家樂氏 (K) 2002 Q3 法說會逐字稿

Good morning.

My name is Jeff and I will be your conference facilitator today.

At this time I would like to welcome everyone to the Kellogg company third quarter Earnings Conference Call.

All lines have been placed on mute to prevent any background noise. and after the speakers' remarks there will be a question and answer period.

If you would like to ask a question during that time, simply press star then the number 1 on your telephone keypad.

If you would like to withdraw your question press the pound key.

Thank you.

You I no now like to introduce John Renwick, Vice President of investor relations.

Sir, please go ahead.

Thank you and good morning, everyone.

Thank you for joining us for a review of our third quarter 2002 results and for some discussion about our strategy and outlook. with me here in Battle Creek (ph) are Carlos Gutierrez, chairman and CEO and John Bryant, CFO.

By now you should have received a press release by E-mail or fax and the slides that accompany today's present are on line www.kellogs.com on the investors page.

Just a few words on the presentation of our results.

The press release provided gives our full income statement, balance sheet and cash flow on a reported basis.

And as we have stated in previous calls, in 2002 we have changed the number of weeks in each quarter for certain business units, notably Keebler.

This means that those business units had three fewer weeks in the third quarter, pulling down the quarter results for that period, but one additional week back in the first, second and becoming fourth quarter.

Also remember that our year ago third quarter results were reduced by Keebler integration costs and that this year's profit was aided by FAS 142's elimination of amortization.

We also completed this year the divestiture of our Bake line private label business.

None of these factors was new by I wanted to remind you of them because of the impact on reported results.

Again for analytical purposes, during this call we will mostly discuss our sales, profits and EPS figures on a comparable basis. to remind you, comparable basis growth figures for net sales and operating profits adjust the year ago results to exclude the sales and profit impact of our change in reporting weeks and last year's integration activities as well as this year's bake line divestiture and amortization eliminated by FAS 142.

For complexity reasons we don't make as many adjustments to EPS.

We just make the adjustments that you tend to look at our EPS on, specifically we adjust the EPS to exclude the -- from the year ago results the profit impact of last year's Keebler integration activities and the amortization eliminated by FAS 142.

Turning to slide 2, we must point out that certain statements made today such as projections for the Keebler foods integration and Kellogg company's future performance including earnings per share spending growth operating profit expense investment sales, tax rate, cash flow innovation, currencies, share repurchases, capital expenditures, shares, margins, products, returns and synergies are forward looking statements.

Actual results could be materially different from those projected.

For further information concerning factors that could cause these results to differ please refer to the second slide of this presentation as well as to our public SEC filings.

A replay of this call will be available by phone through Friday by dialing 800-642-1687, passcode number 600-3313, and it will be available by webcast through Thursday evening.

Our next public presentation will be at an industry conference on the morning of November 12th, and that will be webcast.

Now let me turn it over to Carlos Gutierrez

Thanks, John, and good morning, everyone.

We have shown you slide number 3 many times before.

As you know, in 2001 we changed everything from our organizational structure to our portfolio, to our capabilities and our business model.

In 2002 our goal was to accelerate our sales and profit growth, gathering enough momentum to set us on a course for steady consistent growth in 2003 and beyond.

Today we are pleased to report another solid quarter offering the best evidence yet that we are on track.

Our net sales were strong in the quarter and grew at a comparable basis growth rate of 7 percent, and this growth was broad based.

All of our major businesses in the U.S. posted strong gains in international our core markets grew in response to our grand building initiative.

Our earnings for the quarter came in at 49 percent share or modestly ahead of our forecast.

While its up side is partly timing related it does reflect an acceleration in comparable basis profit growth.

Of course the important thing is how we're getting the results that count because they will tell you whether the growth is sustainable or not.

Slide 4 illustrates two of our key guiding principals for running our business. for those of you less familiar, volume to value means adding value for the consumer to achieve higher dollar sales and profit.

Rather than pushing volume through discounting.

Manage for cash refers to a primary emphasis on cash flow and how our entire organization is focused on turning earnings into cash.

These principles have put our business on a cycle that can deliver consistent dependable growth for our company.

In the third quarter we continue to make progress on all of the elements shown on this slide.

Our CFO John Bryant will walk you through our results from the perspective of these principles then I will cull back and describe how we are improving our execution.

John.

Thank you, Carlos and good morning, everyone.

Let me begin by summarizing the results for the quarter.

Slide 5 shows our performance both on a reported basis and comparable basis.

Again, we [inaudible] reported results are affected by the reduction in shipping weeks in the quarter, the elimination of most of our amortization, the divestiture of bake line and last year's integration costs.

Net sales declined 2 percent on a reported basis, due to the three fewer shipping weeks of Keebler and the bake line divestiture.

On a comparable basis net sales were up a very strong 7 percent.

Operating profit increased 20 percent on a reported basis, helped by the elimination of amortization.

However, on a comparable basis, profit was up 15 percent, aided by an improved gross margin.

Once again, the quality of our operating profit was good as our marketing investment was up and we again absorbed several costs that could be considered unusual including integration costs and an asset write down in Australia.

We reported third quarter diluted EPS of 49 cents a 32 percent improvement over last year's earnings on our reported basis.

Excluding last year's integration costs and this year's elimination of amortization, EPS was up 2 percent on a comparable basis.

As a reminder, the comparable basis growth rate for EPS shown on the slide is not adjusted for the reduction of shipping weeks in the quarter which explains why third quarter EPS growth was more modest than previous quarters.

Actually, it was better than our forecast to flattish EPS, though we did correctly predict there could be some earnings shifted in the third quarter from the fourth due to the timing of marketing programs and a tax rate adjustment to our anticipated full year rate of 37 percent.

Cash flow for the quarter came in 26 percent, higher than last year's strong performance.

As Carlos said, these third quarter results put us squarely on track for our 2002 goal.

Year to date, through the first nine months, comparable basis growth for net sales was over 4 percent, ahead of our low single digit target.

Operating profit was up 9 percent, ahead of our mid single digit target.

And EPS was up 9 percent.

We will discuss our outlook for the rest of 2002 and full year 2003 in a moment.

But first let me walk you through the steps of volume to value and how the strategy performed this quarter.

The first step in our volume to data strategy is gross margin expansion.

In the third quarter we continued to rebuild our gross profit margin further continuing an improving trend that began last year.

Slide 6 shows that on a comparable basis our gross margin increased by 20 basis points in the quarter and by 100 basis points for the year-to-date period.

Our growth in sales created operating leverage in the quarter and we continue to shift our mix toward a more profitable products.

We also continue to realize Keebler related cost savings even sooner than we had anticipated.

In fact, our latest outlook for Keebler savings is $120 million for 2002 up from our previous 2002 projection of $100 million.

This gives us even more confidence in our ability to achieve the 170 million run rate projected for 2003.

If our 20 basis point gross margin increase for the quarter seems modest, consider that it would have been 70 basis points higher had it not been for an increase in value added promotions.

These promotions such as inserts are important brand building activities and on the new accounting standards they are now included in cost of goods sold.

The third quarter's gross margin expansion was also held back by an asset write down in Australia.

Looking ahead, operating leverage Keebler cost savings and favorable mix should continue to help our gross margin.

However, our value added promotions will also increase and near term we should start to feel the impact of higher commodity costs.

These factors should cause our gross margin expansion to decelerate in coming quarters.

What's most important is that we have successfully raised our gross margins to allow us to increase our brand building investment.

Slide 7 shows how we have increased our brand building investment considerably in 2002.

In the quarter our marketing increase at a mid single digit rate on a comparable basis.

Year-to-date it's high single digit increase has well out paced or comparable basis sales growth.

The good news is that we are not simply spending more money.

Some of this investment is returning to key international markets after reductions in the last couple of years.

But in all markets, we are prioritizing our investment behind proven innovation and marketing ideas and behind our most profitable brand.

This is volume to value at work.

We should report a substantial increase in marketing spending in the fourth quarter, ending the year with a high single digit or even double digit increase.

Ultimately volume to value and brand building investment should result in internal sales growth.

Our reported basis net sales growth components are shown on slide 8.

Stripping out the impact of the bake line divestiture, the change in shipping weeks and a slightly favorable currency translation, the slide shows our internal sales growth was a very strong 5.6 percent in the quarter.

Volume was up almost 1 percent in the third quarter.

Remember this is pound volume, and it's growth is muted by our efforts to shift our mix away from heavy low priced products and toward lighter higher priced and higher margin products.

If we measured our volume in units instead of pounds, we would be reporting even higher growth in volume for the quarter.

The pricing mix improvement was once again impressive at nearly 5 percent, and it compared against an increase in last year's third quarter as well.

Also, remember that we have left many of the list price increases we took last year, including those on U.S. cereal in June 2001.

Therefore, most of the third quarter's price mix improvement came from reduced discounts and a favorable mix shift.

Again, volume to value is working.

A highlight of our food quarter was that our sales growth was broad based.

Slide 9 shows our comparable basis sales growth by major products segment in the U.S.

Our U.S. cereal performance was again strong with more than 6 percent growth, led by our new products and improved pricing and mix.

Our snacks business saw an acceleration to 5 percent growth due to continued strength in whole some snacks and strong club channel growth in biscuits.

Carlos will give you more color on these businesses in a moment.

The rest of the U.S. businesses turned in very strong collective growth as well.

As the slide shows, no other businesses of Kellogg's USA posted an 11 percent comparable sales gain for the quarter.

This was led by double digit growth in both Worthington foods and in the non-cereal business of Kashi.

All of our U.S. businesses are embracing volume to value and all of benefiting from brand building investment.

The result was a broad based acceleration in sales growth.

We do face notably difficult comparisons in the coming quarters, especially in U.S. cereal.

Year over year growth may not look quite as robust going forward however the broad based nature of our growth suggests that Kellogg's USA is executing well.

Kellogg international is in the early stages of volume to value and is getting increased marketing resources for the first time in a long while.

Yet if sales growth is already accelerating and it is doing so in numerous key markets.

Slide 10 shows comparable basis sales growth was up 5 percent in local currencies during the third quarter.

Our sales were broad based as Europe is up 2 percent, Latin America was up 10 percent and all other which includes Canada, Australia and Asia was up 7 percent.

Carlos will describe our performance in these markets in more detail in just a minute.

What's important from the financial standpoint is that the increased marketing investment is paying off.

And by adopting volume to value we are seeing increased price mix contribution in all of the major markets.

Our operating profit growth was very strong in the third quarter.

Slide 11 shows that on a comparable and FX adjusted basis, we posted growth in every major reporting segment and 14 percent growth overall.

In the U.S. 14 percent comparable growth was driven by the gross margin impact of strong sales, favorable mix and Keebler related cost savings.

In the international division, solid gross margin expansion offers evidence that volume to value is working, but a strong increase in brand building held back profit growth in the quarter.

In Europe, the effective sales growth was partially offset by a strong increase in marketing investment.

In Latin America, marketing was up strongly and economic difficulties in Venezuela and Argentina partially offset continued growth elsewhere in the region, notably Mexico.

All other regions profit was up significantly even with increased marketing investment and a write down of some private label production assets we inherited with an acquisition in Australia a few years ago.

Looking below the operating profit line, interest expense was down slightly from the year ago period.

Despite an accelerated interest charge of about $6 million and a high percentage of fixed rate debt.

We look for full year interest to come in around $395 million.

Other income increased due in part to favorable foreign exchange gains and higher cash balances.

Now effective tax rate came in at just under 37 percent, bringing our year-to-date rate to anticipated full-year level of 37 percent.

Average diluted shares outstanding were up year over year due to increased option exercises and the dilution impact of a higher share price.

Importantly, we began to repurchase shares using option exercise proceeds and this was successful in containing the share dilution as evidenced by a sequential decline in diluted shares outstanding from the second quarter.

Overall, the quality of our earnings was again very good as marketing investment continued to grow and as we absorbed integration costs and asset write down, and an accelerated interest charge.

And each metric volume to value wheel showed improvement.

Now let's turn to management of cash in slide 12.

By emphasizing cash over accounting earnings and by giving our business unit ownership and accountability for cash flow, we have greatly improved our ability to turn earnings into cash.

We have been much more disciplined in making capital expenditures, they give us the [inaudible] return.

Our full year capital expenditures should be around $250 million. a slight decline from last year.

Perhaps even more impressive has been our continuous improvement in working capital.

As shown on slide 12, our core working capital is a percent of sales has improved 140 basis points versus a year ago to 9 percent. the result has been a strong improvement in cash flow.

Our cash flows through the first nine months of this year was $935 million, well ahead of the $701 million we recorded in the year ago period.

We do face our toughest cash flow comparison in the fourth quarter thanks to a notably large working capital contraction in the year ago period.

However, it certainly appears that we will finish the year with a larger cash flow than our previous guidance which was somewhere between the 650 million we recorded in 2000 and the all time record $856 million in 2001.

Cash flow is so strong, in fact, that we are considering making a cash investment in our pension and other post retirement funds.

Understand that this is strictly voluntary.

We have not triggered any requirements to make a cash contribution in the U.S.

Any contribution will occur only after we've met our debt reduction target for the year.

Debt reduction remains our priority for cash flow.

Slide 13 indicates that our debt reduction slowed a little as we built up our cash balances in the quarter.

This was ahead of an interest payment due on October 1st and a principal and interest payment due on our U.K. based debt on November 1st.

So our net debt position actually did continue to decline in the quarter.

Our debt balances should continue to decline even after any potential cash contribution into our pension and other post retirement plan.

Our cash flow and debt reduction are clearly improving our financial flexibility.

The bottom line is that our results show that manage for cash is working just as volume to value is working and these principles should allow us to sustain our improved performance into the years ahead.

Before I turn it back over to Carlos, let's take a quick look at our near term earnings outlook.

Slide 14 indicates that despite the better than expected third quarter, we continue to look to EPS of a 1.73 in 2002.

This of course excludes the notably large favorable legal settlement back in the first quarter.

In effect, we believe that because of timing the earnings up side of the third quarter comes out of the fourth quarter.

Keep in mind that while reported results will benefit from an extra shipping week in some of our businesses we do face an unusually difficult 10 percent sales growth comparison in U.S. cereal.

We also face the first impact from this year's sharp run up in commodity costs.

On the whole, though, the fourth quarter should be another good one and it should send us into 2003 with the momentum needed to achieve our ongoing growth targets.

We are still in our budgeting process, but as part of our effort to give you visibility, I'd like to give you an early idea of how we expect 2003 to shape up.

Up to now, the only guidance we have given for 2003 has been our target for low single digit sales growth, mid single digit operating profit growth and high single digit EPS growth.

Slide 15 shows that after preliminary review of our plans, we believe we are on track to achieve these growth rates.

Internal net sales should grow low single digit rate.

We do face difficult comparisons particularly in Euro cereal, but across the company we have a solid pipeline of innovation and consumer promotion and should continue to improve our price to mix contribution.

We should be able to generate mid single digit operating profit growth despite several cost pressures.

Our gross margin should increase modestly in 2003 thanks to operating leverage, favorable mix and cost savings.

But if expansion should be slowed considerably for three factors.

First, we intend to continue increasing our value added promotions, many of which are accounted for in cost of goods sold.

Second, commodity costs have risen significantly and while we are partially hedged on many commodities we are exposed to higher wheat, cocoa and packaging prices.

Third, gross margin should also be affected by an increase in pension and post retirement benefit expense.

We have productivity programs in place to offset the rises in commodity costs and benefits costs.

These costs should slow down our gross margin improvement.

Now SG&A expense margin may increase slightly in 2003 as we plan to increase brand building investment at a rate faster than sales growth.

This brand building is critical to sustaining our growth.

Earnings per share should increase at a high single digit rate as growth in operating profit is augmented by decreased interest expense due to debt reduction and a 100 basis point reduction in our effective tax rate to 36 percent.

These factors should more than offset the impact of a full year bake line dilution which amounted to more than a couple of cents in 2002 and higher shares outstanding.

On this basis our EPS guidance for 2003 is a 1.86 to 1.90 which is in line with our long term guidance. the high end of our range is 1.90 which is a 10 percent growth off slightly above ho our high single digit guidance.

Under normal circumstances, such a gain would not be a stretch given our businesses' current momentum.

However, we feel more comfortable giving you a range given the unusual cost increases that have recently arisen in commodities, benefits and even bake line dilution.

I would also emphasize that we are committed to increasing our brand building investment and to generate a level of dependable profit growth that can be sustained year after year. with that, let me turn it back over to Carlos.

Thanks, John.

So volume to value and manage for cash put us on a more sustainable model, but to truly grow our company we know we have to continue to execute better and better. 2002 has been about honing our execution in the third quarter provided excellent times, of progress across our company.

Let's start first with our U.S. cereal business.

This was the first business we overhauled nearly two years ago and it is therefore the furthest along in terms of improved execution.

John already mentioned that our U.S. cereal sales to the retail channel were up 6 percent in the quarter.

Some of the reasons for this growth can be found on slide 16.

Each of the products shown on the slide are new within the last 18 months.

Each is differentiated.

Each carries a higher price and gross profit than our portfolio average.

These include Special K with red berries, which is a build a 1.6 share in the latest quarter, Cinnamon Crunch Crispits and Scooby Doo which have posted solid early gain.

Our Disney products give us new platform in kids segment, and Kashi GoLeen Crunch currently the number one cereal in the natural channel, and yet another driver of Kashi's overall double digit growth.

We combine this ovation with strong consumer targeted marketing all year long.

The box on slide 16 shows that these volume to value efforts are working using our IRI data.

We continue to gain dollar share of the category with our share up point 8 points year over year in the quarter, and 1.1 year to date.

Base sales which attempt to measure the sales made with no price promotion are the best indication of whether we are competing by adding value or by dropping price.

In the quarter our base sales were up more than 5 percent year over year while our branded competitors were flat to down.

Our average promoted price was up 90 percent year over year, more than twice the category rate.

This means our consumer promotions offer enough added value that we do not have to discount as deeply.

It also reflects the fact that we are relying lesson price promotions and focusing more on increasing our base sales.

Our average price on all of our sales promoted and not promoted was up 4 percent while the category as a whole was up 2 percent.

This is a function not only of our higher promoted prices but also of favorable mix shift to value products.

Next month we will be sharing with you some of the innovations and marketing programs we plan for 2003.

No matter which measure you look at, it is clear that our U.S. cereal business is implementing volume to value effectively.

It made us more competitive and more profitable as we finished 2002 and head into 2003.

Let's now turn to our U.S. retail snacks business which includes wholesome snacks, cookies and crackers sold to the retail channels.

Slide 17 shows in 2002 we have progressively improved the growth of this business.

In the first quarter sales were flat as we faced difficult comparisons and we were in the process of resuming investment behind our snack brands and for the first time since the integration.

In the second quarter whole some snacks led a 3 percent sales gain.

In the third quarter this business posted its best growth yet at 5 percent.

Collectively sales of our whole some snacks, cookies and crackers increased a double digit rate from the club and convenience store channels with the latter aided by the addition of 65 in store reps last year.

In Keebler's DSB (ph) system sales growth was again led by double digit gains in whole some snacks.

Nutrigrain and Rice Krispies Treats were an investment priority for us this year and we assess the power of our newest capable of direct store distribution.

Our DSP reps have improved solid in store merchandising for these brands.

In addition these brands are getting significant lift from innovation.

Our innovation on Nutrigrain which includes the new minis and Yogurt bar lines has been much more differentiated from the simple line expenses of the past, helping lift the brand franchise to double digit growth this year.

Meanwhile, our new Special K bar launched during the third quarter is generating demand far greet greater than we ever anticipated.

Slide 18 shows the advantage of having a full snacks portfolio.

Because our whole some snacks enjoyed strong category growth, innovation activity and newly acquired DSP capabilities, we are able to be more selective in our invest.

In cookies and crackers.

So while our whole some snacks grew strongly in DSP, sales in business cuts were off slightly.

We generated slight decline in crackers despite good gains in key brands, but we did see an increase in cookies despite a soft category in decline of several de-emphasized SKU's.

Indeed, evidence of good execution on biscuits was blurred by the fact that many of these brands were de-emphasized during the integration.

During the quarter, such de-emphasized brands as Sesame Street, Grahams, Brochs and certain Saltines all declined year over year.

But where we have invested in brand building, we have executed well in achieved growth.

In the quarter, for instance, we generated good growth in many of our most important cracker brands such as cheese it's, town house toast it and wheatables.

In cookies we saw a growth in Murray's sugar free, EL Fudge, Sandies and Vanilla Wafers -- in the form of investment in innovation and marketing.

Let me single out Cheez-It.

Much has been made in the competitive cheese cracker sales, yet sales are up 12 percent in latest 12 week consumption data.

Meanwhile our EL fudge brand was trending a 2 percent growth when we launched EL Fudge double stuff.

The latest 12 week data show E L fudge growth is up 59 percent versus a year ago.

Recall that our biscuit business is being structured for the next phase of life cycle, a change from an acquire strategy to one of sustainable, organic growth.

That requires new brand building capabilities both in consumer marketing and innovation and this represents a considerable transition.

As we move Keebler to this organic growth strategy, we will step up our innovation and marketing activity and you will see a lot more of this in the coming months.

We'll talk more about cereal and snacks and we generally spend a lot of time talking about these two businesses because of their size, but there's also improved execution in our other U.S. businesses as well.

Some of these reflect in slide 19.

Our natural and frozen foods division posted solid double digit sales growth behind strong sales growth at Worthington, Eggo and Kashi non-cereal items.

Worthington posted an impressive growth for the quarter with most of the gain coming from this year's new products such as pop pies and pizza and distribution gained into the mass channel.

We re-launched three items under our Natural Touch brand in the natural channel with labeling depicting the use of organic ingredients.

During the quarter these three items enjoyed a double digit increase in sales.

Eggo's strong quarter can be attributed to more efficient back to school promotion.

Kashi's noncereal products displayed impressive growth behind existing Go-Lean slimming bars as well as the recently launched tasty little crackers and Go-Lean waffles.

Obviously these items leveraged Keebler's biscuit expertise and Eggo's waffle expertise, and yet another example of synergy from our acquisitions of Keebler and Kashi.

Our Food Away From Home business continue to post solid sales growth despite softness in the overall food service channel.

Earlier this year we introduced cereal in a company, an innovation that emphasizes convenience in packaging and serving size.

Sounds like a simple and small idea, but its growth has been impressive and we may take this packaging into other channels.

Again, volume to value has improved our focus and we are executing a lot better than ever before.

Now let's turn to Kellogg international and slide 20.

In international we're only just getting started on practicing volume to value reinvesting in brand building.

However, it's already working.

As John mentioned, we are realizing favorable price mix contribution in virtually every market.

As a result, we have accelerated our internal sales growth each quarter in 2002.

Slide 21 offers some examples of our volume to value efforts in some of our core markets.

In the U.K. we made great progress on a key goal regaining a share of the kids segment.

Cocoa Pop Crunchers and Chocolate Frosties were launched in September with great initial trial rates.

Also our newly launched Disney product continues to perform well with the ACV distribution on those products quickly reaching 80 percent. the market data for the latest 12 week confirmed our efforts were on track as we posted a two and a half point gain of share in the kids segment.

In addition, our healthy snacks business in the U.K. grew at a double digit rate and our new Special K bars and our expanded Fruit Winders line continues to post solid growth.

In Australia we posted our best results in a long time.

Net sales increased at a double digit rate in local currencies with cereal and convenience foods benefiting from newly implemented volume to value initiatives.

Innovation, strong value added promotions and great sales execution allowed us to gain share of a rejuvenated cereal category.

For example, we ran an on-pack video game Nutri-Grain cereal and a Disney music CD on Corn Flakes and Cocoa Puffs.

These promotions provide a significant lift to those brands.

In Canada where volume to value efforts have been highlighted in previous quarters, sales grew at a mid single digit rate in local currency.

In Mexico we reached our highest cereal category share since 1995.

We have seen double digit growth in our adult brands such as Special K and All Bran, and we continue to have success with our weight loss challenge programs.

The new Disney products and Choco Crispies lines are driving our kids segment growth in Mexico.

These types of value added promotions and innovations are the corner stones of volume to value and they are being executed extremely well.

So far Kellogg International is showing solid progress on this front and we feel we are just getting started.

So, in summary, the third quarter reaffirmed that 2002 is shaping up to be the year of acceleration that we had planned for.

We have made better progress than anticipated in building momentum for 2003 and beyond.

Our targets low single digit sales growth, mid single digit operating profit growth and high single digit EPS growth are realistic and challenging and very importantly we're seeking dependability.

And that's a very important goal for us as we communicate with our investors.

Our primary business philosophies, volume to value and manage for cash are being embraced throughout our company and we are very pleased with how engaged our people are with the total business.

Key initiatives are being executed well and many of them are only just beginning to yield benefits.

Best of all, our results are clear, from our accelerated net sales growth to our gross margins, to our gains in operating profit, and cash flow, we are hitting our targets even while increasing marketing and absorbing unusual cost that we would have excluded from earnings in the past.

Commodity costs and health care and pension costs represent significant challenges for us in 2003, and yet we are confident that our business' momentum is sufficient to achieve our growth target anyway.

The third quarter on the heels of similarly successful of first and second quarters, should give you confidence that our company is on track.

We are building up the momentum needed to deliver steady dependable growth.

So now I'm going to turn it back to John Renwick and he's going to steer us through the Q&A session.

NEW SPEAKER1Okay.

Thank you.

Before we start the Q and A session, let me ask everyone to please limit themselves to one question per call.

I'd rather you get back into the Q than block someone else out from asking any questions.

Operator, can we open that up?

At this time I would like to remind everyone in order to ask a question, please press star then the number 1 on your telephone keypad.

We'll pause for just a minute to compile the Q&A roster.

Your first question comes from Eric Katzman with Deutsche Bank.

I'm not used to going first.

Good morning.

Good morning, Eric.

I guess my one question would be it looks like for next year you know you're being a bit more cautious for things that we've been, you know, on the buy and sell side have been looking at.

Can you I guess quantify the costs a little bit more between the pension expense, the commodities, because it seems between the lower tax rate, free cash flow and the cost savings, that you've got a fair amount of money, I guess, to play with.

So maybe you could kind of quantify in a little more detail what some of these higher costs are incurring on a per share basis.

Eric, we're in the midst of our budgeting process for next year.

It's too early to give you specific numbers on some of those variables, but there are really two areas where we have cost increases.

One is benefits and second is commodities.

I'll want you to go through each of those.

Firstly on benefits, because it is early in the process, we haven't decided what all our key assumptions are going to be for next year.

I'll just walk you through some of the key assumptions and give you a sense sort of magnitude they can have on earnings per share.

The one of the first ones is assumed long term return on assets.

This assumption is important because we had approximately $2 billion in assets at the beginning of this year.

Our current assumption is ten-and-a-half percent, which is high compared to the peer group, but from the date our pension fund was put in place in 1976, through to September 30 of this year, our actual return on that fund has been 10.3 percent. 10.5 isn't that unrealistic given our historical performance.

We will look at that assumption at the end of this year.

This is something we do every three to four years.

Remember, this is an assumption over the long term return. to give you a sense of magnitude of that, each 100 basis point change in that assumption is roughly a $20 million pretax impact of about 3 to 4 cents of EPS.

Another key assumption is the discount rate. the discount rate is usually calculated the size of the pension liability and the discount rate comes down the liability increases.

As you know interest rates have come down so we may have to decrease our discount rate for of the next year.

Put that in context, maybe 25 basis point reduction in the discount rate has an adverse impact of about 1 cent on EPS.

Another key category is experience losses.

These losses can arise when the actual asset returns are less than we expected and we change various other assumptions such as the discount rate.

The unrecognized losses are amortized through the P&L over an extended period of time.

This is the area that's most difficult for us to estimate for 2003 because it depends where the market ends up at the end of this year and what changes are made to discount rate.

Another one to look at is the health care intakes working to reduce health care intakes we have continued to experience high levels of inflation this year and may need to revise those expectations as well.

That could be another one to 2 cents of EPS.

So, Eric, that gives you a sense on benefits of what's out there.

Do you have any questions on benefits as far as commodities?

No, that's good run down.

On commodities we had a very hot summer this year.

Contracts was up 70 percent, wheat up about 50 percent and cocoa up even more.

While we were largely hedged or 2002, we are partially hedged in 2003.

So we'll see some of those costs coming through our P&L.

In addition to that, Latin American business has input costs such as packaging in U.S. dollars and as those currencies are devalued that will lead to higher input costs in Latin America.

As I look at commodities in totality, while we expect to see cost pressures on a full year basis, we have enough productivity initiatives to offset them.

That includes the Keebler synergies.

So I'm confident on a full year basis we will offset the commodity impact.

So the cost savings that you're getting from Keebler, which I guess are around 7 or 8 cents a share after tax you think that the bulk of those are probably going to go to offset the commodities and then the productivity should allow you to fund the A and P?

Eric, I think your best bet is the synergies and some other productivity is required to offset the commodity cost increase. and we'll still have even when that is all said and done we'll still have gross margin expansion that will enable us to fund the A&P investment.

Okay.

Thank you.

Thank you.

Your next question comes from David Nelson with Credit Suisse First Boston.

Diving into '03 again here, since it looks like we have '02 largely wrapped up, could you comment on interest expense and capex expectations as well as cash flow?

Sure, David.

As we look at 2003, I expect the capital expenditure to stay around a similar level this year to $250 million.

We're targeting about 3 percent of net sales, in the long term context for you.

Interest expense for next year we're look at somewhere between 360 and 365, obviously depends where the short term interest rates are throughout next year. and depreciation this year was about 350, next year is likely to be around 340.

Okay.

Thank you very much.

Thank you, David.

Your next question comes from Bill Leach with Banc of America Securities.

Good morning.

I wonder if you could just talk about the discrepancy between the I R I data and your volume numbers that you gave us on the call?

If you look at IRI it shows your volumes basically down actually, about 2 percent, and your dollar sales up about 1.

Well, a couple of things to keep in mind, Bill: I think we mentioned this every time IRI comes up.

First of all it doesn't include a major retailer.

Second of all there are other channels in which we are doing quite a bit of business that are not captured in that data such as Club stores and C stores.

I can tell you this.

That our trade inventories for the quarter are actually down 6 percent versus the same period last year. and as you know for us, that's an important measurement, pretty much flat sequentially.

We closed the second quarter with some very healthy stocks and they're down 6 percent from where they were at this time last year.

So we think we've got a good grip on trade stocks, we think they're healthy.

We don't see any loading at all. and again, for us that's part of what we're trying to do with our business.

So basically IRI has just become worthless?

No, you have to take into account that it's not the total universe.

You know, there are other factors --

Right.

But I mean when you talk about serial sales being up six and this year they're flat and down $4 in volume that's a huge discrepancy for such a big category.

Well, you've got some very big customers that aren't included in the data.

And did you say you have one extra week in the fourth quarter?

Yes, that's correct.

For all businesses??

Yes.

Primarily the Keebler business we'll have an extra week in the fourth quarter.

Not cereal?

I think maybe one day moving between third and fourth quarter.

That's it.

Thank.

Thanks, Bill.

Your next question comes with from John Macmillin from Prudential Securities.

Trying to figure out how to put two questions into one, but just a notion that you've -- using this 100 basis point lower tax rate next year that you kind of lowered the tax rate because you needed to stay on course.

You know, in past sometimes we've gotten a lower tax rate and it's been incremental to the earnings.

Here it its being used, I think to fund some unexpected cost.

How would you comment to that?

Well, as John mentioned, we do have -- we do have somewhat unique costs coming at us in 2003, such as commodities, such as pension expense and health care.

So, you know, it all works out as part of our some costs go up and some costs come down.

Typically you're right, an increase in tax would yield an increase to our EPS guidance, but it is a unique sort of a year.

We are seeing some unique, extraordinary and somewhat unusual cost increases that we have to offset.

We also want to continue investing in brand building, so we started down this trend and that's something that we absolutely need to stay on so we don't want to offset the cost increases through reductions in brand building.

That's fair enough.

We're trying to balance the whole thing out.

Just one question, John, if I can break the rules a little by.

Can you quantify the asset breakdown in Australia for the quarter?

It was about $6 million, John.

Thank you, John.

Your next question comes from Terry Bivens with Bear Stearns.

Bivens (ph): Good morning, everyone.

Good morning.

Bivens (ph): You guys hear me?

Yes.

Bivens (ph): I guess my one question would go to volume to value in the U.S.

I guess I'd hate to be an IRI salesman after Bill Leach's comment.

But to the extent there is some validity in that, it would appear to show on a fairly sustainable basis that even private label seems to be emphasizing base a little bit more than incremental as is your number two competitor.

Is there -- I guess I'd like to get your view on that.

Do you think that's something that we should see sustained as we move into the next year or are you seeing competitively that sort of thing?

I can tell you what we're trying to do, Terry, it's always difficult to assume what others are going to do.

But as you know, our base for the quarter was up over 1 percent and our incremental was down, once again, on a year to date basis our base is also close to 2 percent, our incremental is down.

So that's the direction that we'd like to head. and as you mentioned; this is public data.

Private label is doing pretty much the same.

Their base is growing ahead of their incremental and we think that is a positive trend.

Now, everyone's going to do and workout their strategies based on what makes sense for them, but we're going to continue heading in the direction of emphasizing base more profitable business, de-emphasizing the amount of volume that we sell on heavy discounts, and that's the way we're going to drive our business and we'll see what everybody else does.

Terry, one clarification there. the base sales increases that car Carlos mentioned are what I R I gives it a category.

Bivens (ph): Right.

Okay.

Thanks.

Thanks, Terry.

Your next question comes from John Feeney with SunTrust Robinson Humphreys.

Hey, guys, congratulations.

Thanks.

You mentioned the possibility of making a cash contribution to pensions and I just wanted to know if you have internal targets that you're looking at after which you'd look more closely at share purchase.

And I mean specifically contribution to pensions and debt reduction.

Are there specific targets you're looking for before some of this great incremental cash flow you're generating can make its way to shareholders?

Our number one priority is debt reduction. and put that into context, at the time we closed the Keebler acquisition we had debt down to $6 billion by the end of this year.

We're already down to 5.8 billion and we expect to see that debt balance continue to come down. the reason we're looking potentially at some of the contributions to the post retirement fund is because the liabilities are growing and the assets are decline this year and we have a desire to keep those assets and liabilities more in line.

I think it we didn't have that situation we'd still be paying down even more debt rather than turning back over to share repurchases.

And that's not a statement on share repurchases.

That's just a statement on us wanting to bid in the Keebler acquisition and return the financial flexibility.

If I could just ask one quick follow-up.

In a perfect world, do you have a debt level in mind?

Well, we said that we're moving toward the A rating for debt, for our long term debt..

Very long term goal.

We're not managing the company to get a debt rating but that's a multi year perspective.

Thanks a lot.

Thank you.

Thank you.

Your next question comes from Stuart Havanski (ph) with Vanguard.

Havanski (ph): My question has been asked and answered.

Thank you.

Thanks, Stuart.

Your next question comes from David Adleman with Morgan Stanley.

Good morning, everyone.

Good morning, David.

I'm curious, what assumptions have you made preliminarily in your 2003 plan in terms of pricing given the cost pressures you're facing?

And do you believe the competitive and trade dynamics would allow you to take a modest price increase to clearly offset what you've characterized as a unique and extreme cost pressures?

David, for competitive reasons and other obvious reasons I'm not going to get into our pricing plan.

I will just say that the guidance we've given you assumes those cost pressures are in the numbers, so we'll have to manage our way through them and we believe we can. and we believe we can hit our long term guidance of high single digit EPS in spite of those cost pressures.

But I'm obviously not going to get into what we're going to do on a pricing standpoint.

I appreciate the question.

Thank you, Carlos.

Thank you.

Your next question comes from Jane Mehring with Salomon Smith Barney.

Mehring (ph): Good morning.

Good morning, Jane.

Mehring (ph): For the guidance for next year which is basically 17 cents of growth, and I just want to go back to this issue again.

If I remember direct correctly, earlier comments in the company had said I think you were this year ash associating about absorbing 7 cents of stuff on the negative side that wouldn't necessarily be recurring next year.

You got a lower tax rate I think it's about 4 percent, you have incremental synergies from Keebler which have already been pointed out which I think is 7 cents.

So all in -- to play did he have ill's advocate, if you take all those things, that's really all your growth next year, and at the high end of your range.

So in a sense, how is this a sustainable business model when it feels like most of your growth is coming from , you know, some of these other things?

And you still need to raise your value added promotional levels?

If you want to talk about the unusual things.

Mehring (ph): I know there are unusual things for next year, like pension, like commodities and such.

Just before asking John to get into some of the specifics, please recall that we are investing in brand building.

So the sustain ability of the model is that we're able to increase our investment in new products, in marketing, in consumer promotions, in sales executions, and that's really what enables us to sustain the growth.

Mehring (ph): Right.

But -- and I appreciate that.

But what I'm saying is you have the ability to reinvest.

But if you strip out those other things, it looks like you'd sort of be -- what growth would you really be having in operating profit in EPS without some of the things that I named?

I mean it's great that you have Monday toy plow back into your business to keep your top line growing.

Right.

Mehring (ph): But without, you know, quote, incremental synergies from Keebler and the absence of restructuring costs and the lower tax rate -- I mean there are always sort of issues that come up that can be negative that a company has to face.

Okay.

Let me just take a stab at your question.

I agree that the dollar 73 this year is very high quality.

We've absorbed integration costs, dilution [inaudible] bake line the assets that you pointed out.

We are showing very strong mix in the business.

We are predicting very high increases in commodities and pension costs.

Partially offset by productivity issues not fully offset, and including the final year of Keebler synergies as well as bake line dilution.

As we look to the future, that dollar 86 to dollar 90 enables us to continue to reinvest in the brands that we need to.

I think all the one time items you merged and you add all those up they're still considerably less than the commodity and pension combination -- in combination.

So I think the size of the cost increase there might be more than what your [inaudible] math would come up with.

Jane, I actually like the fact that we're able to take some of these one time charges given behind us and not have to make a big deal about them.

It is a reflection of the quality of our delivery.

Mehring (ph): I'm not trying to penalize you for having quote good earning quality this year.

I'm just sort of talking about -- unless you're assuming there's some other stuff that we're not even seeing yet that you're going to be ash absorbing next year like other restructure or integration or something like that.

But again, I'm not trying to take away from you your better execution, your much improved business month model and your rational thinking in the great cash flow, but this is just a little devil's advocate there.

Okay.

But it still looks good, though.

Mehring (ph): Are you asking or telling me?

I'm telling you.

Thank you, Jane.

Mehring (ph): Thank you.

Your next question comes from Chris Growe with A.G. Edwards.

Growe (ph): Good morning.

Good morning, Chris.

Growe (ph): Good morning.

My question for you, I just one of them here is relative to your gross margin expansion which you said is going to be limited going forward given the cost pressures among other things, what's that going to allow for in spending growth and I guess maybe a larger question is what are we leaded for in terms of marketing in terms of percent of sales?

Is there a goal in mind over multi year period?

We're looking to increase our obviously our gross profit ahead of our sales and that will fund marketing investment around that level, slightly above gross profit expansion.

So as opposed to a net sales target that we have in mind, what we'd like to do is on a consistent basis have our investment in grand building out brand building out pace our sales.

Growe (ph): So does the slower gross margin expansion work against those plans in the near term?

Well, it may not be there as much as we'd like it in the first couple of quarters, you know, because of commodities, but over time, we see consistent improvement in gross margin.

We don't think that any short term cost pressures will impede our ability to invest behind our brand.

It's all part of our guidance and it's all part of our plan --

Just to add to that, Chris, we will be using a lower tax rate to help fund the brand as well.

Growe (ph): That's helpful.

Thank you.

Thank you.

Your next question comes from Rowme Thanali (ph) with Goldman Sachs.

Thanali (ph): Good morning.

Carlos, debt repayment still seems to be the priority for free cash flow use.

But given the success of the Keebler acquisition and how smoothly you were able to integrate it are acquisitions moving up on your priorities list?

We're always keeping our eye open.

We're always in the market, we're always looking at things that interest us and exploring options.

Frankly, I don't see much out there at this point that would make us change, but you can be sure that we'll continue to look.

We are going to be very selective, so we're not -- we're never going to go back, we're never going to go to an acquisition, but within that selectivity.

We're always keeping our eyes open.

Thanali (ph): Could you talk about the type of acquisition opportunities that you take a look at and also whether you would contemplate teaming up with another food company to pursue an acquisition?

In terms of acquisitions we look at, as we mentioned over the past year, we're being very selective.

We're looking at acquisitions that are close in acquisitions that can expand our current portfolios, whether it be serial, whether it be snacks.

Acquisitions that can either use our capabilities or bring us a new capabilities, but pretty much which Ives acquisitions that are pretty close in.

I don't see us doing something dramatically different get into a dramatically different category.

We're going to stay very stoke focused.

We have a simple business.

It's very contained within the supermarket, really simple raw material, simple manufacturing, want to keep that.

In terms of whether we team up with someone else, I'd rather not get into that.

It's all speculation and there really aren't any plans or anything going on.

Thanali (ph): Okay.

Thank you.

Thank you.

Your next question comes from Christine McCracken with Midwest Research.

McCracken (ph): Good morning.

Good morning, Christine.

McCracken (ph): John, if I could go back to the commodity exposure, you had mentioned some relative price changes in corn oil, wheat and cocoa.

Wondering, are you using those expectations for the remainder of the year or is it your expectation you could have some benefit in the second half of the year if the new crop comes in?

Christine, we're expecting the counter prices to moderate across 2003.

McCracken (ph): So, in fact, you'd have more of a hit in the first half of the year and probably some benefit in the second half?

That's exactly right.

McCracken (ph): And in particular, is it my understanding that wheat is your largest exposure at this point and could you give some relative idea as to maybe some exposure there?

Well, we certainly allow exposure, it's one of the our largest.

Cocoa also is quite large with the Keebler products consumer international businesses having some heavy chocolate.

So in terms of the two it's probably though two.

Even a little bit of packaging inflation causes -- can cause some fairly large dollars in terms of inflation.

Put that in context, though, the ingredients and packaging is only 50 percent of our cost of goods, I don't want to over state the impact.

McCracken (ph): Thank you.

Thank you.

Thank you, Christine.

Your last question is from Andrew Lazar with Lehman Brothers.

Good morning.

Good morning, Andrew.

Just with your renewed focus on revenue versus just volume growth, I'm curious if your cost structure and sort of your manufacturing capacity is commensurate with that with that type of focus.

Or do you think over the course of the next couple years more rationalization could be necessary on that front?

It's a very broad question.

As you know, we are running our manufacturing facility extremely hard, and our focus on dollars versus volume allows us to use our capacity more efficiently and more effectively because we're using our capacity to manufacture the highest -- highest value and highest margin opportunity.

In terms of consolidation opportunities within our system, we've got a very broad manufacturing system.

We have our serial network, we have our bakery network in the U.S. cereal we're always looking for opportunities.

We have the next wave of Keebler synergy, so we're always looking for ways to be more efficient, for ways to extract more value out of our assets. and that's an ongoing task.

We believe very strongly in utilizing our assets as hard as we can.

We're doing that today.

It helps us minimize capital, it helps us maximize our productivity, and we're going to do that ongoing.

You've done a lot of it obviously in the past already and there's nothing that generally stands outright now as out there in terms of needing to be dealt with sooner than later.

You feel comfortable at the moment anyway?

Yeah, that's right.

If anything, Andrew, we just bought this large bakery network in the U.S. and we're applying and will be applying many of the principles that we've used on the serial side.

So that's really our next opportunity to look at, you know, consistent productivity gains will be there.

Thanks very much.

Thank you.

Operator, I think that's all we have time for.

Okay . this concludes today's conference call.

You may now disconnect.