Kellanova (Kellogg's) - 10-Q quarterly report FY

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Quarter ended March 29, 2008:

Fair values of derivative instruments in the Consolidated Balance Sheet designated as hedging instruments as of April 4, 2009 were as follows:

Kellogg Company is the world’s leading producer of cereal and a leading producer of convenience foods, including cookies, crackers, toaster pastries, cereal bars, fruit snacks, frozen waffles and veggie foods. Kellogg products are manufactured and marketed globally. We currently manage our operations in four geographic operating segments, comprised of North America and the three International operating segments of Europe, Latin America and Asia Pacific.

We manage our Company for sustainable performance defined by our long-term annual growth targets. These targets are low single-digit (1 to 3%) for internal net sales, mid single-digit (4 to 6%) for internal operating profit, and high single-digit (7 to 9%) for net earnings per share on a currency neutral basis. See the “Foreign currency translation” section for an explanation of management’s definition of currency neutral.

For the quarter ended April 4, 2009, we reported a 3% decline in net sales, with internal net sales increasing by 4%. Consolidated operating profit declined 3%, with internal operating profit increasing by almost 7%. Diluted earnings per share (“EPS”) grew 4% to $.84, compared to $.81 in the comparable prior period. EPS on a currency neutral basis grew 14%.

For 2009, despite a tough economic outlook, we expect our business model and strategy will deliver internal net sales growth of 3 to 4% and internal operating profit growth of mid single-digits (4 to 6%) which are in line with our long-term annual growth targets. We expect our earnings per share to grow at high single-digits (7 to 9%) on a currency neutral basis.

The following table provides an analysis of net sales and operating profit performance for the first quarter of 2009 versus 2008:

Our consolidated net sales decreased by 3%, driven by a significant negative impact from foreign currency translation. Excluding this negative impact, internal net sales grew by 4%, driven by the continued momentum of our pricing and mix initiatives. Internal net sales grew despite the decrease in volume compared to the prior year. We experienced volume growth in global ready-to-eat cereal, which was more than offset by a volume decline in snacks due to the recall of certain peanut-related products and the re-sizing of certain snack boxes in North America, and the move from a volume to value model in Russia.

Our North America operating segment had internal sales growth of 4%. The retail cereal product group grew by almost 6% as we experienced broad based growth in our core brands such as Mini-Wheats, as well as our innovations such as Special K Blueberry, Jumbo Rice Krispies andFrosted Mini-Wheats Little Bites. The retail snack product group (cookies, crackers, toaster pastries, cereal bars, and fruit snacks) grew by 2% with growth from our FiberPlus innovation, Rice Krispies Treat Squares and our Kashi TLC cereal bars. Our snacks growth was negatively impacted by the peanut-related recall. See the “Product recall” section for further information. The frozen and specialty channels (frozen foods, food service and vending) grew a strong 6% driven by solid growth in Eggo waffles and Eggo Bake Shop innovations.

Our International operating segments collectively achieved net sales growth of 4% on an internal basis. Europe’s internal net sales grew by 1%. Net sales were negatively impacted by retailer disputes resolved during the quarter. Snacks products continued to perform well across the region, especially in the UK driven by Rice Krispies Squares. Latin America’s internal net sales growth was 8% attributable to price increases initiated in 2008 and by cereal sales in Venezuela. Asia Pacific had a very strong quarter, building on last year’s momentum with 11% internal net sales growth. Retail cereal grew exceptionally well in Australia, South Africa and India.

Consolidated operating profit decreased by 3% on an as reported basis and increased almost 7% on an internal basis, when excluding the impact of foreign currency translation and acquisitions. While we continue to experience significant commodity cost pressures, we have been able to more than offset those pressures by savings from our cost reduction initiatives and our pricing/mix. Costs incurred as a result of the peanut-related recall of Kellogg products adversely impacted North America’s operating profit by $27 million or 7% of the quarter’s operating profit. See the “Product recall” section for further information. North America also had higher up-front costs associated with cost reduction initiatives as discussed in the “Other cost reduction initiatives” section. Internal operating profit increased in Latin America due to strong top line growth and lower up-front costs. Europe’s internal operating profit benefited from lower up-front costs, pricing/mix and savings from cost reduction initiatives. Strong top line growth in Asia Pacific resulted in strong internal operating profit growth. Reported operating profit growth was negatively impacted by foreign currency and the acquisition of Navigable Foods. For further information on our acquisitions, see pages 34 to 35 in our 2008 Annual Report on Form 10-K.

Margin performance for the first quarter of 2009 versus 2008 is presented in the following table:

We strive for gross profit dollar growth to reinvest in brand-building and innovation expenditures. We maximize our gross profit dollars by managing external cost pressures through product pricing and mix improvements, implementing productivity savings and technological initiatives as well as entering into commodity hedges and fixed price contracts to reduce the cost of product ingredients and packaging. For the quarter, our gross profit was down $62 million and was negatively impacted by foreign exchange and peanut-related recall costs. Our gross profit would have been higher by $108 million if we excluded the impact of foreign exchange. Operating margin remained unchanged from the prior year due to disciplined spending in promotions.

As illustrated in the preceding table, our consolidated gross margin declined 80 basis points in the quarter. Our recent acquisitions lowered gross margin by approximately 20 basis points for the quarter. We also continue to

experience inflationary cost pressures for fuel, energy, commodities and employee benefits. During the quarter, higher costs, including recall related costs were offset by savings from cost reduction initiatives and price increases. We expect our full year margin to be flat compared to the prior year by continued price realization and cost savings which will offset cost pressures.

Foreign currency translation

The reporting currency for our financial statements is the U.S. dollar. Certain of our assets, liabilities, expenses and revenues are denominated in currencies other than the U.S. dollar, primarily in the euro, British pound, Mexican peso, Australian dollar and Canadian dollar. To prepare our consolidated financial statements, we must translate those assets, liabilities, expenses and revenues into U.S. dollars at the applicable exchange rates. As a result, increases and decreases in the value of the U.S. dollar against these other currencies will affect the amount of these items in our consolidated financial statements, even if their value has not changed in their original currency. This could have significant impact on our results if such increase or decrease in the value of the U.S. dollar is substantial.

The recent volatility in the foreign exchange markets has limited our ability to forecast future U.S. dollar reported earnings. As such, we are measuring diluted earnings per share growth and providing guidance on future earnings on a currency neutral basis, assuming earnings are translated at the prior year’s exchange rates. This non-GAAP financial measure is being used to focus management and investors on local currency business results, thereby providing visibility to the underlying trends of the Company. Management believes that excluding the impact of foreign currency from EPS provides a better measurement of comparability given the volatility in foreign exchange markets.

Below is a reconciliation of reported diluted EPS to currency neutral EPS for the quarter ended April 4, 2009:

In January and February, 2009, we recalled certain products because they included ingredients that had the potential to be contaminated with salmonella. The recall stemmed from the U.S. Food and Drug Administration and other authorities’ investigations of Peanut Corporation of America, which supplied us with peanut paste and other ingredients.

The recall represented a Type I subsequent event and in accordance with U.S. GAAP, we recorded certain costs associated with the recall in our 2008 financial results. See Note 15 on page 52 of our 2008 Annual Report on Form 10-K for further information on the recall. We incurred additional costs in the North America operating segment associated with the recall for product manufactured and sold in 2009 of $27 million or $0.05 of diluted earnings per share.

We view our continued spending on cost reduction initiatives as part of our ongoing operating principles to provide greater visibility in achieving our long-term profit growth targets. Initiatives undertaken are currently expected to recover cash implementation costs within a five-year period of completion. Each cost reduction initiative is normally up to three years in duration. Upon completion (or as each major stage is completed in the case of multi-year programs), the project begins to deliver cash savings and/or reduced depreciation. Certain of these initiatives represent exit or disposal plans for which material charges will be incurred. We include these charges in our measure of operating segment profitability. Management has recently announced its intention to achieve $1 billion of annual cost savings in three years (beginning in 2012). These initiatives are integral to meeting our $1 billion savings challenge.

In 2009, we incurred costs related to our global lean manufacturing program, Kellogg’s lean, efficient, agile network (K LEAN). Lean manufacturing is a philosophy, that when applied to production methodologies, increases the efficiencies of manufacturing plants by reducing waste and errors, minimizing equipment downtime, and increasing equipment and labor productivity. This program seeks to optimize our global manufacturing network, reducing waste, developing best practices across our global facilities and reducing capital expenditures. We expect to incur approximately $20 million in each of 2009 and 2010 related to exit costs associated with K LEAN. The charges represent cash payments for severance and other cash costs associated with the elimination of hourly and salaried positions at various global manufacturing facilities.

For the quarter ended April 4, 2009, we recorded $4 million of charges in cost of goods sold for severance payments in the North America operating segment. As of April 4, 2009, we had reserve of $1 million for employee severance payments.

We incurred $9 million of costs for the quarter ended March 29, 2008 for two projects: the European manufacturing optimization plan impacting our facility in Manchester, England; and the reorganization of production processes to reflect changing market dynamics which impacted our plants in Valls, Spain and Bremen, Germany. These costs were recorded in cost of goods sold and were attributable to the Europe operating segment.

These programs were completed in 2008. There were no exit reserves related to either of the programs as of April 4, 2009 and as of the end of the Company’s 2008 fiscal year. See page 37 in our 2008 Annual Report on Form 10-K for further information on these projects.

The European manufacturing optimization plan began in 2006 to improve utilization of our facility in Manchester, England and to better align production in Europe. The following table presents total project costs for the quarter ended March 29, 2008.

In October 2007, management committed to reorganize certain production processes at its plants in Valls, Spain and Bremen, Germany. The following table presents total project costs for the quarter ended March 29, 2008.

In addition to exit costs, we incurred additional charges related to our K LEAN cost reduction initiative for the quarter ended April 4, 2009. We incurred $15 million of costs for consulting recorded in cost of goods sold in the following operating segments (in millions): North America - $13, Europe - $1 and Latin America — $1. Total project costs to date are $27 million and are recorded in cost of goods sold in the following operating segments (in millions): North America — $25, Europe $1 and Latin America — $1. The total cost and cash outlay for this program, excluding exit costs, is estimated to be $65 million. This project is expected to be substantially complete by the end of 2009.

For the quarter ended March 29, 2008, we incurred $10 million of expense in connection with a payment for the restructuring of our labor force at a manufacturing facility in Mexico. The cost, which was recorded in cost of goods sold and was attributable to the Latin America operating segment, resulted in employee benefit cost savings.

For the quarter ended April 4, 2009, interest expense was $67 million and interest income (which is recorded within other income) was $1 million, as compared to the quarter ended March 29, 2008 with interest expense of $82 million and interest income of $5 million.

For the full year 2009, we expect gross interest expense to be approximately $270 to $275 million, compared to 2008’s full year amount of $308. The forecasted decline is driven by lower short-term borrowing rates.

Other income (expense), net includes non-operating items such as interest income, charitable donations, foreign exchange gains and losses and costs related to commodity options. We recognized net foreign exchange gains of $6 million for the quarter ended April 4, 2009, as compared to losses of $7 million for the quarter ended March 29, 2008. The net foreign exchange gains for the first quarter of 2009 included $14 million of gains on translational hedges. We are currently not entering into translational hedges.

The consolidated effective income tax rate was approximately 31% for the quarter ended April 4, 2009, as compared to 30% for the comparable quarter of 2008.

For the full year 2009, we currently expect the consolidated effective income tax rate to be approximately 30% to 31%. Our estimate of the effective income tax rate for any period is highly influenced by country mix of earnings, changes in statutory tax rates, timing of implementation of tax planning initiatives, and developments which affect our evaluation of uncertain tax positions.

Our principal source of liquidity is operating cash flows, supplemented by borrowings for major acquisitions and other significant transactions. Our cash-generating capability is one of our fundamental strengths and provides us with substantial financial flexibility in meeting operating and investing needs.

We believe that our operating cash flow, together with our credit facilities and other available debt financing, will be adequate to meet our operating, investing and financing needs in the foreseeable future. However, there can be no assurance that increased volatility and disruption in the global capital and credit markets will not impair our ability to access these markets on terms acceptable to us, or at all.

The principal source of our operating cash flow is net income, meaning cash receipts from the sale of our products, net of costs to manufacture and market our products. Our cash conversion cycle (defined as days of inventory and trade receivables outstanding less days of trade payables outstanding) is relatively short, equating to approximately 23 days for the trailing 365-day periods ended April 4, 2009 and March 29, 2008.

The following table presents the major components of our operating cash flow during the current and prior quarters:

Net cash provided by operating activities for the year-to-date period ended April 4, 2009 was relatively flat compared with the same period in 2008. A reduction in cash-based earnings in the first quarter of 2009 was offset by a positive change in other working capital. Other working capital in 2009 included a favorable impact related to income taxes and cash paid for advertising and promotion, partially offset by an increase in cash paid for interest in the first quarter of 2009. Unlike the first quarter of 2008, the first quarter 2009 included April 1, which is a date we pay interest under certain debt agreements.

Our pension and postretirement benefit plan contributions amounted to $74 million and $41 million for the year-to-date periods ended April 4, 2009 and March 29, 2008, respectively. During the remainder of 2009, we currently project that we will make additional contributions to pension and postretirement plans totaling $25 million. Our actual contributions for 2009 could be different from this projection, since contribution levels may change as a result of changes in regulatory requirements or our decision to undertake discretionary funding of our benefit trusts versus other competing investment priorities.

We define cash flow as net cash provided by operating activities reduced by expenditures for property additions. We use this non-GAAP financial measure of cash flow to focus management and investors on the amount of cash available for debt repayment, dividend distributions, acquisition opportunities, and share repurchases. Our cash flow metric is reconciled to the most comparable GAAP measure, as follows:

For full year 2009, we are forecasting cash flow (as defined) ranging from $1,050 million to $1,150 million. This projection assumes an adverse impact on 2009 cash flow of approximately $100 million associated with changes in foreign currency exchange rates.

Our net cash used by investing activities for the year-to-date period ended April 4, 2009 amounted to $73 million, a decrease of $99 million when compared with $172 million in the comparable prior year period. The decrease was primarily attributable to cash outflows of $105 million associated with an acquisition during the year-to-date period ended March 29, 2008, further discussed in Note 2 within Notes to Consolidated Financial Statements.