Kellogg Co.
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Feb. 21, 2007
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MANAGEMENT DISCUSSION SECTION
Bryan Spillane, Vice President & Monthly Chair, Bank of America
All right if we could take our seats, want to get started. And before we do, just want to take a
moment to recognize some of our past Presidents. This conference continues to be a premier
destination for companies to come to present and I think part of that is the legacy that our
Presidents have built. So I am going to call out the names of our past Presidents that are here and
if you can stand just to be recognized. It’s Clint Mayer [ph], Bob Cummins, Bill Nobler [ph], Jane
Gilday [ph] Lenny Teitelbaum, Beth Mowe [ph], Rick Larson, John McMillan, Kim Raime [ph], Ann
Gillan [ph] and Andrew Lazar.
All right and then before we get started, also just want to take a minute to recognize our current
President, Mariann Montagne. In her time serving at CAGNY, Mariann has taken a no-nonsense
approach leading the board. She’s led along with Tal Klausner a real thoughtful deliberation on the
move from Arizona to Florida and well it seems easy to decide -- it seems like it would be an easy
decision just on time zone alone and proximity to New York. There was actually a lot more that
went into that decision, in terms of how you move a conference that had to accommodate roughly
1,000 people and the money that’s spent on meals, the money that’s spent on presentations and
making sure that that happens seamlessly.
Mariann has also been a strong advocate for this -- for you for CAGNY, making sure the
conference is branded, making sure that -- a program has the appropriate speakers and that
company’s recognize that this is the place that they want to come to and I think that is something
that she has carried forward and we want to thank her for coming through CAGNY, serving her time
on the board and leaving it stronger than it was when she got here. So Mariann if you could come
up?
Mariann Montagne, President, Thrivent Asset Management
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Thank you very much. Thank you. Again I just want to thank my board and all those who’ve come
before me. 37 years is quite a legacy and it’s kind of a responsibility on my shoulders. But I think,
we’re getting better every year and I think we’re all going to enjoy this year and then the move on -so progress. Thank you.
Leonard Teitelbaum, Conference Chair, Roosevelt Investment Group
And now to business. When I went to business school, I know Simon’s going to say they used pelts
and pieces of stones back then. But we were always told that if you’re going to look for a good
company, you had to look for them to obtain, maintain and sustain cash. Because it gave the
management the options of what to do with that precious commodity and then you judge
management on their ability to deploy the cash and to earn a return. And I think if those principals
which were annunciated back in the 60s, early 60s, I think it’s nice to put Kellogg up against a
model that seems to have lasted with the ages.
And indeed I think Kellogg stands up well to that. Their cash generation ability and I think their
ability to turn a cash cycle it’s probably the high -- one of the highest treats in the food industry,
distinguishes the company and how it’s managed. And to I think enlighten that premise and for us
to judge the conclusions, though obviously David and John, when they speak today you’ll know as
analysts for those who may not have heard them speak before, that they come from the Southern
part of New York or as Dave [ph] would say the Bronx and they are not -- they are little South and
East or West depend on which way you are facing, but we’ll that you decide.
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Kellogg Co.
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So David if you’ll start us out. We appreciated hearing Kellogg story this morning. Thank you very,
very much for breakfast. John when you were running the checks, I know we used to have to bring
our own cereal, but I am glad that you have moved on to bigger and better things. Thank you
Kellogg and David the floor is yours.
A. D. David Mackay, President and Chief Executive Officer
Thank you, Lenny and good morning ladies and gentlemen. Before I get into the presentation, of
course we start with the obligatory words from our lawyers. In fact there are a lot of them here; I am
not going to read them. I would start by saying it is a privilege and an honor to be here as Kellogg’s
CEO. I was reflecting back -- this I think is my sixth or seventh CAGNY. The first time I’ve actually
got up to kick the presentation off. And with me here of course is John and somewhere in the
audience, there’s Simon Burton, the Head of IR.
And as we look at the presentation, clearly three weeks ago we gave our 2006 results which were
outstanding. We reported on Q4 and we gave our forecast for 2007. So you’re not going to hear
anything dramatically new today, but I think this slide probably talks about what you’re going to hear
about from us today, it’s about sustainability.
And I think you’ve heard this over the last five years, our overarching financial target is sustainable,
dependable performance. And everything we do as a company is aimed towards that, building
sustainability and building off the success that we’ve had. And it really is the same story with
perhaps a new old-face.
raw transcript
And what I want to do is take you through what’s evolving at the company and what’s not. And
really when you think about what’s evolving, there isn’t a huge amount evolving. I do want to
reinforce a number of things that we have been doing and we will continue to do as we go forward.
And I’ve been talking to a few of you last night and then this morning and the whole concept of
volatility being in favor has come up, which probably means Kellogg is very much out of flavor,
because when you talk to someone about sustainable, dependable performance, it sounds a little -the ultra of volatility. But that’s what we’re all about and that’s what we intend to be about as we go
forward.
So I want to take you through a number of things, want to talk about our focused strategy just
reinforce it; talk about why we believe it’s the role that [ph] I’m working today. I’m going to go
through our operating principles, our business model. I’ll talk a little bit about some of the business
challenges we have and then touch on a couple of things that are evolving.
But I think starting with our focused strategy and I think everyone has seen this, although as I look
around the room, CAGNY gets bigger every year and there are a lot of new faces. But our focused
strategy is really served us very well for the last 5 years. We think it’s got a great potential for the
next five to ten years and we are not complacent though. As we think about what we have done
over the last five, it is a process of with continuous improvement. We are not going to stand still; we
are going to challenge ourselves. We constantly get better and improve on all we do.
But the fundamentals of the business; Our focused strategy, we were looking to grow our Cereal
business, globally it’s over 50% of our sales and well in excess of $5 billion for us. Expanding our
Snacks business is the second part of the strategy and I will take you through these in a little bit of
detail. And finally pursuing selected growth opportunities is the final part.
And if we at look at growing cereal, cereal is at the heart of what Kellogg Company is. It is how we
were founded it by W.K. Kellogg in 1906. It remains the biggest part of our business and it remains
an area where we will continue to grow and as we grow we will continue to perform well. And if you
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Kellogg Co.
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look at the Cereal category globally, it’s a $23.5 billion category. So it’s a very large category, it’s a
very strong category, not only for us but for our trading partners. It’s growing as best we can tell by
the euro data monitor about 3% per annum. The margins are very good in the category and it
responds to innovation and brand building which is really critical as we look at it today. Our whole
model which I’ll talk about in a little bit is around innovation and brand building. So this is a category
that we believe has a lot of potential for us. We are well positioned and we intend to keep pushing
and growing this category.
And if you look at where we stand and this is not all of the markets in which we compete but a
selection. And what it shows is Kellogg in the red, our market share and the relative market share
position of the number two player in those categories listed. And what I think you will draw from this
is we have a very strong market share position in many of the markets around the world where we
compete. That puts an onus on us to drive the category, to finds ways to stimulate consumers in all
of these markets, to keep the category growing. And it also puts us in a very strong position to
build-off the success we’ve had. And we think this is a very positive position for us to be in as a
company and one that we want to ensure that we capitalize on as we move forward.
If you look at our biggest market in the world, the U.S. market, this shows the internal, the IRI Data
for the last six years. And as you can see we’ve been successful in growing our Cereal shares in
the U.S. over the last six years, up from about 31 to 34 shares at the end of 2006. And really the
key to success here have been pretty straight forward. Very strong innovation, aggressive brand
building and support of that innovation and outstanding execution in all we do, particularly when it
comes to in-store, but across all aspects of the business. And those things have really worked for
us; I’ll talk more about those a little bit later on in the presentation.
raw transcript
The other aspect is our global cereal business is really looking at the per capita consumptions
around the world to see is there still a potential for us as we look forward. And we believe there’s
huge global potential for us to continue our growth in Cereal and we’d like to say, God bless the
Irish, because if you look at this chart, you’ll see that the Irish consume 8 kilos per head of cereal. It
actually nearly drifts off the chart, it’s so high. And if you look -- it really breaks it down in to four
groups here: The top five countries which have an average per capita consumption of 6 kilos, the
second five at 3.5, the third five at 2.1 and just the staggering number of countries where the
average per capita consumption is running at about 0.6 kilos, so massive opportunities for us to
continue to grow our Cereal business around the world.
A lot of these countries with low per capital consumption, that’s driven by our income levels. And as
many of these countries start to improve and grow and prosper, more consumers come in to the
field category, per capita consumptions rise and we take advantage of that clearly with our strong
global positions. The other point I’d make is, when you look at the more developed markets here
with high per capita consumptions, there is a real skew in the cereal consumption demographically
where kids eat a lot of cereal and then it drops down from between about 15 to 45 and from 45 to
50 cereal consumption actually shoots up.
So as we think about our portfolio globally, we have a very strong focus on our adult portfolio in all
of the developed markets, those with high per capita consumptions and the demographics actually
work very well there for us, because adult where the population’s are ageing will eat more cereal
and therefore we continue stable growth in those markets. So really when we look at cereals, it’s a
very attractive category, we’re very well positioned globally. It remains of absolute focus for us to
continue that growth and we believe it offers a great potential for us as we go forward.
Now if we turn now to our Snacks business. And expanding Snacks is a huge opportunity for us
again. If you looked at our 2006 results in North America, we grew our Snacks business 11%, I’ll
show you that in a little bit more detail and worldwide we’re -- principally we’re in the snack-bar
business, that category is growing at 10%. And I’ll show you a chart on our global business in a
minute. And really the other thing to note when we think about the potential for us in the future in
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Kellogg Co.
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expanding snacks is we compete really meaningfully in only seven market globally. So a lot of
potential, we have entered some and I’ll talk to those in a minute.
But starting with our North American business. And if you look at the break up of the business
starting with toaster pastries, in 2006 we grew shipments 5%, we grew share a nine-tenth of a
percent on a very strong share position, our Crackers business grew 7% for 2006 and we actually
grew one-tenth of a share, so the category was growing very strongly. Our Cookies business which
we’ve had a lot discussion about over the preceding two or three years actually grew shipments 8%
in 2006, it outpaced crackers if you can believe that and we grew 0.5 a share point; so a very
meaningful turn around in the cookies business. Our Wholesome Snacks business grew 13% and
we grew 0.5 share in the Wholesome Snacks business and that category also grew very strongly
across all players and Food Snacks while not shown here, we grew 34% in our Food Snacks
business and added 5 share points.
So across all of the sub-components of what makes up in North America, our retail Snacks
business. We not only grew share but we had very strong consumption, giving us an aggregate
performance across the portfolio plus eleven.
Now it isn’t our forecast that we will continue this growth as I’ll talk to you in a minute, but certainly
that was a sensational performance driven not only by very strong innovation, but great execution
across many of these sub-components by our -- these organizations who really did a fabulous job
in 2006.
raw transcript
If we look at our International business in Snacks: this shows what we have done over the last four
years from 2002 through 2006. We’re double the business from 225 million to $450 million. It lists
the seven markets I mentioned which are really we’ve been for at least a couple of years and that’s
a compound annual growth rate of -- I calculate about 22%, so a very strong performance here and
one that we’re very pleased of and we think we can continue to build on this as we go forward.
In 2006, we entered a number of markets, we went in to Venezuela and we have established a
DSD system in Caracas and that business has done extremely well and continues to grow. We
entered Columbia and Central America and both those geographies on our Snacks portfolio are
doing very, very well. And the last entry was in to Japan in 2006 and the Japanese Snacks
category we’ve entered, is roughly the same size as the Cereal business in which we’ve competed
for an excess of 50 years. It’s early days, but through the first three months -- the last three months
of last year, we managed to gain a fixed share in that category and the business seems to be doing
well, so hopefully that will continue.
So, really as we look at this, the growth potential as we expand into new geographies, as we take
some of the learnings we’ve got from the markets we’re currently in and spread those across these
other geographies, as we actually take innovation that succeeds in one market and use it more
quickly and effectively in others, we think we can continue to grow our Snacks business very
strongly in to the foreseeable future.
The last element of our strategy is pursuing selected growth opportunities and really it breaks down
in to one big bucket of existing business in our Frozen Foods business which is over $500 million in
net sales and then grew it in excess of 9% in 2006; this was about the third year, I think when we’ve
grown high single-digit near double digit. Frozens made up of the Eggo brand, both waffle and
about a year ago we entered the pancake segment, we were number four in pancakes. We finished
2006 as the second largest player in pancakes, frozen pancakes. Morningstar Farms our meat or
vegetarian alternative products grew very strongly in 2006 and I think we’ve found finally a way to
market these great products to a very different group of consumers that are made up of different
pockets that are very difficult to get to in one sell swoop and that business continued to do well and
we entered the Entrees business with the Kashi Entrees, the launch of six Kashi Entrees targeted
very much towards the natural sub-segment of the Entrees business which currently today Amy’s
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Kellogg Co.
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Feb. 21, 2007
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[ph] is the market leader. And those six products well it’s early [ph] and they’re still building
distribution rank six of the top 10 in the natural segment today as far as popularity.
The following one is Health & Wellness. We announced that we were launching and expanding our
special K brand which was very much positioned against the need start of weight management
include meal replacement bars and beverages. And the whole aim here was to try and offer
consumers the ability to manage their weight across more day parts and breakfast. It’s very early
with this, but it started well. The campaign actually kicked off in January. So we will know probably
in three or six months how it’s going. But these are some key things that we are always looking at
as we get in to new segments and this is true as we thought about fruit snacks as much as it is
about something like Health and Wellness.
We believe we have to have a unique point of difference or else there is no point actually trying to
enter a market. Our aim is always to be number 1 or number 2 within 3 to 5 years in any segment
within which we enter and want to compete, that segment has to have scale and size to make it
attractive, and it has to be a segment that’s growing. And we take a very aggressive investment
posture whenever we enter these segments to ensure that we have really driven the offering as
hard as we can, driven trial as hard as we can. So hopefully within 6 months, we have a very good
sense for whether this entry is going to succeed or fail. And if it is not going to succeed, then we
can take the appropriate action. If it is, then we’re in a position to know that we can continue to
invest with confidence.
raw transcript
And finally in these segments, we look for branded margins. I’ve shown on here the special K Meal
Replacement Bars and the special K Protein Beverage and also our product that we’ve selling in
our Mexican business for about 6 months, which is a ready-to-drink dairy-based beverage with
cereal in it. It’s a UHT shelf stable, ready to drink breakfast. It’s doing particularly well in Mexico;
we’ll see how it goes through every period of time, before we do anything else with that.
Moving now to our operating principals and again these are things that the Company has been
focusing on and using consistently for the last 5 years. As we look at them and think about them,
then they remain as relevant today as they did when we started using them some 5 years ago and
we believe they’re going to hold us in good stead as we go forward. Now there’s a lot on this chart,
so I’m not going to go through it and you can’t read half of it. But sustainable growth which is the
volume to value wheel we badge [ph] slightly. And really as you look at sustainable growth and I
think John is going to go through it, but this is really the virtual cycle that we’ve tried to establish
within the business, where we look to expand gross profit margins, manage our overheads,
increase brand building, drive innovation, manage our price spend effectively, grow internal net
sales, which leads back to a virtual cycle of doing the same again.
Manage for Cash, John will go into a lot more detail on that, again this has worked extremely well
for us and has meant that we’ve got a very disciplined approach on capital and we’re always
looking to drive effectively. The last three which we really haven’t talked extensively about
externally, our executional excellence and that’s something that we believe has been one of the
greatest strengths of the business over the last 4, 5 years. Focusing on keeping things simple,
focusing on the desire to win in-store, ensuring that whatever we do as a global business, we have
a methodology for sharing what works and what does not work as quickly as possible, so we can
get that best practice shared around the world.
And finally on continuous efficiency improvement and this is an area we have been and will remain
diligent on going forward especially in this high inflation environment. And this is where we’re
looking at our cost of goods, trying to offset cost inflation with cost savings. We’re looking at our
overhead; we were trying to manage our trade and trade efficiencies, where we’re looking to drive
safety as a key metric within the business.
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And finally on IT, looking for our IT platform to be an enabler to the business to drive future cost
savings and efficiency benefits. And last year in 2006, we completed the implementation of SAP in
a number of markets through the Latin America and the rest of the world and we are currently as a
company roughly 96% implemented on SAP globally. So that gives us a real opportunity, taking our
IT platform as an enabler to the business, to look at things differently, to streamline the business
and to -- really to drive for continuous cost improvement as we go forward.
Our business model is relatively simple and straight forward and I think you have all heard about
realistic targets, the fact that we continue to want to invest in brand building, we want to continue to
drive our innovation and we want to continually focus on cost control. And I think well, if you look at
the last four or five years we have actually beaten most of these numbers on a consistent basis. It
is our fervent belief that as a food company over the long-term that’s setting realistic targets
ensures the people within the company actually worth on things in the right way. We don’t
encourage bad behavior; hopefully we encourage and reinforce positive behavior. And as we have
stuck with these targets we have managed to achieve good results over the last five years we
believe they are the right targets for us going forward.
So low single digit, in turn our revenue growth remains a long-term target, mid single digit operating
profit growth and high single digit EPS growth. And I think these targets remain as relevant and
appropriate today as they have been through our business over the last five years.
raw transcript
Investment in advertising and promotion remains absolutely critical to us. It’s something we have
looked to do every year and our overall long-term approach is to try and increase our investment in
advertising at or above the rate of sale, which we have done pretty well consistently over the longterm. We did, I remember talking to CAGNY at this conference a year ago, talk about a program
that we undertook in the course of 2006 looking at consumer promotions activity. Our consumer
promotion spend has been rising at a rate that we thought was potentially a little high. So we did a
process globally looking at best practiced, where could we source inserts [ph] more globally, how
could we take cost out and actually drive efficiency and that has been a very successful for us as a
business and that’s enabled us as we come into 2006 to increase the level of advertising to a
higher rate than normal, but still have our brand building basically growing roughly in line with sales.
And then finally, on sustainable innovation and I think the key here for us -- this chart actually
measures rate of innovation for products launched over a rolling three-year basis. And the reason
we do it over a rolling three-year basis is because what we’re looking for is innovation that sticks,
innovation that will sustain us, not innovation that goes in one year, fails and comes out the next
and creates that negative cycle where you’ve got to do more and more just to keep up with what
you did the previous year. And we think that’s the right measure for us. And you can see the
results. We’ve actually set a target of having 15% of net sales from innovation on a rolling threeyear basis. Over the last three years we’ve actually exceeded that target. We’ll keep the target at
15 because the result of doing 16 and 17 has purely been the level of innovation that’s actually
worked and is around today that we might have launched two or three years ago.
Interestingly, if you would look at where this was from a North American and International
perspective, International actually lagged North America and we put more resources against
innovation on the International market. We’ve stepped up the level of focus and they are starting to
increase. 2006 we saw their number come up and we believe it will come up again in 2007.
And there was something I wanted to read to you. We were recently named in the -- Kellogg was
part of a Booz Allen Hamilton Global Innovation 1000 study. I don’t know how many people in the
room
innovation 1000 study. I don’t know how many people in the room actually read it, very prestigious
study I might say. Certainly from our perspective because it’s given our things [ph] and this study
reviewed the 1000 R&D companies and 94 companies out of the 1000 globally that outperformed
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the peers and I quote they get more bang for their R&D back than their peers even their hardly
innovated peers and they managed to do so consistently over 5 year period. Now I say that Kellogg
was the only food company to make the list and I will further quote from the study if these high
achievers have one thing in common, it seems to be a focus on building multifunctional
companywide capabilities that can provide them with sustainable competitive advantage. And I only
read it because it is completely consistent with what we have been trying to do and that is to try and
build through what we do in innovation sustainable competitive advantage. And again, I’ll just
reinforce that that’s why we believe the three year metric is so critical to us.
The last element of our business model managing either head [ph] which we continue to focus on
and will look for opportunities to manage going forward and again offsetting cost inflation in anyway
that we can. So let me move quickly to the biggest challenges that we face as a company and I
think we’ve talked about these. We went through them at the conference call, so I hope that there
will be no surprise and I think you will hear more talk about food versus fuel. The whole issue of
ethanol and what’s happening with grain and it’s not just corn. We mentioned corn. We don’t -- we
not a massive user of corn but we do use a fair amount of corn not only in the U.S and Latin
America but its impact this will have on all grain, because most grain are into changeable especially
if your feeding chickens and pigs, etcetera. And if you think about our cost environment and John
will take you through a slide giving you more detail on this.
raw transcript
But in 2006, we saw a big ramp up in inflation above the norm, some $0.28 or nearly $170 million
above what we would normally expect to see any given year and then this year, we gave guidance
for another $0.18 to $0.22. So a lot going on there and really if I show you this one chart, this has
got the price of corn over the last 2 years and the price of wheat. Now if you look at the price of
corn, it’s up well over double what it was 2 years ago. I think since we got the third quarter
conference call, it actually jumped another 30%. Our view as a company is that corn will stay at
relatively high levels for the foreseeable future. We think the government pushed the ethanol into
one that is potentially right for the country, but it certainly is one that they are not going to back off
of and therefore the price of corn and other grains is going to stay high and our whole view of the
future is based on, we’re going to assume these costs are going to stay high. We’re going to
manage our business accordingly. We have taken that into account as we gave guidance for 2007
and we will ensure that we do whatever is necessary to make sure that we can absorb these costs
and continue out sustainable and dependable performance going forward. And I think that will be a
challenge for many. We would manage to get through it year and we feel very confident that we can
surround the high grain costs as we go forward.
Interestingly, our belief is the wheat which has driven more by drought and global issues will come
down as we go forward. So fortunately and I think, I’m not showing the slide jumble, unveil the slide
that he presents but we’ve managed to offset a lot, when you look at our logistics, manufacturing,
R&D, purchasing groups. They have done just a sensational job over the last five years of actually
driving cost savings through our business. They will continue to do that as we go forward. The
focus on this will remain very strong for us as the business to ensure that we have the flexibility and
capability of continuing to innovate strongly and continuing to put money back into brand building.
So what is evolving and there isn’t a lot but there are a couple of things that we are looking at. The
first and the really two areas; one is geographic expansion and the opportunities that could exist.
Therefore Kellogg is a company as we think about the sustainability in the future and the second is
our actions on you nutrition.
I think we have talked a number of times now about our interest in participating in some of these
high growth markets in which we currently do not participate Central and Eastern Europe, Russia
and Asia and most of these markets are growing across a basket of food products double digit
relative to most of the developed markets which typically are very low single digit. So entry into
these markets potentially become a very viable and powerful part of how we can maintain or
improve our sustainability as we look to the future, and I think -- I’ve joked with John a number of
times given he has been hard [ph] to get an entry platform for this for two years. So this clearly is
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not easy to do and may take us some time. We take the risk of raising expectations and what I can
tell you is, would love to participate, we are working hard on it. It’s not that easy and for us to get in
here, we have to find the right entry vehicle and it has to be something that we believe because the
medium for short-term will be very positive from a shareholder perspective.
raw transcript
The one example I would give you is Turkey. We’ve mentioned this before, not a vast market but a
market about a year ago when we looked at it, we had in Turkey a two share of the ready-to eat
cereal market which is about a 50 or $60 million market that’s growing roughly 15%. So it’s not big,
but 50, 60 million growing 15%, five years it will be nearly 100 million. We had a two share so we
entered into a joint venture with the largest food company in Turkey called Ulker which was about
$3.5 billion food company. Within one year, our share has gone from 2 share to 22 share and within
the next few weeks, we will start selling from a local Turkish plant who will be producing our cereals
within Turkey, which will improve the economics and enable us to latch [ph] up the investment even
more and continue that growth as we go forward, so we are looking at acquisitions. We are looking
at joint ventures. This is an area of right interest for us. We are little late to the game, a lot of food
companies and a lot of our peers have been in these markets for a number of years and have
establish positions. Nevertheless, we will continue to work on it and I wonder if we get some
positive news, I’m sure that you will be the first to hear about it.
In health and nutrition it’s interesting you go back -- Kellogg was founded in 1996 by W.K. Kellogg
on the basis of offering consumers healthier food choices. And I think when you look at cereal
today, it still resonates as one of the best ways to start your day for breakfast and as we think about
the changing environment in which we compete what’s going on with the overarching growth and
heath and wellness by the issues of obesity. There are a number of things that we are looking at
and doing. The first is when you think about innovation, I think most companies are doing exactly
the same, so we are not unique. If you think about Smart Start Healthy Heart, we have a product
call Guardian that’s selling in Canada and Australia, which was based on a heart health, low in
cholesterol. We’ll bring Yogurty a product that enables adults to get up to half of the part [ph] that
they need on the diet. A lot of their innovation is skewing towards healthy and more nutritious
offerings, our overarching belief is we will need to offer choice, and we have great choice in the
market, but innovations will play a part as we continue to grow and evolve that full trolley going
forward. Trend setting efforts, we have done a lot of work. We really didn’t have trend setting efforts
in these cereals but in cookies and crackers they existed and some of the other products. We’ve
actually removed them in most of those and the prices of taking them out but the balance of the
portfolio is well under way, we just need more of the oil that we’re using -- a low-lin soybean oil that
farmers need to grow more of. But that progress is well underway and should be behind us in the
next 6 to 12 months.
Portion control, I think is becoming more important not only for us but many other companies and
you’ve seen that resonate very well with consumers. We’re participating with more offerings in that
regard and will continue to do so as we move forward. Labeling, in the UK and Australia and
around Europe, we’ve undertaken on the front of cereal boxes giving people information on
guideline daily allowances and what is in each of those cereals. That gives more information to
consumers than they’re getting today. We’re looking at that along with the industry to see if that’s
something that maybe valuable for consumers in the US, then hopefully you’ll see more on that as
we go forward.
And finally on community efforts; before I was pretty clear on the issue of obesity. It’s all about
calories in, calories out. The Institute of Medicines report that came out recently was very clear that
kids are not increasing the amount of calories they eat. They are just not burning as many calories
as they used to burn 10 or 15 years ago. So most of our community efforts and a lot of our
advertising is skewing towards encouraging consumers to exercise more and to lead more active
lives, whether it’s Girls on the Run, whether it’s in Earn Your Stripes. We have a program called
Healthy Beginnings where we do health screenings in supermarkets to help people understand
where their cholesterol is, their blood pressure, et cetera. And our whole resource [ph] is how can
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we actually encourage consumers especially parents to encourage their kids and kids to get more
active, so that they can burn more calories and therefore address some of the issues that exist
today.
I’m just going back. Before I hand over to John, I thought there was a slide in there said run ads,
we’re going to run some commercials and then John’s going to come up, run you through the
financials, go into a little bit more detail on the issue of margin which I know has perplexed a
number of you, and then I’ll come back up, do a quick summary, and then Q&A. So if we could run
those commercials that would be great.
[Advertisement]
John A. Bryant, Executive Vice President and Chief Financial Officer, Kellogg Company;
President, Kellogg International
Thank you, David. Good morning everyone. I’ll take you through our financial model, both some
history of what’s been happening in the last few years. I know there is some questions on gross
margin; I want to take the time to answer. Also talking about how that model continues to take us
forward in the future, continue to drive the long-term sustainable growth.
First I want to go back and reiterate the guidance for 2007. This is the same guidance we gave at
the recent fourth quarter conference call. The important point here is that despite the continued
increase in inflation that David mentioned, that we saw in 2006, we were able to exceed our longterm guidance and in 2007, we have confidence again that we will meet or exceed our long term
guidance. As you can see here our internal sales growth, which we’re flagging could be up to 4% in
2007. That reflects a strong momentum we have coming out of 2006, we were up 7% in that year.
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Despite the inflation, we can still see our way to mid single digit operating profit growth and
continuing to invest back in the brands in terms of brand building and that will enable us to achieve
high single digit EPS growth around 2.68 to 2.73. If you look at some other key elements of
guidance as Lenny said, the key to most [ph] companies is its ability to generate cash flow; looking
at cash flow for 2007 in the 950 to 1.25 billion range, that’s up from 957 in 2006.
We expect to continue to have up front cost, and I’ll come back and talk about these costs, what
they are for in the role in our financial model. We expect those to be again around $0.14 a share,
similar to what they were in 2006. And then again we expect capital expenditure to be around 4% of
sales, which reflects a very strong internal sales growth the company has achieved over the last
couple of years.
I want to turn to the Volume to Value wheel, what we now call the sustainable growth model. And
you see here the bar [ph] hasn’t changed over the last 3 or 4 years. This has been our performance
against our metrics over that time period, 2003 to 2006. You can see that it starts with expanding
gross margin. Now over that time period, our gross margin actually declined by 20 basis points.
Within that time period, 2006 was down 70 basis points. So we’re actually seeing expansion in
gross margin, up until the significant inflation that it hit us in 2006.
Despite gross margin being down by 20 basis points, our gross profit in absolute dollars is up $900
million over this time period, so our gross profit in absolute dollars which at the end of the day is
what gives us the flexibility to invest back in our business has been growing very strongly. That’s
enabled us to increase our brand building by 25% over this period. And just a reminder the brand
building for us is advertising and consumer promotional activity like toys-in-the-box. It is not trade
spending. In fact over this period, our advertising was up by over $200 million.
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That increase in brand building as well some of investments that David mentioned directly back in
our R&D facilities and processes and people has enabled us to increase our rate of innovation. So
in 2006 we generated almost $2 billion of sales from products launched in the last three years. And
the way we look at innovation is the three year old metric that David mentioned, but also we look at
the gross margin per kilo, the gross margin per unit and the gross margin percentage of sales for
those products to ensure that at least two of those three hurdles is positive, so we are not
cannibalizing the base portfolio. If we account for [ph] the base portfolio, we are taking it to a higher
mix, higher return portfolio over time.
The result of that is not surprising; we grew price mix by 9 points -- 9% over this period. That
helped us drive internal sales growth of 20% since 2003. As you can see price mix and volume are
both a component in delivering outstanding results. So over the last three years, this model has
worked very well for us. And that we would have to continue invest back strongly in the brand and
we see this model continuing to be a key part of how we drive the business going forward.
I do want to take a moment though to talk about gross margin and what happened in 2006. This
page shows the incremental cost of goods inflation each year offset by the incremental productivity
savings each year which is the yellow bar. You can see over the period 2003 to 2005, we were
largely able to offset increases in cost of goods inflation. In ‘03 and ‘04 we had some small bleedover benefits of synergies from the Keebler acquisition. In ‘05 and ‘06 we had additional savings
from the various up-front projects we have been executing over the last four or five years.
As you can see, the big issue we had in 2006 is our rate of inflation was almost double our
historical experience over the prior three years. That inflation primarily came from commodities,
energy, benefits type costs. If we had been able to offset that inflation in 2006, so if 2006 inflation
had been more inline with the norm, we would have been able to offset that with additional
productivity initiatives instead of our gross margin being down by 70 basis points, it would have
been by over 50 basis points. So the issue that occurred to us in the gross margin line was really
the impact of higher cost of goods.
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Now the important points I want to stress, despite that higher increase in cost of goods in 2006, the
company still delivered an additional $260 million in gross profit of up 6%. So we were able to offset
all of that additional inflation and still deliver $260 million of additional gross profit which enabled us
to continue to invest strongly back into the business.
As we go forward in to 2007, we expect cost of goods inflation to continue there, not necessarily at
the same rate as 2006, but still well above what we saw 2003 through 2005. For that reason, we
have guided that our gross margin is likely to be down by up to 50 basis points in 2007. Despite
that, we still have the ability to reinvest back in our business.
I want to talk some more about up-front costs and their role in our financial model. Over the last
four or five years, you can see we’ve been consistently taking up-front costs. These are projects
that are designed to give us savings in cost of goods and overhead. So we have visibility into the
future to help us offset inflation. Examples of projects over this time period include closing a variety
of bakeries in the U.S., restructuring our Cereal network in Europe, implementing SAP and a variety
of other overhead initiatives.
As we go into 2007, we expect to continue to have up-front costs. And as we go into the future we
continue to have up-front costs, because this is an integral part of our model to help us offset
inflation. We flag up-front costs to you as analysts, not so that you can take these numbers out of
our reported results, we flag this so that you can understand the volatility in our earnings from
quarter to quarter, because sometimes these projects can be quite lumpy. But the intent again is to
invest in these projects to avoid for us having to do a large restructuring charge ever two or three
years and to enable us to continue to drive productivity across the company.
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Now let’s turn to the other side of key metrics we follow as a company; the Manage for Cash
metrics. Obviously it starts with growing net earnings. Over last three years, the Volume to Value
wheel or Sustainable Growth Model has enabled us to do that with net earnings growing by -- is up
28% versus 2003. We continue to reduce core working capital with core working capital on a rolling
12 basis down below 7% of sales and 140 basis point improvement over this time period. We
continue to be very disciplined on capital expenditure, running around 4% of sales. We use core
[ph] manufacturers aggressively wherever we can. We only put capital down in our own facilities
when we are very confident of a strong return on investment.
With that strong cash generation, over the last three years we have been able to improve our
financial flexibility. Out net debt over this period has reduced by about $400 million and we returned
almost $3 billion to shareholders through share repurchases and dividend programs.
Not surprisingly, with our earning growth coming from our Substantial Growth Model and very
disciplined approach to invested capital from Manage for Cash, our return on invested capital has
continue to expand over this time period. If you look back over the last four or five years, you can
see a continuous progression and improvement in ROIC. As we go forward, we expect to continue
to work these metrics hard and therefore we expect to continue to see expansion in our return on
invested capital.
Now, in terms of the uses of that cash, returning cash to shareholders has been an important part
of our story over the last couple of years. Share repurchases are important part of our model as are
dividends and I’ll come and talk to more of that on the next page. We continue to see modest
reductions of net debt going forward. However given the strong financial performance of the
company, I am quite comfortable with the capital structure that we have as a company.
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We expect to continue to look at complimentary acquisitions particularly in some of the emerging
markets that David mentioned before. And we’ll continue to look at benefit funding, but quite frankly
given the level of funding we have done over the recent years as well as the very strong returns we
have had in those funds, we are not in great need of doing any additional benefit funding in the
near term.
So as we go forward with our strong cash generation, we expect to continue to see cash going to
back shareholders. So in 2007, we will again look at our dividend payment and again recognize that
that’s important part of holding the stock. We have an authorization from our Board to buyback up
to $650 million of shares in 2007. So we will continue to return our cash to shareholders going
forward.
If you steer back and look at our financial model, we have been able to deliver at or above our longterm guidance in 2006 and 2007, despite absorbing a significant step up in the cost of some of our
input ingredients. As David said before we see that as a permanent increase in those costs. We’ve
able to absorb those in our P&L, continue to invest back in to business, continue to drive a longterm sustainable growth. These metrics around the Sustainable Growth Model as well as Manage
for Cash serving their purposes enabling us to see our long-term growth and have confidence for
the long-term financial position of the company.
So with that I want to hand it back over to David for concluding remarks.
A. D. David Mackay, President and Chief Executive Officer
Thanks John. I think we remain very confident with the business. We are going to continue to invest
heavily back against the business to improve the fundamentals. We are going to continue to drive
with strong innovation as we go forward and even in the relatively high cost environment, we
remain confident that we will deliver another year of on target performance. So as we look at 2007
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and our confidence in the business remains strong and I think the 26,000 employees we have
working diligently for us everyday continue to make Kellogg a very strong and great company. And
with that, I would love to open it up for questions.
<Q>: David just as a measure of the discipline on some of these acquisitions you might look at
overseas. Now you recently said on your upfront projects that you expect the returns there to
exceed your returns on invested capital overall. Would you apply the same spring to acquisitions in
some of these developing markets?
<A – A. D. David Mackay>: Yeah, we are going to be very disciplined on what we do -- everyone
in this room is well aware. There is a lot of money around at the moment [ph] sometimes maybe
about what we believe is reasonable. And so that’s why the cost will not be an easy one but we will
be disciplined. We will continue to look at acquisitions and joint ventures. We will continue to study
the markets. We’ve learned a lot in the last two years. I think we are well positioned if the right
opportunity comes up Terry [ph] to go after. But not in a way that is not going to be positive for
shareholders in a reasonable period of time.
<Q>: Thank you.
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<Q>: Andrew, and given the choice, I’ll take the mike. I guess two questions, one short term, one
long term. Short term on trying to get some of the concerns coming out of the fourth quarter was
the inventory issue in US retail. Can you kind of update us on what’s happening so far this quarter
regarding cereal in US? And then second longer term, I think Jeff, when he was CFO, talked about
a number of emerging markets where you’ve been investment spending for 10 years and those are
starting to turn and become profitable. And I’m wondering can you give us some view as to what
percentage of the business that represents and is there kind of a swing factor that you’re counting
on over the next few years in terms of consolidated?
<A – A. D. David Mackay>: Yeah, I think the first question regards our inventory in the fourth
quarter and really that was a little bit of a surprise for us driven more by the price increase, I think,
that we took at the end of September. And typically, we’ll get a price increase. We’ll do a check in
lieu. Because of the price increase and the fact that there was some pack size changes, we didn’t
do that this year. There was more volatility coming into the fourth quarter than normal, which meant
the level of inventory was higher than we thought. We finished the year basically where we wanted
it to be. All I can tell you is that you’ve seen the [indiscernible] out of this publicly available through
the first four weeks. Our consumptions looking reasonably good and our expectations for cereal this
year in the US is it will grow in low single digits.
On the second question, I think Jeff might have been referring to one market, India, where we’ve
been in for about 10 or 11 years. We have been losing money up until a year or so ago. It’s not a
big business for us and that isn’t probably the model as we look to the future that we’d look to
replicate. We’re patient but we’re not that patient anymore. So there aren’t a large number of those
markets that probably are going to give us a benefit that were a strain on us. Unfortunately, we wish
that were the case, but in the last 5 or 6 years we really haven’t done much in the way of market
entry. If anything, over the last 6 years, we’ve actually contracted more than we’ve expanded.
<Q>: I just want to explore [ph] here, I think the comment around doing whatever it takes or
whatever is necessary to offset ongoing cost inflation on a multiyear basis, as you look out over the
next couple of years to the extent we have the same kind of environment give or take that we have
now, is the category healthy enough to -- when do you start to bump up against sort of major price
points at retail, if that becomes an issue, or is the category in a situation where you can handle
larger than average price taps versus private labels than maybe you have historically. I’m trying to
get a sense of how far we can push some of the levers if needed for a multiyear basis?
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<A – A. D. David Mackay>: We don’t really comment on future pricing but I think the current
environment is going to affect everyone in certain ways and it will be interesting to see what
happens to all grains next year. But that’s -- obviously it’s going to impact us and we’re going to
take the right actions to ensure that we can continue our performance into the future and we’re
giving guidance that we can do that. So we’re very comfortable with where we’re at and the future.
What the competition does, I don’t really know but as we look at -- you go out a year or two and you
stop thinking about if you’ve still got cost opportunities. There’s plenty of things we are still working
on that we believe can yield great benefit for us as we go forward and there are a variety of areas
and I mentioned how I see basis [ph] I think it’s goes to across 96% of the Kellogg world does open
up opportunities for us to utilize that as an enabler to drive greater efficiency than we’ve been able
to do up till this point. And you may see some projects in that regard as well as what we can do
across our supply chain and purchasing logistics, etcetera. So there are merits [ph] of things we are
working on but pricing we really can’t get into. You say price points and if you look at prices across
the US S and you go to the West Coast versus the East Coast, what is the price point? Selling itself
is 399 on the East Coast. It’s 499 on the West Coast. I mean, it’s all over the place.
<Q>: Could you perhaps give a couple of examples on SAP, where that will be a benefit for you in
terms of efficiency, maybe a example or two of metrics there? And separately, international spend
about a third of your incremental profit in recent years, is the mix three years looking like that
incremental profitability would be less as you reinvest more or perhaps with the help of M&A that
this will become a greater percentage of your growth?
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<A – A. D. David Mackay>: On SAP, I think really is an enabler. We can use SAP to reduce some
of the manual costs that are down within the business today, and that’s the area we are looking at.
How do we streamline and some of the things that we do today and give us a greater efficiency or
effectiveness. I don’t feel that we will see a massive change in the profit delivery from international
business and it should consistently be about where it is now and if there is a message change, it
will be a good reason for us but I can’t see one at the moment.
<Q>: Just a quick question with reference to John’s presentation. I think you have this gross margin
growth of the target and I guess at first glance it’s something you guys have been very important to
company for the past 5 to 6 years but if expanding from that meaningfully is what looks to be a
bigger part of the picture over the next 3 or 4 years. I mean why you even set that as a target, I
wonder, just because if you growing growth profit and your margins are down a little bit and you
might continually find yourself when you absolutely shouldn’t be as long as the snack business it
might inherently be lower gross margin is going to grow faster over the next five years. Can you talk
a little bit about that?
<A – A. D. David Mackay>: I think if we look at the three metrics John mentioned, as long as we
hit two of those three metrics, we’ll still be meeting our internal guidelines and if you look at snacks
typically it hits two of the three, the one that it typically misses even though it’s got a high dollar per
unit and gross profit financial dollars per unit, the percentage typically is a little low to you point. But
it still meets our guidelines. If the level of that gets to a point where it is having a detrimental impact
on our overarching company gross profit, then we will get it a little more public. It is having an
impact. John, do you want to add anything to that?
<A – John Bryant>: No I think -- you want to use a backup.
<A – A. D. David Mackay>: He actually has a slide here that tries to get exactly to that point. Now
I’ll read this to the people on the webcast. So you see here our next for internationally our snacks
business versus obviously rest of the portfolio. It’s 152% higher for snacks. Gross margin is a 141%
higher for snacks but gross margin as a percent is actually 8% lower than the rest of the portfolio.
So the more we drive snacks internationally, the more we’re going to see a gross margin percent
issue even though gross profit absolute dollars increases. At the end of the day, quite frankly, we’re
more focused on gross profit dollars because that’s what we can bank, so we can reinvest back in
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the business. For this stage, we still challenge ourselves internally and externally to see if we can
achieve gross margin expansion, once we get past the unusual inflation we find ourselves in today.
<Q>: You haven’t been CEO long enough for the Board to really start riding you, I would think. But
you know clearly, you’re relative performance and even your relative valuation if you do apples to
apples and add that charge [indiscernible] do the same, even though you don’t wanted to, John,
here. What can you do to narrow this discount, if anything? What can you do to kind of narrow the
discount and does it bother you?
<A – A. D. David Mackay>: To be frank, it doesn’t really bother us. We would rather we’re valued
and we believe we should be valued but I think at a time the matter will catch up on that. I think a
number of people have mentioned the whole opportunity from volatility, you know, and people
looking for that. Buying into stories [ph] where it could be a turnaround, this is Kellogg which is
consistently performing. But I think whether it’s a year from now or two years from now, I think
eventually the worm will turn so to speak. Then ultimately people will value us pretty consistently
performance we have over the last 5 years or the next 5 years. And that’s really what we’re all
about. And the Board is completely aligned on the notion of driving sustainable, dependable
performance. Because having been through, go back 10-15 years, having been through some of
those ups and downs, we had a lot of Board members who have been around awhile and that’s
driven in their memories and consistently hitting and beating the numbers and growing a strong
organization as a result is really something that board buys into completely.
<A>: It’s the last question.
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<Q>: I just had a question for you on the sales growth. You increased your target a bit for ‘07
looking for close to 4% sales growth in the year. Have you seen an increase momentum in some of
your categories, surely, you have in snacks and frozen and it has really helped the performance
overall? And I’m curious also in terms of your sales growth outgrowth for the year against with the
effect in sort of a good balance between volume and price mix in the year based on price mix that
you have already announced forward-looking?
<A – A. D. David Mackay>: Yeah, we’ve said up to 4% and we have done that basically because
we have seen some momentum both in the international businesses and in the US businesses and
some of the categories are doing very well. We think that’s reasonable for this year. You could
expect that in 2008 we will be back to low single digits because that is our [ph] long-term guidance.
So nothing dramatic but we feel confident that we are going to hit our numbers else we wouldn’t
have given them to you.
Bryan Spillane, Vice President & Monthly Chair, Bank of America
We like to thank Kellogg for their presentation for breakfast this morning. We will now adjourn to the
breakout room. One question on meals, lunch today is outside, the dinner is inside both are family,
friendly. Be back here in 15 minutes for Dean Foods.
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