue to drive that efficiency to get it to the back of the store. The opportunity then is how do we leverage all of our great in-store presence to drive incremental merchandising, like bundling some of our bigger programs to make it even better. And you’re already seeing examples of that right now with the back-to-school program. And you saw the picture in the deck with the Pringles being integrated into our school bus program. So we're getting it up on display and leveraging the in-store sales force.

Jonathan P. Feeney - Janney Montgomery Scott LLC, Research Division

Leveraging the in-store but not the actual delivery component, is that right?

Todd Penegor

That's right. And we don't have an intention to actually change the way we get it to the back of the store.

Jonathan P. Feeney - Janney Montgomery Scott LLC, Research Division

Does that limit -- I mean, let me ask it this way. I mean, what -- does that limit -- does Pringles have more points of distribution in North America right now or Keebler? I mean, are you limiting Pringles distribution by doing that? Or is there -- is Pringles' footprint the same size and it's just there's no point in integrating the 2?

Todd Penegor

A similar footprint. I think the biggest opportunity that we see is Pringles acts a lot like Cheez-It, when you look at lift-top display. And what we want to do is just continue to drive the display element of it. It's got a different shelf life, so we've got more opportunity to grab inventory to pull from the back of the store and get it up into our bigger and better and integrated promotions going forward.

Operator

And our next question comes from the line of Ken Zaslow from Bank of Montreal.

Kenneth B. Zaslow - BMO Capital Markets U.S.

So what other key regions and products that you will expect to see the biggest relative change in the brand building? Because you said it's going to build. Can you just talk about which regions and which products? And then secondly, are you surprised, given the significantly higher brand building, that volume in Latin America kind of fell 1.5%? If you could touch on those 2 points, that would be great.

John A. Bryant

Yes. If you look at the brand building investment in the back half of the year, it's going to go disproportionately against where we believe our longer-term growth is in the company. So Asia Pacific and Latin America are going to receive more brand building in the back half of the year. We have very exciting long-term growth plans there. And then to your question on Latin America specifically, I think we do have an opportunity to improve our volume performance in Latin America over time. In the second quarter, and even a little bit in the third quarter, you will see some trade inventory coming out of the Latin American business as we work down those inventories that did have a little bit of an impact on the Q2 volume performance.

Kenneth B. Zaslow - BMO Capital Markets U.S.

And which products within Asia and Latin America do you expect to be spending the most behind? Is it certain brands or product categories?

John A. Bryant

Primarily cereal, as well as probably starting to open up the brand building on Pringles over time as well. I think one of our challenges or opportunities on Pringles is just to get additional capacity on line. We have a lot of growth potential, and as Todd said, we have a very excited U.S. Snack organization. One of our challenges is to open up more capacity so we can drive that business even harder.

Operator

And our next question comes from the line of Chris Growe from Stifel, Nicolaus.

Christopher Growe - Stifel, Nicolaus & Co., Inc., Research Division

Just want to ask a few questions, John, about the Pringles. And just to understand the degree or the extent which you can sort reinvest back in that business now. I think as I understand, you have a pretty tight capacity for that business. I think you've got to bring on some more capacity. And then I also want to understand, in relation to that, again, kind of the investments you can make back into the business to achieve revenue synergies, whether it's selling the product in Mexico or it's selling more Kellogg products on the platform in Asia? It's a bit of a wide-range question, but can you give a better sense of when you can start to expect heavier investment in Pringles?

John A. Bryant

Well, I think we do have an opportunity to drive revenue synergies in Pringles. Day one, as Todd mentioned in the U.S., we are bolting on the Pringles to the in-store execution within our U.S. business. And so we're seeing some early response from that. And to enable us to supply those initiatives, we're going back

[Audio Gap]

our facilities and challenging the mix and challenging the opportunity to get more volume out of the current network. Going forward, though, we need to add to that network, and it's going to take us a year or so to get that capacity on line so we can really drive the business even harder.

Operator

And our final question comes from the line of Alexia Howard from Sanford Bernstein.

Alexia Howard - Sanford C. Bernstein & Co., LLC., Research Division

I just wanted to ask about Latin America because it's clearly your main driver of growth internationally. I know the focus has been on Mexico historically. Your main competitor is about to close a pretty meaningful snacking acquisition in Brazil, and I just wanted to ask about your strategy for Brazil. Is Pringles going to give enough of a platform to start to roll out snacks products there? Or are there other alternatives that you will consider to get bigger in that market? Or is the focus going to continue to be Mexico?

John A. Bryant

Alexia, if you look forward over the next 10 years, we'd like to see more balanced profile for Latin America. We continue to have growth opportunities in Mexico, but we believe we have even stronger growth opportunities in the Southern Cone and in Brazil, in particular. We are the category leader in Brazil, and the category is growing strong double-digits, as are we. And we are actually investing more in Brazil this year. In fact, we will probably see more of that come through in the back half of the year. And we also believe that Pringles represents a long-term opportunity in Brazil as well.

Simon Burton

Okay, everyone. Thanks very much for joining us today. We'll be available throughout the rest of the day and the rest of the week for follow-up questions. Thanks again.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program, and you may now disconnect. Everyone, have a good day.

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Source: Kellogg Management Discusses Q2 2012 Results - Earnings Call Transcript
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