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Kellogg (NYSE:K)

Q3 2012 Earnings Call

November 01, 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

David Denholm

Analysts

John J. Baumgartner - Wells Fargo Securities, LLC, Research Division

David Driscoll - Citigroup Inc, Research Division

Scott Andrew Mushkin - Jefferies & Company, Inc., Research Division

Matthew C. Grainger - Morgan Stanley, Research Division

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

Eric R. Katzman - Deutsche Bank AG, Research Division

Robert Moskow - Crédit Suisse AG, Research Division

Diane Geissler - Credit Agricole Securities (NYSE:USA) Inc., Research Division

Andrew Lazar - Barclays Capital, Research Division

Edward Aaron - RBC Capital Markets, LLC, Research Division

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

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

Operator

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

Simon Burton

Thank you, Sean. Good morning and thank you for joining us today for a review of our third quarter 2012 results. I'm joined by John Bryant, our President and CEO; Ron Dissinger, our Chief Financial Officer; and David Denholm, President of our U.S. Morning Foods business. Intention is to highlight different business units periodically and David is here to discuss our U.S. Cereal and Pop-Tarts businesses in a little more detail.

Also, I just wanted to mention, for those of you don't know, they will be hosting a day of presentations for analysts and investors in Chicago on November 8. Please contact us if you'd like to attend and haven't yet registered.

The press release and slides to support our remarks this morning are posted on our website at www.kelloggscompany.com. As you're aware, certain statements made today, such as projections for Kellogg company's future performance, including earnings per share, sales, profit, cash flow, brand building, cost, investments and the integration of Pringles, are all 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.

As a reminder, a replay of today's conference call will be available by phone through Monday, November 5. The call will also be available via webcast, which will be archived for at least 90 days. Now, I'll turn it over to John.

John A. Bryant

Thanks, Simon, and thanks to everyone for joining us today. I know the recent storm has had an impact on many of you. I hope that you and your families are safe.

Turning to our third quarter results. We're pleased that our underlying performance in the third quarter was broadly in line with expectations and reflects continued progress. Internal net sales growth was almost 3%, the high end of our guidance for the full year. As expected, our top line growth has been improving sequentially as we've progressed through the year. Consolidated internal operating profit would have also increased in the quarter were it not for the impact of the Mini-Wheats recall, which I'll discuss in more detail in a minute. And as with sales growth, we've seen some sequential improvement in underlying operating profit during the year, particularly in North America.

Underlying operating results in North America were very strong as we saw a significant improvement in the Cereal business. We continue to see strong performance from Pop-Tarts, Specialty Channels and the Frozen Foods business.

We also saw some additional improvement in the European business. In the U.K., we've seen benefits from better commercial programs and strong innovation. As a consequence, we've posted sales growth in both Cereal and Snacks in the quarter in the U.K. As we've discussed before, the Continental European business continues to be under pressure due to economic conditions where we've taken actions and have seen some early signs that they're having an effect. Underlying sales growth was strong in both Asia Pacific and Latin America and, as we mentioned on our last call, we increased our investment in brand building to double-digit rate in both regions.

Now, I'd like to address the Mini-Wheats recall of a few weeks ago. Obviously, we never want to have a recall. But as you know, these things do happen periodically in our industry. We reacted quickly and effectively to the situation. I remain confident that we have turned the corner in our supply chain over the last 2 years, that we have proactively identified and addressed the challenges. This places us in a much stronger position to avoid and mitigate these issues in the future.

Let's turn to Slide 4 in a brief update regarding Pringles. As you know, we have seen better operating performance from Pringles than we expected. In fact, Pringles in North America posted organic sales growth of 10% in the third quarter. This a testament to the strength of the brand and the team that's running the business. We're very pleased that we've been able to attract many of the Pringles employees to Kellogg. They're excited to become part of a large food company and we're pleased to be gaining such energized and knowledgeable people.

And finally, the integration continues to go well. The teams running the integration are doing a great job. They've executed well in North America and have already seen some benefit and we're currently in the middle of the integration in Europe. So we're excited about the potential of this iconic global brand and as you might imagine, we'll give you more detail in next week's Investor Day.

And now, let me turn it over to Ron for a discussion of our financial performance.

Ronald L. Dissinger

Thanks, John, and good morning, everyone. Slide 5 provides a summary of our quarterly and year-to-date financial results. We posted reported revenue growth of 12.3% in the quarter and internal sales, excluding the impact of Pringles, divestitures and foreign exchange, increased by 2.8%. Reported operating profit increased by 3.2%. Internal operating profit decreased by 4.9% in the third quarter. This included investment in brand building that increased at a high single-digit rate. It also included the impact of the recall. Excluding that impact, internal operating profit would have increased by approximately 1%, so the recall is approximately a 6-point headwind to operating profit in the quarter. Reported earnings per share were $0.82 in the third quarter, up 2.5% and in line with our expectations but this includes $0.04 of integration costs, so earnings per share, excluding integration costs, were $0.86, up 7.5%. As we mentioned a few weeks ago, good performance from Pringles and certain below-the-line items, including lower-than-expected share dilution, offset the $0.06 impact of the recall on EPS in the third quarter.

Now let's turn to Slide 6 and details of third quarter sales growth. As I mentioned, reported sales increased by 12.3% and internal net sales increased by 2.8%. Volumes increased slightly in the quarter, reflecting the improving trends we've seen as we progressed through the year, particularly in North America. We also continued to see both positive price and mix improvements, which was up 2.7 points in the quarter. As was the case last quarter, we increased internal sales in the quarter globally across Cereal, Snacks and our Specialty and Frozen businesses. Pringles added more than 11 points to overall reported sales growth in the quarter and currency reduced overall growth by 1.6 points.

Slide 7 shows our gross profit performance. Reported gross profit was $1.4 billion in the third quarter, up nearly 7% but gross margin was lower by 190 basis points. Gross margin was impacted by continued commodity inflation in the quarter. In addition, margin was reduced approximately 60 basis points by the recall. Also, we owned Pringles for the entirety of the third quarter and as you know, Pringles has a lower gross margin than the company's average. This had a dilutive effect on the company's gross margin of approximately 40 basis points. Having said that, we have developed and are already implementing initiatives to increase the Pringles margins over time.

Now let's look at Slide 8 and details of our investment in brand building. As you can see on the chart, investment increased significantly in the quarter. Our plans were always for our investment to be weighted to the second half of the year and this has certainly turned out to be the case. This activity has supported innovations launched since midyear, various new commercial programs and activities such as the Olympics. And as you can see on the chart, we expect that investment in the fourth quarter will also be higher than during the fourth quarter of last year.

We continue to expect that investment in brand building for the year will increase at a rate equal to or greater than sales growth. It is worth noting that we're planning this increase, including the efficiencies we've been able to realize this year. And of course, we'll continue to develop plans for efficiencies next year as well.

Slide 9 shows the internal operating performance for each of the regions. As I mentioned earlier, internal operating profit for the total company decreased by 4.9% in the quarter. North America's internal operating profit decreased by 1.6% in the quarter. While sales growth was strong, the business increased its investment in brand building by 10%. In addition, commodity inflation had a significant impact as did the recall. In fact, without the recall, North America's operating profit would have increased by more than 6%.

Europe's internal operating profit declined by 7.7% in the quarter. This was the result of the difficult economic environment in the region. However, these results were broadly in, line with our guidance and represent a significant sequential improvement from the first 2 quarters of the year.

While commodity inflation and a double-digit increase in investment in brand building had an impact on the quarter's operating profit in Latin America, we also worked hard to reduce trade inventory levels in Mexico. As a result of all 3 of these items, Latin America's internal operating profit decreased by approximately 17% in the quarter. Outside of Mexico, the region posted double-digit operating profit growth.

Finally, internal operating profit in Asia Pacific was 3% lower year-over-year. While sales growth was strong, the business also increased its investment in brand building at a double-digit rate. We have improved commercial plans in Australia and has started to show in the third quarter's results.

Slide 10 shows our year-to-date cash flow. Year-to-date cash flow was approximately $1.1 billion, an increase of more than $236 million versus the comparable period last year. Remember, this year's amount includes the working capital benefit we got as a result of the Pringles' acquisition. Year-to-date capital spending was $262 million or 2.5% of sales. Our capital spending is more back-end weighted, consistent with our investment profile in prior years and it does include investment in Pringles. We invested at a rate greater than our long-term targets last year and we now expect to invest at a rate of approximately 4% of net sales this year or at the low end of our previous guidance range of 4% to 5% and at the high-end of our long-term range of 3% to 4%.

And consistent with our plan, we didn't purchase any shares during the quarter. Instead, we have reduced our levels of debt by approximately $350 million. Finally, we still expect cash flow to be in the $1.1 billion to $1.2 billion range for the full year. While we are already at $1.1 billion, the timing of our capital spending will impact the fourth quarter results. Based upon our year-to-date performance and dependent upon timing of cash around year end, we could be at the high-end of our range.

You can see on Slide 11 that our guidance for 2012 net sales and earnings per share remains unchanged, but the recall had an impact on guidance for internal operating profit. Internal sales and operating profit guidance continues to exclude the impact of Pringles. Our earnings per share guidance includes the expected accretion and one-time costs related to the acquisition. Our expectations for full year internal sales growth remain unchanged at 2% to 3%, consistent with the improving trends we've seen. Our estimates for cost inflation of 7% and cost savings of slightly greater than 3% are consistent with previous guidance. Gross margin is expected to decline by a little more than 150 basis points. Pringles will dilute gross margin by approximately 40 basis points and the recall has impacted full year gross margin by approximately 20 basis points. So our estimate is that underlying gross margin will be down around 100 basis points. Internal operating profit is now expected to be down by between 4% and 6% due to the cost of the recall. We expect interest expense to be approximately $260 million, including the cost of debt issued to acquire Pringles and we expect our effective tax rate to be approximately 29%.

And as we told you a few weeks ago, our estimate for reported earnings per share has not changed. Better-than-expected performance in the Pringles business, lower than planned share dilution and better-than-expected performance on some below-the-line items has allowed us to maintain our earnings per share guidance. An earnings per share walk has been included in the slide appendix for your reference.

And finally, we had intended to give you guidance for 2013 on the fourth quarter conference call scheduled for early February of next year. However, as we're holding our Investor Day in a week, we'll give you a high level first look at next year's sales and earnings guidance at that time. Obviously then, we'll give you additional information on the fourth quarter call as we had always intended.

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

John A. Bryant

Thanks, Ron. Let's turn to Slide 12 which illustrates the internal revenue growth posted by Kellogg North America so far this year. As you can see, we have delivered good growth with the business, posting 4% internal sales growth for the second consecutive quarter.

Now, let's look at individual North American segments, starting with U.S. Snacks on Slide 13. The business posted internal net sales growth of 0.3% in the quarter. The Cracker category grew during the quarter, as did our business. It was building on strong sales growth in excess of 6% in the comparable period of last year. And Special K Cracker Chips and Cheez-It both did well in the quarter. We're also encouraged that the introduction of Special K Popcorn Chips appears to be going well and that sales seem to be mostly incremental.

Consumption in the Cookie category, as a whole, remained unchanged in the third quarter. Our performance was impacted in part by the timing of our programs, although the Keebler brand posted growth even off a 4.5% growth comparison last year. We have more to be planned for the fourth quarter as well, although we're lapping a difficult comp.

The wholesome snack business remains a focus for us and we have more activity planned for the months to come. However, of note in the quarter was a strong performance of Special K Pastry Crisps. Consumption is strong and results thus far this year have exceeded expectations. This is a product that we recently launched in the U.K. under different branding and initial results are encouraging there too. We're very pleased with the responsiveness of the Pringles business to our merchandising efforts. As I mentioned before, sales growth in North America was 10% in the third quarter.

Slide 14 shows the performance of the U.S. Specialty segment. This segment posted internal revenue growth of 5.5% in the third quarter. This was a result of strong innovation introduced during the year, including Special K Cracker Chips, 2 new Rice Krispies Treats and new Eggo products. The gains have been broad based, with year-to-date sales increasing with all major customers. In addition, the Pringles business is also doing well in the Specialty Channels. Sales have outpaced our expectations in these channels as we're gaining points of distribution.

Now, let's turn to Slide 15 in the North America Other segment, which posted sales growth of more than 5% in the quarter. Within this segment, Frozen Foods posted strong sales growth. Both the frozen breakfast and Veggie Foods businesses did well. As pictured on the Slide, the recently launched Special K Flatbread Breakfast Sandwiches are off to a great start. The frozen veggie business has responded well to the advertising we began at midyear and we have more activity planned for both businesses in the fourth quarter.

Also within this segment, the Canadian business increased its share of the Cereal category by 0.5 points in the quarter, driven by our new Krave cereal, which has gained more than a share point in Canada. Also, we saw share gains in the Snack category. And Special K Cracker Chips and special K Pastry Crisps are both doing very well.

Slide 16 shows the performance of the Morning Foods and Kashi segment over the past couple of years. As you can see, this segment posted very strong growth in the third quarter. So now, I'd like to hand it over to David Denholm, the Head of our U.S. Morning Foods segment for a more detailed discussion of this business.

David Denholm

Thanks, John. Now, let's turn to Slide 18 and our quarterly performance. As you can see, the Morning Foods and Kashi segment posted strong growth in the third quarter, after a weaker-than-expected start to the year. The Cereal category responds to brand building, innovation and nutrition. And we've seen the benefit of our actions as we've progressed through the year.

For Cereal, the volume declines that we experienced early in the year in response to previous price increases certainly had the most significant impact in the first 2 quarters, although obviously, the situation has improved sequentially, as pricing moderated as we've moved through the year.

Slide 19 shows the shipments and market share performance of our Cereal business. The business posted growth of almost 6%, driven by innovation, a strong increase in the level of brand building and a relatively easier shipment comp. So while our inventories are in good shape this year and are in line with average levels, the year ago comp helped shipment growth exceed consumption in the quarter.

The Slide also shows our xAOC category share performance in the Cereal category in the 12-week period ended 1 October. As you can see, our Cereal business posted category share gains of 0.3 points, building on good gains in the comparable period of last year, and we continue to post share gains in early October behind increased investment in brand building.

Slide 20 outlines some highlights from the quarter and how well our business responds to brand building, the execution of big events and innovation. We increased investment in brand building at a double digit rate in the quarter with strong support behind key brands, such as Frosted Flakes, Mini-Wheats and Special K.

We also continue to increase the level of investments in Hispanic-oriented advertising and we are seeing an increasingly positive response. We had a successful back-to-school promotion with Scholastic to provide free books to school children. The execution of our Olympic program was fully integrated across the path to purchase, which included a heavy digital component and a PR program that delivered approximately 1 billion impressions. In fact, it was the largest PR program in the history of the Kellogg company.

Our cereal innovation strategy involves having the right level of pressure each year while working to improve the stickiness of our launches. During Q3, we saw the benefit of this as our innovation continued to build momentum.

Turning to Slide 21, you'll see that our share of innovation is now 50% of the category, with the next biggest competitor at 35%. Our innovation has been performing well this year and Krave, which we introduced in January, continues to hold almost a share point of the category. That represents a strong start for just 2 SKUs and shows that both trial and repeat have been strong since introduction. In addition, we relaunched Special K Protein at midyear to appeal to those consumers looking for increased protein in their diet. Although it's early, we are pleased with the results so far, as this innovation has also been well received and trial rates have been strong. And we have a strong lineup of introductions planned for 2013, including Special K Chocolate Strawberry, Cinnamon Jack's, Mini-Wheats Crunch and Scooby Doo. Kashi innovation will focus on expanding the brands all-family offerings with the launch of Berry Fruitful. 2 SKUs of Bear Naked Fit will also be launched.

The Morning Foods business unit also includes the Pop-Tarts brand, which has annual sales of more than $0.5 billion. Slide 22 highlights the 30 years of continuous growth posted by Pop-Tarts. This truly is an iconic brand with good economics supported by strong execution.

Slide 23 shows the quarterly performance of the Pop-Tarts business. And as you can see, the business also had a very good quarter, posting sales growth of more than 6% and increasing share by 0.5 point. This gain was driven by strong retail execution, brand building behind the Crazy Good advertising campaign and programs such as the summer concert tour.

Slide 24 highlights our 84% share of the Toaster Pastry category. Our winning formula for this brand is simple. We have breakthrough advertising, including social media, we drive strong innovation and we ensure that we win in-store every day. Our next big innovation is 2 SKUs of oatmeal delights which will be launched nationally in January. We drive a lot of retail activation via seasonal events, such as our recently launched college football branded Pop-Tarts, which were a big success. And as you can imagine, we also have strong demand for our pumpkin pie flavor during the fall season. So our Pop-Tarts business is in great shape and we have good visibility into our future growth.

Now, let's turn to Slide 25 for a summary. We're excited about the long-term potential of our business. We have excellent share positions in the categories in which we compete. We have increased our focus on health and wellness and we have brands that play naturally in those areas, such as Special K and Kashi. And we have a number of iconic brands that consumers love and that respond to both brand building and the introduction of innovation, 2 of our strengths. And finally, we have a great team. They've done a lot of work this year and I'd like to thank them for all the effort and dedication. So we're optimistic about the future and the great potential of our brands and our businesses.

And with that, I would like to turn it back over to John.

John A. Bryant

Thanks, David. Now, let's turn to Slide 26 and the performance of our international businesses so far this year. As you can see, after a difficult start to the year, primarily in Europe, the International business has posted progressive improvement as it moved through the year. As we told you last quarter, we've done a lot of work in Europe to improve the business and strengthen our organization and we're investing for future growth in both Latin America and Asia Pacific.

Now, if you'll turn to Slide 27, you'll see some more detail regarding our International businesses. The European business continued to improve sequentially in the third quarter. The U.K. business posted sales growth in both Cereal and Snacks as a result of much better commercial plans, tactical pricing actions on some SKUs and improved innovation. Special K Biscuit Moments, Nutri-Grain Breakfast Biscuits and Special K Cracker Crisps have been launched in the U.K. and all are off to a good start.

On the continent, sales in France increased and we saw early signs of improvement from the relaunch of Special K in Italy and Spain. However, as you've heard from other manufacturers, Southern Europe continues to be a difficult environment and we know it will take some time to improve. So due to this, we remain cautious on Europe as we look into 2013.

The Latin American business posted growth of 4% in the quarter. As we said previously, we have worked aggressively to lower trade inventories in Mexico in the quarter, which led to lower shipments, although consumption in Mexico increased in the quarter. A part of this difference affects timing between the third and fourth quarters.

In addition, the other businesses in the region are performing strongly and posted double-digit sales growth. We increased Latin America's investment in brand building at a double-digit rate in the third quarter. And we've also launched Special K Cracker Chips and Special K Crisps in the region as well as Choco Krispies Pops and Special K Chocolate in certain geographies and all are doing well.

The Asia Pacific business had a strong quarter, posting 7% sales growth. And as we mentioned, we increased brand building during the quarter at a double-digit rate. The Australian business improved as new advertising started to have an impact and innovation on All-Bran, Be Natural and Sultana Bran all contributed to growth. Also in the region, India and South Africa performed well as a result of innovation and continued penetration gains.

Now, let's turn to Slide 28 and the summary. Sales growth continued to improve in the third quarter as we expected and was in line with our expectations for the full year. North America posted strong top-line growth as the Cereal, Pop-Tarts, Frozen Foods and Specialty channel businesses all did well. Underlying profit growth, adjusted for the recall, was also strong. Europe remains a difficult environment, but we have seen some early signs of improvement. For example, the U.K. performed much better as a result of improved commercial plans and innovation. We increased our investment in our brands at a high single digit rate in the third quarter, and the Asia Pacific and Latin American businesses increased their investment in brand building at a double digit rate. We saw a better performance than we expected from the Pringles business.

All in all, it was a good quarter and I'd like to thank all our employees for their efforts around the world. With that, I'll open up for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from John Baumgartner Wells Fargo.

John J. Baumgartner - Wells Fargo Securities, LLC, Research Division

Thinking about your JV with Wilmar, there wasn't anything in the press release and the PowerPoint here. Wondering if you can touch on your thought process in building the relationship? What are your expectations there? What are some of the opportunities Wilmar affords, anything Navigable didn't? And what might the lingering headwinds still be in China distribution, even with Wilmar?

John A. Bryant

Thank you, John. We're excited about the Wilmar joint venture and we'll actually talk more about that next week at Day at K. But the reason we're so excited about Wilmar, it is roughly the third largest consumer goods company in China. It has a tremendous infrastructure across that market and they're very excited as are we in the potential growth of the category in China. The category today, the Cereal category, is relatively small but it is growing rapidly at strong double-digit rate. And so we believe that together, we're better positioned to unlock that opportunity. If you go back to the Navigable business, that was a low-margin cookie business in China that was not really helping us build out our infrastructure, or really set ourselves up for the future. So we're excited about China, both from a Cereal perspective as well as a Snacks perspective, and we believe that Wilmar is extremely well positioned to help us make that a reality.

Operator

Our next question comes from David Driscoll of Citi.

David Driscoll - Citigroup Inc, Research Division

A question on Pringles. So you gave original accretion guidance back when you closed the deal, but since then, you've had a chance to do the purchase price allocation. And according to the best estimates that we can make, amortization expense looks like it's going to be a lot lower. And then as you mentioned in your prepared script, John, the sales growth also looks to be much better than anything you would've expected on day 1. So can you update us on the accretion expectation in '12 and in '13 from the Pringles deal?

Ronald L. Dissinger

David, this is Ron. I'd be happy to give you an update on the expectation for 2012. We haven't provided 2013 details yet. But we've moved the accretion expectations from $0.08 to $0.10, which is what we communicated before, to $0.11 to $0.13, so -- and we've got about $0.03 better. We are seeing stronger sales performance than we previously expected. And in addition, we're seeing better performance come through our supply chain. We've been able to improve throughputs in our supply chain and done some other things that have improved our cost structure. In terms of the amortization and the balance sheet valuations, frankly David, we're still working through that. So you may see a low level of amortization expense come through for now, but we're still working through that as we go through the end of the year.

David Driscoll - Citigroup Inc, Research Division

Okay. Final question. It's just on upfront costs. I think your original guidance was for upfront charges to be approximately the same as last year. But as of the third quarter and year-to-date results, you're running behind last year. Are you going to get a big -- a fairly big upfront number in the fourth quarter?

Ronald L. Dissinger

We are, David. So as we look at the fourth quarter, we'll certainly have more upfront costs and better than the fourth quarter than we did last year. That's correct.

David Driscoll - Citigroup Inc, Research Division

And it's flat, the total number is flat year-on-year?

Ronald L. Dissinger

Still investing at similar levels. It could be in the range of $0.10 to $0.12, consistent with prior years.

Operator

Our next question comes from Scott Mushkin of Jefferies.

Scott Andrew Mushkin - Jefferies & Company, Inc., Research Division

So I just wanted to understand a little bit of the difference between what's going on with the Mini-Wheats recall and some of the issues you saw over the last couple of years. That'll be my first question.

John A. Bryant

Thanks, Scott. I think we've made some great progress in our supply chain over the last few years. We've made significant investments, as we mentioned last year, adding people back into the facilities, improving certain core processes within the facilities and we're seeing a much better performance out of our supply chain. We are very disappointed by this latest event. It was a failure in a piece of equipment. We've been using that sort of equipment for 20 years in this facility and it's the first time we've seen a failure like this. But I think our recent investments have enabled us to identify the issue quickly, to respond to it and I think the company did a great job of very effectively and efficiently dealing with the situation. We have -- Alistair Hirst is our Head of Supply Chain who will be talking about some of the great progress we've made at Day at K next week. But we do believe that we have definitely made progress in the supply chain. I think this is a unique issue that we had more recently and I believe the investments we've made will help us mitigate and reduce the probability of these sorts of events in the future.

Scott Andrew Mushkin - Jefferies & Company, Inc., Research Division

So you don't think it's part of a systemic issue? You think it's more of a little bit of maybe a bad luck with a piece of equipment, not maybe -- that maintenance wasn't done on there or anything like that? You think it's more a little bit of a bad luck situation?

John A. Bryant

Yes, I think it's really unfortunate. Clearly, Our goal is to avoid these things happening in the future.

Scott Andrew Mushkin - Jefferies & Company, Inc., Research Division

Okay, perfect. And then my second question really goes to the brand building. This is 2-part. I wondered if you could kind of delve into how those funds, the extra funds are being spent, number one. And then number two is, I'm playing a little bit of a devil's advocate. It seems like clearly, you're turning the tide on sales, although it seems to be costing you a lot of money in North America that you also see in some other markets. When did that period of extra investment or maybe more of a flow through to the bottom line? So kind of a two-part question then I'll yield.

Ronald L. Dissinger

I think if you look at brand building and what we're doing this year, we're investing our brand building in the areas where we're expecting future growth. So we're investing behind Asia Pacific and Latin America and you saw the double-digit increases in brand building in the third quarter. And you'll see a continued investment in those regions. A part of our long-term model is to increase brand building at or above the rate of sales growth and we're going to do that this year and we expect to do that in the future. At the same time, we're always looking to drive efficiency. We've seen a big move towards digital. We're saving money on nonworking cost within the advertising line. So we have a series of efficiency programs there as well, but at our heart, we are a branded food business. We believe it's what enables us to succeed. It's part of our sustainable growth model and I would expect us to continue to invest in brand building in the future.

Operator

Our next question comes from Matthew Grainger with Morgan Stanley.

Matthew C. Grainger - Morgan Stanley, Research Division

Just 2 questions on the phasing of costs and sort of how that plays into results during the second half of the year. I guess in recent quarters, you've given a sense of how the phasing of supply chain spending was impacting year-on-year operating profit growth and I know the level of investment in the third quarter of 2011 was particularly high. I was just wondering how much the flighting of that spend impacted this quarter's results. And then just with respect to the $0.06 per share recall impact, sort of in compensating for those expenses during the quarter, was there any degree of sort of shifting innovation, planned brand building spend from 3Q into 4Q?

Ronald L. Dissinger

Let me take the phasing of the supply chain cost first. We did invest more in the back half of last year. We are lapping that impact this year and we did see that benefit come through. Having said that, as we communicated on the second quarter call, we are seeing higher commodity costs over the back half of the year. So we're seeing more commodity inflation and that's had an impact on our inflation, not just in the third quarter, but it will in the fourth quarter as well. We still do expect our input inflation to be at the rate of 7%. It might be a little bit above that. In terms of the impact of the recall and any R&D investment associated with that, that had no impact whatsoever.

John A. Bryant

And just to build on that, remember the recall occurred in early October. It was actually a subsequent event to the quarter itself. So our actual spend and everything was in place. We were in the process of closing the quarter when the event occurred.

Operator

Our next question comes from Jon Feeney with Janney Montgomery Scott.

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

Ron, I wanted to ask about the phasing of cost more specifically as we look through the next year. If costs stay where they are right now, and I understand they've increased recently, do you -- how much would you expect -- do you expect to -- the need to take new pricing in the marketplace in North America at some point in the next 6 months given where costs are today?

Ronald L. Dissinger

John, as you know, we don't comment on perspective price increases. We have said in the past that we expect an inflationary environment in 2013. We haven't yet discussed the phasing. One thing I would say though is at this point in time, you'd expect us to be taking hedge positions and we are in a hedge position, very similar to where we were at this time last year, which is about 40% to 50% hedged.

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

I guess I was very impressed at the share of innovation that you've talked about on your slide presentation. Looking forward into next year, I mean, do you -- does that affect pricing plans at all that you took significant innovation? How does that typically work? Is that -- in this case, SKU pricing higher or lower, do you think, particularly in the Cereal -- ready-to-eat Cereal business the past few months?

John A. Bryant

I think innovation, at a very macro level, is a driver more of volume than any pricing decisions that are out there. So we expect next year to have even more innovation at a total company level than what we had this year and innovation's clearly a core driver of our success.

David Denholm

Just building on John's comment and talking specifically about Cereal, we have good visibility into our innovation pipeline. We have strong ideas and we're looking forward to executing a stronger plan next year.

John A. Bryant

And in general, I'd say that the innovation drives positive mix and in fact, in this quarter, we saw a positive mix coming out of innovation.

Operator

Our next question comes from Eric Katzman with Deutsche Bank.

Eric R. Katzman - Deutsche Bank AG, Research Division

Ron, I've got a couple of questions, kind of following up on Dave Driscoll's, because I'm not sure that we got full kind of Pringles impact. So I see on Slide 32, in the appendix, that you took the Pringles accretion up $0.03. But your free cash flow generation is better than you thought and you said you paid down some debt. So the impact of that, plus less dilution on the share base, wouldn't that make, all in, Pringles actually more accretive than what the $0.11 to $0.13 shows?

Ronald L. Dissinger

We do show the share impact as well on that same slide. And remember, we were saying before that shares might be an impact of $0.07 to $0.08. We now think it's $0.05. So we picked up $0.02 to $0.03 there. And then the operating income -- impact of Pringles is giving us another $0.03 of benefit, Eric.

Eric R. Katzman - Deutsche Bank AG, Research Division

And then your interest cost is lower than you thought, right?

Ronald L. Dissinger

Our interest costs, Eric, is very comparable to what we previously expected.

Eric R. Katzman - Deutsche Bank AG, Research Division

And how about on the currency side?

Ronald L. Dissinger

The currency isn't too far off. Right now, we're saying $0.05 of currency impact and over the course of this year, as we've spoken to you, it's been anywhere from $0.04 to $0.06 of impact.

Eric R. Katzman - Deutsche Bank AG, Research Division

Okay, and so -- then just following up on the free cash flow comment, and I wasn't really sure if I followed the benefit of working capital associated with Pringles and why that's making the free cash flow better. What does that mean?

Ronald L. Dissinger

Sure, Eric. Be happy to elaborate on that. And we've talked about this before. Basically, when we acquired the Pringles business, we picked up a working capital benefit based on the way that the deal was structured. And we talked about that as being in the range of anywhere from $140 million to $150 million worth of benefit. We essentially picked up virtually no liabilities, only a few and no payables. So we've seen that benefit come through over the course of some in June and through the third quarter as well. So we're getting essentially a one-time benefit to our cash flow here that you're seeing in the year-to-date $1.1 billion.

Eric R. Katzman - Deutsche Bank AG, Research Division

Okay. Last question and I'll pass it on and see you next week, but do you expect if you're towards the high end of the free cash flow range, with CapEx being lower, plus this one-time benefit. Do you see making a pension contribution that could knock the free cash flow down?

Ronald L. Dissinger

We haven't discussed any pension contributions at this point in time, Eric. And right now, we're in good funding positions on our pension plans.

Operator

Our next question comes from Robert Moskow with Crédit Suisse.

Robert Moskow - Crédit Suisse AG, Research Division

I have more of a modeling question. On Cereal, if you look at, I think, it was Slide 16 that the cereals sales were pretty stable sequentially first, second and third quarter of this year. But when you look at fourth quarter last year, they dropped off quite a bit. And I want to know, should we expect the same kind of seasonal impact in fourth quarter for Morning Foods? Or is it going to be different this time? And then I have another question on the interest expense. I guess I don't quite get the interest expense guidance.

David Denholm

It's David here. There is seasonality in the Cereal category and that's relatively consistent over time. We have increased our investment in brand building versus last year and we do have a stronger innovation in the marketplace. So we've got off to a strong start in October and are well positioned in Q4.

Robert Moskow - Crédit Suisse AG, Research Division

Yes, but David, do you -- should we expect the same kind of seasonality that you typically have? Was fourth quarter seasonality last year typical or was that a steeper drop-off than normal?

David Denholm

Robert, last year's seasonality was typical.

Robert Moskow - Crédit Suisse AG, Research Division

Typical, okay. And then I guess on the interest expense, $260 million -- I think that kind of implies like something like in the 60s for quarterly interest expense and fourth quarter this year. Ron, is that a good run rate to use going forward, like $65 million or so per quarter?

Ronald L. Dissinger

We haven't communicated guidance for 2013 at this point in time. Of course, Rob, you'd expect us we're paying down our debt that our interest cost will come down over time.

Robert Moskow - Crédit Suisse AG, Research Division

Okay. But it is a -- you are guiding to sequentially lower fourth quarter interest expense, is that correct?

Ronald L. Dissinger

Yes, we're guiding to lower interest expense in the fourth quarter, $260 million for the full year, Rob, so lower than the third quarter.

Robert Moskow - Crédit Suisse AG, Research Division

Is this a lot? You said it's the same as what you expected but again, I was modeling something very different. So have you communicated $260 million before or is this new?

Ronald L. Dissinger

I don't know that the range came up previously, Rob.

Operator

Our next question comes from Diane Geissler with CLSA.

Diane Geissler - Credit Agricole Securities (USA) Inc., Research Division

I wanted to ask about the organic growth in Pringles in North America, in particular where you saw, I think, you said double-digit growth. And I think you commented that it was incremental merchandising but I just was wondering if there was incremental distribution into new channels since you've purchased the business or what would account for that significant growth in that business?

John A. Bryant

Yes, Dianne and the answer is both. We saw additional merchandising opportunities in the third quarter in the U.S. We're able to leverage some of our very strong relationships across some key customers and we achieved some placements that business had not historically been able to achieve. And so I think you saw a very strong response from that activity. In addition to that, as I mentioned in the prepared comments, the Specialty Channels have also seen some very strong growth and we've been gaining some distribution in those channels also. If I think back to the Keebler acquisition, the part of the Keebler acquisition has surprised us positively, was the Foodservice business, when the 2 businesses came together. I suspect, on this acquisition, the Specialty Channels will be upward surprise as these 2 businesses come together.

Diane Geissler - Credit Agricole Securities (USA) Inc., Research Division

Okay. Can you just define for me what you would include in the Specialty Channels?

John A. Bryant

Convenience, vending, dollar as well as Foodservice itself.

Diane Geissler - Credit Agricole Securities (USA) Inc., Research Division

Okay. And then I just wanted to ask quickly on the trade deload in Mexico and that impact on the Latin American business. Are you -- are there any other areas globally where you are concerned that, that might be a factor in the future, for instance, because of the slower growth that we've seen, particularly in continental Europe? How do you feel about where your inventory levels are either internally or in the trade?

John A. Bryant

I think we're in good position from an inventory perspective, particularly if you think about Continental Europe and the need for European retailers to drive their cash flow very aggressively. I think what's happened in Mexico, we're talking before about the seasonality of the Cereal category, and the seasonality in trade inventory as well. What happens is early in the year, we bring out innovations, cereal inventory grows through the year and then as retailers get ready for the holiday season at the end of the year, they pull back on cereal inventory and build up on other holiday season-type inventories. What's happened in Mexico is that seasonality in cereal inventory is more than what we think it should be. And so what we've done in the back half of this year is we brought the inventories down more aggressively in the third quarter. That inventory reduction would normally occur in the fourth quarter, so it's a bit of a switch between those 2 quarters. Also remember, as we go into 2013, we wouldn't expect to build as much inventory in the first half of 2013, but we'll have a very easy comparison when we get to the third quarter of 2013 against this year's numbers. So we are trying to keep inventories lower. We believe lower retail inventory is actually very good thing for the company because it helps us bring our in-store activities on the shop at the same time as the advertising is on air.

Operator

Our next question comes from Andrew Lazar with Barclays.

Andrew Lazar - Barclays Capital, Research Division

A question for David. You have that slide where you talked about having 50% of the Cereal category innovation. I'm curious where that level is, where that level has been for Kellogg's, let's say, in Cereals, the last couple of years. And perhaps, maybe more important, where is the overall level of innovation as you see it or measure it for the overall Cereal category today, relative to where it's been? Because there's a lot of discussion and concern out there that the category itself is in some way going to be different, i.e. slower growth going forward or just less relevant to consumers and if the structural issue versus one where -- hey, the big players just haven't done their fair share of innovating over the last couple of years combined with all the pricing. So trying to get a sense of maybe how you measure some of the metrics there to get some insight.

David Denholm

Andrew, we're very confident about the long-term prospects of the Cereal category. We see it as a low single-digit growth category. It really responds to brand building, innovation and nutrition. So in terms of innovation specifically, the 50% that we outlined today in terms of share is a higher share than Kellogg has achieved in recent years. So we have improved our end market performance from an innovation perspective. In terms of the absolute level of innovation in the category, it has been lower over the last year or 2 and we're seeing that improved and it's improved sequentially throughout the year. And as I highlighted, we have strong visibility into next year's innovation plan.

Andrew Lazar - Barclays Capital, Research Division

And from what you can see in the marketplace, just competitively, would you sense -- is your sense that you will get some help on the innovation front or the category will get some help others or is it just not clear yet?

David Denholm

I think the category responds to innovation from all participants and we expect there will be increased levels of innovation in the category and we model that and we then look at our pressure and the quality of our ideas and we are confident we can have a continued strong share of innovation within the category.

Operator

Our next question comes from Ed Aaron of RBC Capital Markets.

Edward Aaron - RBC Capital Markets, LLC, Research Division

Question. I wanted to actually ask about the Kashi brand. There's been some negative publicity out there just around the brand centered on GMOs and there also seems to be some recent distribution loss of Kashi frozen products in the natural channel. I was hoping you can maybe address what's happening with that brand at a high level and then also talk about how it performed in the third quarter?

David Denholm

It's David here, Ed. Kashi is a great brand and it's very well positioned to grow in the future when you think of the changing demographics and the health and wellness trends, so we're very excited about the future of the Kashi brand. During the quarter, we did see some softness. We see that as temporary. There were 2 or 3 specific customer issues with the Kashi brand that we've been working through. We've also built plans for the future based on increased brand building and innovation. And in fact, you'll hear next week at the Day at K that we've got a 50% increase in the level of the cereal innovation behind the Kashi brand. We're also stepping up our support behind GOLEAN because there was some softness in the most recent quarter with the GOLEAN brand and we're relaunching our As Much Protein as an Egg campaign behind GOLEAN which works very hard for that brand.

John A. Bryant

If I can add on to that, I think if we look beyond cereal business, we're seeing good growth from Kashi and frozen as well which would suggest that the brand is still very strong and doing well out there.

Operator

Our next question comes from Alexia Howard with Sanford Bernstein.

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

Just following on from Andrew's question on competitive dynamics in the U.S. Cereal segment. I think we recently heard that Post Cereals is launching their Good Morenings line at a much lower price point. I think they've got a regional test going on of 4 or 5 SKUs at the moment. And I think judging from their latest announcements, they're planning a national rollout come early 2013. Can you just give us any idea, any thoughts about what you've learned so far? Are you very confident that this is not going to have a major impact on the competitive dynamics and pricing dynamics in the Cereal segment next year? How are they doing terms of distribution? I mean, I know you can't comment about a specific brand but does seem to be potentially a bit of a change.

John A. Bryant

Alexia, the Cereal category has always been a very competitive category. It's a great category and time and time again, it responds to brand building, innovation, nutrition. I think you saw in most recent quarter that our strong Olympics campaign worked very hard for us. And in addition, the innovation that we're bringing to the marketplace is highly differentiated and our most recent innovation, Krave, which has almost a share point, has really brought something that's new, better and different to the category. Another example is adults seeking more protein. We're seeing that in our consumer tracking. Hence, we relaunched Special K Protein in the middle of this year and it's off to a fantastic start. So we will continue to play our game of brand building, innovation and nutrition messaging in the category.

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

And then maybe as a follow-up, on the commodity outlook, many other cereal -- many other food companies have been talking about deflation or easing of commodity costs. That doesn't seem to be the case here. How are you seeing the commodity outlook as we go into the next couple of quarters, particularly on the grain side, which I thought might be getting easier, given the way that you tend to forward contract on the hedge?

Ronald L. Dissinger

Yes, sure, Alexia. So as we said -- as I said a little earlier and on the second quarter call, we picked up some inflation in the back half associated with the grain costs going up, and that's included in our guidance, we have it managed within the earnings per share. We do expect inflation as we're moving into 2013. We haven't talked about the levels, obviously. Hedges we had from -- for 2012 will roll off and we'll have new positions coming up for 2013, but we do expect an inflationary environment. Obviously, we are going to do everything we can to drive productivity improvements to offset as much of the inflation as we possibly can.

Operator

Our next question comes from Chris Growe with Stifel, Nicolaus.

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

So I just had 2 questions for you, a bit of a follow-up on Alexia's question there. In the third quarter, I don't know if you can go this far Ron, but did your pricing that came through in the quarter offset cost inflation?

Ronald L. Dissinger

Our pricing was a little bit lower than cost inflation. So it didn't fully offset it. And that's why when I commented on the commodity inflation having an impact on gross margin, it's because the pricing didn't quite fully offset it.

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

Okay, understood. And I guess a bit of a follow-up on Europe. If I look at this quarter, you had a fairly -- if you look at your internal sales, had a pretty similar sales performance, obviously, a little bit better sequentially but still a little soft on the volume side, you had an easier comp on the profit side, but you did have a much better profit performance overall. And I guess maybe the answer is the comp, but I was just curious about of the U.K. performance, how that improved in the quarter and the degree which that helped your profit performance overall for Europe.

John A. Bryant

Certainly, Chris, I think we're happy to see the improved performance in Europe. We're still not satisfied with where it is and we expect to see a better fourth quarter out of Europe from a top line perspective. And the U.K. certainly helped that turnaround as we look within the year. We also saw some good growth in France and some -- it's really -- the challenges for us are in southern Europe, with Spain and Italy in particular were soft. As we build for the future year we need also continue to invest back in the business to that a top line growing as well, so you'll see some of that come through in the fourth quarter. So I would expect to be -- to continue to have a profit decline in Q4 for Europe and as we go into 2013, we remain very cautious on our outlook for Europe.

Ronald L. Dissinger

Excuse me. Sean, I think that's about all we have time for?

Operator

All right. Thank you very much. Would like to close the call now?

Ronald L. Dissinger

Yes. Thank you everybody for joining us today. I appreciate it very much and we'll be available, as always, to take your questions.

Operator

Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the conference. You may now disconnect. Good day.

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