UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934
(Mark One)
OR
Commission file number 1-4171
KELLOGG COMPANY
One Kellogg Square, P.O. Box 3599, Battle Creek, MI 49016-3599
Registrant’s telephone number: 616-961-2000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes No
Common Stock outstanding July 31, 2001 — 406,166,805 shares
TABLE OF CONTENTS
INDEX
Kellogg Company and SubsidiariesCONSOLIDATED BALANCE SHEET(millions, except per share data)
Refer to Notes to Consolidated Financial Statements
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Kellogg Company and SubsidiariesCONSOLIDATED EARNINGS(millions, except per share data)
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Kellogg Company and SubsidiariesCONSOLIDATED STATEMENT OF CASH FLOWS(millions)
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Notes to Consolidated Financial Statementsfor the three and six months ended June 30, 2001 (unaudited)
1. Accounting policies
The unaudited interim financial information included in this report reflects normal recurring adjustments that management believes are necessary for a fair presentation of the results of operations, financial position, and cash flows for the periods presented. This interim information should be read in conjunction with the financial statements and accompanying notes contained on pages 24 to 39 of the Company’s 2000 Annual Report. The accounting policies used in preparing these financial statements are the same as those summarized in the Company’s 2000 Annual Report, except as discussed in Note 6 below. Certain amounts for 2000 have been reclassified to conform to current-period classifications.
The results of operations for the three and six months ended June 30, 2001, are not necessarily indicative of the results to be expected for other interim periods or the full year.
2. Acquisitions
Keebler acquisition
On March 26, 2001, the Company completed its acquisition of Keebler Foods Company (“Keebler”) in a transaction entered into with Keebler and with Flowers Industries, Inc., the majority shareholder of Keebler. Keebler, headquartered in Elmhurst, Illinois, ranks second in the United States in the cookie and cracker categories and has the third largest food direct store door (DSD) delivery system in the United States.
Under the purchase agreement, the Company paid $42 in cash for each common share of Keebler or approximately $3.65 billion, including $66 million of related acquisition costs. The Company also assumed $208 million in obligations to cash out employee and director stock options, resulting in a total cash outlay for Keebler stock of approximately $3.86 billion. Additionally, the Company assumed approximately $700 million of Keebler debt, bringing the total value of the transaction to $4.56 billion. Approximately 80% of the debt assumed was refinanced on the acquisition date.
The acquisition was accounted for under the purchase method and was financed through a combination of short-term and long-term debt. The assets and liabilities of the acquired business were included in the consolidated balance sheet as of March 31, 2001. For purposes of consolidated reporting during 2001, Keebler’s interim results of operations are being reported for the periods ended March 24, 2001, June 16, 2001, October 6, 2001, and December 29, 2001. Therefore, Keebler results from the date of acquisition to June 16, 2001, have been included in the Company’s second quarter 2001 results.
As of June 30, 2001, the components of intangible assets included in the allocation of purchase price, along with the related straight-line amortization periods, are presented in the following table. The Company is in the process of finalizing valuations of several assets and obligations that existed as of the acquisition date. As a result, the amount of goodwill could change upon completion of this work.
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As of June 30, 2001, the purchase price allocation included $88.9 million of liabilities related to management’s plans to exit certain activities and operations of the acquired company (“exit liabilities”), as presented in the table below. Cash outlays related to these exit plans are projected to be approximately $50 million in 2001, with substantially all remaining amounts spent in 2002.
Exit plans implemented thus far include separation of approximately 70 Keebler administrative employees and closing of a bakery in Denver, Colorado, eliminating approximately 470 employee positions. Additionally, during June 2001, the Company communicated plans to transfer portions of Keebler’s Grand Rapids, Michigan, bakery production to other plants in the United States during the next 12 months. The impact of this initiative on the current workforce of approximately 675 employees is, in part, dependent on discussions under way with union and local government officials.
The following tables include the unaudited pro forma combined results as if Kellogg Company had acquired Keebler Foods Company as of the beginning of either 2001 or 2000, instead of March 26, 2001. The first table also includes consolidated results for the second quarter of 2001 for comparison purposes only (Keebler was part of Kellogg Company for this entire period.)
Each pro forma period presented below includes separate company results of Keebler Foods Company as follows:
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The pro forma results include amortization of the intangibles presented above and interest expense on debt assumed issued to finance the purchase. The pro forma results are not necessarily indicative of what actually would have occurred if the acquisition had been completed as of the beginning of each of the fiscal periods presented, nor are they necessarily indicative of future consolidated results.
Prior-year acquisitions
During 2000, the Company paid cash for several business acquisitions. In January, the Company purchased certain assets and liabilities of the Mondo Baking Company Division of Southeastern Mills, Inc., a convenience foods manufacturing operation, for approximately $93 million. In June, the Company acquired the outstanding stock of Kashi Company, a U.S. natural foods company, for approximately $33 million. In July, the Company purchased certain assets and liabilities of The Healthy Snack People business, an Australian convenience foods operation, for approximately $12 million.
3. Restructuring charges
During the past several years, management has commenced major productivity and operational streamlining initiatives in an effort to optimize the Company’s cost structure. The incremental costs of these programs have been reported during these years as restructuring charges. Refer to pages 30-31 of the Company’s 2000 Annual Report for more information on these initiatives.
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Operating profit for the six months ended June 30, 2001, includes restructuring charges of $48.3 million ($30.3 million after tax or $.07 per share), related to preparing Kellogg for the Keebler integration and continued actions supporting the Company’s “focus and align” strategy. Specific initiatives included a headcount reduction of about 35 in the U.S. business and global layer of Company management, rationalization of product offerings and other actions to combine the Kellogg and Keebler logistics systems, and further reductions in convenience foods capacity in South East Asia. Approximately 70% of the charges were comprised of asset write-offs, with the remainder consisting of employee severance and other cash costs.
Operating profit for the three and six months ended June 30, 2000, includes restructuring charges of $21.3 million ($14.7 million after tax or $.04 per share) for a supply chain efficiency initiative in Europe. The charges were comprised principally of voluntary employee retirement and separation benefits related to an hourly and salaried headcount reduction of approximately 190 during 2000.
Total cash outlays during the June 2001 year-to-date period for ongoing streamlining initiatives were approximately $23 million, compared to $34 million in 2000. Expected cash outlays are approximately $19 million for the remainder of 2001, with the balance of the reserves spent after 2001.
The components of restructuring charges, as well as reserve balance changes, during the six months ended June 30, 2001, were:
As a result of the Keebler acquisition, the Company assumed $14.9 million of reserves for severance and facility closures, related to Keebler’s ongoing restructuring and acquisition-related synergy initiatives.
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The restructuring-related reserves are attributable to the closing of Keebler’s manufacturing facility in Sayreville, New Jersey, in 1999, and are expected to be utilized during the remainder of 2001. The acquisition-related reserves are attributable primarily to the closing of various distribution and manufacturing facilities. Of the acquisition-related reserves, approximately $6 million is expected to be utilized in 2001. The remaining balance of approximately $8 million is attributable primarily to non-cancelable lease obligations extending through 2006.
4. Equity
Earnings per share
Basic net earnings per share is determined by dividing net earnings by the weighted average number of common shares outstanding during the period. Diluted net earnings per share is similarly determined, except that the denominator is increased to include the number of additional common shares that would have been outstanding if all dilutive potential common shares had been issued. Dilutive potential common shares are comprised principally of employee stock options issued by the Company and had an insignificant impact on earnings per share during the periods presented. Basic net earnings per share is reconciled to diluted net earnings per share as follows:
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Comprehensive Income
Comprehensive income includes all changes in equity during a period except those resulting from investments by or distributions to shareholders. For the Company, comprehensive income for the periods presented consists of net earnings, unrealized gains and losses on cash flow hedges pursuant to SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities”, and foreign currency translation adjustments pursuant to SFAS No. 52 “Foreign Currency Translation” as follows:
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Accumulated other comprehensive income (loss) as of June 30, 2001, and December 31, 2000 consisted of the following:
5. Debt
Notes payable at June 30, 2001, consist primarily of short-term debt borrowings in the United States in the amount of $580.7 million with an effective interest rate of 4.8%. Long-term debt consists primarily of fixed rate issuances of U.S. and Euro Dollar Notes, as follows:
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In order to provide additional short-term liquidity in connection with the Keebler Foods Company acquisition referenced above, the Company entered into a 364-Day Credit Agreement, expiring in January 2002 (subject to a renewal option) and a Five-Year Credit Agreement, expiring in January 2006. Each of these agreements permits the Company or certain subsidiaries to borrow up to $1.15 billion (or certain amounts in foreign currencies under the Five-Year Credit Agreement). These two credit agreements contain standard warranties, events of default, and covenants. They also require the maintenance of at least $700 million of consolidated net worth and a consolidated interest expense coverage ratio (as defined) of at least 3.0, and limit capital lease obligations and subsidiary debt. These credit facilities were unused at June 30, 2001.
Keebler Foods Company is also a party to a note purchase and servicing agreement, which contains standard warranties, events of default, and covenants, as well as the financial covenants in the prior paragraph. The agreement also contains limits on indebtedness, dividends, loans and other investments, capital expenditures, affiliate transactions, and sales of assets and stock of subsidiaries.
6. Accounting for derivative instruments and hedging activities
On January 1, 2001, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 133 “Accounting for Derivative Instruments and Hedging Activities.” This statement requires that all derivative instruments be recorded on the balance sheet at fair value and establishes criteria for designation and effectiveness of hedging relationships. For the six months ended June 30, 2001, the Company reported a charge to earnings of $1.0 million (net of tax benefit of $.6 million) and a charge to other comprehensive income
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of $14.9 million (net of tax benefit of $8.6 million) in order to recognize the fair value of derivative instruments as either assets or liabilities on the balance sheet. The charge to earnings relates to the component of the derivative instruments’ net loss that has been excluded from the assessment of hedge effectiveness.
The Company is exposed to certain market risks which exist as a part of its ongoing business operations and uses derivative financial and commodity instruments, where appropriate, to manage these risks. In general, instruments used as hedges must be effective at reducing the risk associated with the exposure being hedged and must be designated as a hedge at the inception of the contract. The Company designates derivatives as either cash flow hedges, fair value hedges, net investment hedges, or other contracts used to reduce volatility in the translation of foreign currency earnings to U.S. Dollars. The fair values of all hedges are recorded in accounts receivable or other current liabilities. Gains and losses related to the ineffective portion of any hedge are recorded in other income (expense), net. This amount was insignificant during the six months ended June 30, 2001.
Cash flow hedges
Qualifying derivatives are accounted for as cash flow hedges when the hedged item is a forecasted transaction. Gains and losses on these instruments are recorded in other comprehensive income until the underlying transaction is recorded in earnings. When the hedged item is realized, gains or losses are reclassified from accumulated other comprehensive income to the Statement of Earnings on the same line item as the underlying transaction.
The total net loss attributable to cash flow hedges recorded in accumulated other comprehensive income at June 30, 2001, was $56.5 million, primarily related to a forward-starting interest rate swap (refer to Note 5), which is being reclassified into interest expense over periods of 5 to 30 years beginning in the second quarter of 2001. Other insignificant amounts related to foreign currency and commodity price cash flow hedges will be reclassified into earnings during the next 12 months.
Fair value hedges
Qualifying derivatives are accounted for as fair value hedges when the hedged item is a recognized asset, liability, or firm commitment. Gains and losses on these instruments are recorded in earnings, offsetting gains and losses on the hedged item.
Net investment hedges
Qualifying derivative and non-derivative financial instruments held by the parent company are accounted for as net investment hedges when the hedged item is a foreign currency investment in a subsidiary. Gains and losses on these instruments are recorded as a foreign currency translation adjustment in other comprehensive income.
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Other contracts
The Company also enters into foreign currency forward contracts to reduce volatility in the translation of foreign currency earnings to U.S. Dollars. Gains and losses on these instruments are recorded in other income (expense), net, generally reducing the exposure to translation volatility during a full-year period.
Foreign exchange risk
The Company is exposed to fluctuations in foreign currency cash flows related primarily to third-party purchases, intercompany product shipments, and intercompany loans. The Company is also exposed to fluctuations in the value of foreign currency investments in subsidiaries and cash flows related to repatriation of these investments. Additionally, the Company is exposed to volatility in the translation of foreign currency earnings to U.S. Dollars. The Company assesses foreign currency risk based on transactional cash flows and enters into forward contracts, all of generally less than twelve months duration, to reduce fluctuations in net long or short currency positions.
For foreign currency cash flow and fair value hedges, the assessment of effectiveness is based on changes in spot rates. Changes in time value are reported in other income (expense), net.
Interest rate risk
The Company is exposed to interest rate volatility with regard to future issuances of fixed rate debt and existing issuances of variable rate debt. The Company currently uses interest rate swaps, including forward-starting swaps, to reduce interest rate volatility and funding costs associated with certain debt issues, and to achieve a desired proportion of variable versus fixed rate debt, based on current and projected market conditions.
Variable-to-fixed interest rate swaps are accounted for as cash flow hedges and the assessment of effectiveness is based on changes in the present value of interest payments on the underlying debt. Fixed-to-variable interest rate swaps are accounted for as fair value hedges and the assessment of effectiveness is based on changes in the fair value of the underlying debt, using incremental borrowing rates currently available on loans with similar terms and maturities.
Price risk
The Company is exposed to price fluctuations primarily as a result of anticipated purchases of raw and packaging materials. The Company uses the combination of long cash positions with suppliers, and exchange-traded futures and option contracts to reduce price fluctuations in a desired percentage of forecasted purchases over a duration of generally less than one year.
Commodity contracts are accounted for as cash flow hedges. The assessment of effectiveness is based on changes in futures prices.
7. Operating Segments
Kellogg Company is the world’s leading producer of cereal and a leading producer of convenience foods, including cookies, crackers, toaster pastries, cereal bars, frozen
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waffles, meat alternatives, pie crusts, and ice cream cones. Kellogg products are manufactured in 19 countries and marketed in more than 160 countries around the world.
The Company is managed in two major divisions — the United States and International — with International further delineated into Europe, Latin America, Canada, Australia, and Asia. This organizational structure is the basis of the operating segment data presented below.
The measurement of operating segment results is generally consistent with the presentation of the Consolidated Statement of Earnings. Intercompany transactions between reportable operating segments were insignificant in the periods presented.
8. Recently issued pronouncements
Revenue measurement
In April 2001, the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB) reached consensus on Issue No. 00-25 “Vendor Income Statement Characterization of Consideration to a Purchaser of the Vendor’s Products or Services.” The EITF also delayed the effective date of previously finalized Issue No. 00-14 “Accounting for Certain Sales Incentives” to coincide with the effective date of Issue No. 00-25. This guidance will now be effective for Kellogg Company beginning January 1, 2002.
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Both of these Issues provide guidance primarily on income statement classification of consideration from a vendor to a purchaser of the vendor’s products, including both customers and consumers. Generally, cash consideration is to be classified as a reduction of revenue, unless specific criteria are met regarding goods or services that the vendor may receive in return for this consideration. Generally, non-cash consideration is to be classified as a cost of sales.
This guidance is applicable to Kellogg Company in several ways. First, it applies to payments made by the Company to its customers (the retail trade) primarily for conducting consumer promotional activities, such as in-store display and feature price discounts on the Company’s products. Second, it applies to discount coupons and other cash redemption offers that the Company provides directly to consumers. Third, it applies to promotional items such as toys that the Company inserts in or attaches to its product packages (“package inserts”). Consistent with industry practice, the Company has historically classified these items as promotional expenditures within selling, general, and administrative expense (SG&A), and has generally recognized the cost as the related revenue is earned.
Effective January 1, 2002, the Company will reclassify promotional payments to its customers and the cost of consumer coupons and other cash redemption offers from SG&A to net sales. The Company will reclassify the cost of package inserts from SG&A to cost of sales. All comparative periods will be restated. Management is currently assessing the total combined impact of both Issues, including the proforma effect of the Keebler acquisition. However, management believes that based on historical information, combined net sales could be reduced up to 15%, with approximately 95% of this impact reflected in the U.S. operating segment. Combined cost of goods sold could be increased by approximately 1.5%. SG&A would be correspondingly reduced such that net earnings would not be affected.
Business combinations
In July 2001, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 141 “Business Combinations” and SFAS No. 142 “Goodwill and Other Intangible Assets.” Both of these Standards provide guidance on how companies account for acquired businesses and related disclosure issues.
Chief among the provisions of these standards are 1) elimination of the “pooling of interest” method for transactions initiated after June 30, 2001, 2) elimination of amortization of goodwill and “indefinite-lived” intangible assets effective for Kellogg Company on January 1, 2002, and 3) annual impairment testing and potential loss recognition for goodwill and non-amortized intangible assets, also effective for the Company on January 1, 2002.
Regarding the elimination of goodwill and indefinite-lived intangible amortization, this change will be made prospectively upon adoption of the new standard as of January 1, 2002. Prior-period financial results will not be restated. However, earnings information for prior-periods will be disclosed, exclusive of comparable amortization expense that is eliminated in post-2001 periods.
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Management is currently assessing the impact of these provisions. However, management believes substantially all of the Company’s total after-tax amortization expense could be eliminated under these new guidelines. Based on acquisitions completed to date, management expects total after-tax amortization expense in 2002 (before impact of the new Standards) of approximately $110-$115 million.
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PART I — FINANCIAL INFORMATION
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Results of operations
Kellogg Company is the world’s leading producer of cereal and a leading producer of convenience foods, including cookies, crackers, toaster pastries, cereal bars, frozen waffles, meat alternatives, pie crusts, and ice cream cones. Kellogg products are manufactured in 19 countries and marketed in more than 160 countries around the world. The Company is managed in two major divisions — the United States and International — with International further delineated into Europe, Latin America, Canada, Australia, and Asia. This organizational structure is the basis of the operating segment data presented in this filing.
During the first quarter of 2001, we completed our acquisition of Keebler Foods Company (the “Keebler acquisition”), making Kellogg Company a leader in the U.S. cookie and cracker categories. Primarily as a result of the Keebler contribution, second quarter 2001 net sales and operating profit increased significantly. Despite these increases, net earnings and earnings per share were down versus the prior year, primarily due to increased amortization and interest expense from the Keebler acquisition, the business impact of product rationalization and Keebler integration activities, and unfavorable foreign currency movements. U.S. retail cereal dollar category share increased year-over-year for the fifth consecutive quarter, and is currently at the highest level of the past two years.
The following items have been excluded from all applicable amounts presented in this section for purposes of comparison between historical, current, and future periods:
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Reported results for the quarter and year-to-date periods are reconciled to comparable results, as follows:
The year-to-date decrease in earnings per share of $.19 was primarily the result of $.13 from incremental interest expense, $.06 from incremental amortization expense, $.06 from a higher effective tax rate due primarily to the Keebler acquisition, and $.04 from unfavorable foreign currency movements. This was offset by $.10 of favorable business growth, which includes the results of the Keebler business.
The following tables provide an analysis of net sales and operating profit performance for the 2001 second quarter and June year-to-date periods:
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On a comparable business basis, consolidated net sales for the quarter were down 1.8% (volume decline of .8% and pricing/mix decline of 1.0%), resulting primarily from a 2% decline in both U.S. retail cereal and snack sales, the discontinuation of the Company’s private-label program in Germany, and exiting the convenience foods business in certain smaller international markets. The decline in U.S. cereal sales was expected due to a difficult year-ago comparison (+4% growth in second quarter 2000) and payments made to the trade in order to expedite our announced price increase. The decline in U.S. snack sales was primarily due to our product rationalization initiative and postponed marketing support, preceding the integration of this business into the Keebler DSD system. Strong sales growth in key Latin American markets and Australia partially offset this decline.
On a comparable business basis, consolidated operating profit for the quarter was up nearly 1%. Increased profitability in international businesses offset the comparable sales declines discussed above, as well as the impact of increased marketing investment in the U.S. cereal, and the natural and frozen foods businesses, and additional sales force hiring and training costs.
As presented in the tables above, Keebler integration activities reduced consolidated net sales for the quarter by 1% and operating profit by nearly 8%. During the quarter, this integration impact primarily consisted of the sales and operating profit impact of working down trade inventories to transfer our snack foods to Keebler’s DSD system, and employee-related costs such as relocation and retention. We estimate that these activities reduced net sales by $17.8 million, reduced gross profit by $16.4 million, and increased selling, general, and administrative expense by $5.1 million, for a total operating profit reduction of $21.5 million.
As presented in the tables above, the inclusion of the Keebler business in consolidated results increased our net sales for the quarter by over 35% and operating profit (excluding Keebler amortization expense and restructuring charges) by 27%. On a pro forma basis, assuming we had owned Keebler during the prior year quarter, consolidated net sales would have been down 2.3%. Excluding foreign currency and integration impacts, pro forma consolidated net sales would have increased .4%. Keebler’s net sales for the quarter (excluding Kellogg snacks integrated into the DSD system during the quarter) increased approximately 2% versus the prior year. Pro forma operating profit (excluding Keebler amortization expense, restructuring charges, foreign currency and integration impacts) would have increased 7.2% for the quarter.
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Margin performance (excluding restructuring charges but including integration impact) for the quarter and year-to-date periods was:
Gross interest expense, prior to amounts capitalized, was up versus the prior year, due primarily to interest expense on debt issued late in the first quarter to finance the Keebler acquisition. (Refer to the section below on liquidity and capital resources for further information.)
The consolidated effective tax rate increased significantly over the prior year, primarily as a result of the impact of the Keebler acquisition on non-deductible goodwill and the level of U.S. tax on 2001 foreign subsidiary earnings.
Restructuring charges
During the past several years, we have commenced major productivity and operational streamlining initiatives in an effort to optimize our cost structure. The incremental costs of these programs have been reported during these years as restructuring charges. Refer to pages 30-31 of our 2000 Annual Report for more information on these initiatives.
Operating profit for the six months ended June 30, 2001, includes restructuring charges of $48.3 million ($30.3 million after tax or $.07 per share), related to preparing Kellogg for the Keebler integration and continued actions supporting our “focus and align” strategy. Specific initiatives included a headcount reduction of about 35 in the U.S. business and global layer of our management, rationalization of product offerings and other actions to combine the Kellogg and Keebler logistics systems, and further reductions in convenience foods capacity in South East Asia. Approximately 70% of the charges were comprised of
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asset write-offs, with the remainder consisting of employee severance and other cash costs. Savings generated from certain of these initiatives are expected to contribute to cost synergies related to the Keebler acquisition.
Total cash outlays during the June 2001 year-to-date period for ongoing streamlining initiatives were approximately $23 million, compared to $34 million in 2000. Expected cash outlays are approximately $19 million for the remainder of 2001, with the balance of the reserves spent after 2001. Total incremental pre-tax savings expected from all streamlining initiatives during 2001 (except those connected with the Keebler integration) are approximately $75 million. Refer to Note 3 within Footnotes to Consolidated Financial Statements for further information regarding the components of restructuring charges, as well as reserve balance changes, during the six months ended June 30, 2001.
As a result of the Keebler acquisition, we assumed $14.9 million of reserves for severance and facility closures related to Keebler’s ongoing restructuring and acquisition-related synergy initiatives. Approximately $7 million of those reserves are expected to be fully utilized in 2001, with the remainder being attributable primarily to non-cancelable lease obligations extending through 2006. Refer to Note 3 within Footnotes to Consolidated Financial Statements for further information on these reserve balances.
On March 26, 2001, we completed our acquisition of Keebler Foods Company in a transaction entered into with Keebler and with Flowers Industries, Inc., the majority shareholder of Keebler. Keebler Foods Company, headquartered in Elmhurst, Illinois, ranks second in the United States in the cookie and cracker categories and has the third largest food direct store door (DSD) delivery system in the United States.
Under the purchase agreement, we paid $42 in cash for each common share of Keebler or approximately $3.65 billion, including $66 million of related acquisition costs. We also assumed $208 million in obligations to cash out employee and director stock options, resulting in a total cash outlay for Keebler stock of approximately $3.86 billion. Additionally, we assumed approximately $700 million of Keebler debt, bringing the total value of the transaction to $4.56 billion. Approximately 80% of the debt assumed was refinanced on the acquisition date.
The acquisition was accounted for under the purchase method and was financed through a combination of short-term and long-term debt. The assets and liabilities of the acquired business were included in the consolidated balance sheet as of March 31, 2001. For purposes of consolidated reporting during 2001, Keebler’s interim results of operations are being reported for the periods ended March 24, 2001, June 16, 2001, October 6, 2001, and
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December 29, 2001. Therefore, Keebler results from the date of acquisition to June 16, 2001, have been included in our second quarter 2001 results.
As a result of the acquisition, we expect amortization expense to increase by approximately $90 million in 2001 (approximately $75 million after related deferred tax benefit). As a result of a recently issued accounting pronouncement (refer to “Accounting changes” section below), we believe this amortization expense will be eliminated in post-2001 years. We are currently assessing the impact of this new pronouncement. We are in the process of finalizing valuations of several assets and obligations that existed as of the acquisition date. As a result, the amount of goodwill — and related 2001 amortization expense — could change upon completion of this work. Refer to Note 2 within Footnotes to Consolidated Financial Statements for further information on goodwill and the components of intangible assets.
As of June 30, 2001, the purchase price allocation included $88.9 million of liabilities related to our plans to exit certain activities and operations of the acquired company (“exit liabilities”), comprised of Keebler employee severance and relocation, contract cancellation, and facility closure costs (refer to Note 2 within Footnotes to Consolidated Financial Statements for further information). Cash outlays related to these exit plans are projected to be approximately $50 million in 2001, with substantially all remaining amounts spent in 2002. Exit plans implemented thus far include separation of approximately 70 Keebler administrative employees and the closing of a bakery in Denver, Colorado, eliminating approximately 470 employee positions. Additionally, during June 2001, we communicated plans to transfer portions of Keebler’s Grand Rapids, Michigan, bakery production to other plants in the United States during the next 12 months. The impact of this initiative on the current bakery workforce of approximately 675 employees is, in part, dependent on discussions under way with union and local government officials. Additional actions, which are expected to be completed by March 2003, will be announced as exit plans are initiated.
As discussed in the “Results of operations” section above, during the second quarter 2001, we experienced business disruption from trade inventory reductions due to integration activities and incurred integration-related costs for Kellogg employee relocation, employee retention and recruiting, and consolidation of computer systems, manufacturing capacity, and distribution systems. As we complete our integration plans, we expect these financial impacts to continue, reducing operating profit by up to $100 million in total during the full-year 2001 and 2002. The relative 2001 versus 2002 operating profit impact will depend on various factors, primarily the timing of completion of planned supply chain and information technology initiatives, and our transition to DSD distribution for certain Kellogg snack products. These activities and other actions are expected to result in Keebler-related pretax annual cost savings of approximately $170 million by 2003, with supply chain initiatives expected to generate the bulk of these savings.
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During 2000, we paid cash for several business acquisitions. In January, we purchased certain assets and liabilities of the Mondo Baking Company Division of Southeastern Mills, Inc., a convenience foods manufacturing operation, for approximately $93 million. In June, we acquired the outstanding stock of Kashi Company, a U.S. natural foods company, for approximately $33 million. In July, we purchased certain assets and liabilities of The Healthy Snack People business, an Australian convenience foods operation, for approximately $12 million.
Liquidity and capital resources
For the six months ended June 30, 2001, net cash provided by operating activities was $418.7 million, up $26.8 million from the prior-year amount of $391.9 million. The increase was due primarily to favorable core working capital (trade receivables, inventory, trade payables) trends, excluding amounts from the Keebler acquisition, with core working capital representing approximately 8.2% of net sales, versus the year-ago level of approximately 9.4%. This favorable trend was offset partially by lower earnings and a payment to settle interest rate hedges, as discussed further below. We expect our measure of full-year “cash flow” (net cash provided by operating activities less expenditures for property additions) to be approximately even with the 2000 level of $650 million.
Net cash used in investing activities was $3.93 billion, up from $255.5 million in 2000, as a result of the Keebler acquisition discussed above. Expenditures for property additions were $78.8 million, $48.6 million less than the prior year. In relation to net sales, property expenditures were 1.9% of net sales compared with 3.6% in 2000. We believe full-year 2001 expenditures for property additions will represent approximately 3% of net sales or approximately $275 million. This amount includes some one-time investment related to the Keebler integration.
Net cash provided by financing activities was $3.55 billion, related primarily to issuance of $4.6 billion of long-term debt instruments to finance the Keebler acquisition, net of $946.9 million of long-term debt retirements. The debt retirements consisted primarily of $400 million of Extendable Notes due February 2001 and $546.2 million of Notes previously held by Keebler Foods Company. Our year-to-date 2001 per share dividend payment was $.505, up from $.49 in the comparable prior-year period.
In February 2001, we paid holders $11.6 million (in addition to the principal amount and accrued interest) to extinguish $400 million of Extendable Notes prior to the extension date. Thus, for the six months ended June 30, 2001, we reported an extraordinary loss, net of tax, of $7.4 million.
At June 30, 2001, consolidated long-term debt included $130.0 million of 10.75% Senior Subordinated Notes, which is an obligation of Keebler Foods Company. We redeemed these Notes on July 2, 2001. The cost to redeem (in addition to principal and accrued interest) of $5.6 million approximated the fair value adjustment to the debt recorded in conjunction with the Keebler purchase accounting.
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On March 29, 2001, we issued $4.6 billion of long-term debt instruments primarily to finance the Keebler acquisition. These instruments were initially privately placed, or sold outside the United States, in reliance on exemptions from registration under the Securities Act of 1933, as amended (the “1933 Act”). We commenced an offer to exchange new debt securities for these initial debt instruments, with those new debt securities being substantially identical in all respects (except for being registered under the 1933 Act) to the initial debt instruments. This exchange offer ended on July 13, 2001.
In conjunction with this issuance, we settled $1.9 billion notional amount of forward-starting interest rate swaps for approximately $88 million in cash. The swaps effectively fixed a portion of the interest rate on an equivalent amount of debt prior to issuance. The swaps were designated as cash flow hedges pursuant to SFAS No. 133 (refer to Note 6 with Footnotes to Consolidated Financial Statements for further information). As a result, the loss on settlement was recorded in other comprehensive income, net of tax benefit of approximately $32 million, and is being amortized to interest expense over periods of five to thirty years. As a result of this amortization expense, as well as discount on the debt, the overall effective interest rate on the total $4.6 billion long-term debt issuance is expected to be approximately 6.75% during 2001. We expect full-year interest expense to be approximately $380 million.
In order to provide additional short-term liquidity in connection with the Keebler acquisition, we entered into a 364-Day Credit Agreement, which expires in January 2002 (subject to a renewal option), and a Five-Year Credit Agreement, which expires in January 2006. Each of these agreements permits the Company or certain subsidiaries to borrow up to $1.15 billion (or certain amounts in foreign currencies under the Five-Year Credit Agreement). These two credit agreements require the maintenance of at least $700 million of consolidated net worth and a consolidated interest expense coverage ratio (as defined) of at least 3.0, and limit capital lease obligations and subsidiary debt. These credit facilities were unused at June 30, 2001.
Despite the substantial amount of debt incurred to finance the Keebler acquisition, we believe that we will be able to meet our interest and principal repayment obligations and maintain our debt covenants for the foreseeable future, while still meeting our operational needs through our strong cash flow and program of issuing short-term debt and maintaining credit facilities on a global basis.
Accounting changes
Hedging activities
On January 1, 2001, we adopted Statement of Financial Accounting Standards (SFAS) No. 133 “Accounting for Derivative Instruments and Hedging Activities.” This statement requires that all derivative instruments be recorded on the balance sheet at fair value and establishes criteria for designation and effectiveness of hedging relationships. For the six months ended June 30, 2001, we reported a charge to earnings of $1.0 million (net of tax benefit of $.6 million) and a charge to other comprehensive income of $14.9 million (net of tax benefit of $8.6 million) in order to recognize the fair value of derivative instruments as either assets or liabilities on the balance sheet. The charge to earnings relates to the
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component of the derivative instruments’ net loss that has been excluded from the assessment of hedge effectiveness.
In April 2001, the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB) reached consensus on Issue No. 00-25 “Vendor Income Statement Characterization of Consideration to a Purchaser of the Vendor’s Products or Services.” The EITF also delayed the effective date of previously finalized Issue No. 00-14, “Accounting for Certain Sales Incentives” to coincide with the effective date of Issue No. 00-25. This guidance will now be effective for Kellogg Company beginning January 1, 2002.
This guidance is applicable to Kellogg Company in several ways. First, it applies to payments we make to our customers (the retail trade) primarily for conducting consumer promotional activities, such as in-store display and feature price discounts on our products. Second, it applies to discount coupons and other cash redemption offers that we provide directly to consumers. Third, it applies to promotional items such as toys that the we insert in or attach to our product packages (“package inserts”). Consistent with industry practice, we have historically classified these items as promotional expenditures within selling, general, and administrative expense (SG&A), and have generally recognized the cost as the related revenue is earned.
Effective January 1, 2002, we will reclassify promotional payments to our customers and the cost of consumer coupons and other cash redemption offers from SG&A to net sales. We will reclassify the cost of package inserts from SG&A to cost of sales. All comparative periods will be restated. We are currently assessing the total combined impact of both Issues, including the pro forma effect of the Keebler acquisition. However, we believe that based on historical information, combined net sales could be reduced up to 15%, with approximately 95% of this impact reflected in the U.S. operating segment. Combined cost of goods sold could be increased by approximately 1.5%. SG&A would be correspondingly reduced such that net earnings would not be affected.
In July 2001, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 141 “Business Combinations” and SFAS No. 142 “Goodwill and Intangible Assets.” Both of these Standards provide guidance on how companies account for acquired businesses and related disclosure issues.
Chief among the provisions of these standards are 1) elimination of the “pooling of interest” method for transactions initiated after June 30, 2001, 2) elimination of amortization of goodwill and “indefinite-lived” intangible assets effective for our company on January 1,
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2002, and 3) annual impairment testing and potential loss recognition for goodwill and non-amortized intangible assets, also effective for us on January 1, 2002.
Regarding the elimination of goodwill and indefinite-lived intangible amortization, this change will be made prospectively upon adoption of the new standard as of January 1, 2002. Prior-period financial results will not be restated. However, earnings information for prior periods will be disclosed, exclusive of comparable amortization expense that is eliminated in post-2001 periods.
We are currently assessing the impact of these provisions. However, we believe substantially all of Kellogg’s total after-tax amortization expense could be eliminated under these new guidelines. Based on acquisitions completed to date, we expect total after-tax amortization expense in 2002 (before impact of the new Standards) of approximately $110-$115 million.
Forward-looking statements
Our Management’s Discussion and Analysis contains “forward-looking statements” with projections concerning, among other things, our strategy and plans; integration activities, costs, and savings related to the Keebler acquisition; cash outlays and savings related to restructuring actions; the impact of accounting changes; our ability to meet interest and debt principal repayment obligations; the effect of the Keebler acquisition on factors which impact the effective income tax rate; amortization expense; cash flow; property addition expenditures; reserve utilization; and interest expense. Forward-looking statements include predictions of future results or activities and may contain the words “expect,” “believe,” “will,” “will deliver,” “anticipate,” “project,” “should”, or words or phrases of similar meaning. Our actual results or activities may differ materially from these predictions. In particular, future results or activities could be affected by factors related to the Keebler acquisition, including integration problems, failures to achieve savings, unanticipated liabilities, and the substantial amount of debt incurred to finance the acquisition, which could, among other things, hinder our ability to adjust rapidly to changing market conditions, make us more vulnerable in the event of a downturn and place us at a competitive disadvantage relative to less leveraged competitors. In addition, our future results could be affected by a variety of other factors, including
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Forward-looking statements speak only as of the date they were made, and we undertake no obligation to publicly update them.
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PART II — OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders
Item 6. Exhibits and Reports on Form 8-K
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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