Welcome to the Kellogg Company 2008 second quarter earnings call. (Operator Instructions) At this time I will turn the call over to Joel Wittenberg, Kellogg Company Vice President of Investor Relations.
Thank you for joining us for a review of our second quarter results and for some discussion regarding our strategy and outlook. With me here in Battle Creek are David MacKay, President and CEO; John Bryant, CFO and Gary Pilnick, General Counsel.
We must point out that certain statements made today such as projections for Kellogg Company’s future performance including earnings per share, net sales, margins, operating profit, interest expense, tax rate, cash flow, brand building, up front costs and inflation are forward-looking statements. Actual results could be materially different from those projected.
For further information concerning factors that could cause these results to differ please refer to the second slide of this presentation as well as to our public SEC filings.
A replay of today's conference call will be available by phone through Monday evening by dialing (888) 203-1112 in the U.S. and (719) 457-0820 from international locations. The pass code for both locations is #5646116. The call will also be available via web cast which will be archived for 90 days.
Now let me turn it over to David.
We're pleased to announce another strong quarter despite the impact of continued commodity price volatility. This quarter's performance provides further evidence of the strength of our business model. Our business momentum
along with price realization grew a reported sales growth of 11% and earnings per share growth of 9%.
We continue to invest for the future absorbing up front costs of $0.04 per share and increasing our advertising investments at a double-digit rate. In addition, we continued our expansion in emerging markets through the acquisition of Navigable Foods, a biscuit
company in China.
We're entering the back half of the year with confidence in our ability to achieve our full year goals and we have raised our 2008 earnings guidance to $2.95 to $3.00 per share versus our previous estimate of $2.92 to $2.97. This increase reflects our strong underlying business momentum.
As we said previously, this year's first half performance would be measured against difficult 2007 comparables due to the timing of commodity market increases, various tax items and our very strong first half performance in 2007.
Given the tough comparables we are very pleased with our Q2 performance. As you know we manage the business for the long-term and we will drive performance through an ongoing commitment to investing in great ideas that keep consumers engaged and aware of our brands and their benefits.
Our second half innovation pipeline looks solid and we continue to focus on maximizing the value of our advertising dollars. Our business model and strategy continued to deliver strong results despite unprecedented volatility in the commodity and energy markets. To help recover some of these cost increases we are executing additional pricing across many of our businesses. On the cost side we will continue to aggressively focus on SG&A optimization, productivity initiatives and longer term projects funded through up front cost investments.
As another sign of our continued confidence we also announced this morning that our Board of Directors approved another $500 million share repurchase authorization. As you know we completed our $650 million authorization during the first quarter. We do not anticipate that the purchases will have a meaningful impact on this year's EPS as we plan to commence the repurchase late this year using our balance sheet cash.
Now I'd like to turn it over to John to discuss the financials.
Slide 4 highlights our financial performance. Reported sales increased by 11% in the second quarter, lapping last year's strong 9% growth. Internal sales growth, which excludes the effect of foreign exchange and our recent acquisitions, was 6% building on last year's strong 6% growth. Both reported and internal operating profit rose 2% against last year’s tough comp of 12% reported growth
and 9% internal growth.
We achieved this performance despite significantly higher commodity costs and a double digit increase in advertising offset by lower up front project costs. For the full year we still anticipate a mid single digit increase in internal operating profits.
Our second quarter earnings per share rose 9% to $0.82 compared to last year’s $0.75/. Let’s turn to page five to discuss our second quarter net sales growth components.
As you can see our price and mix initiatives continue to flow through with solid 4.7% growth. The price component contributed 3.4% of the total, even more than the first quarter's 2.7% contribution and significantly ahead of last year. We continue to expect the price component to be higher in 2008 than prior years.
Tonnage provided 1.3% growth and foreign exchange had a 3.1% impact on our sales. Our recent acquisitions performed well [inaudible] in the second quarter.
Let's turn to slide six to discuss our advertising investments. We continue to increase our investment in advertising with double digit growth in the second quarter on top of last year's double digit growth. Our commitment to advertising investment is a key component of our strategy and our strong execution gives us the confidence that we will continue to achieve our goals.
As we previously discussed we are also driving a series of initiatives across brand building to further improve the efficiency and effectiveness of these investments. For example, we are driving cost savings through more efficient global media purchasing and production efficiencies. We will continue to focus on other efficiencies in our advertising spending as we move forward.
Let's turn to slide seven to discuss gross profit. Our gross profit for the quarter was $1.4 billion, a 5% increase over Q2 of last year. As you know, our focus is on gross profit dollars as this is what allows us to continue to grow our investments in advertising and innovation. On a year-to-date basis, gross profit was $2.8 billion, a 6% increase over 2007.
For the full year we still anticipate gross profit dollars will rise at a mid single digit rate. As some of you anticipated our gross profit margin during Q2 declined by about 250 basis points to 43.2% versus last year’s tough comparable when gross profit rose by about 120 basis points.
Contributors to the decline were our recent acquisitions which reduced gross margin by about 70 basis points as well as incremental commodity, fuel, energy and benefits inflation. Offsetting these were the benefits of price, mix, productivity initiatives and operating leverage.
We now anticipate gross margin will decline by approximately 200 basis points for the full year, up from our prior estimate of 150 basis points driven largely by our increased inflation estimate which I will come back to in a moment as well as our recent acquisition in China.
About half of the full year growth margin decline was due to our recent acquisition as well as higher up front costs in cost of goods while the remaining decline was driven by commodity inflation. As you know even though we have tried to offset inflation the map leads to a lower gross profit margin as a percent of sales.
Let's turn to slide eight for further discussion on our inflation outlook. Our full year outlook now includes approximately $0.90 of incremental commodity, fuel, energy and benefits inflation versus our prior estimate of $0.80. If we consider all cost pressures, the full impact of inflation of cost of goods is estimated to be approximately 9% for full year.
While we anticipate continued volatility in the commodity markets our business model and strategy give us the ability to manage through this volatility. On the cost side we have met the challenges through our continued drive for productivity savings and a
focus on managing SG&A costs.
On the revenue side we are focused on strong innovation backed by advertising support as well as price realization. These proactive actions have allowed us to meet or exceed our original targets despite significant cost volatility.
Let's turn to slide nine to discuss our operating profit. As expected total internal operating
profit rose by 2% versus last year's strong 9% growth. The quarter was helped by our strong sales execution, price mix and productivity initiatives and was offset by significantly higher commodity inflation as well as a double digit increase in advertising. Our North American business reported an internal operating profit increase of 5.3% building on last year's 11% growth.
This resulted from a mid single digit increase in sales as well as productivity savings and lower up front cost investments and was partially offset by significant cost inflation. Our European internal operating profit declined 4% versus last year’s difficult 19% comparison. Performance was driven by higher commodity costs and a strong increase
in advertising investment.
In Latin America operating profit rose by 2.1% including the impact of commodity cost increases and higher advertising spending. In Asia Pacific internal operating profit increased by 1.4% despite a double digit increase in advertising.
Up front costs for the quarter totaled $0.04 per share including a $0.03 charge in corporate SG&A to eliminate the reload feature that was a part of our employee stock option program grant until 2004. The elimination of this feature from those grants will result in a lower option expense going forward.
Below the operating profit line interest expense was $77 million in line with last year and other income expense was an $8 million expense. The tax rate declined to 29.9% and we benefited from fewer shares outstanding.
Let's turn to slide 10 to review cash flow. In Q2 cash flow was $329 million versus last year's $280 million. Year-to-date cash flow is above our expectations at $510 million versus last year’s $569 million. Cash flow benefited from higher operating profit and other strong improvement in working capital. In fact, our cash conversion cycle improved by three days over last year to an impressive 22 days.
For the full year we continue to expect cash flow of $1 billion to $1.75 billion.
Let's turn to page 11. For the full year we continue to expect mid single digit revenue growth driven by both strong execution and price realization. Operating profit is also expected to rise at a mid single digit rate driven by revenue growth, productivity initiatives, operating leverage and lower up front costs. We now expect earnings to be between $2.95 and $3.00 per share.
We anticipate full year up front costs of about $0.14 per share in 2008 while we have determined that at least $0.03 of the 53rd week’s profit are being invested in the new acquisitions and we are still evaluating alternatives for the remaining $0.02.
Below the operating profit line we expect interest expense to be slightly lower compared
with last year and other income expense is forecasted to be a $0.02 to $0.03 expense for the full year. Our full year tax rate is still expected to be approximately 31%.
Finally, our additional $500 million share repurchase is not expected to materially impact our 2008 EPS.
Although we generally do not provide quarterly guidance we want to give you a feel for the shape of the second half outlook. During the third quarter we will once again face tough comparables due to 2007’s lower tax rate which was driven by discreet items. We expect to post the year's highest EPS growth in the fourth quarter due to last year's high Q4 tax rate and the 53rd week.
The strength of our business model and strategy give us the confidence that we can
meet our goals despite the volatile commodity and economic environment that we are experiencing today. We will continue to invest for the future to deliver sustainable and dependable long-term performance.
Now I’d like to turn it back to David for slide 12.
If we start in North America where we posted solid growth versus last year's strong 6% our growth was broad based across all the business units and we’ll discuss each business unit in more detail starting with slide 13.
North American cereal grew sales grew 5% during Q2, building on last year's growth. The [inaudible] cereal category growth remains strong and we are very pleased with our performance in the current competitive environment. During the quarter our IRI measured channel share declined by about one point driven by a significant increase in our largest competitor’s incremental or trade driven sales.
However, when we include the impact of retail in the non-measured channel we achieved a significantly better performance. In addition, price realization was strong and our price per pound in measured channels rose 4%. Our solid price mix performance resulted from the realization of our price increases and innovation like Special K Cinnamon Pecan.
In addition, Corn Pops sales showed strong growth for the quarter. As we discussed last quarter our cereal box size adjustments have now been completed. Kashi once again posted another double digit sales increase driven by GOLEAN Crunch and Organic Promise. Our second half innovation included introductions from Mini Wheats, Smart Start and Kashi franchises.
Our Canadian sales also rose by mid single digits driven by innovation like Special K Satisfaction and the accelerated expansion of Kashi where we saw strong cereal growth.
Let's turn to slide 14 to discuss our snacks performance. Snack sales rose a strong 6% in Q2 on top of last year's exceptional 9% comp. As we discussed during the Q1 call the transition of Kashi cookies, crackers and bars, as well as fruit snacks to DSD continues to deliver solid results.
Sales of Kashi snacks are up sharply due to significant increases in distribution and quality merchandising. Our snacks business will continue to be driven by innovation and our recently announced second round of pricing.
Let's turn to slide 15 to look at more detail on the quarter. Our Pop Tarts business posted a slight sales decline verse last year's growth. While we achieved mid single digit growth from our core Pop Tarts we were still lapping last year’s Go Tarts sales which are now declining.
Our cracker business continues to post strong results with sales rising double digits during the quarter and we gained one point of market share. Innovation performed well ahead of expectations with products like Cheez-It [duos] and Town House Flip Sides driving all of our share gains.
Our cookie business also achieved low single digit sales growth in Q2 as the category showed good growth and we achieved IRI share gains. We had strong performance from brands like Chips Deluxe, Fudge Shoppe and Rite Bites Portion Control Packs.
Second half innovation was strong with the return of Hydrox by popular demand. Growth in our whole foods snacks business was driven by products like Rice Crispies Treats and Kashi TLC Chewy Granola Bars.
If we turn to slide 16 we can discuss our frozen and specialty channels performance. Frozen and specialty channels had another great quarter with sales rising 10% versus
last year's 7% comp. Our frozen sales grew at double digits which drove share gains across the business. Key to our growth was great innovation supported by strong advertising and promotion.
Eggo waffles, pancakes, and french toast varieties achieved solid base sales growth. In addition, new innovation performed well including new Eggo Mini Muffin Tops resulting in frozen breakfast IRI share gains of more than two points during the quarter. The Morningstar Farms veggie foods business also turned in another solid quarter as our healthy lifestyle message grows strong consumption.
Once again our Kashi all natural frozen entrée’s and pizzas performed very well and ahead of expectations. We drove IRI market share gains and we have just recently launched some new Kashi pocket bread sandwiches.
Our specialty businesses also achieved strong mid single digit growth in food service and vending channels during Q2.
If we turn to slide 17 we can review our international business performance. You can see on the slide that our international business posted another solid quarter with internal sales
rising 6% versus last year's 6% growth. Sales growth was broad based around the world.
Let's turn to slide 18 to discuss this in further detail. In Europe we achieved solid 5% internal sales growth on top of last year's strong 7% increase. Our solid U.K. performance
was above expectations driven by category growth and strong execution in both our cereal and snacks business.
We also achieved growth in Italy as well as the Nordics, [inaudible] and the Middle East regions. In addition, our European snacks business achieved double digit sales growth driven by solid performance across the region. We are also pleased to report that the integration and development plan for a United Bakers acquisition in Russia is progressing well.
In Latin America we posted 7% internal sales growth versus last year's strong 8% increase. Growth was broad based with mid single digit increases in both cereal and snacks. We saw solid growth in Mexico behind our core brands. In addition, we saw good growth in Central America, Venezuela and Brazil.
Our Asia Pacific business unit posted solid 9% internal sales growth. In the very competitive Australian market our cereal business grew mid single digits driven by brands like Nutrigrain, Special K and All Bran. Our South Africa, India and South Korea businesses once again achieved double digit growth largely driven by per capita growth in ready to eat cereal.
For the rest of 2008 we will continue to invest in advertising and innovation to drive further growth in these markets.
Let's turn to slide 19 to talk about our second half innovation. Our innovation plans give us additional confidence in our sales and price mix contribution. While this is only a sample of the new products we're introducing you can see that the variety spans
geographic regions and categories. Our long term goal is for innovation introduced in the prior three years to account for roughly 15% of current year's sales.
As you know we have exceeded this goal in recent years and it is the contribution from this innovation that has helped drive our mix performance.
If we turn to slide 20 for a summary. We are very pleased with our 2008 year-to-date performance. We came into 2008 anticipating earnings of $2.92 to $2.97 per share including more than $0.65 of incremental commodity, fuel, energy and benefits inflation. Despite our current expectation of approximately $0.90 of inflation we have increased our earnings expectation to $2.95 to $3.00 per share.
We have responded to these challenging times by continuing to make the right decisions for the long term. We will achieve our increased targets while countering the cost headwinds by driving price realization as well as increased cost and productivity savings.
This is strength of our consistent business model and strategy. We also expanded our geographic footprint with the addition of United Bakers in Russia and Navigable Foods in China. Both acquisitions represent exciting opportunities to help build sustainable and dependable growth in the future.
Overcoming the volatility we are experiencing today requires a strong and dedicated work force and Kellogg employees have met the current challenges, executing our business plans with excellence. They continue to drive cost savings, innovation and strong marketing execution.
Our long term growth will be driven by our commitment to investing in great ideas and keeping consumers engaged with our brands and their unique benefits. Our focus remains steadfast on continuing our consistent track record of delivering sustainable and dependable growth.
With that I'd like to open it up for questions.
(Operator Instructions) Our first question comes from the line of Alex Patterson – RCS.
Alex Patterson – RCS
On your cost of goods 9% increase, I just wanted to get a sense of that. That is inclusive of all the hedging initiatives you put in place at the beginning of the year?
That is correct.
Alex Patterson – RCS
I believe you said you were probably in the order of 80-85% covered at that point?
That is correct.
Alex Patterson – RCS
And that number still pretty much holds?
That number is now higher. We are probably about 90% hedged where we can hedge. There are clearly some items you can’t hedge but we have taken as much hedging for this year as we can and I think for that reason we feel very confident about the year even though volatility in commodities and energy remains high.
The next question comes from the line of Andrew Lazar - Lehman Brothers.
Andrew Lazar - Lehman Brothers
I guess you had mentioned that x acquisitions and higher up front spending that are flowing through cost of goods this year your gross margin would be down about 100 basis points for the full year. I guess 200 including all that. I guess that is not dramatically out of line in kind of what we have seen with a lot of food companies but maybe a bit at the lower end. I guess I just thought with your productivity plan both with the base productivity and all the up front projects you have been doing perhaps you’d be maybe better equipped than some of your peers to sort of deal with some of this.
I’m just curious what some of the differences might be. Is it in the way you are hedged versus others do you think? Is it the way some of the commodity costs have hit you versus others? Or is there something around operating leverage that perhaps you are not seeing that you want to? I’m just trying to get a sense of that. I would think you would be frankly better equipped than many others.
I think we are in pretty good shape with broadly offsetting inflation with pricing and when you do that the mass clearly will drive down your gross profit margin percent. As we have said before we are very much focused on gross margin dollars. They are going to be up mid single digits for the year. That enables us to invest back in the business to drive sustainable and dependable performance and I think what you are seeing now in our current momentum and strong first half with all of the investments we have made and continuing focus on cost reductions and efficiency gains actually enabling us to weather a fairly volatile environment. We still continue to perform with a heavy degree of confidence about the future. So I think we are in pretty good shape. Others are doing a variety of things on hedging. I don’t really want to get into that. We have a fairly conservative approach where we try to take volatility out. I think while you can hedge things roll off eventually and you do need to price for the market and the way you view it.
We feel good about where we are and where we are going.
The next question comes from the line of Eric Serotta – Merrill Lynch.
Eric Serotta – Merrill Lynch
First, John you mentioned with respect to the 53rd week I think the $0.03 would be attributable to reinvestment towards acquisitions and $0.02 would be to be determined. From that I took that the full $0.05 would be reinvested. But then later on when you were talking about year-over-year growth on the break out between the third and fourth quarter you mentioned the extra week as being a factor in the fourth quarter. Is that just a timing difference? Could you explain that to me a bit?
That’s right Eric. The 53rd week will be reinvested back in the business but we will reinvest that back in the business across the year. In fact we have already started with some of the investment in Q1 and Q2 as we make those acquisitions. Then all of the reported benefit of the 53rd week comes in the fourth quarter. Somewhere between $0.03 and $0.02 yet to be determined.
Eric Serotta – Merrill Lynch
To pick up on David’s comment about the reality of hedges continually rolling off. I know it is early in the year about a quarter earlier than you typically give outlook for the following year but given the commodity volatility and what was still a significant benefit from hedging this year could you give us some sort of feeling as to how you are looking at the commodity picture for next year? Do you have any coverage in place yet? Should we expect any kind of a step change as the coverage from this year rolls off?
It is a bit early to give too much on 2009. Our expectation for 2009 is that we will see cost inflation again. Not in our view at this point to the levels of 2008 but likely above what we saw in 2007. That is the current basis on which we are planning for the future. At this early stage we feel that is appropriate. We have taken some coverage but it is not dramatic at this point. As you were saying the markets remain extremely volatile but our belief is, as we have said to our investors over the last 18-24 months, we are in a new upwards cycle in commodity inflation and that is our view that we will see a further increase in 2009.
The next question comes from the line of Chris Growe - Stifel Nicolaus.
Chris Growe - Stifel Nicolaus
I wanted to ask a few questions just relative to kind of along the same lines. Seemingly shifting along the channels of non-measured channels, I wonder if you could speak to that for Kellogg and particularly I think you said in cereal for example. Related to that your view of kind of the private label trade down. Do you get some feel for what happened to cereal in the second quarter that has become more of an issue or problem for the business?
What you are seeing is I think growth is pretty strong in the non-measured and many of the major channels also doing very well. We did pretty well in the non-measured. We did okay in the measured channels. I think what we are seeing is in general a belief that center store sales are actually benefiting from a consumer trade or reduction in consumption. I think casual dining is declining. I think people are buying more through the grocery stores and us and many others are benefiting from that. We would expect that trend to probably continue. So I think that is why we are seeing…as we look at cereal for example growth in the category for the second quarter was probably the strongest we have seen in a number of years. By our estimation while we grew 5 the category was up anywhere from 5-6%. We haven’t seen that level of growth in quite a while so that is a very positive indication that we are seeing people actually move to the grocery store.
We and many others are benefiting from that. I think while consumers are under a lot of pressure and private label is in aggregate doing pretty well our view is that we are seeing the benefit from out of home drop. We have strong brands. We have got strong innovation. As the number one or number two in the categories in which we compete we don’t think it is going to have a massive impact on us.
Chris Growe - Stifel Nicolaus
Could you just clarify one comment from John before on the $0.03 charge that is actually in this quarter and then reversed in the second half?
The $0.03 charge in the second quarter is the charge of eliminating the reload feature of the options we have outstanding. So what will happen is we will have lower option expense going forward. There will be some of that in the back half of this year and we will have a full run rate in 2009.
Chris Growe - Stifel Nicolaus
Is it a $0.03 benefit in 2009 then?
The next question comes from the line of Jonathan Feeney – Wachovia.
Jonathan Feeney - Wachovia
I wanted to ask a couple of questions if you don’t mind. The first is a big picture question. With all the discussions you have had with retailers and activity you have had taking pricing what do you think would happen in the second half of this year or first half of next year in commodities particularly wheat, corn, soy, etc. if they continued their relatively precipitous declines? Do you think it would change the pricing dynamic in a meaningful way?
No, I think we have said we price typically behind inflation. We took a round of pricing at the beginning of this year that we though out offset inflation in 2008. We are taking incremental pricing across a lot of the businesses in the second half because inflation as we said exceeded our expectations. We typically do price behind inflation and the reasons for that is the one you are mentioning. We don’t want to price and then see a commodity and costs drop precipitously. I have to tell you that is not our view. Some of the reductions we are seeing while they might look dramatic when you think of where they come from and even with our today most of the major commodities are more than double what we would have seen 2-3 years ago.
We are in a very different environment from a commodity and energy perspective and our view is that will persist. Some things could drop. Others will continue to go up. In aggregate we think we will continue to see inflation as we go forward.
Jonathan Feeney - Wachovia
On United Bakers it seems to be there could be a huge opportunity here. I know it is an unorthodox way of looking at it, but Kellogg’s has about $440,000 in sales per employee. This company you just bought in Russia, a very fast growing market, has about $25,000 in sales per employee. It seems like there are some differences there but I know it is probably not 90% different. Is there a huge opportunity to leverage distribution there? How soon can we see new Kellogg products sort of going through that distribution network?
I think that acquisition is going to prove a great one for us in the medium to long term. We are looking at the opportunities. Russia is a market that continues to grow rapidly. I think we have bought a fantastic platform for cookies, crackers and cereal off which we can no doubt expand and grow into the future. Yes, we did inherit with the acquisition a lot of employees. We intend to utilize them to continue to grow that business into the future.
Jonathan Feeney - Wachovia
Can you give us any sense of what products may be first and how soon we would see new products in there?
We’ll roll that out for you when everything is finalized and we are closer to actually talking to the market participants. There is a lot of work going on as we speak to ensure we have the opportunity to maximize that business as we go forward.
The next question comes from the line of Vincent Andrews - Morgan Stanley.
Vincent Andrews - Morgan Stanley
If I could just ask a question on Europe. I understand the difficult comparison with last year but the first quarter did as well and the top line grew substantially in the second quarter. I’m just wondering what the difference was between 1Q where you grew a great profit and 2Q where it declined?
I think as we said on the call when the second quarter last year our operating profit grew 19%. This year it was down 4%. Through a very, very tough comp commodities as we said in the last couple of calls while it was predominately a Latin America/U.S. issue it has now spread to the EU over the last 12 months. That impacted us and also United Bakers, the acquisition in Russia, had an impact on our profit. So we feel pretty good about Europe. It is a challenging market but we are doing pretty well at the moment.
Vincent Andrews - Morgan Stanley
The other question I had was just to make sure and I think this is the case…some companies have been reporting different types of hedging gains or losses within their results and I assume there was nothing material for you in that regard?
Nothing significant. Most of our hedges get hedge accounting treatment. Within our other income expense you will see we are in a slight expense position. Because we are expensing some premiums on commodity options through that line.
The next question comes from the line of Robert Moskow - Credit Suisse.
Robert Moskow - Credit Suisse
A big part of the story for Kellogg over the years has been the mix to higher dollar per pound items. I’m just wondering as you see a consumer that is weakening whether you have reassessed your portfolio or at least taken another look at whether it is possible that consumers could trade down to lower dollar per pound items? Are there any parts of your portfolio you think you might want to emphasize at value offerings to consumers?
We’ll see and we are watching that closely. If you look at mix year-to-date for this year we are at about 1.6. If you look at the prior three years we were around 2. So it is pretty similar. We could see a mix within our portfolio where people go to more basic foods within the Kellogg portfolio. We are fortunate that in most of our portfolio the operating margins and returns are pretty good. We don’t…it is a concern to watch but at this point we are not seeing it. Who knows what the future holds but at this stage we feel very good about our business and our portfolio in aggregate.
The next question comes from the line of Eric Katzman - Deutsche Bank.
Eric Katzman - Deutsche Bank
Gross profit dollars I think getting back to I think it was Andrew’s question, the gross profit dollars up mid single digit. John can you kind of dice and slice that to the extent we exclude M&A and we exclude 53rd week? Are gross profit dollars for the full year expected to be flat if we exclude some of these items?
The M&A does not have a significant impact on it because of the margin structure of the businesses we are acquiring. The 53rd week also is not a significant driver of that. It would be probably around that mid single digits, maybe a little bit lower than that with a little bit of foreign exchange getting in that.
Eric Katzman - Deutsche Bank
As a follow-up, we have been hearing some companies getting more concerned about the European consumer. I guess there is also some concerns in emerging markets as to whether the consumer holds in there. Dave perhaps you can take us on a little bit of a tour around the world as to kind of what Kellogg is seeing from the consumer outside the U.S.
I think when you go to Europe there are a couple of markets there that for a variety of reasons are demonstrating a little bit of weakness; Spain has a particularly tough economic environment at the moment. While our business is doing okay there I think in general terms consumers are under pressure. That is true in France. I think if you speak to most companies I think 75% of the grocery categories in France are down due to economic conditions. Retailers there have actually cut inventories pretty significantly so we are seeing a little bit of weakness there. Whether that persists depends on whether that inventory cut is one-time as one would expect.
In aggregate we grew 5% so even with a couple of markets showing a little bit of weakness our business in totality continues to do well. We do track what is going on with private label and hard discounters. As always there is a concern there but that is still growing and we haven’t seen a massive acceleration. You go to markets like Latin America and we saw pretty good growth. There were a couple of markets there that I’ll point out were a little bit weaker than normal. Venezuela we grew double digits but it was significantly lower than we have seen for awhile. The key reason was there was an issue with milk and the price of milk and there was no milk available in Venezuela for probably the first 3-4 months of this year.
As you can imagine, in the cereal business that can be a little problematic. So our growth there was significantly slower than it had been in the prior year. Then Columbia the economy is a little weak there. I’m not sure you can draw any aggregate conclusions from any of that. It is all isolated. Again, in Latin America our business grew 7% and while we are watching it at this point we feel fairly comfortable with the future for our business and the strength of our brand and continued factors and innovations should hold us in pretty good stead.
The next question comes from the line of Terry Bivens – JP Morgan.
Terry Bivens – JP Morgan
Back on the cereal topic for a second, certainly a good growth rate. That is not what we see in Nielsen I know which only gives us part of the picture. Can you kind of pars what you are seeing in terms of the growth rate in the measured channels versus WalMart and or unmeasured I should say in the aggregate and also if you could give us an update on market share now that we are kind of nearing the end of General Mills’ strategy?
I think on the category, as I said earlier, we believe the category across all channels grew anywhere from a low of 5 to a high of 6%. If you look at the IRI data through the 13 weeks ending the 29th of June it was up 3.6%. Typically would add anywhere between 2-3% of that to get to the overall market. So you can see that while IRI is 3.6 the category is doing significantly better in aggregate. Let’s call it 5.5%. We grew 5% so we did lose share in measured channels. We lost one share point. I think one of our competitors was aggressive there and are probably lapping a weak comp because of their Right Size Right Price initiative last year but incremental up 42% for a 13-week period was a long time. We’ll probably see in the third quarter with our lapping weakness again they will probably do well and that side of our business might not look so good but we are very comfortable with the way our cereal is going.
I have to tell you we have started well as we go into Q3 so the cereal category actually does appear to be benefiting from this overall change in consumer behavior where out of home consumption and casual dining looks to be down at least double digits and center store in aggregate does appear to be picking a lot of that up as consumers buy more and eat more at home. I think that is reflected not only in cereal but across a number of the categories in which we compete where we are seeing relatively strong and maybe even marginally stronger growth than we have seen over the last couple of years.
Does that get at your question Terry?
The next question comes from the line of David Driscoll – Citi.
David Driscoll – Citi
Gentlemen on the last two calls you highlighted that the first half earnings faced very difficult earnings comparisons. Second quarter earnings are up 9%, a very solid number. David I’d just like to ask you, what specifically came in better versus your plan in the second quarter? Can you call out a couple of factors?
Yes, top line was strong. While we got impacted by high commodities in the quarter and we had tough comps and we had a tax benefit last year that we didn’t have this year our tax rate actually was positive in the quarter. So I think it was more the momentum and strength of the top line in the quarter across almost all the markets. We saw broad based growth almost everywhere and typically we will have a pocket of weakness somewhere but in aggregate it is pretty hard to come up with one in the second quarter as far as top line goes.
David Driscoll – Citi
In the U.S. cracker business it looks like competitive activity is picking up there. Can you talk to us a little bit about trends for Kellogg and your new product plans that are coming? I did notice but I’m just curious if there was any other announcements on new products in crackers?
Yes we have a few things coming out. Our innovation we kicked off in the first half of the year continues to actually grow and that is really the Cheez-Its Duos and the Townhouse Slip Sides and I think we are going to see a further momentum and up side from that. We have a low fat white cheddar Cheez-It coming out and a couple of other innovations. Our innovation through the first half I still think has legs through the second half and we are going to enhance on those as we go forward.
The whole category in crackers and cookies again very strong. We saw strong growth and even though we priced early in the year we have announced a second price increase for the back part of the year because probably if you look at snacks it is probably one of the most negatively impacted from a commodities inflation perspective as we look across our portfolio.
I think the category is going to continue to do well and I think all players can continue to grow and succeed.
The next question comes from the line of Alexia Howard - Sanford Bernstein.
Alexia Howard - Sanford Bernstein
A question on commodity comps. I know you said last quarter it was $0.15 a share you were facing. Could you let us know what it was for this quarter? Given that outlook for commodities what are the primary drivers of the better EBIT growth that you are expecting in the second half of 2008? I know you mentioned some of them earlier but could you repeat them? Is it mostly pricing? Is it a slow down in the up front costs? Is it better productivity improvements coming through? Is it a slow down in marketing spend? Could you just give us an idea of which of those factors you think are the most important?
I’ll let John take the commodity inflation in Q2 because I think we have got the number. In the back half as John said the third quarter is going to be a challenge. The fourth quarter is going to be very strong. A number of factors in that. One time costs from last year. Our increase in advertising was extremely high. Our expectation would be while we will have strong advertising we won’t see the levels of increase we saw in the fourth quarter last year. In general terms I think when you look at third quarter the commodity impact is higher there than it is in fourth.
Those are some of the things. John do you want to follow-up?
The commodity impact in the second quarter was about $0.24.
The next question comes from the line of Judy Hahn – Goldman Sachs.
Judy Hahn – Goldman Sachs
First, in terms of the price gap versus private labels in cereal has the trend changed in any way up or down?
Not dramatically. I think we are seeing them price maybe slightly below the branded players in the category but typically that is the lag effect because they get pricing through probably a little slower than the branded players. We are up fourish. They are probably up in the low 3’s. We would expect they will catch up in that. They have cut the amount they promote too because I think they are trying to make their P&L’s work. No real dramatic change in the spreads at this point. As we see historically we are seeing occasionally a particular retailer or two have a greater focus on private label and drive it aggressively and that can tend to skew the data until we dig into it and look at the fundamentals of what is going on.
We’d expect that to continue. In general terms the price gaps really haven’t moved. I think as we look at it while given the consumer is under a fair amount of pressure you’d expect private label to do well. We believe we can continue to do well due to the strength of our brands, our strong innovation and the high quality of our product offerings.
Judy Hahn – Goldman Sachs
You talked about the incremental pricing in the second half. Can you give us the magnitude of the price increases in the second half particularly if you compared that against the price increases taken at the beginning of the year?
No, I haven’t actually done the math. All I’d say is that it is sort of broad across many of the businesses. A lot of them have been announced and some are coming probably in the low single digits.
Judy Hahn – Goldman Sachs
That is a difference from what you have done earlier in the year?
The next question comes from the line of Timothy Ramey – DA Davidson.
Timothy Ramey – DA Davidson
I’m wondering if you can give me a little more clarity on the change in estimates of $0.90 of cost that you now adopt versus the $0.80 you said before. There weren’t that many things that go worse in Q2 except I suppose energy. Was it the $0.03 from the reset options? What else might have been in there?
It was both energy and also edible oils. Those are two I would point out. In general terms anything that is energy based also continues to rise. Across a number of items we did see an increase.
To clarify the $0.03 for option expense was not part of that $0.90 expectation.
Timothy Ramey – DA Davidson
David you mentioned healthy snacks were up but I don’t think you give us an order of magnitude. Is that business doing as well as it has done in the past given a weaker consumer?
I think it is growing about mid single digits. It had grown historically probably a little higher than that and our expectation had always been in the medium to long term it would grow mid single digits so it is performing pretty much as we would expect it to perform. We grew about with the category for the quarter so it was a pretty solid performance and it continues to be a category that I think will grow around that level going forward.
The next question comes from the line of Ken Zaslow - BMO Capital Markets.
Ken Zaslow - BMO Capital Markets
Just going back to Europe what steps can you do to reverse the profit trends in Europe? Is it more just doing the same or is there something that the pricing environment can get better? What steps can really change the profit outlook for Europe?
I think if you look at the year when we finish the year I think you’ll look back at the year and you’ll go okay the profit in Europe was pretty solid. I wouldn’t be drawing any negatives from a quarter number because the comparatives are the single biggest driver of why it didn’t look so good and I think when we finish the year we’ll look at our European profit and it will be where we expect it to be. It will be relatively healthy. I wouldn’t draw too much from the quarter number because when you are up +9 a year ago and you are down 4 and your aggregate is still pretty healthy out of the 2-year period.
We will have more up front costs in Europe this year relative to last year so that will slightly deflate some of the quarter numbers.
Ken Zaslow - BMO Capital Markets
Up front costs this quarter on Europe or no?
There was a little bit but it wasn’t that significant.
That does conclude today’s question-and-answer session.
We just want to thank everybody for attending our call today. We appreciate your interest.
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