家樂氏 (K) 2006 Q2 法說會逐字稿

Thanks very much for holding everyone. Good morning and welcome to the Kellogg Co. 2006 second-quarter earnings call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question and answer period. (OPERATOR INSTRUCTIONS) At this time I would like to turn the call over to Neal Goldner, Kellogg Co. Director of Investor Relations. Mr. Goldner, you may begin your conference.

Thank you, Kevin, and good morning everyone. Thank you for joining us for a review of our second-quarter results and for a discussion regarding our strategy and outlook. With me here in Battle Creek are Jim Jenness, Chairman and CEO; David Mackay, President and COO, and Jeff Boromisa, CFO. We must point out that certain statements made today such as projections for Kellogg Co.'s future performance, including net sales, operating profit, cash flow, earnings per share, margins, upfront costs, and dividends 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.

Beginning with the first quarter of 2006, the Company adopted SFAS 123(R) and began to recognize expense related to employee stock option grants and reported results. To help investors understand comparable performance, we will consequently be using certain non-GAAP measures, such as internal operating profit growth to discuss 2006 results. Please refer to the appendix reconciliation to U.S. GAAP results at the end of this presentation. A replay of today's conference call will be available by phone through Monday evening by dialing 888-203-1112 in the United States and 719-457-0820 from international locations. The pass code for both numbers is 4817395. The call will also be available via webcast at www.KelloggCo.com, which will be archived for 90 days. And now I would like to turn the call over to Jim.

Thanks Neil and good morning everyone. We see our 2006 performance as evidence of the strength and sustainability of our business model. We express confidence that 2006 would be another year of sustainable and dependable performance during our January call, and again at CAGNY. During our April call we reiterated our confident view and raised our net sales guidance to mid single digit. EPS, to the top end of our high single digit target, and tightened our cash flow delivery range to between $900 million and $975 million. While absorbing an incremental $0.04 of EPS due to fuel, energy and commodity inflation. Our confidence to deliver the increased April guidance continues. Based on better-than-expected first-half results against difficult comps, a strong second half outlet and despite absorbing unexpected additional cost inflation. Cost inflation has gone from $0.16 of EPS in our original guidance $0.20 of EPS at the end of the first quarter and now stands at up to $0.30 of EPS in our current guidance. Just to be clear, we are absorbing up to $0.30 of EPS or $180 million of cost inflation this year and still delivering on our earnings guidance.

The strength of this guidance also includes a mid single digit increase in brand building, investing $0.15 of EPS in cost-savings initiatives to drive sustainability and growing operating profit in line with our mid single digit target. Generating operating profit leverage is a key ongoing focus for us as we manage through this extraordinary cost inflation period. As we move through the year the strength and visibility of our innovation and marketing programs are strong. The pricing actions we've taken, including the most recent U.S. cereal and frozen food increases, will help.

Our marketshare performance across categories continues to be positive. Our U.S. cereal share continues to grow for the sixth straight year. U.S. cookie and cracker shares are up, and we've held or increased share in 9 of our top 10 international markets during the last year. And these markets account for over 80% of our international net sales and profits.

Slide 4 highlights our financial performance this quarter. Reported net sales increased by 7%. This follows the strong 8% reported sales growth in the second quarter of last year. Internal sales growth, which excludes the effect of FX, was also 7%. For the first half of the year internal sales growth was 7%, well ahead of our long-term guidance of low single digits.

Second-quarter reported operating profit declined 2% while internal operating profit growth, which excludes the effect of FX and stock option expense, grew by 1%. We achieved this better-than-expected internal operating profit growth despite a difficult year-over-year comparison and a significantly higher fuel energy and commodity costs. Year-to-date internal operating profit growth increased 3%, in line with the guidance we gave at the end of April but stronger than our expectations going into the year.

Reported EPS increased by 8%. However on a comparable basis, excluding options expense, EPS increased a solid 13%, which is well ahead of our long-term target of high single digit growth. Year-to-date cash flow was $340 million. We expect cash flow for the year to be in line with our previous guidance of $900 to $975 million.

So when we examine our first-half results, you can see why we have continued confidence in our business model. Now let's take a look at these results in a little more detail. Slide 5 details our second-quarter sales growth. As I mentioned, reported sales growth was 7%, in line with internal sales growth for the quarter and the year-to-date. This growth came on top of a strong 7% internal growth in the prior year. Revenue growth was driven by gains in price mix and tonnage just like in previous quarters. And as we've talked previously, we planned for a significant increase in brand building in the first half of this year to support our base business and our innovation. And as the next slide illustrates, that's what we did.

As you can see, brand building was up mid single digits in the first half, and to put this in perspective our sales growth in the first half of the year significantly exceeded our internal expectations. Remember we began the year anticipating low single digit growth, and as I just discussed, we have done considerably better than that. Additionally, brand building was up double-digits in the second quarter of last year, making the comparison difficult for the quarter and for the first half.

Recall at CAGNY we outlined several moves we are making to drive the effectiveness and the efficiency of our advertising and promotion dollars. We have made good progress getting some benefit this year and expect even greater benefit in 2007. In a moment Dave will review each of our businesses, but first Jeff will walk you through our financial results.

Thanks, Jim, good morning, everyone. In the second quarter gross profit margin was 44.5%, a decline of 180 basis points. Similar to the first quarter we faced a very difficult comparison as gross margins last year increased 110 basis points. Still the main reason for the gross profit margin erosion this quarter was higher fuel, energy and commodity costs, as well as higher benefit costs. In fact, input cost inflation and increased benefit costs together negatively impacted gross margin by approximately 160 basis points in the second quarter. As I will discuss later, we do expect our gross margin to expand in the second half of this year.

We continue to execute cost savings and productivity initiatives which are helping us to partially mitigate the cost inflation we are experiencing. We've had good productivity savings year-to-date, which we expect to continue in the second half of the year. In addition, as Jim mentioned earlier, we recently announced price increases in our U.S. cereal and frozen businesses. This is the first U.S. cereal price increase we've taken in two years. Once these price increases take effect, it means we have raised prices in each of our major North American businesses within the past 12 months, and we've also had price increases across all of our major international markets.

Upfront costs this quarter were approximately $0.03 per share, equal to the amount we recognized in the prior years' second-quarter. We are forecasting upfront costs for the full year to be approximately $0.15 per share, similar to last year with the largest year-over-year increase to occur in the fourth quarter. In North America, internal operating profit declined 1.7%. This region had a very difficult prior year comparison, lapping a strong 9% internal profit growth. Despite very strong sales, North American profitability was particularly hurt by the higher fuel, energy and commodity costs facing the industry.

In Europe internal operating profit growth was up 5%; the region benefited from pricing actions and mix improvements in the quarter. This was partially offset by higher procurement and energy costs, as well as increased brand building investments. In Latin America internal operating profit grew 14%, and brand building investments increased at a very strong double-digit rate. This region is well on its way to reporting its fourth consecutive year of strong sales and operating profit growth to go along with strong category share gains.

In Asia-Pacific region internal operating profit declined 5% due to a very difficult prior year comparison, lapping a very strong 24% internal profit growth last year. This was an improvement from the first quarter's results. Overall the Company reported a 1% internal operating profit growth for the second quarter, even with the gross profit margin impact we talked about, continued investment in brand building and innovation. Below the operating profit line interest expense in the quarter was lower than the prior year due to the call of a debt issued in last year's second quarter. We still expect interest expense for the full year to be approximately $300 million. The tax rate in the quarter was 31.3%, in line with our guidance of 31 to 32% we'd given you previously. For the full year we now expect our tax rate to be approximately 32%.

Slide 9 shows our working capital measured as a percentage of net sales. This continues to be an area of focus for the entire organization and I'm pleased to report another 20 basis points of improvement compared to last year. As I mentioned in previous conference calls while we do expect to see improvements in our working capital as percentage of sales in the foreseeable future, we don't expect working capital to be a significant driver of cash flow.

Now let's turn to slide 10 for a discussion of cash flow. Cash flow in the first half of 2006 was $340 million versus $474 million last year. The decline year-over-year was primarily driven by increased capital investment and higher working capital, consistent with the first quarter our core working capital was negatively impact by a difficult comparison to favorable trade payable movements in the prior year. For the full year we continue to expect cash flow to be between 900 and $975 million, an improvement over 2005 of up to 25%. Despite the fact that we've increased our capital expenditures as a percentage of sales to accommodate the strong growth we've been experiencing. The major factor giving us the strong growth this year is due to lower benefit funding in 2006, after last year's significant increase.

Slide 11 shows the results of nearly $1 billion of share repurchases we've done in the past 12 months. As you can see, the average shares outstanding has declined by nearly 20 million or 5% of the Company's outstanding shares since the second quarter of 2005. Our Board of Directors authorized a share repurchase program of $650 million for 2006. As a reminder, we repurchased over $500 million worth of shares in the W. K. Kellogg Foundation Trust in the first quarter alone. And as of the end of the second quarter we had completed a total of $580 million of the authorization. We anticipate repurchasing the balance of the authorization by the end of this fiscal year.

Now before I turn to our guidance for the remainder of the year, I thought I would take a few minutes to examine our better-than-expected first-half results in the context of the expectations we had previously shared with you. At CAGNY we talked about the full-year operating profit delivery being balanced between the first and second half, which is still the case. In April we expected to report mid single digit internal sales growth in the first half of the year, which was ahead of our long term target. We actually reported a high single digit internal sales growth. We also thought that we would report a low single digit internal operating profit growth for the first half, and that is exactly what we delivered. And finally, we said that we would report a high single digit earnings per share growth excluding the impact of option expense. As you've seen in this morning's release we reported 13% EPS growth on a comparable basis. We had a good first half relative to our expectations due primarily to the very strong top line growth.

Now let's turn to the next slide for a discussion of our full-year guidance and how we see the next quarters shaping up. In the second half we expect to report internal sales and operating profit growth above our long term target. Good operating leverage and EPS growth in the mid single digits. Gross margin will be up approximately 20 basis points. In the third quarter our guidance calls for a high single digit increase in brand building to support the launches of our new product innovations. This will result in the third quarter operating profit and EPS growth being down slightly. This move is all about sustainability and gives us continued top-line momentum in the third and fourth quarter and into 2007.

For the full year we expect internal net sales and operating profit growth to be in the mid single digits. We now expect the impact of incremental fuel, energy and commodity costs to total up to $0.30 per share, a $0.10 per share increase from our previous guidance. We are also estimating benefit costs to be at the high end of the previous range. With this we expect gross margin for the full year to be down approximately 50 basis points, even with the stronger second half performance. However, even after absorbing all of these cost increases we expect full-year EPS to be between $2.45 and $2.49 per share, consistent with our previously raised guidance.

I would now like to turn the call over to David. Thank you.

Thanks, Jeff. Let's take a look at our results by business segment. If you look at slide 14 you can see the North American division once again reported very strong growth across all businesses. This quarter's result was very impressive due to the difficult year-over-year comparisons, particularly in retail cereal and retail snacks where internal sales growth last year was 10% and 8%, respectively. So let's take a look at these results in more detail. In slide 15 shows that the North American retail cereal business had a very strong quarter, with internal growth of 4% building on 10% growth in the prior year. In the U.S. for the 12 weeks ending July 2, we had a 34.9 category share in measured channel, up 30 basis points from year ago.

Our Canadian business also grew internal sales and share in the quarter with category share in Canada up 10 basis points from a year ago. That renovation is working, and we expect to continue it. We launched six new cereals at the end of June, organic versions of Kellogg's Rice Krispies, Kellogg's Raisin Bran and Kellogg's Frosted Mini-Wheats as well as Peanut Butter Swirlz, Caramel Nut Crunch and Eggo Cinnamon Toast. And we are leveraging a great property to Pirates of the Caribbean across all of our North American businesses.

Our Kashi business also had a strong quarter, up double-digits in major channels. And we just started shipping two new additions to the Kashi family this month, Vive and GoLean Crunch! Honey Almond Flax. We invested heavily behind our cereal business in the first-half of the year, and we plan to continue this investment with strong impactful advertising in the second half of the year. So as you can see our business is strong but with energy and commodity costs increasing, we recently raised prices in our retail cereal business in the U.S. and Canada to partially offset the high commodity costs. While we believe we will have a strong second half we do face some very difficult comparisons due to last year's strong growth.

Our new health and wellness unit, which we first talked about at CAGNY, recently announced its first initiative, a line of weight management products under our number one global brand Special K. These great tasting, protein fortified products are designed to help consumers stay on track with their weight management goals throughout the day. The product will hit the shelves in November with advertising to begin in January. They will be located in the diet and attritional aisles of your local grocery and drugstores.

Now let's turn to slide 17 for a discussion of our snacks business, and as you can see our North American retail snacks business had another strong quarter posting 11% internal growth against a very tough 8% comparison. Once again each of the businesses in this segment increased sales and category share in major channels for the quarter and year to date. Pop-Tarts posted strong sales and grew category share behind strong innovation in the quarter. Go-Tarts is off to a good start; in just a few month's time this product has captured over 9 share points in the toaster pastry category. Our fruit snacks business grew double-digits in the quarter and gained category share, in fact in the second quarter we reached a 33% share with Kellogg's Yogos, which was launched earlier this year, capturing 9 share and trial and repeat are both encouraging at this early stage. The crackers business grew double-digits in the quarter due to our innovation and strong DSD execution. Category share was up over one point. Cheez-It was up double-digits in the quarter with good performance out of our base business and the strength of our recent innovations, Cheez-It Crisps. We also saw good growth out of our Club, Kashi and Town House crackers as well as our 100 Calorie packs. We announced a number of new products at the end of the quarter, including Town House Toppers and Toasteds Organic Wheat, and will begin supporting them in the third quarter. Our cookies business grew low single digits in the quarter and gained 40 basis points of share. The growth in the quarter was driven by the performance of Keebler Chips Deluxe Fudge Stripes, Keebler Fudge Shoppe, Murray Sugar Free and again our 100 Calorie packs. We recently launched two new Famous Amos varieties, as well as Keebler Soft Batch peanut butter cookies and we'll be launching Kashi TLC cookies in three varieties later this quarter. Our wholesome snacks business also grew double-digits and gained 2.5 share points. Driving this growth was the performance of two of our oldest and largest brands, Rice Krispies and Special K Bars. And we recently launched a number of new products, including two versions of Crunchy Nut Sweet & Salty bars, Smart Start bars and All-Bran bites. Our snacks business remains strong and we will be supporting our new products heavily in the second half of the year. So we are confident our snacks business will show continued growth in the second half, though possibly not at the rates we are seeing in the first half.

Slide 19 shows the results posted by our North American frozen and specialty channels businesses in the second quarter. These businesses each reported strong growth in the quarter with internal sales growth of 9%. The frozen business delivered a robust quarter with double-digit internal sales growth. Eggo expanded its number one position in the frozen breakfast category with strong share gains in both waffles and French toast and pancakes increased an amazing 15 share points. And we recently launched Eggo Jungle pancakes and Eggo French vanilla waffle. Morning Star farms also delivered good growth in the quarter. Our Veggie foods business gained 4.5 share points during the quarter, driven by growth in the base business and strong innovation such as Veggie Bites and Meal Starters. And last quarter we told you about our exciting entry into the frozen entrees category under the Kashi brand. While shipments only began at the end of June, I can tell you retail acceptance has been very strong. We recently increased prices in our frozen foods business to help recoup some of the inflationary impact hitting our businesses in energy and commodities, and we do expect continued strong results from this business for the rest of the year. Finally, our specialty channels businesses turned in another great quarter with mid single digits internal sales growth driven by the base business as well as strong innovations, and we saw growth in the quarter reported in our food service, in our vending, in our convenience and in our drug channels businesses.

Slide 20 shows reported and internal sales growth from Kellogg International. Internal sales growth was 5% in the second quarter and it was relatively broadbased. In fact, we posted sales increases in most of our international businesses even though the competitive environment remained challenging. Europe and Latin America posted excellent growth and Australia continued the recovery we saw beginning late last year. And again here we've taken pricing in most of our major markets in the past 12 months, including the UK, France, Australia and Mexico. Now let's look at each of these areas in more detail, starting with our European business which posted 4% internal sales growth in the quarter.

The UK cereal business grew mid single digits during the quarter, and our year-to-date cereal category share is up 60 basis points behind strong innovations. A number of new cereal launches are planned for the second half of the year including All-Bran Crunchy Oatbakes and Optivita Oat Crunch, a new heart health cereal. The cereal bars business continued its strong growth up midteens in the quarter. Sales growth and share gains were also registered in a number of other markets in the region including France, Italy and the Mediterranean regions. France gained 90 basis points of share in the quarter and the trading environment remains positive.

Turning to Latin America where reported growth was up a strong 10% internal sales, lapping 8% growth in the prior year. In Mexico the largest country in this region, the cereal business gained over two share points year-to-date, driven by Special K and promotional programs around Choco Krispies and Fruit Loops. The snacks business also gained category share. We saw double-digit growth reported by a number of markets in the region, including Venezuela, Columbia, Central America and the Caribbean. And the Latin American region benefited in the quarter from our Kellogg's Soccer World Cup promotion and product introductions such as All-Bran in Colombia, Special K Vanilla Almond and Corn Flakes Oats in Mexico, as well as the geographic expansion of the snacks business into Colombia, Venezuela and Central America. Our Asia-Pacific business declined 1% in the quarter primarily due to a very difficult 8% internal sales growth comparison from the prior year. In Australia our cereal category share declined in the quarter, but it does appear that the business is stabilizing after yet last year's competitive situation. In the second half we have a number of new products launching including Special K Honey Almont and Corn Flakes Chocolate Malt. We launched Special K in Japan late last year and it is doing very well. And we have two new wholesome snack products that were recently introduced to the Japanese trade with very strong acceptance. Shipment of these products will begin in August. And in Korea we had a strong quarter behind double-digit growth in Chaco Chex and the grain story products launched late last year. Our global business remains strong and with strong support planned in the second half of this year behind our recent innovations, we are confident that the second half will continue to see positive internal sales growth. The recently executed pricing actions will help address some of the margin erosion driven by high and volatile energy and commodity costs. We remain positive and confident about the business and delivering on our commitment for the balance of the year. Now I will turn it back to Jim.

Thanks, Dave. With half of the year now complete and a strong second half outlook ahead of us, our message is one of continued confidence. First, delivering another year of sustainable, dependable performance, second, continuing to invest in our brands and future cost savings initiatives, and third, driving visibility into innovation and marketing programs. The commitment to our overarching driver of sustainable and dependable performance based on realistic goals continues and is reinforced in this environment. Our focused strategy continues to provide good visibility, and our operating principles are driving the right behavior. And with that I would like to open it up for questions.

(OPERATOR INSTRUCTIONS) Pablo Zuanic, JPMorgan.

Good morning, everyone. I guess what I want to understand in terms of the guidance that you are giving us here, on the one hand there's about a $0.10 higher in commodity costs which is about $60 million but you're keeping guidance unchanged. From the press release and your commentary it is not clear to me whether you are funding the cost savings with lower brand building. I know you said that for the third quarter that is going to be increased but just can you help us understand you are giving the guidance, there is a number of wins, what is upsetting that really compared to your original guidance? Is it (indiscernible) brand building?

Pablo, absolutely not. Our commitment to brand building is a key driver to our business, and I will always continue. Where you are seeing the increase related to commodities really coming from is increased sales performance. Because our brand building has been very successful and is driving the top line faster than our long-term guidance of low single digits. We are expecting the second half to be essentially mid single digit sales growth, operating profit really being at the high single digits. So it is a very strong second-half performance and EPS coming in at the mid single digits. No, brand building is certainly a good avenue where we reinvest even more.

Okay, and just in terms of the price increase can you say how much was that in cereal and frozen roughly, and how long will it take to really show at the retail level?

Pablo, the price increase in U.S. cereal was around about low single digits, and really typically when we take a price increase we are out three to four, sometimes six months with trade deals. So it will come through late in the year but more principally in 2007.

Okay, and if I may according to a Nielsen date, I know its not perfect there has been just a more price competitive environment in cereal. I understand there's more cost inflation out there but aren't you concerned that maybe others will not follow, that that price increase will not stick?

There has been, and when we look at category growth it is sort of flat to up one. I mean our perspective is we think category growth is lower than we would like, and until all of the other branded players step up innovation and brand building, the category may not perform to its full potential. But we are sticking to our game, renovating, we are supporting the brands. And it is working for us, Pablo.

Thank you.

(OPERATOR INSTRUCTIONS) Eric Serotta, Merrill Lynch.

Good morning. Your gross margins in the quarter were down significantly more than they had been in previous quarters. I realize you were up against some extraordinary cost pressures this quarter, but I don't think they were really all that different from what you saw in recent quarters. I am just wondering -- and in recent quarters Kellogg has really done I would say an exemplary job of offsetting those cost pressures with productivity savings and mix improvement. I'm wondering just what happened in this past quarter, why we didn't see better gross margin performance or why you were not able to offset more of the commodity and fuel headwinds.

By and large it is a commodity situation in Q2, and the increase in the second quarter was significant for the company particularly in some of our major items, fuel, energy and the commodities. Also the comps last year were very, very high. So you have to take that in light, last year we were up 110 basis points. But when you look at some of the other things that have happened in the quarter, certainly we had some one-off things that hit us in gross profit margin in our cost that will be more timing coming out in the second half. Also our innovation strategy is a very smart one where we use a lot of COGS manufacturers to commit the capital versus us. The other side of the coin is we have a little lower margin when those products come out but it gives us a great opportunity going forward. And also in our COGS, and a lot of people probably don't know that, we do have brand building that gets classified into our cost of goods sold, and that was up in the quarter.

Okay, and then could you comment on your visibility into the input cost situations of the second half of the year; how much of that $0.30 increase is locked in? And then I know you haven't really given out any guidance toward '07 yet, but as you look at the overall input cost basket, we have a lot of moving pieces, I guess energy is the real wild-card here. But could you give some overall comments on how you're looking at the basket for '07 given the increase in grain prices that we've seen?

Really it is a little early for us to comment about '07 but when you look at our second half, I mean we are able to overcome that and have an increase gross profit margin. But it is a $0.10 increase from our previous guidance on commodities, and the company is able to still deliver its numbers.

Right and just to get to the first part of the question how much of that is -- what is your visibility on that $0.30 for the year or the incremental $0.10? Is that pretty much locked in or you still exposed on fuel or any of the other commodities?

Certainly fuel is something the company cannot effectively hedge. You know that is something that doesn't work from an accounting treatment for the company, but the big increases we are seeing on this latest $0.10 increase is wheat, sugar, energy costs. And we are able to feel very good about absorbing all of that and still hitting our numbers.

Great. Well, thank you very much.

A. G. Edwards, Chris Growe.

Good morning. I just have a couple questions for you. First off, on the marketing side I think you're indicating to be up in line with sales and you give a little commentary on that. But your sales growth is stronger this year. Is that one of the reasons why you have kind of taken that growth estimate down a little bit from perhaps exceeding sales and not on the line with sales? Is that a fair statement?

That is fair, Chris. This is Jim. And as we started, you know we are executing the plans that we have in place for share and it is simply related to the exceptional sales growth that we are seeing.

Okay, and then the second question just on the upfront costs, you have kept your guidance in line with the year, you haven't given much color on what to expect for the second half of the year. Are there programs already in place that will constitute the entire sort of $90 million number for the year?

We are still forecasting the full $0.15, Chris. The majority of it will be in Q4, and as typically we can't really talk about those initiatives in advance. But you will --.

I would like to add one thing to add to Jeff's point there, and I think a lot of the confidence that we have in our model performance as you we are seeing for the full-year is that within our guidance we are absorbing to the points you made out, $0.15 of EPS related to investing in cost savings for sustainability in the future. And that is included in this guidance and included in the just the strength of it as we are viewing our business model.

Absolutely, okay. And a little quick one on the new Special K products. I am just curious how far I feel you're willing to go beyond your core categories and with water and some of these more specialty products, I realize these are more niche categories for you. Should we envision Kellogg pushing pretty far beyond its existing categories as part of this new health and wellness push?

I think, Chris, we are launching a protein fortified beverage that is completely consistent with the whole positioning of Special K, our biggest brand in weight management. Wherever we can find ways to bring to consumers things that help against the particular need state and work off our current brand, that is exactly what we're going to do. And that is probably all I would say at this point.

Okay. Thank you.

Morgan Stanley, David Adelman.

The $0.30 increase in input costs year-over-year, can you quantify approximately how much of that has been absorbed in the first half?

Essentially when you look at it on a first-half, second-half basis the incremental going from $0.20 to $0.30 is basically a back-half event. So probably a good 50-50 split is a good assumption and commodities fuel and energy started the year high and we haven't seen any relief on that so far year-to-date, and that is our projections going forward.

And can you clarify the comment you made in your prepared remarks about the third quarter operating income and EPS growth down slightly? Do you mean on an absolute basis down versus the year ago third quarter, or just growth at a slower rate than what you've seen through the first half?

No, we would be expecting Q3 to be slightly down on an OP and EPS basis, and it is really related to what we are doing on brand building. It is a great move for us for the sustainability and keeping the momentum going into the second half of the year and normally that gives us a good momentum going into '07.

Okay. Thank you.

Eric Katzman, Deutsche Bank.

Good morning, everybody. I have maybe a little bit more longer-term oriented question. Jim when you took over you inherited this model, and it has proven to be obviously very successful. But we are now in a period of high inflation, which you recognize today with the $0.10 incremental increase. I am kind of wondering why continue to lock yourself into longer-term kind of low single digit sales growth, mid single digit EBIT growth if we continue to have such cost pressures over time. You're going to be forced I assume to raise prices so we could get into this kind of mid single digit sales growth and mid single digit EBIT growth scenario which is kind of what you are projecting for the second half in any case. So maybe you could just talk a little bit longer-term about if inflation keeps as pressured as it seems, what that means.

The first thing I would say is and we got at this in our prepared remarks a little bit, but if there has ever been a period of time that has given us more confidence in our business model and the ability to continue deliver dependable results, it is this environment. And while we are continuing to drive innovation, drive brand building, continue to invest in cost savings initiatives to help sustainability, and as Jeff mentioned and a question on the quarters, we are not running this business by quarters, we are running it for annual delivery consistent, sustainable growth. So we found that planning the business around realistic targets is the best way, gives us the best chance to over deliver against those targets. It drives the right behavior in the company among our folks and our managers in terms of brand building, and that has been a great perspective.

And obviously as we see the impact of this particular cycle of cost inflation we believe in pricing and we are pricing against that to help sustain our business model. The one thing that we are really encouraged by is just the strength out of this business model of the marketshare performance. And I am not sure if as Dave went through that but every category, every major business unit except one around the world significantly and continuing to grow share. So I think the strength of our business model is just being proved out.

Yes, I am not going to argue that the share performance isn't anything but excellent and that you have proven so far that your pricing can sustain itself without any dilution to volume or consumption. But I am just kind of wondering could we be into a period here, given your raw material and energy exposure, where top-line is going to have more pricing in it and its going to be more of a mid single digit target, not a low single digit target? And that puts I guess less pressure on the model to deliver operating margin improvement or leverage, because it may just not be able to get there given the cost side of things.

Trying to project the future in this environment is -- we certainly have a hard time doing it; I am not sure anybody can, so we have that. What we -- the essence of our model around the discipline of continuing to drive efficiencies into the model is something that is there that goes forward regardless of the environment. The discipline in the model of driving brands and leveraging these great brands and benefit areas we are in and the wonderful categories we are in, that is the key thing we have got to keep focused on. I would say we continue to be very aggressive at driving, as we mentioned the efficiency effectiveness of our marketing dollars and the mix of those dollars where we get to really build the brands. We're very aggressive about that and we continue to be very aggressive about cost savings initiatives and having the money to invest in those to drive sustainability. So if there is anything this environment has given us more confidence in our business model for the long-term.

Thank you.

Jonathan Feeney, Wachovia Bank.

My question would be you talk a lot about productivity investments you've made in the past offsetting cost increases, and I know we talked a little bit about pricing, but I wanted to focus on the pricing environment. Because here you're the second major food company, (indiscernible) center the store food company this week to, I think deliver strong pricing. And the difference of course is that you've been delivering strong price mix for some time and it seems to me that others are getting better pricing. And so then they have been in the past. Is there an environment out there among your retail customers that is materially different than 2004 in that you are more able to take pricing more readily across the portfolio? I know you announced a price increase across the board, and I guess I am just wondering is that a feature of the business today that is materially different than it was -- I remember a couple of years ago when grain prices were actually hurting everybody.

I think there is two things to that. One is that we only take pricing where we can justify them where we think it makes sense. The retail environment, they are feeling a little of the cost pressures we are with fuel and energy and some of the commodities. They buy packaging like we buy packaging. So they certainly understand the cost pressures we are under because they are under many of the same. So I think the environment is just one where given the relatively high increases we've seen many other people are seeing the same things depending on the mix of business. The pricing to recoup some of that is a very sensible approach.

Interesting. Thank you.

Bear Stearns, Terry Bivens.

Good morning, everyone. Just in terms of the category you made the point I think that the category, David, was a little bit flattish as measured in obviously public channels. So the question would be you are continuing to get a good increment on your cereal sales from the unmeasured channels. Could you talk a little bit about how your marketshare is progressing in the unmeasured channels? That seems to continue to be quite an area of meaningful strength for you. That's my question.

We typically get this question because the IRI data always undervalues where the category truly is. If you look at the numbers for the 12 weeks it is sort of -- you can see it saying 2% IRI. Our view is that it is flat, maybe up to 2% depending on the way you cut the numbers. And the differential is coming from ultimate channels outside of IRI's basket. So I think you could broadly take that as an indication that many of their channels are growing at a faster rate than the IRI measured channels. That is certainly our case. I think that is true for the industry. I do not want to talk about any specific business, but we are doing well across the board. We are working with all of our trading partners equally, strongly to try and drive their business and ours.

If I could sneak in one follow-up but are you indeed gaining marketshare in those unmeasured channels?

We don't typically comment on that, Terry. Some of that data is proprietary. In fact, in a number of cases we really don't know what it is. But we just feel like we are doing well in measured and nonmeasured channels, and we continue to try and drive that.

Well, I always give it a try. Thank you very much.

David Palmer, UBS.

Could you just talk about the impact of your pricing. You said that has gone up in each of your major North American businesses within the past twelve months and obviously this rolls into your results with lags. Last quarter, second quarter you had a 3% price mix. How would we look at that going forward? See that going up from here?

I think if you look at the back half certainly as the prices start to flow through, we will see more price mix than we will volume. The split will increase there. I think if you looked across all of the business units and geographies around the world we probably took between 3 and 5%. It varied market to market, category to category. Most of that benefit will probably not flow through the P&L until we get into '07; we will get a little bit late this year but nothing that major.

Quick follow-up you mentioned that higher fuel energy, commodity and other hit gross margins by 160 basis points, and I calculate that is equal to $0.07, maybe $0.07 or $0.08 per share. And that seems kind of in line with the $0.30 run rate if that math is right. Are you going to continue to see hits, it is just that the key difference maker on the gross margin line is perhaps this incremental price? Is that one way that I could possibly think about it? Does that sound reasonable?

You remember last year when Katrina hit there were impacts on energy and gas, there were issues with sugar and sugar pricing really took off. So when we get to the back half of this year, certainly the last four months of the year, the inflationary levels are lower. They are still higher because no one expected that oil would be at this level, but some of those costs are not as significant in the last four months as they were in the first six. That is certainly a component to the second half versus first half.

And inventory levels there we calculated they are a couple days higher in terms of sales, and it would seem to be both finished goods and raw materials. Could you help explain that?

Yes, we said in the call we launched a lot of products at the end of June which will start supporting strongly in the third quarter. That probably did push up our inventories a little bit purely because of the innovation. But those things typically work themselves out over the next four to eight weeks. We don't see any problems there.

Citigroup, David Driscoll.

This is [Michael Levry] for David Driscoll. Congratulations on a great quarter. Just want to get a sense for some of your cereal expectations for the second half. In the U.S. specifically, how much does the competitive environment shape some of your expectations there? And did anything change with some of the cereals that Mills announced specifically something like a fruity cheerios?

No, as I said earlier, the more the competitive fit in the category innovates and spends on brand building, the happier we will be as a company because that will have a positive overarching impact on cereal category growth. And our view is that the more we do that the better. The competitive environment, cereals always competitive. We don't really comment on that specifically. Their view is innovate, support the brands, drive the category, bring interest to the category and our business will grow and hopefully will gain share as a result.

And outside the U.S., some of the markets where you cited share gains, what is really driving that? Is that new products also, or is it baseline growth or what is the drivers there?

As you look at our markets the fundamentals, it is no mystery. It is great brand building, it is very strong innovation that we try to keep ahead of our marketshare in the particular market. And the just the exciting thing from our end in looking at it is the relevance of the benefits we're talking about to consumers, whether it is [adjusted] health, heart health, weight maintenance -- these are big, important benefits to consumers, and the more we can enervate into these things the strength of our portfolios. And it doesn't really matter whether we are in a market where we have a 40 share or markets where we even have significantly higher shares than that. And Dave mentioned Mexico in our remarks where even in those very strong markets we still can make progress. So it's innovation, it's brand building, and it is great execution at retail. And those are common themes regardless of the market you're talking about.

That's very helpful. If you had to put one ahead of the other do you feel like, say Mexico for instance, the new products make a bigger difference than the brand building, or how would you compare them?

Over the years we've had a saying in the company that you have to have all guns loaded. And to try to prioritize you get out of balance and think it's one thing -- it is not a simple thing. It is having all the guns loaded all the time in these very challenging categories, but great categories we are in.

That's helpful. Thank you very much.

Andrew Lazar, Lehman Brothers.

Jeff, even excluding some of the incremental input costs that you talked about, like gross margins were still lower year-over-year, despite the strong top line. And so not a lot of operating leverage, and you mention some of the other items that are at play there. I am wondering is some of the reason also for the contraction perhaps similar to what happened in the first quarter when your sales were very good but kind of the way the production cycle goes was not where sales were? And that is kind of the driver of some of that manufacturing leverage? And if so, does that kind of start going the other way in the second half so that you kind of have more confidence that that operating leverage flows through?

Absolutely, and it gets pretty complicated from a cost accounting standpoint, but you talk about fixed cost absorption. And certainly last quarter, last year's second quarter we had a tremendous benefit from fixed cost absorption. That certainly this year impacted us a little that there. But evens out over the year, and we do have a lot of confidence in the back half about our gross profit margin and the performance of the company.

And just is there the upfront cost just where they all in one line item in the P&L this quarter, or where they broken out between the gross margin and SG&A?

No, they are all in cost of goods sold.

Great. Thank you very much.

Kevin, one more question please.

Goldman Sachs, Steven Kron.

A question on the European marketplace. There seems across, broader retail, there seems to be some mixed signals coming out of there. You had some pretty good results in the quarter. Just wondering you talked about innovation and new product rollouts, but is there anything as far as kind of a retailer perspective, in the challenging operating environment, is there any marginal shift as it relates to hard discounter versus soft discounters or something like that that perhaps is fueling some of your success there?

I think the key driver of our success across the markets in Europe has been consistent, innovation and brand building and great execution as Jim said. Harder discounters are still growing although the rate of growth on our view does appear to have abated somewhat. And in France where last year the trading environment because of the changes and the [galland] law working their way through they seem to have worked their way through. And France as a market certainly at the moment is stable until we get to Phase II of that process next year. So I think from our perspective I think hard discount is still doing okay. The best thing we can do as a company and most branded manufacturers can do is bring excitement and news and relevant products to consumers with great brands. And then you will do better than the norm, and I think that is what has happened in our case.

We will close the call; want to thank everybody for listening to our call. Please call us if you have any additional questions this afternoon and have a good morning.

Again, thanks everyone for joining; that concludes today's conference call. Have a good day.