Download Transcript - Kellogg Investor Relations

Kellogg Co.
Company▲
K
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Q3 2006 Earnings Call
Event Type▲
Oct. 26, 2006
Date▲
MANAGEMENT DISCUSSION SECTION
Operator: Good morning. Welcome to the Kellogg Company 2006 Third Quarter Earnings Call.
[Operator Instructions]. At this time I would like to turn the call over to Simon Burton, Kellogg
Company Vice President of Investor Relations. Mr. Burton, you may now begin your conference.
Simon D. Burton, Director of Investor Relations
Thanks Matt, and good morning everyone, and thank you for joining us for a review of our third
quarter results and for a discussion regarding our strategy and outlook. With me here in Battle
Creek are Jim Jenness, Chairman and CEO; David Mackay, President and COO; Jeff Boromisa,
CFO; and Gary Pilnick, General Counsel.
corrected transcript
I must point out that certain statements made today such as projections for Kellogg Company's
future performance, including net sales, operating profit, cash flow, earnings per share, margins,
up-front costs, share repurchases, debt reduction, ROIC and dividends 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 fillings.
Beginning with the first quarter 2006, the company adopted FAS 123R and began to recognize
expense related to employee stock option grants in reported results. To help investors understand
comparable performance, we will consequentially be using certain non-GAAP measures such as
internal operating profit growth to discuss 2006 results. Refer to the appendix reconciliation to US
GAAP results at the end of this presentation. 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 passcode for both numbers is 4244212. The call will be available via
web cast at www.kelloggcompany.com, which will be archived for 90 days. Now I would like to turn
the call over to Jim.
James M. Jenness, Chairman and Chief Executive Officer
Thanks Simon and good morning. As a close friend of mine, Tony the Tiger would say and I fully
agree, Dave’s promotion to our CEO is great, great for our company and great for our shareowners.
This move locks in and further builds visibility for our strong management continuity. It insures we
stay 100% committed to our overarching sustainability performance driver, managing the business
with realistic goals and leveraging our focus strategy and operating principles. It also ensures
continued appreciation for and belief in the legacy of our founder, Mr. Kellogg. Our Kellogg folks
around the world see Dave’s promotion as a positive, natural, well-deserved succession.
Throughout the year we expressed confidence that 2006 would be another year of sustainable
growth. Our continued business momentum reflected in strong third quarter results and the visibility
we have into the reminder of the year further drives our confidence. We are raising our full year
EPS guidance because of this. The increased guidance and our continued confidence in delivering
sustainable growth goes directly to the power of our business approach and model, allowing us to
beat our long-term sales targets again in 2006, providing flexibility to deliver our long-term
operating profit target. While absorbing unprecedented incremental commodity and fuel cost
inflation that I mentioned last quarter as well as increased benefit costs while continuing our
investment in brand building and R&D to drive brand value.
The continued strong share performance we are seeing across categories and geographies in 2006
reflects this. And while continuing to invest in high return cost savings projects to support future
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Kellogg Co.
Company▲
K
Ticker▲
Q3 2006 Earnings Call
Event Type▲
Oct. 26, 2006
Date▲
growth. We will again invest $0.15 of EPS this year and despite all of cost pressures still deliver
our long-term operating profit target. And importantly, our model again has driven strong cash flow
in 2006, enabling a balanced use of cash to further invest in our business, deliver strong dividend
payout, repurchase out stock and reduce net debt.
We are confident 2006 will be another year of sustainable growth. Last year at this same time we
expressed confidence in the coming year. We have the same view as we now look at 2007,
confidence in another year of sustainable growth. Our realistic goals of low-single digit sales
growth, mid-single digit OP growth and high-single digit EPS growth drive the right behavior. They
allow our managers to invest in the businesses without chasing targets that are unsustainably high.
This means they can invest in brand building that will drive future growth. Some of you have asked,
why we continue to target these levels of growth when our recent actual results have been greater.
The reality is our growth has been made possible by our realistic targets. This is the model that
has worked well for us over the last six years and it’s the model that’s gives us confidence for 2007.
And it’s why we can give guidance for strong results next year.
corrected transcript
Now let’s look at slide four, which details some of the quarter’s financial highlights. Net sales
increased by 8% due to strong internal growth and the effect of foreign currency exchange, which
added slightly more than 1%. Internal sales growth, which excludes the effect of the FX was 6%.
OP increased by 5%, and internal growth was 6%, right inline with our long-term target. And we
are pleased with this as it exceeded our expectations.
You’ll remember that we had planned for the third quarter OP to be down slightly due to timing. So
this year performance shows our momentum. And as usual, we achieved this growth and continued
to invest in brand building and up-front costs related to cost reduction initiatives. Operating profit
growth benefited from up-front costs being lower than in the third quarter of last year. Our year-todate internal operating profit growth is 4%, right inline with our long-term target of mid single digit
growth. EPS increased by 9%, excluding the impact of stock option expense, due primarily to
operating income growth. And year-to-date, cash flow is $850 million and the full year target
remains 900 to $975 million.
Let’s look at each of these results in more detail. Slide 5 shows the third quarter sales growth.
Reported sales growth was 7.6% and internal sales growth was 6.5%. This growth exceeded our
long-term targets and built on strong 7% growth in the third quarter of last year. As you can see,
internal growth was driven by a balance between price mix improvement and tonnage. Our model
is working. Our innovation continues to contribute. One of the main focuses of our business and
one of the primary drivers of the sales growth you see on the slide is brand-building investment,
specifically advertising. We again increased the levels of investment in this important metric.
You can see on slide 6 the level of investment we made year-to-date and our expectations for the
full year. The increase in the level of investment we expect for the full year will approximately equal
sales growth. Keep in mind the increase isn’t significantly greater than the sales growth rate
because the sales growth rate we posted so far this year is more than twice our long-term target
and it's also because of our ongoing efficiency program. As we discussed this with you throughout
the year, we have done a lot of work in this area. We have taken a vigorous approach to our media
planning and buying and the changing media landscape is working to our benefit in terms of more
targeted communication and costs.
We have improved our return on investment modeling techniques, particularly in the area of
consumer promotion and this in combination with our global leverage of promotions like Shrek or
Xbox has continued to drive our competitive advantage. And we’ve generated savings, much of
which we are re-investing. We expect our brand building programs to continue to provide strong
stimulus to our top-line. We’ve definitely seen it, seen the benefit and we expect the trend to
continue. We will continue to make investments in the fourth quarter and you should expect
continued strong investment in 2007, particularly in advertising. We are committed to this
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Kellogg Co.
Company▲
K
Ticker▲
Q3 2006 Earnings Call
Event Type▲
Oct. 26, 2006
Date▲
investment and we will not sacrifice investment in advertising to over deliver short-term results. In a
moment, Jeff will review our financial performance in more detail. But first, let me turn it over to
David who will walk you through our business results.
A. D. David Mackay, President and Chief Operating Officer
Thanks Jim. And thank you for those positive comments. From my perspective I truly do feel great
and I am both excited and honored to have the opportunity to become CEO of the Kellogg
Company. I see my key task will be to continue the company’s momentum by working closely with
the talented group of executives Kellogg’s has both in North America and around the world. We will
stay focused on our current strategy and business approach.
Now lets turn to slide 7, which shows the internal growth posted by each of our North American
businesses in the third quarter. As you can see each of the businesses posted excellent growth
and it’s even more impressive when you consider the very difficult comps set in 2005.
corrected transcript
Lets look at our North American businesses in more detail. And as you can see on slide 8 we had
solid sales growth continued in North American retail cereal in the third quarter. Growth in the
quarter was 3%, building on a very strong 11% growth in the third quarter of 2005, which was the
year’s highest comp. Year-to-date our category share is up 30 basis points in the latest measured
channel data and was broadly flat in the third quarter. We saw slightly higher inventories at the end
of the third quarter, which are coming out naturally in the fourth quarter.
Given the tough year ago comps, stronger competitive innovation and tactical activity in Q3, we are
pleased with these results. The US posted strong results driven by our adult portfolio. In fact 52
week sales of our Smart Start, Mini-Wheats, and Special K brands all increased at double-digit
rates in measured channels. We’ll continue to innovate behind these brands to drive momentum.
We have a Special K chocolate and Rice Krispies, Real Strawberries, a Cinnamon Raisin version of
our popular Smart Start brand and a new variety of Cocoa Krispies all shipping in January of next
year. And finally, Kashi continue to do very well. Sales growth continued at a double-digit rate and
our Go Lean and Heart To Heart brands did well as a result of both strong, base programs and
innovation.
We gained category share again in Canada as a result of strong performance by existing brands in
new products. We recently introduced All-Bran Honey Nut and All-Bran Guardian, which are both
doing well, and we supported their products with very effective programs, including an Xbox impact
promotion which has been extremely successful. We’re excited about this as many of our
businesses will be running a similar promotion during Q4.
Now lets turn to slide nine on our Snacks business. As you can see, Snacks posted strong 11%
growth in the quarter, considerably ahead of our long-term target and building on 6% growth last
year. Year-to-date our Snacks business has posted 11% internal revenue growth. As we have
seen in previous quarters, this growth was again broad based across the categories as shown on
slide 10.
Our Pop-Tarts across the Pastries businesses is having another good year. We are gaining
category share again in 2006 driven by some excellent advertising and great new flavors including
Mint Chocolate Chip and the launch of Go-Tarts. Consumption in the quarter increased at a high
single digit rate while shipments were down slightly due the timing of promotions. So expectations
are for a positive fourth quarter.
We also saw a strong growth in the Crackers business in the quarter. Cheez-It gained category
share as both base Cheez-It and innovations such as Cheez-It Crisps did well. Our Club and
Townhouse brands also both did well as a result of this year’s strong innovation and we continue to
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Kellogg Co.
Company▲
K
Ticker▲
Q3 2006 Earnings Call
Event Type▲
Oct. 26, 2006
Date▲
see solid growth in our Cracker Packs businesses. We gained share again in the Cookie category
and Chips Deluxe, Fudge Shopee, Sandies and Murray Sugar Free all contributed and Famous
Amos continues to show accelerated growth.
The wholesome snack business was also very strong in the third quarter. New Crunchy Nut, Sweet
and Salty Bars, Smart Start bars, base Rice Krispies Treats and Special K Bars all did exceptionally
well. In fact Special K Snacks alone posted more than 30% sales growth in measured channels in
the quarter. In addition, our Fruit Snacks business a category we entered less than three years
ago, continues to do well. For example, the popularly new Yogos product that we launched earlier
this year already holds a category share of more than 5% and is helping drive our overall category
share towards 30%. And in Canada we introduced Froot Loops Yogos Fruit Snacks, Nutri-Grain
Munch'ems in the third quarter and both are off to a good start.
corrected transcript
Slide 11 shows that in combination, the frozen and specialty channels business posted internal
sales growth of 8% in the quarter and year-to-date growth has been 7%. Eggo Morningstar Farms
and the specialty channels businesses all posted very good results. Eggo posted double-digit sales
growth, driven by new products and there is more to come at the start of next year. We are
introducing a couple of new Waffles, which will add to our already successful line. Morningstar
Farms and our new frozen entrees business also posted good growth. The new Kashi entrees that
we showed you last quarter are off to a great start and specialty channels business also did well in
the quarter. This group of businesses continued to execute very well and achieved great results
despite a difficult mid-single digit comparison. In fact the food service, convenience, and drug
businesses all posted very strong rates of growth as a result of good innovation and execution.
Now lets turn to slide 12 and our international businesses. Internal sales growth from our
international businesses has been good all year and builds on growth throughout 2005. As you can
see, these businesses again posted internal growth of 5% and year-to-date growth is also 5%, both
above our long-term targets.
Now let’s look at slide 13, which highlights growth by region. In Europe, we posted internal sales
growth of 6% behind excellent growth in many countries in the region, including the UK, our largest.
The UK cereal business posted high single-digit sales growth benefiting from strong innovation
including new Optivita, All-Bran Crunchy Oat Bakes and Special K Creamy Berry Crunch. UK
share grew 80 basis points in Q3 and is up 50 basis points year-to-date.
The snacks business posted solid mid single-digit sales growth behind strong results from existing
products such as Nutri-Grain and Rice Krispies Squares and significant new innovation, including
Special K Bliss Bars, a great new product. We’re also pleased with our plans for brand building
and innovation in the UK for Q4 in 2007. Importantly, good growth was achieved outside the UK
with France, Ireland, Spain and the Mediterranean all posting very strong growth.
In Latin America, we again posted good growth in both our cereal and snacks businesses. In
Mexico, we launched Special K with chocolate and All-Bran with a fruit mix and we benefited from a
seasonal Special K promotion. In the snacks business, we gained share and introduced NutriGrain chocolate strawberry bars and a new variety of NutriDía. In addition, many of the other
countries in the region posted strong growth in cereal and snacks.
The Caribbean posted strong growth driven by Zucaritas. Venezuela posted very high double-digit
growth behind Special K and the introduction of snacks. And Central America and Colombia posted
good growth in both cereal and snacks. And finally in Asia Pacific, we saw sales growth,
consumption growth and category share growth in our Australian cereal business.
This was driven by the introduction of Just Right Berry Apple and Corn Flakes Honeycomb in the
first quarter of this year and Special K Honey Almond and a new variety of Mueslix in the third
quarter. Our snacks business posted lower sales in the quarter due to an increase in competitive
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Kellogg Co.
Company▲
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Q3 2006 Earnings Call
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Oct. 26, 2006
Date▲
activity. In Asia, we saw growth in Japan driven by the introduction of All-Bran and Genmai snacks
during the quarter and we’ve got some great new products planned for introduction in early 2007.
In Korea, we gained share recently due to strength in Grain story and Chex driven by new Chex
Crunch and strong brand building. As in many parts of the world, Asia will participate in our Xbox
promotion during the fourth quarter.
As we have said over the years, our goal is and will continue to be the delivery of dependable,
sustainable growth across our businesses. Realistic goals allow us to do what’s right for the
business such as invest in our brand and on new products to drive our market shares around the
world. Given the commodity and energy cost pressures we have had to absorb this year, it
highlights how our consistent focus on driving cost efficiency while also driving innovation and
brand building continues to work for us. These are the right ways to drive long-term consistent
growth and shareholder value, which is really the underlying goal of our sustainable business
model. And with that, I would like to turn it over to Jeff.
Jeffrey M. Boromisa, Senior Vice President and Chief Financial Officer
corrected transcript
Thanks David and good morning everyone. Slide 14 shows our gross margin performance over the
past couple of years. And the steady improvement we made since the significant acceleration in
cost inflation, which began in the second half of last year. Gross margin in the quarter was 45.1%, a
slight decline from last year’s third quarter. In fact, cost inflation from commodities, fuel, energy and
benefits decreased our gross margin by 140 basis points in the quarter alone. More than offsetting
the benefit of having less impact from up-front costs and also the offsetting positive impact that
came from our cost efficiency projects and productivity initiatives.
Also as we told you in the first quarter, there was some margin impacts on the growth that we have
seen in certain new co-manufactured products this quarter. These arrangements allow us to
introduce innovative new products and test their popularity without initially committing capital. As
we said last quarter, we continue to expect full year gross margins to be down. However in the
fourth quarter, excluding the significantly greater amount of up-front costs, we expect the gross
margin to be up. This improvement will be driven by three things. One, the effect of pricing actions
taken over the past year. Two, easier comparisons to cost inflation we saw in the fourth quarter of
last year. And also, three, the ongoing benefit of our cost savings programs. In addition we
continue to expect full year up-front costs will be approximately $0.15 per share, right in line with
our guidance.
Slide 15 shows the growth in internal operating profit in each of our geographic reporting areas, this
internal growth which excludes the impact of currency translation. In North America internal
operating profit growth was 4%. This result was achieved despite the effect of significant cost
inflation and a mid-single digit increase in brand building investment. In Europe, operating profit
growth increased by 20% as a result of strong sales growth and gross margin expansion. In Latin
America, internal operating profit growth was 9% driven by sales growth. And this excellent
performance also included a high-single digit increase in brand building investment. And in Asia
Pacific, we posted an internal operating profit decline of 11%, driven by difficult comparisons to last
year and strong double digit increases in brand building in Asia due to the launch of Snacks in
Japan.
Our consolidated operating profit growth was significantly greater than our expectations due to
good growth and positive momentum across many of our businesses, and we expect this
momentum to continue into the fourth quarter. Below the operating profit line, interest expense
increased due to higher debt as a result of share repurchase activity. The tax rate in the third
quarter was 32%, and note that we continue expect that the full year tax rate will be around 32%, in
line with our original guidance.
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Q3 2006 Earnings Call
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Now let’s turn to slide 16, which shows the history of our core working capital measured as a
percentage of sales. This progression is important to us as it demonstrates our commitment to the
generation of cash flow and our ability to focus on the right metrics. We are pleased with the
progress that we made again this quarter and the progress we’ve made over the years, and we
expect to maintain our industry leading position.
Now let’s turn to slide 17 and a more detailed discussion of cash flow. Year-to-date, cash flow was
$850 million versus $915 million last year. The strength and expected timing of our cash flow
performance throughout the year gives us additional confidence that we will meet full year guidance
of between 900 million and $975 million in 2006.
corrected transcript
Our Manage for Cash operating principal remains extremely important throughout the organization
and we remain committed to providing strong rates of cash flow growth for our shareowners, and
we’ve returned a significant amount of cash to our shareowners. We have increased our dividend
again this year and year-to-date we repurchased 580 million of our shares. We expect to complete
the remaining 70 million of our authorization in 2006. And in the last 12 months we repurchased
nearly $1 billion of our shares. We remain committed to a balanced use of cash flow. We will
continue to assess our dividend. We will continue to repurchase our stock. We will continue to
focus on decreasing net debt and we will continue to invest in future growth initiatives, which is
helping to drive ROIC.
Now let’s look at slide 18 and our outlook for the remainder of the year. Our guidance for strong
mid-single digit net sales and operating profit growth hasn’t changed. Our expectations for
operating profit continue to include significant incremental fuel, energy and commodity costs.
Remember we said that we expected that these costs would be much higher than original
expectations. We have seen some recent benefits from fuel costs, but as always, costs remain
volatile and the entire industry has seen similar inflation. While prices continue to move, we feel
confident that we have got them covered while still increasing our brand building investment in the
fourth quarter. Our guidance also includes incremental benefit costs at the high-end of our
guidance range, as we told you last quarter. In addition, we now expect full year earnings per
share to be in a range of $2.48 to $2.50. At the high-end, this is $0.03 greater than the initial
guidance we gave for 2006.
As I mentioned, we still expect up-front costs to equal approximately $0.15 per share. In addition,
we now expect to absorb $0.11 from the effect of expensing stock options, up $0.01 per share from
our previous guidance. And we have also narrowed the range of our full year guidance by bringing
up the lower-end due to current momentum and excellent visibility into the balance of the year. As
Jim said, we have realistic targets and we are comfortable with the current range for 2006 given
that we have even more investment planned for the fourth quarter than we originally expected.
This will support new and existing products and give us momentum for 2007.
Now let’s turn to slide 19 and our 2007 guidance. And it really should not to be a surprise to
anyone. As usual, we expect low-signal digit internal net sales growth, mid-signal digit internal
operating profit growth, giving us operating leverage. And earnings per share of $2.67 to $2.72, or
high-single growth, all right in line with our consistent commitment.
First a word on the shape of the year, although we don’t give quarterly guidance, I will say that
we’re excepting to have lower operating profit in the first quarter due to significant reinvestment
plans to support new product introductions and other brand building ideas. As you know, we
mange the business for the long-term and we can give you more color on the shape of the year on
the Q4 conference call as we finalize our plan.
We except gross margins to be broadly flat in 2007 as a result of pricing actions taken around the
world and while current commodity markets are highly volatile. We don’t expect the impact of
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Q3 2006 Earnings Call
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commodity inflation to be worse than it has been this year, although it will be significant. And right
now we are anticipating up-front costs to be approximately equal to this year’s level. If the amount
is lower than we expect, we will either reinvest in the future growth or we will drop the benefit to the
bottom line.
We are budgeting for investment in brand building to increase at a rate greater than sales growth
also right in line with our term target, despite the fact that we are generating the efficiencies that
Jim discussed earlier. The investment will be skewed to advertising, as we will focus even more on
the efficiency of our investment in consumer promotions. Below the operating profit line, we expect
interest expense will increase by approximately 10%, primarily due to higher floating rates.
Although a third of the increase will be offset by higher interest income and we expect the tax rate
will be between 31 and 32%, slightly lower than this year. However, at a level that we believe will
be sustainable for the foreseeable future. Cash flow is expected to increase at a rate approximately
equal to net earnings growth, including capital expenditures totaling approximately 4% of sales, an
amount similar to this year.
And with that I would like to turn it over to Jim.
James M. Jenness, Chairman and Chief Executive Officer
corrected transcript
Thanks Jeff. We are confident 2006 will be another year of sustainable growth. Last year at this
same time we expressed confidence in the coming year. We have the same view now as we look
at 2007, confidence in another year of sustainable performance. With that, we’ll take questions
now.
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Q3 2006 Earnings Call
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QUESTION AND ANSWER SECTION
Operator: [Operator Instructions]. And we’ll take our first question from Terry Bivens with Bear
Stearns.
<Q – Terry Bivens>: Hey, good morning everyone.
<A – James Jenness>: Hi Terry.
<A – A. D. David Mackay>: Good morning Terry.
<Q – Terry Bivens>: On the gross margin, Jeff, thanks for that detail. I am wondering, initially I
think we started off ’06 if I recall $0.20 of a push from input inflation, later it went to $0.30. How is
your outlook, how – what is incorporated into ’07 in terms of input inflation, if you’re prepared to
give a cents number?
<A – Jeffrey Boromisa>: Yeah, you know Terry, just a little back, we started ’06 certainly with the
$0.13 to $0.16 and we went up to $0.20 and we still see that range up to $0.30. But for ’07, very
similar position starting the year as we did in ’06, it’s extremely volatile as you have seen on the
wheat market.
<Q – Terry Bivens>: Yes.
corrected transcript
<A – Jeffrey Boromisa>: And some of the other commodities. There is a lot of speculation that we
see in the marketplace, very high levels. But broadly, we are basically in the same position as we
started last year, probably a broad range of cost inflation that we see would be between $0.10 and
$0.16 of EPS.
<Q – Terry Bivens>: Okay.
<A – Jeffrey Boromisa>: That’s built into our guidance for next year.
<Q – Terry Bivens>: I know you are traditionally reluctant to say too much about hedging. But
incorporated in that, is there a need to go back into the market perhaps, lets talk about wheat
maybe and some caution there as to when you might go back in, pricing at the time, et cetera.
<A – Jeffrey Boromisa>: Well you know Terry from a competitive standpoint, we usually don’t talk
much about our hedging strategy, but certainly have an active program.
<Q – Terry Bivens>: Okay, thank you very much. I will adhere to the one question rule here,
thanks.
Operator: And we will take your next question from Alexia Howard with Sanford Bernstein.
<Q – Alexia Howard>: Hi guys.
<A – James Jenness>: Hi Alexia.
<Q – Alexia Howard>: Hello, can anyone tell me little about what your longer-term plans are for
Asia versus Latin America. It seems to me that the Latin American business is really on fire. It has
been doing well for awhile now. The margins out there are great and yet the business seems to be
struggling more in Asia particularly in terms of the top-line growth and the operation margins. Can
you tell us a little bit about what drove the operating margins down in Asia this year and also what
your plans are in terms of resource allocation between the two regions?
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Q3 2006 Earnings Call
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<A – A. D. David Mackay>: Yeah Alexia, I think as we look at Asia, you know, clearly the scale of
our business in Asia relative to most FMCG companies is, we’re probably sub-scale, so it
represents an opportunity. We have been doing a lot of work, John Bryant and the team working
with the Asian team. Looking at what the opportunities could be in that area. Clearly while cereal
will remain a core part of our business, we are looking at how else could we participate in growth in
Asia. And when and if we come up with firm ideas we will let you know. But it’s an area of focus for
us. And really as you look at the third quarter. As Jeff said really, we did launch snacks into Japan.
So we are using Japan as a, if you like, a bit of a test market for Asia with the snacks launch to see
how that goes. It started very well, but it’s very early days at this point.
<Q – Alexia Howard>: And on Latin America, I assume that will continue to be a focus.
<A – A. D. David Mackay>: Latin America continues to be our fastest growing region in the world
and we will do everything we can to continue that momentum. They are doing an outstanding job
and we see that continuing as we go forward.
<Q – Alexia Howard>: Thank you very much.
Operator: And we will take our next question from Jonathan Feeney with Wachovia.
<Q – Jonathan Feeney>: Good morning.
<A – A. D. David Mackay>: Morning.
<Q – Jonathan Feeney>: David, congratulations, finally.
corrected transcript
<A – A. D. David Mackay>: Thank you Jonathan.
<Q – Jonathan Feeney>: The, you have been pulling a lot of productivity savings out of the
business now for a few years, particularly in the area of trade spending. And I am just wondering
and I know you’ve wisely reinvested that, you know in brand building. So I am not really so worried
about the margin as I am that are we coming to the end of a period of kind of optimizing that trade
spending and we need to look for other areas of productivity growth. Or do you think there is still
more to sort of reallocate in terms of the way you build your business as far as you maybe pulling,
de-emphasizing the sort of trade spending and you know promotional stuff and emphasizing some
of the advertising and longer-term brand building?
<A – A. D. David Mackay>: I don’t think it ever ends, Jonathan. We are always obviously looking
to optimize our investment and get better returns. And sometimes it’s not so much that the
investment levels drop as we’re just driving different methodologies of deploying that money and
getting better returns and better paybacks for the company. And that will be an ongoing focus for
us as we look to try to invest in working with our retail partners to try and help them and help us, get
better value out of the money we do spend.
On consumer promotions, they will remain a vital part of our business and really what we’ve been
doing there over the last 12 months is working globally on how can we drive efficiencies, take some
of the less effective programs out, optimize sharing around the world. And actually get a much,
much bigger bang for our buck. And we’ve really done I think a great job on that and you are seeing
some of that this year and you will see more as we go into 2007. And you know even on media,
we’re constantly reviewing our media buying practices and looking to drive efficiencies there. And
again in 2006 and going into 2007 we will see some real benefits coming through there as well. So I
don’t think, Jonathan, it ever stops and even if the level of absolute spend remains flat, then the
focus is how do we get a better return for that investment.
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<Q – Jonathan Feeney>: Thanks and just as a follow up to that. Is there anything, I mean there
has been a lot of news about, you know, maybe Wal-Mart slowing their growth a little bit, some
other retailers that have historically put up really tough comp numbers, getting a heck of a lot better.
Is it becoming maybe, I don’t want to say easier because it’s never easy, but a more friendly, more
partnership environment for optimizing trade spending/maximizing value and profit in these
categories through pricing?
<A – A. D. David Mackay>: Yeah, without getting into any detail, I think the retail landscape has
changed. And I think many of our retail partners talking to us and other companies about how they
can more effectively engage their customer base and draw shoppers into their stores.
<Q – Jonathan Feeney>: Okay, thanks very much.
<A – A. D. David Mackay>: Thanks.
Operator: [Operator Instructions]. And we will take our next question from Hernan Romero with
Ultima Advisors.
<Q>: Thanks. My question was covered.
Operator: Thank you. And we will take our next question from David Adelman with Morgan
Stanley.
<Q – David Adelman>: Hi, good morning everyone.
corrected transcript
<A – A. D. David Mackay>: Good morning David.
<Q – David Adelman>: I had a question on the US ready to eat cereal market and it’s this. If these
higher levels of competitive new product innovation persist when you look out to ’07 and longer
term do you think that Kellogg can continue to profitably gain market share in the market?
<A – A. D. David Mackay>: Yeah, I think David our view is that the great benefit of the realistic
targets we said is we think that’s sustainable year-after-year. You know, I think if you look at the
third quarter, we had a great third quarter against incredibly tough comps. Our base business did
very, very well. A couple of the major competitors in the category were a bit more aggressive on
incremental price driven south than we’d like. But no, I think to the extent that people are putting
more into innovation and brand building that will help the category. And even if their share growth
slows we will still be getting a reasonable growth level in what is a very big and mature category.
<Q – David Adelman>: Thank you.
Operator: And we'll take our next question from Eric Katzman with Deutsche Bank.
<Q – Eric Katzman>: Hi, good morning everybody.
<A – Jeffrey Boromisa>: Good morning Eric.
<Q – Eric Katzman>: Just one question is so tough. I guess my question has do with the mix
issue in the business and that as cereal or if cereal slows a bit, if the market does become more
competitive. I don't know whether your competition or any of them have followed the pricing move
that you announced. It doesn’t sound like it. But and you put more capital behind the snack
portfolio globally and in the US for that matter. How do we think about the mix impact between
cereal versus non-cereal and how does that kind of affect your gross margins over time?
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<A – A. D. David Mackay>: You know, I think, Eric, there is potential if that mix was significant that
over the next year or two that could have a slight impact on our mix. Our view is that hopefully we
are going to keep growing our cereal business even if the rates of growth aren’t at the same levels.
And even on snacks and most of the other portfolio the margins are very good. So there could be a
bit of a shift. The margin has been closer in the mature market than they are in the developing
market. So it’s really a matter of where we are building businesses. The margins are lower in the
first 1 to 3 years. As those businesses mature, than that sort of effect will dissipate anyway
<Q – Eric Katzman>: Okay, so it’s kind of a combination of geography and product. But you are
pretty comfortable that it’s manageable as long as cereal kind of keeps, let's say, slowly upticking?
<A – A. D. David Mackay>: Yes.
<Q – Eric Katzman>: Okay, and then just one follow-up. Did you mention how much currency
benefited you on the bottom line in the quarter and how is that factored into the full year in ’07?
<A – Jeffrey Boromisa>: Well, for the quarter there was a very minor effect from the exchange
rates and you know normally Eric for next year we would consider from a foreign exchange to be
relatively flat with what we have seen this year. We have certain currencies that kind of balance
between each other.
<Q – Eric Katzman>: Okay, all right thank you.
Operator: And our next question will come from Chris Growe with A.G. Edwards.
corrected transcript
<Q – Chris Growe>: Hi, good morning.
<A – A. D. David Mackay>: Hi Chris.
<Q – Chris Growe>: Hi, I just wanted to ask a quick follow up to Eric’s and that is with Eric’s
question and that is that your Snack division within you international business, roughly how much of
your sales does that constitute? Is it around 15% of your sales for that division?
<A – A. D. David Mackay>: That’s not a bad guess, it’s 15 plus.
<Q – Chris Growe>: Okay, and then my question was really for on the US Cereal business. Have
you said or could you say how much pricing benefited you this quarter and you had showed
therefore are we seeing some of that pricing coming through?
<A – A. D. David Mackay>: Yeah, in the quarter Kellogg’s average price per pound was up and
was up above the category, which also grew. And unfortunately, our two largest competitors price
per pound was down, which really just reflects the heavy levels of price driven incremental sales.
<Q – Chris Growe>: Okay, and then the question on the cereal than is you mentioned that
inventory levels were a little higher in the third quarter. Is that a material level or something we
should be worried about for the fourth quarter in our modeling?
<A – A. D. David Mackay>: Now Chris, as you know, we manage most of our major accounts on
VMI, vendor managed inventory. So we monitor inventory levels very closely. As we looked at the
end of the third quarter while our base business sales were stronger, incremental price driven sales
were soft because of what the competition was doing. That means our inventories drifted up a bit.
You know, as we look at it, it’s probably less than a percent than we got in the third quarter that will
come out in the fourth. So you know it's not material but it’s - that’s why we mentioned it.
<Q – Chris Growe>: Sure, that’s helpful, thank you.
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<A – A. D. David Mackay>: Thanks.
Operator: [Operator Instructions]. Now we’ll take your next question from John McMillin with
Prudential Equity Group.
<Q – John McMillin>: David, congratulations.
<A – A. D. David Mackay>: Thank you John.
<Q – John McMillin>: Jim, I hope your hamstring is better.
<A – James Jenness>: Thank you John.
<Q – John McMillin>: I did try your idea of realistic targets with my teenager. I told him to shoot for
C’s and it didn’t work like it does in cereal business I guess.
<A – A. D. David Mackay>: It was a good try though.
<Q – John McMillin>: Yeah, I guess.
<A – James Jenness>: It will come back to you John.
corrected transcript
<Q – John McMillin>: Thank you. Simon, I just follow up Simon. Just Jim, David I don’t know if
you are going to answer it, so probably allow me another question. But every CEO changes
something and maybe you don’t want to go into some of the details. But you know what do you
think you can change or what are you thinking of changing organizationally or?
<A – A. D. David Mackay>: Well John, what I can tell you is if we can repeat what we have done in
the last five or six years. Even though we won’t repeat it exactly the same, I think shareholders
would be very happy with that sort of, you know, major changes you might be looking for, I think
you are going to be disappointed.
<Q – John McMillin>: And just since you didn’t answer that one I’ll ask another one just on a
reference. I was going to Wal-Mart this week. And I saw all the Yogos products in the candy aisle it
was in the cash register coming in. Is that what you wanted and can you really kind of compete
against the Hershey’s and Mars of the world. Is that where you want the product?
<A – A. D. David Mackay>: You know, I think in most of our retail partners, it fits in the wholesome
snacks aisle. Some of them maybe trying it in different parts of the stores. You know, so we’ll see
what the results are, but that’s not where currently it exists in most of the - our trading partners.
<Q – John McMillin>: Okay, thank you.
<A – A. D. David Mackay>: Thanks John.
Operator: And next we’ll go to Andrew Lazar with Lehman Brothers.
<Q – Andrew Lazar>: Good morning.
<A – Jeffrey Boromisa>: Good morning Andrew.
<A – James Jenness>: Hi Andrew.
<A – A. D. David Mackay>: Hi Andrew.
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<Q – Andrew Lazar>: Dave, let me add my congratulations as well.
<A – A. D. David Mackay>: Thank you Andrew.
<Q – Andrew Lazar>: I want to push I guess Jeff if I could just a little bit harder on the gross
margin in the quarter. I know you mentioned all of the various things that were headwinds and
there have certainly been some other things that were headwinds in the first two quarters as well?
<A – Jeffrey Boromisa>: Right.
<Q – Andrew Lazar>: But it just seems and maybe I am just off here, just seems like with the kind
of sales growth that you have had that the operating leverage of your business. Particularly given
the margins around cereal should be allowing you perhaps some more gross margin flexibility even
understanding the costs that you have been pushing up against. So I guess are there any other
notable things in the quarter that maybe impacted gross margins negatively that are kind of. I know
you mentioned some of the co-packing things. But is there way to maybe qualify that, do you have
a sense of what’s impacting you, because I am having trouble understanding it?
<A – Jeffrey Boromisa>: Sure, sure. You know, actually Andrew, we think our gross profit margin
performance, if you look at the chart, is certainly improving quarter-by-quarter. And we are very –
feel very good about the Q3 results only thing down 10 basis points with fuel, energy, commodity
benefits. That’s a negative 140 basis points that we are trying to basically offset. Now some of that
was offset by lower up-front costs, probably around 50 basis points. So the net positive of…
corrected transcript
<Q – Andrew Lazar>: And you had some additional…
<A – Jeffrey Boromisa>: Our productivity. Our productivity savings are being about 70 basis
points, which we feel is a very good level, but there wasn’t anything unusual certainly in the quarter.
It’s a story of commodities.
<Q – Andrew Lazar>: Okay, all right, that’s helpful.
<A – Jeffrey Boromisa>: Yeah.
<Q – Andrew Lazar>: Thanks very much.
<A – Jeffrey Boromisa>: Thank you.
Operator: And Eric Serotta with Merrill Lynch has a question.
<Q – Eric Serotta>: Good morning.
<A – Jeffrey Boromisa>: Good morning Eric.
<Q – Eric Serotta>: Following up on Andrew’s question on gross margin. I know that you’ve cited
over the past couple of quarters the impact of the co-packing arrangements you’ve had on new
products?
<A – Jeffrey Boromisa>: Right.
<Q – Eric Serotta>: With your very strong innovation pipeline should we expect a continued sort of
replacement or continuation of the trend as new products come, as existing co-products – sorry coproduced products come in house. But new innovation goes to co-manufacturers? Or should we
expect some sort of margin benefit at some point from this volume coming in house?
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<A – A. D. David Mackay>: Eric, I think that depends. You know, we’re taking a responsible view
with some of the new products that we don’t want to invest the capital until we have a degree of
certainty about their likely success rate. So that could generate an opportunity in the future, but it
does depend, and if it hurts us a little bit in the short-term, we think that’s a better way for us to
manage the exposure putting capital in.
<Q – Eric Serotta>: Okay, and along the lines of some of these new products that you may not be
sure of the ultimate success of. You didn’t mention some of these Special K extensions in the
health and wellness area. I know it’s still very early, but could you give us a little bit of color as to
how they’ve tracked versus your expectations on the Special K waters and the like?
<A – A. D. David Mackay>: Yeah, it’s the Special K Protein Beverage we call it.
<Q – Eric Serotta>: Okay.
<A – A. D. David Mackay>: And the bars well – you know they have gone into most of the drug
and pharmacy sections. They wanted them in there early, the actual major advertising or launch
doesn’t start until January. So it really is too early to give you any sense of that, I’d say by the end
of the first quarter next year, we will have. We will start to get a reasonable sense for that but you
know we actually drove distribution in front of our launch program at the request of our customers.
<Q – Eric Serotta>: Okay thank you very much.
<A – A. D. David Mackay>: Thanks.
corrected transcript
<A – Jeffrey Boromisa>: Thank you.
Operator: And next we will go to David Driscoll with Citigroup.
<Q – Michael Avery>: Hello this is Michael Avery for David Driscoll.
<A – A. D. David Mackay>: Hi Michael.
<A – Jeffrey Boromisa>: Hi Michael.
<Q – Michael Avery>: Congratulations.
<A – A. D. David Mackay>: Thank you.
<Q – Michael Avery>: I just want to get back to cereal for a minute. I know the Nielsen data has its
reliability issues that you have mentioned in the past. But to the extent that it might be consistently
unreliable it has shown some worse trends with an actual cereal decline for Kellogg of almost 3% in
the period that correlates pretty closely to the quarter. How do you see the cereal category for your
business and what would drive the biggest difference between the shipments and the Nielsen data.
Is it the pipeline shipments or other channels or how do you break that down.
<A – A. D. David Mackay>: You know well, you know, we constantly have this debate when you
look at IRI versus the overall market even if you just take the category. The category looks like it’s
flattish, you need to add between 2 and 3 points to the category to get a true reflection of what’s
going on with the category. And that’s probably true across all of the players in the category. And it
can vary, we’ve had up to a - I think a 6 or an 8 point spread at certain times between IRI and our
reported numbers. It’s actually, you know, a little bit close in there with us up 3. And if you look at
the IRI data really showing us up a little bit, relatively flat. But remember our year-to-date share is
up 30 basis points. We were broadly flat depending on which period you look at in the quarter. And
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our base sales, which is really the thing that we focus on, grew much faster than the category and
our average price per pound was up. Our two biggest competitors, their base sales were - grew
lower than the category. Their incremental was up higher than the category and their average price
per pound both declined. So in that context and up against an 11% year ago comp, Michael we
feel very good about our third quarter performance in cereal.
<Q – Michael Avery>: No, that’s great, that’s very helpful. Thanks a lot.
Operator: And we will take our next question from David Palmer with UBS.
<Q – David Palmer>: Hi guys. Congratulations, David and Jim.
<A – A. D. David Mackay>: Thank you.
<A – James Jenness>: Thank you.
<Q – David Palmer>: I think I found a way kind of combine several questions into kind of a big
theme one. It seems…
corrected transcript
<A – James Jenness>: It’s a paragraph.
<Q – David Palmer>: It’s a paragraph. It seems that snack aisle has been particularly active with
innovation and Kellogg has really pursued it very well with a variety of trademarks and extensions
in there. But it does seem like the snack aisle has been getting kind of cluttered. And I wonder if
there is kind of a point in the evolution of that part of your business where the growth might begin to
cool over time. And the big picture is that you are perhaps hoping for other new things, you have
the fruit snacks, now the new weight management products and that. And the big picture is that
those will pick up the slack and as you perhaps in-source those eventually that the margin swap
might be fairly neutral?
<A – A. D. David Mackay>: Yeah. I think firstly on the wholesome snacks category, it’s clear that
we’re talking with our retail partners about potentially adding more space because it is under
spaced relative to its growth and its return. Not only to them, but to the players, and we would hope
to see an expansion in some of the space allocated. Our view is that we will grow, and that
category will grow at about mid single-digits. It will be slightly higher above our low single-digit but
we think it will abate and it does go through cycles as we have seen before. And normally what
happens David is the clutter shakes out. You remember when we had the low carb situation we
had a massive number of new products come in, almost all of those have gone or are about to go.
So we have very strong brands. We continue to expect good performance as we go forward.
<Q – David Palmer>: Thank you very much.
<A – A. D. David Mackay>: Thank you.
Operator: And we will take the last question from Pablo Zuanic with J.P. Morgan.
<Q – Pablo Zuanic>: Good morning everyone, congratulations Jim and David.
<A – James Jenness>: Thanks Pablo.
<A – A. D. David Mackay>: Thanks Pablo.
<Q – Pablo Zuanic>: It’s good to see a company that actually gives a Chairman role and CEO role
separate. Just one question in terms of the cereal category David, according to the data we look
the category has really slowed and even including Wal-Mart in the last few months the category has
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actually been down. And I am just wondering is that true, is that – have you seen that decline in the
category in terms of growth? We also get a sense that Wal-Mart is reducing the space to cereal
because the growth of cereal at Wal-Mart has also slowed down. So can you help me understand
that? And tell me also within cereal what’s next, I mean Omega-3 we had fiber, we had whole
grain, we had reduced cholesterol, what’s next to really I guess bring back excitement to the
category in terms of innovative breakthroughs?
corrected transcript
<A – A. D. David Mackay>: Yeah, actually Pablo as we look at the category, the third quarter was
stronger than either the first or the second. And when you look at the fourth quarter last year it was
the weakest quarter. So you know our view is that the category is actually the opposite. It has
picked up a little bit third quarter versus the first half. And our view is that the cereal category will
continue to do well as we have said if you blend the other channels you know our view is it’s
growing two maybe a little bit more than 2%. And the extent to which we can continue to bring
excitement to category, we’ll keep growing the category and hopefully performing well. You know, I
am not aware a slowdown in any of our major customers and it remains a big focus for most of
them because the category management data that we have looked at indicates that anyone who
buys cereal has a higher shopping basket than people who don’t. So it remains a destination
category. We have strong plans for innovation and we are going to continue what we have been
doing. There are some exciting things in the future, but it’s a bit early to really lay those out.
<Q – Pablo Zuanic>: Okay and just one follow up if I may for Jeff. Jeff, when I hear you talking
about gross margin and EBIT margins. First of all to talk apples-to-apples we have take out the
option expense from SG&A and then we have to take out the charges which in this case were lower
than last year and what I have seen and bear with me here. I see that Kellogg gross margin from
2000 to 2004 increased and you actually were able to maintain your SG&A, so we saw margin
expansion. In ’05, as you guided SG&A to sales increased because you were reinvesting in the
business, but in 2006 that model has really broken. I mean, for the first three quarters if you adjust,
maybe these adjustments, your gross margins have dropped in fact in this quarter they fell 50 basis
points. And it seems to me that you have funded some of that with lower SG&A to sales, again
adjusting it. So what I am trying to understand if you are saying that brand building has happened,
I am sure it is. Where are the savings coming from? And if they are coming G&A why didn’t we see
that before, because again in adjusted terms, SG&A to sales from ’02 to ’05 was not declining like it
has this year, when you have made a bigger emphasis on increasing brand building. Help me
understand that?
<A – Jeffrey Boromisa>: Pablo, certainly you have to take into effect the up front and cost of
goods sold in ’05.
<Q – Pablo Zuanic>: Right, so we take that out.
<A – Jeffrey Boromisa>: Because and when you look at our SG&A, you know, certainly the
reported number you have to back off the stock option expense. The savings are really coming
from our overhead area. We look at overhead just like we do on cost of goods sold from an
efficiency standpoint. So, and you got to look also that our sales growth has been frankly at the
high single digit level. Which when you look on a margin basis of SG&A and brand building as a
part of that it’s going up in line with that if not a little bit more. So I think you’ve got to look at the
sales growth factor in line with a brand building growth factor.
<Q – Pablo Zuanic>: Okay and if I may just last one David and I am the last one in the queue and I
guess it’s still not 10:30. But in terms of our you know you are improving the business, you are
saying keep doing what you are doing and I hear you, but when could we see somebody could
make to our maybe Carlos’s strategy on international business, if it was too focused. It was really
Mexico, Australia, UK, Canada and some business in other markets, emerging markets have been
pretty much not explored, Asia and other markets could be mentioned. And I find that you have left
Nestle and obviously CBW get a head start in emerging markets. Is there something that you plan
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to address in a different way or its not really a big deal, there is no hurry to worry about cereal
consumption in China. Help me understand that David, your strategic vision in that regard?
<A – A. D. David Mackay>: Yeah Pablo, I think we said at CAGNY that we were looking at the
areas of the world where you know potentially to your point we backed off a bit when we did focus
in line. We may be a little bit behind, but it doesn’t make the opportunity any less significant.
<Q – Pablo Zuanic>: Okay that’s good, thank you.
Simon D. Burton, Director of Investor Relations
Okay, we are going to end the call now, Operator, if we may.
corrected transcript
Operator: Yes that does conclude today’s conference call. We do thank you for attending today
and have a great day.
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