家樂氏 (K) 2005 Q2 法說會逐字稿

Good morning and welcome to the Kellogg Company 2005 second quarter earnings conference call. [OPERATOR INSTRUCTIONS].

This call is being recorded.

At this time I would like to turn the conference over to Mr. Simon Burton, Kellogg Company Director of Investor Relations.

Mr. Burton, you may begin your conference.

Thanks, Amy and good morning everyone and thanks for joining us for a review of our Q2 results and for some discussion regarding our strategy and outlook.

With me here in Battle Creek are Jim Jenness, Chairman and CEO;

David Mackay, President and COO;

Jeff Boromisa, CFO; and Gary Pilnick, General Counsel.

We must point out that certain statements made today, such as projections for Kellogg Company's future performance, including earnings per share, net sales, brand building, operating profit, cash flow, share repurchases and debt reduction 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 reply of today's conference call will be available by phone through Monday evening by dialing 888-203-1112 in the U.S., and 719-457-0820 from international locations.

The pass code for both numbers is 5849454.

The call will also be available via webcast, which will be archived for 90 days.

So now let me turn over to Jim Jenness, Chairman and Chief Executive Officer.

Thank you, Simon and good morning, everyone.

We are pleased to report another quarter of strong financial results.

We again saw strong growth throughout our business, which led to better than expected results across the P&L.

Obviously, our business momentum continued in Q2 and we used that momentum to invest in our business.

Sales growth was again very strong.

Reported net sales grew by 8.4%, which added to the 6.1% we posted last year.

Internal net sales growth, which as always excludes the impact of foreign exchange, acquisitions, divestitures and differences in the numeric of shipping days, was 6.6%.

This built on internal growth of 4.6% in Q2 of 2004.

Gross margin expanded by 110 basis points.

Gross margin expansion is a very important component of volume to value and we were very pleased to see such strong results.

Remember, gross margin expansion provides the opportunity for us to invest in our business, and as you all know, benefits costs are treading higher so we pleased to post margin expansion, despite the challenging environment.

We invested in the business and executed well.

As we said last quarter, we continue to invest in cost reconduction projects and of course, we invested in brand building and innovation during the quarter.

More importantly though, we executed behind our ideas and drove sales growth.

In fact, it's this momentum and the excellent results we have seen in the first half of year that allows to us raise our full year guidance, while investing even more in the business over the remainder of the year than we had previously planned.

We want to achieve good results now and into the future and this increased level of investment represents our commitment to invest in our business for the long-term.

We have a strategy and operating principles work.

We strive to deliver dependable sustainable rates of growth, and that goal will not change.

Slide 4 details some of the key financial highlights of this excellent quarter.

Net sales increased by 8.4% as a result of the broad-based strength I mentioned and continued momentum.

Internal sales growth, which excludes the effect of foreign exchange, was 6.6%, significant growth over last year.

The favorable effect of currency translation accounted for the difference.

Operating profit increased by 7.8% and internal growth was 6.2%, right in with our long-term targets.

We increased brand building investment at a double-digit rate, outpacing sales growth, we continue to face benefit cost increases and we absorbed in excess of 3% of up-front costs in line with last year.

Earnings per share grew by 9% after increasing 14% last year, and year-to-date cash flow was $474 million, an increase of 22% versus the comparable period last year.

Let's look at these results in more detail.

Slide 5 shows our net sales growth in its various components.

Reported sales growth was 8.4% in Q2, driven by strong internal sales growth of 6.6%, which built on 4.6% internal growth in Q2 of 2004.

The favorable effect of currency translation added 1.8% to reported growth due to the relative weakness of the U.S. dollar.

As you can see internal growth came from both price mix improvements and tonnage growth.

The price mix increase of 1.9% was driven by mix and by price The improvement is mix is also an important part of volume to value.

The price gains came as a result of price increases during the past year, including last year's July U.S. cereal price increase.

Know too, that tonnage increased by 4.7%.

The first quarter's momentum continued in Q2 and provide us the flexibility to continue to invest in our business.

As can you see in slide 6, which detailed our investment in brand building for Q2 and the year-to-date period.

Our long-term strategy is to increase investment and brand building at a rate greater than sales growth.

In fact, we increased this investment at a double digit rate in Q2 and expect to achieve our goals for investment over the full year.

Remember that for us, brand building does not include trade promotion, just advertising and consumer promotion.

We see a lot of opportunity to continue the increase in investment in brand building in all of our businesses.

Brand building and innovation are essential for our continued success and we intend to focus on becoming even better in the future.

We have done well over the past few years, but we have a long way to go.

In a moment, David will review each our business in more detail, but first let me turn over to Jeff Boromisa to talk you through our financial results.

Thanks, Jim and good morning.

As Jim discussed, our gross profit margin increased by 110 basis points during Q2.

We were especially pleased as this was significantly more than our long-term target for an improvement of 50 basis points per year.

The improvement was driven by various factors, continued productivity gains, resulting from previous cost initiatives, gains in price mix, operating leverage and favorable commodity costs.

These factors result from the execution of our volume to value and manage for cash operating principles.

These gains more than offset the $0.1 incremental investment in cost to goods sold from up-front costs in the quarter.

In addition we also offset significantly higher benefit and energy costs.

We expect a continued mix improvement, operating leverage and productivity savings will more than offset the continuing negative cost pressures that we see.

Now let's turn to the operating profit growth by business.

Slide 8 details this growth by each our geographic reporting areas in Q2, and as it does every quarter, internal growth excludes the benefit of currency translation.

In North America, internal operating profit growth was 9%.

We increased our investment in brand building at a double-digit rate in the quarter.

Keep in mind that all of the up front costs year-to-date have been recognized in North America so we are very pleased with this quarter's resulting.

In Europe, operating profit growth was down 1.9%.

This was due to expected sales growth, impacted by issues with the customer, cereal and snacks performance in the UK and a double-digit increase in the area's brand building investment.

In Latin America we increased our investment in brand building at a double-digit rate, and posted internal operating profit growth of 1.1%.

As you remember, last year, Latin America posted a strong 14.2% operating profit growth.

Sales were strong enough in this business that we could significantly increase our investment in brand building and still achieve targeted levels of operating profit.

We also increased brand building investment at a significant double-digit rate in Asia-Pacific and saw internal operating profit growth of 24% on an easy comp, so we are very pleased with this quarter's 6.2 operating profit growth.

As we invested in future growth in each of our businesses, in addition, as I said earlier, we recognized more than $0.0 3 of up-front cost in the quarter.

Below the operating profit line the tax rate of 33.1% was slightly lower than last year's rate of 33.5%.

Interest expense was higher due to a premium related to the early retirement of debt.

Benefits from lower short-term rates in the remaining quarters of the year will partially offset this expense.

We continue to expect that the full year tax rate will be approximately 33% and that total interest expense for the full year will only be slightly lower than last year, due to the timing of bond maturities.

Slide 9 shows our continued improvement in core working capital, or receivables plus inventories, less traditional payables.

This excludes customer trade liabilities.

Divided by our last 12 month's sales.

This was our 16th continuous quarter of core working capital.

We continue to expect that core working capital as a percentage of sales will improve over a more moderate pace, but over the long term, we don't expect to be a significant source or use of cash.

Slide 10 shows our cash flow performance for the year-to-date period.

The increase is due to earnings growth and lower contribution to benefit plans.

You remember that we made an interest payment of $112 million in the first quarter of 2005.

The corresponding payment in 2004 fell during the second quarter.

The distortion has corrected it itself for the year-to-date period.

So we are very pleased with the excellent year-to-date results and expect to reach our full year target of cash flow between $950 million and $1.025 billion.

Separately, we like many other companies are facing significant benefit cost inflation.

As a result we are reevaluating whether to make an additional contribution to benefit plans later in the year.

This would obviously affect the full year cash flow number.

We have successfully paid down a significant amount of debt since the acquisition of Keebler, and we have shifted to a more balanced use of cash flow by increasing the dividend and share repurchase program.

While we don't yet know whether it will be necessary to make any contribution, we are pleased that the continuing success of our manage for cash operating principle, provides us the opportunity to consider alternative uses for our strong cash flow.

Slide 11 shows the progress we made reducing our debt in recent years.

Our long-term target remains to reduce debt by approximately $300 million a year.

As you can see, we have already reduced debt by $257 million year-to-date.

And through the end of Q2, we have completed a little more than $260 million of our current $400 million share repurchase authorization and are ahead of schedule.

Slide 12 details the progress we made with our return on invested capital in recent years.

We recognize the importance of the return we generate on our capital, and are pleased to have posted steady improvement over the past few years.

Buying to value and manage for cash are our ways of keeping the organization focused on the right metrics, and it is because of this focus that we remain confident that return on invested capital will continue to increase in the quarters to come.

So finally before I turn it over to David, I would like to discuss slide 13 and our financial outlook for the reminder of the year.

Momentum continued in the second quarter, and while we obviously don't expect that the 8% sales growth we have seen in the first half of the year can continue in the long-term, good momentum and strong results gives us additional financial flexibility for the reminder of year.

That is why we are increasing earnings guidance to a range between $2.30 to $2.33 per share.

We continue to expect that up-front costs for the year will be approximately $0.15 per share.

A majority of this amount is related to the snack's capacity rationalization we announced last quarter, the remainder of the year's up-front costs will be split approximately evenly between the remaining two quarters of the year.

You remember that we said last quarter we expected benefit costs with negatively affect annual earnings per share by up to $0.10 per share.

Halfway through the year, we now see the increase in benefit costs coming in around $0.7 per share in 2005.

However, much higher than expected fuel costs are negatively affecting earnings by more than we anticipated and have essentially offset the lower than expected benefit costs.

We'll continue to focus on our future growth through aggressive investment and brand building.

We have very strong innovation planned throughout the balance of year and intend to fully support its introduction with greater than expected investment and brand building.

With that, let me turn it over to David for a review of our businesses.

Thanks, Jeff.

Let's now take a look at our results by business segment and if you look at slide 14, it shows a continued internal growth posted by each North American businesses during Q2.

Growth was again broad-based across cereal, snack and frozen and specialty channels, and note that the growth of 8% in North America, compared to a strong 4.5% growth in the second quarter of last year.

Now let's look at each these businesses in slightly more detail and in slide 15, you see the internal cereal net sales growth was an impressive 10% in the second quarter.

After introducing new cereals at the start of the year, we followed in Q2 with more new cereals including Toasted Honey Crunch and Cran-Vanilla Crunch, and they joined our popular Raisin Bran Crunch brand, and we also introduced new Special K fruit and yogurt.

So we benefited in the second quarter from the introduction of a number of new products.

Also our retail sales team got our innovation on the shelf faster than ever before.

While it's early with some of these products we are happy with the initial acceptance.

Our Canadian business also did very well, posting double-digit net sales growth in the quarter.

That was led by strong performance from Special K and All-Bran innovation in the first quarter and a new variety of Mini-Wheats in Q2.

As you are seeing in recent measured channel data, we have gained a significant amount of share in recent months due in part to the successful new products, and we'll have more to come.

This activity is essential to the success of volume to value and we remain very focused on the innovation process.

We also executed some very successful brand building programs.

The Raisin Bran Crunch series of ads has driven sales.

The fiber message delivered in our Mini-Wheats advertising has also been successful, as has the All-Bran campaign in Canada.

Having the right ideas for new products and existing brands is a very important driver of our sales growth.

Once again, there is a sizeable difference between the sales growth suggested by public take away data and our actual results.

A very small part of the difference is due to the shipment of innovation, during the second quarter, that isn't yet reflected in public data.

However, when we analyze the data we found what we saw in the first quarter, a significant percentage of the difference is attributable to non-measured channels and while inventories levels are up slightly from last year's relatively low levels, they have actually decreased from the end of Q1 and are well within our average range.

Slide 16 highlights some of the North American innovation and consumer promotions planned for Q3.

With some great new products planned for introduction, in cereals, snacks, and frozen, these include split stick Rice Krispie Treats.

A new oatmeal raisin All Bran bar, a chocolate Special K bar, some new fruit snacks, some holiday themed cereals and two new flavors of Kashi hot cereal.

The Star Wars promotion we ran in Q2 was a huge success, not only in the U.S. but also in international markets and we have additional promotions planned in the remainder of 2005 and into 2006.

For 2005, promotions include a tie-in with Disney World's 50th Anniversary celebration, and sponsorship of the popular American Idol tour.

Let's turn to slide 17 and a more detailed look at our snacks business.

The strong results posted over of the last few quarters continued in Q2, in fact, our snacks business in combination posted an excellent 8% internal sales growth rate, And our DSD system continues to execute with excellence.

We have launched some great new products this year and have invested in brand building behind Fudge Shop, Fruit Sandies, the lemon and white fudge raspberry, and new Grip's product, Cheez-it Twisters in cool ranch and cheddar flavors and club snack sticks.

While some of the categories remain challenging, we posted good results in each of the business segments as you can see on slide 18.

Net sales of Pop-Tart toaster pastries increased at a high single digit rate, as a result of growth in both existing products and products introduced in the last year.

We are more innovation planned for this brand and are very pleased with the excellent results of of the last few years.

Our crackers' business posted mid-single digit net sales growth, driven by growth in various brands including Club, which saw growth both in the original and new snack sticks varieties.

Cheez-It also posted strong growth, driven in part by innovation, including the new Grips product and new Cheez-it Right Bites 100 calorie pack.

We'll also introduce new crackers in Q3, including Cheez-It Fiesta.

A crispier Cheez-It in two flavors, cheesy taco and cheddar nacho.

Net sales in our cookie business decreased a a low-single digit rate, driven solely by timing of innovation which shipped in Q2 of last year, including the three SKUs of the Chips Deluxe Low-Carb cookies we launched.

Excluding this effect, our cookies business would have posted a mid-single digit rate of growth, driven by strong results from our Fudge Shoppe, Chips Deluxe, and Soft Batch brands.

Chips Deluxe Right Bites and Grips also added to the growth of the brand, although the base brand posted double-digit growth.

In addition, our caddie packs continued to post good results, and our wholesome snack business again posted good growth as a result of continued strength from fruit snacks, Rice Krispie Treats, Special K bars and the popular All Bran bars and we have a new All-Bran bar and two Special K bars planned for introduction soon.

We are very pleased with the year-to-date performance of our snack business and have more brand building planned, including support for Cheez-it Fiesta, the two new Special K bars, and Grips and Fudge Shoppe.

Slide 19 shows a continued strength of our North American frozen and specialty channels business units.

Internal net sales increased by 5% in the second quarter which built on last year's toughest comp of 5% growth.

Eggo posted strong high single digit sales growth, driven by both existing products and innovation.

With more innovation and associated brand building planned for the second half, new products include waffles, pancakes and a new flavor of Toast It Swirls.

Morningstar Farms posted low-single digit growth and the specialty channel posted high single digit sales growth, driven by strength in food service and club.

These businesses continue to develop products and packaging, specifically for these channels and execution has been excellent as you can see.

We have a new meal starter product planned for introduction by Morningstar Farms in the second half, and we'll also support the introduction with brand building.

Let's now turn to slide 20, which details reported and internal sales growth to Kellogg International.

Reported sales growth in Q2 was 7%, and internal growth, which excludes the favorable effect of foreign currency translation was 3%, and once again, each of our geographical areas added to this growth.

So let's take a look at the results in a bit more detail.

Slide 21 details the internal net sales growth posted by each of our international areas in the second quarter.

Europe posted internal net sales growth of 1% with retail cereals approximately flat.

Our retail cereals sales declined slightly in the UK due to the timing of programs and innovation, with innovation -- new innovation shipping right at the end of Q2.

In addition, we continue to face weakness in Germany, and an issue with one customer in Europe which had a significant effect on sales growth.

Fortunately this situation with the customer has recently been resolved.

Special K, Frosties, Coco Pops and All-Bran all posted good growth across Europe and new innovation launched late in the second quarter appears to be doing well.

This includes a new variety of Special K and Crunchie Nut Nutty in the UK, and we have more to come in the second half of the year.

Across the rest of Europe, innovation and brand building programs, including the successful Star Wars program added to sales.

New innovation, including Special K milk chocolate in France, Special K yogurt in Spain, and All-Bran flake cereal and All-Bran bars in Italy.

Latin America posted internal sales growth of 8% as a result of strength in both of the cereal and snack businesses.

Mexico posted good growth as a result of the success of Star Wars promotion and strength in many of our core cereal brands, including Special K, Frosted Flakes, Corn Flaked and Choco Crispies.

We have introduced new products, including a Choco Crispies bar, a new variety of Nutri-Grain bar and we have more planned, including a new variety of Rice Krispies, and a new Kellogg's "Go", a coffee cappuccino- flavored cereal, aimed at adults and various in and out products.

Australia reported high single digit internal sales growth, and we saw strong results in cereal, driven by All-Bran, Special K. Guardian, and Sultana brand.

We also saw good performance from Nutri-Grain bars and like many of our businesses around the world, Australia also benefited from the success of the Star Wars program.

In addition, this business has a lot more innovation to come in the third quarter, including a Guardian Oat Puff cereal, Be Natural Muesli cereal in three flavors, and new varieties of K Time bars, Nutri-Grain bars and Special K bars. posted high single digit sales growth.

And in Asia we also posted high single digit sales growth.

We saw a strong growth in our adult cereal brands in Japan as Bran Flakes continue to post good results.

We launched Frosty's Plus in Japan at the beginning of the second quarter and are pleased with the initial results.

And again our global Star Wars promotion was very successful in Asia.

Korea posted good growth in both our core brands and new products and we're now lapping easier comps in Korea after weakness last year.

We also saw good growth off a small base in India and we have various innovation planned for Asia, in the second half, including a national rollout of Special K in Japan.

We remain positive, but cautious about the second half of the year after a particularly strong first half.

No doubt the competitive environment will remain challenging and the added pressures of fuel cost and benefit cost increases have been factored into our view of the year to go, and now I will turn it back to Jim.

We are very pleased with the strong results we posted in the second quarter, and first half of the year, and remain comfortable with our outlook.

We posted strong sales, operating profit, and earnings growth, and we increased guidance for full year earnings while remaining committed to and even accelerating our investment in the business.

We have a proven strategy that focuses on our core categories and competencies.

We are committed to growing our cereal business, expanding our snacks business and pursuing selected complimentary growth opportunities.

We have self-sustaining operating principles and volume to value and manage for cash that focus us on the right metrics.

This focus and successful execution provides the resources necessary to drive future growth.

Over the past few years each of these things has helped us build a foundation for future growth.

Our Kellogg employees will not get complacent, and we will continue to focus on executing all that we do with excellence.

We realize that we must remain focused and increase our investment for the long-term, if we are really are to deliver sustainable, dependable growth.

Not just for this year, but for the foreseeable future.

And with that I would like to open it up for questions.

[OPERATOR INSTRUCTIONS].

Our first question comes from Mr. Tim Ramey with D.A. Davidson.

Good morning, congratulations.

Good morning, Tim.

Am I to conclude that the debt or early pay down of debt was a $0.02 since $0.01 was in cost of goods sold?

The early retirement of debt that we did in the quarter here, we had to pay a premium to retire that, and it was approximately $0.02 in our interest expense line.

Okay.

Great.

And thinking about the 10% increase in ready to eat, can you break down what that was in terms of volume versus price mix in cereal only?

Tim, it was roughly about half-and-half, volume and price mix, and clearly we got, in price mix we got a fair amount through in price.

Terrific, thank you.

You know, Tim, this is Jeff, on your first question about the debt maturity, just to make sure you are not confused that is not included in our up front costs.

Up-front costs are cost initiatives that are separate from something like that.

Thank you.

Thank you.

Once again please limit yourself to one question during the Q&A session, in order to allow participants wishing to ask a question to do so.

Our next question comes from Terry Bivens with Bear Stearns.

Good morning everyone .

Good morning Terry.

Adhering to the one-question rule, I think this is the greatest disparity I have seen between your reported number and what is suggested by the market share data.

Could you give us just a little bit more color on where that excess is coming from.

Is it mostly an Arkansas retailer or perhaps a little more color there, if you don't mind.

Terry, we said in the sculpt and it's true, the bulk of the growth in the disparity between ROI, again as it was in the first quarter, is a non-measured channel.

The vast majority of the difference and as we said in the first quarter, I don't think this is going to change.

There is a big difference.

I know it makes it very difficult for you, but we posted the numbers.

We are very happy with that and it's a great level of growth for us and it came the right way behind innovation and very strong brand building.

Well, it seems sustainable, but it certainly seems to be accelerating.

Is that a fair conclusion to draw?

Certainly the second quarter was very strong and going forward our expectation would not be to plan on that level of growth .

Okay.

Thank you, David.

Thank you our next question comes from John McMillin with Prudential Equity Group.

Good morning and congratulations.

Good morning, John.

Just a comment before my question, I guess.

According to Nielsen and including Wal-Mart panel data, the three months ending July 2nd, Kellogg's dollar sales are up 4.5%.

David, is that comparable to what you see?

Well, I'm looking at ROI and ROI is actually slightly lower than that, to be honest.

But the numbers are the numbers and I think the non-measured channel influence, John, is so significant, that even though they say they have it from a panel perspective, we are reconciled the numbers and we see a big difference between what we are actually doing and what the panel is reflecting us as doing.

What are you seeing?

That is what we see of the what the panel is telling you is actually happening is significantly understating the realities of the marketplace.

I think I was just asking what number do you see as your takeaway for the three months?

If 4.5 is not the right number and ROI is not the right number, what do you guess is the right number?

We did for North America plus 10%, and if you exclude the impact of innovation for that, which might have been a point or two, then our takeaway across North America is round about 8%.

You are not making private label, are you?

No, we are not.

And now if this counts a question, I don't know, but the retailer you are talking about is in the UK, right?

It's in Europe.

Oh, yes.

I know it's in Europe and I asked is it it in the UK?

It is not.

Okay thank you.

We'll take our next question from David Driscoll with Citigroup Smith-Barney.

Good morning everyone.

Good morning, David.

Continuing on the cereal comments, Terry was suggesting that cereal was accelerating, but I would take the question in a different line of logic here.

The category itself, I think a number of players benefited from the very high promoted prices by General Mills and my question to you would be, were you budgeting for 10% sales growth in cereal, and really this speaks directly to the sustainability of that number, given what I would argue may be a very odd situation that we had in the quarter with those promoted prices?

David, this is Jim, for us to budget 10% would have the courage that we just do not have and so no, we didn't and the performance and the momentum in the business is very encouraging, but we did not budget 10%.

Given the fact that you would have benefited from something you didn't budget for, what areas came out weaker than you expected?

Well, we are reflecting stronger results and you are seeing that in our official reported versus what we are anticipating.

Another thing, David on promoted prices, through the second quarter, Kellogg promoted prices were up over 5%, 5.2% for the quarter.

Our base prices were up a couple of points.

We gained quality merchandise with higher promoted prices.

We just performed extremely well during the quarter.

We intend to try to maintain that performance and drive it through innovation and brand building as we go forward and our investment levels in that regard around the world on innovation and brand building are going to accelerate so we can drive sustainable growth into the future.

If I could just sneak a quick question to Jeff.

Could you give us a quantification as to what the commodity costs benefit were, and I noticed in your press release, that you broke out your language between energy cost and then you make the phrase "Lower commodity cost" in the same sentence so I assume that energy is a separate commodity cost versus what you are putting in the other bucket?

Yes, David, our commodity costs were probably approximately $0.01 favorable, but offset by the high fuel cost particularly in the energy cost that we see.

Okay thank you.

Thanks, David.

Thank you, once again as a reminder, please limit yourself to one question during the Q&A session, in order to allow all participants wishing to ask a question to do so.

Our next question comes from Jonathan Feeney with Wachovia.

Hey, guys, congratulations.

Hey Jonathan.

Should the cereal category become more competitive, and you mentioned you continuing difficult competitive environment, and I guess I would argue that you ain't seen nothing yet as far as the competitive with the another major branded competitor and given what they are saying about the merchandising support and frankly, merchandise price reductions they are willing to take to get market share back.

Should it become substantially more competitive, are you willing to trade volume for value once again?

How aggressive are you going to be about defending market share over the second half of this year?

Jonathon, the one thing we know is what does it take to drive this business in the category for the long-term and it's about brand building, and that our focus, our re-investment into the brand is what we'll continue to do and that is the piece and that is the place that is underneath why our business is performing the way it is right now.

We certainly want to stay competitive in a price and merchandise area, but the place you add value to and grow your business is innovation that sustains itself with good economics, investment against your core businesses, and this is across all our core businesses around the world.

I just might add we emphasized in the second quarter that we significantly, as we saw the performance coming in, reinvested in our business, and you are going to see that continuing in the second half of the year, particularly in Q3.

A lot of the innovation we put out there, we want to continue to invest in it and make it go and that includes the innovation we put out in the first half.

As you anticipate what you're going to be seeing, anticipate further investment in our brands.

Okay, thank you.

Our next question comes from Eric Katzman with Deutsche Banc.

Hi, good morning.

Hi Eric.

One question with 15 parts.

Just kind of clean up here, I think you said $0.01 of the up-front cost was in cost to goods so $0.02 in SG&A?

Is that right?

No, all $0.03 were in cost of goods sold.

Okay, so $0.02 was asset write-off and $0.01 was up-front?

The $0.03 is a combination of asset write-off for the capacity rationalization program and severance.

It's all in cost to goods sold.

It's $0.01 more than last year's is probably where you are coming from.

Okay and in the interest expense forecast you gave, does that include the $0.02 impact from the amortization of the bonds?

Yes, it does and our guidance for interest expense is to be slightly below $300 million.

Okay.

And now for my real question, you do a great job in describing what sounds like a million new products with a million flavors and a million SKUs.

And quite honestly, however money flavors you introduce of whatever in Australia, that means nothing to me to the extent unless you kind of say what percentage of your volume this quarter, or your sales came from new products globally versus a year ago, or how are you tracking on an annual basis?

Because it sounds impressive and I'm sure your sales suggest it is, but just these little examples just really, I don't know what to make of it.

Eric, with all respect to you, we are not trying to impress you with our new products as much as our consumers, and you recall Special K with red berries when that first came out, and perhaps folks would say it's another flavor and another type and think about what how that has performed, how it has performed over the years, and additional line extensions within the Special K brand.

Those types of additions to the brands highly productive to where our consumers involving these brands.

One of the key drivers in the ready to eat cereal business is your share of innovation on an ongoing basis and that is what we track.

That is what we look at.

And dominating and doing a good job and innovation relative to the market share is a key dynamic and hopefully that is helpful to you in terms of what we are trying to do as we look at our cereal businesses around the world, and obviously, one of the reasons our cereal business has been doing, as well as it has been is the success of innovation.

But I understand that obviously, and I recognize that it's working, but a lot of companies will give a percentage of sales from new products, however they define it.

Line extension is a new product, new flavor is new product, bigger packaging is a "New product."

But some measure what it is.

We can give you the measure of we have driven up innovation as a percentage of sales on a rolling three for the last three years and we target mid-teen's number on annual basis from innovation and that have varies market to market, category to corroborating.

Broadly, that's where we're targeted.

We weren't there two or three years ago.

We are there now and our intent to is try to maintain that level, which as Jim said, may consume a need, hopefully differentiate

Thank you.

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

Good morning and congratulations.

Thanks, David.

What a great performance and it sounds like a great pipeline.

I guess what I'm struggling with is why the back half should slow down so much, after I adjust for lower up-front costs tracked out the extra week and now the lower interest expense, I'm getting very little bottom line growth in the back half.

Are there challenges here I am not seeing?

David, just to put some context around that.

We did have a strong first half, up about 6.5% for the first half and we are expecting for the second half actually growth ahead of our long-term targets.

As I mentioned earlier and David also mentioned this, this innovation we are putting in the market, this additional innovation, we are looking to invest in these businesses to drive them and get them up and going to generate the kind of trial that we need.

So we are giving you a head's up to continue to watch for the increase in brand building.

If you look at the comps last year, we are coming off of very strong comps, and Q3 last year of up 5% and little over 4% in the fourth quarter of last year.

So you put the mid-single digit growth in the second half on top of those comps and clearly we are recognizing a competitive environment we are in, which is difficult and maybe even gets more difficult, so we are trying to reflect that and build our plans around that.

I guess if I could do a follow-up, are you assuming currency tail wind turning into a head wind and within that benefit cost are lower, why are they coming in lower?

Well, we always have an assumption on inflation and health care and throughout our internal programs we have done a little bit better in trying to mitigate some of that increase, and that is where we see some of the lower cost increase this year than we thought.

But on your first comment, the one less week in the second half of this year versus last year is almost about $0.05 of EPS, and even though the benefit costs are a little bit lower they are still up significantly versus last year.

So when you factor that in with our focus and investment in brand building in the second half, it makes our guidance come out to what we indicated.

Okay.

Thank you very much.

Thank you.

[OPERATOR INSTRUCTIONS].

Our next question is Chris Growe with A.G. Edwards.

Good morning.

I will keep to this one question and I'll continue on asking on the cereal category, but there is a new Special K knockoff that has come out and I'm curious, last quarter you discussed how private label had done versus your brands, and if there's any data and if you would consider yourself being on the defensive, given the way private label continues to grow so robustly.

Chris, firstly, we are never on the defensive, but specifically talking about private label, we've continued to track where we are, and it's remained fairly consistent, private label for the latest twelve weeks is up 8.5%, measuring channel data, core Kellogg knockoff, they're growing 2.7, and the remaining private label outside of what Kellogg has are up to about 11.6, so the trends, the private label to be disproportionately hurting other players in the category relative to Kellogg is there and the same trend is also true in private label getting its growth of over half of the growth of private label came from two retailers.

You know who are taking a particularly aggressive approach on driving their private label.

So the other thing as I said, I think at CAGNY is, as we look at private label growth their comparatives in the first half versus the second half changed dramatically and as we told you then, and as we'll reinforce again, we do expect private label growth year-on-year to start to slow as we go into the third, and later the fourth quarter.

Thank you and sort of a clarification from earlier that European trade issue, that is resolved now and shouldn't have any effect on the third quarter, is that correct?

That is correct.

We put it behind us and that will start to positively impact third quarter relative to where we were in the second.

Okay.

Thank you David.

Our next question are comes from Leonard Teitelbaum with Merrill Lynch.

If you'll allow me just to tie two responses into one question, if I could, because I want to make sure I'm getting the right slant on this.

We know that promoted prices have started to move up and I think it's clear that general missile is going to come closer to the four-for-four.

From an environmentality standpoint would you see continuing to rise and the reason I say that is it would describe a much different competitive situation as Mills was to come down and you might go up.

Is that going to be the scenario, Jim, from your background with advertising, et cetera, how is Kellogg look at advertising since you took over versus when Carlos was there and what that might mean for margins going forward?

The folks running the advertising business since I have come in are the same folks running the advertising business before I came in, and they have been doing an absolutely excellent job, along with the agency partners we have long-term relationships.

I would just say that we see tremendous opportunity for to us continue to re-invest around our brands and a point that you may not realize is that within our portfolio and I will just take the U.S. for example.

There are significant number of brands that are unadvertised brands, and we look at the result of our business where we strong copy and put the pressure and the adequate amount of media behind it, we see significantly different performance and more positive performance than against our unadvertised brand.

So one of things that teams have been doing around the world have been looking at your portfolios and what as we develop more financial flexibility and more money to invest, what are those brands that are sitting there that we can really drive against and that is one of the that we can really drive against and that is one of the things we are really excited about, about continuing to drive that process as we go.

If I could just add something on pricing and we don't comment on what is going to happen in the marketplace, because that is not really within our control, but our promoted prices are up and up across the category apart from private label and Malt-o-Meal, and we'd expect that probably to continue the at the end of the day we are getting quality merchandise with higher prices because we're putting added-value consumer programs and programs that our trade customers want together to help them drive sales through their stores.

We think it's better to add value in that way than to focus on price.

Price say differentiator in our category and most categories that we observed, may work short-term, but doesn't sustain a business long term.

So Jim has already said, we are going to focus on innovation brand building and bringing value to our trading partners and we believe that is the best way to grow our business, the category and sustain it into the future.

For clarification, does that mean that traditionally 48% of cereal sold on promotion may actually come down in terms of total amount of sales?

I wouldn't speculate on that, but you know, they wrap into that number all forms of promotion.

If you are on a display with a give away that can sometimes include that, so it's a very loose measure I would say.

Thank you very much.

Thanks.

Our next come comes from Andrew Lazar with Lehman Brothers.

Good morning Andrew.

In looking at some of the paybacks on a lot of your up-front spending that you have done over the several years and you mentioned it in the remarks that that is helping the gross margin now from previous projects.

I guess, by our math, it would appear that perhaps even as soon as next year, '06, Kellogg gets to a point where maybe some of the ongoing savings from these projects enough to offset the annual up-front spending that you will likely continue to do going forward, and it become accretive to the growth profile.

I'm trying to get a sense.

Do I have my math right or least in terms of the way I'm thinking about it?

Well, it's not the way we are thinking about it, to be Frank and I guess it goes back to the core of what we are trying to do, and that is to deliver sustainable, dependable performance.

So as we generate business and if we are generating positive returns in the business, we see as a continuing way of doing business,finding the cost initiatives that we can invest in to provide us sustainable and visibility.

Defined as we generate that financial flexibility, and the brand ideas whether it's new innovation or existing brands that we can drive behind and we see that as much more of our model going forward and there is nothing revolutionary about that.

That is what the company has been doing for the last several years and if we can keep that going and deliver sustainability to our shareholders, that is a win-win for every -- and the right way for us to be managing our business and driving the right kind of behaviors within our managers, in terms of not looking for the short-term hit, but really trying to invest and find the ideas that stick in the markets place.

I'm trying to get a sense of when a lot of these up-front spending becomes self-funding?

I'm expecting that you'll continue to reinvest aggressively.

What I am getting at is when do these become self-funding and therefore be a net positive to give you that much more flexibility around the spending that you will do going forward?

Andrew, this is Jeff and you are probably a little early in that assumption coming into '06, but I would give it a few more years out, and Jim is absolutely right, we take that money and we re-invest it behind our brands to give us the dependability going forward, but you are seeing it in our results right now.

Our gross profit margin for Q2 certainly has part of those savings helping that 110 basis points that we delivered.

And that will only build as you go forward because, more and more of the accumulative nature of these paybacks, which are pretty quick, as you've said in the past, continue to build in?

That is correct.

I think, Andrew, we see a lot of opportunities to invest for growth in the future and that is where we can see it a lot of the money going back for sustainable growth as we look out for the next two to three years.

Thanks very much.

Thank you, as a reminder please limit yourself to one question during the Q&A session in order to allow all participants wishing to ask a question to do so.

Amy, can we just take one more question, please?

Yes sir.

Our final question will come from [Bradley Keats with KDT Investments.]

Good morning.

Thank you for taking my question.

I was wondering if you could give us more clarification on the previously announced plan, to in the future, add Martek Biosciences' DHA to some of your food products and how that is progressing and what your plans are in that area for health and maybe getting additional added market share?

I think, Bradley, we are still in the exploratory phase of that.

So we really have nothing to talk to in the general market and when and if we do, then I'm sure we'll do it on a quarterly call.

Thank you.

Thanks.

Thank you and that does conclude --

Amy, I would just like to thank everybody on the call and their interest in our business and we look forward to seeing you over the coming months as we travel around.

Thank you that does conclude today's conference.

Thank you for your participation and have a great day.

You may now disconnect.