家樂氏 (K) 2006 Q3 法說會逐字稿

Good morning and welcome to the Kellogg Company 2006 Third Quarter earnings call. [OPERATOR INSTRUCTIONS].

At this time I'd like to turn the call over to Simon Burton, Kellogg Company Vice President of Investor Relations.

Mr. Burton, you may now begin your conference.

Thanks, Matt, and good morning, everyone.

Thank you for joining us for a review of our Third 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, Jeff Boromisa, CFO and Gary Pilnek, General Counsel.

We must point out that certain statements made today such as projections for Kellogg Company's future performance , including net sales, operating profit, cash flow, earnings per share, margins, up front costs, share repurchases, debt reduction, ROIC 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 2006, the Company adopted SFAS 123 R and began to recognize expense related to employee stock option grants in 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.

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 U.S, And 719-457-0820 from international locations.

The pass code for both numbers is 424-4212.

The call will be available via Webcast at www.KelloggCompany.Com which will be archived for 90 days.

Now I'd like to turn the call over to Jim.

Thanks, Simon and good morning.

As a close friend of mine, Tony the Tiger would say: and I fully agree, "Dave's promotion to our CEO is grrrreat!

Great for our Company, and great for our shareholders."

This move locks in and further builds visibility for our strong Management continuity.

It insures we stay 100% committed to our over arching sustainability performance driver, managing the business with realistic goals and leveraging our focus strategy and operating principles.

It also insures continued appreciation for and belief in the legacy of our Founder, Mr. Kellogg.

Our Kellogg folks around the world see Dave's promotion as a positive, natural, well deserved succession.

Throughout the year, we expressed confidence that 2006 would be another year of sustainable growth.

Our continued business momentum reflected in strong Third Quarter results and the visibility we have into the remainder of the year further drives our confidence.

We are raising our full year EPS guidance because of this.

The increased guidance and our continued confidence in delivering sustainable growth goes directly to the power of our business approach and model, allowing us to beat our long term sales targets again in 2006 providing flexibility to deliver our long term operating profit target, while absorbing unprecedented incremental commodity and fuel cost inflation that I mentioned last quarter as well as increased benefit costs while continuing our investment in brand building and R & D to drive brand value.

The continued strong share performance we are seeing across categories and geographies in 2006 reflects this.

And while continuing to invest in high return cost savings projects to support future growth, we will again invest $0.15 of EPS this year and despite all the cost pressures, still deliver our long term operating profit target.

And importantly, our model again has driven strong cash flow in 2006 enabling a balanced use of cash to further invest in our business, deliver strong dividend pay out, repurchase our stock, and reduce net debt.

We are confident 2006 will be another year of sustainable growth.

Last year at this same time, we expressed confidence in the at this same time, we expressed confidence in the coming year.

We have the same view as we now look at 2007, confident in another year of sustainable growth.

Our realistic goals of low single digit sales growth, mid single digit OP growth and high single digit EPS growth drive the right behavior.

They allow our managers to invest in the businesses without chasing targets that are unsustainably high.

This means they can invest in brand building that will drive future growth.

Some of you have asked why we continue to target these levels of growth when our recent actual results have been greater.

The reality is, our growth has been made possible by our realistic targets.

This is the model that has worked well for us over the last six years and it's the model that gives us confidence for 2007 and it's why we can give guidance for strong results next year.

Now let's look at slide four which details some of the quarter's financial highlights.

Net sales increased by 8% due to strong internal growth and the effect of foreign currency exchange which added slightly more than 1%.

Internal sales growth, which excludes the effect of FX was 6 %.

OP increased by 5%, and internal growth was 6%, right in line with our long term target, and we're pleased with this as it exceeded our expectations.

You'll remember that we had planned for the third quarter OP to be down slightly due to timing, so this year performance shows our momentum and as usual, we achieve this growth and continued to invest in brand building and up front costs related to cost reduction initiatives.

Operating profit growth benefited from up front costs being lower than in the third quarter of last year.

Our year-to-date internal operating profit growth is 4%, right in line with our long term target of mid single digit growth.

EPS increased by 9%, excluding the impact of stock option expense due primarily to operating income growth, and year-to-date, cash flow is $850 million and the full year target remains 900-$975 million.

Let's look at each of these results in more detail.

Slide five slows a Third Quarter sales growth.

Reported sales growth of 7.6%, and internal sales growth of 6.5%.

This growth exceeded our long term targets and built on strong 7% growth in the third quarter of last year.

As you can see, internal growth was driven by a balance between price mix improvement and tonnage.

Our model is working.

Our innovation continues to contribute.

One of the main focuses of our business and one of the primary drivers of the sales growth you see on the slide is brand building investment, specifically advertising.

We again increased the levels of investment in this important metric.

You can see on slide six, the level of investment we made year-to-date and our expectations for the full year.

The increase in the level of investment we expect for the full year will approximately equal sales growth.

Keep in mind, the increase isn't significantly greater than the sales growth rate because the sales growth rate we posted so far this year is more than twice our long term target and it's also because of our ongoing efficiency program.

As we discussed this with you throughout the year, we have done a lot work in this area.

We have taken a vigorous approach to our immediate planning and buying and the changing media landscape is working to our benefit in terms of more targeted communication and costs.

We have improved our return on investment modeling techniques, particularly in the area of consumer promotion and this, in combination with our global leverage of promotions like Shrek or X-box has continued to drive our competitive advantage and we've generated savings, much of which we are reinvesting.

We expect our brand building programs to continue to provide strong stimulus to our top line.

We definitely have seen the benefit and we expect the trend to continue.

We will continue to make investments in the Fourth Quarter and you should expect continued strong investment in 2007, particularly in advertising.

We are committed to this investment and we will not sacrifice investment and advertising to over deliver short-term results.

In a moment, Jeff will review our financial performance in more detail, but first, let me turn it over to David who will walk you through our business results.

Thanks, Jim, and thank you for those positive comments.

From my perspective, I truly do feel great and I'm both excited and honored to have the opportunity to become CEO of the Kellogg Company.

I see my key task will be to continue the Company's momentum by working closely with the talented group of executives Kellogg has both in North America and around the world.

We will stay focused on our current strategy and business approach.

Now let's turn to slide seven which shows internal growth posted by each of our North American businesses in the third quarter.

As you can see, each of the businesses posted excellent growth and it's even more impressive when you consider the very difficult comps in 2005.

Let's look at our North American businesses in more detail and as you can see on slide eight, we had solid sales growth continued in North American retail cereal than the third quarter.

Growth in the quarter was 3%, building on a very strong 11% growth in the third quarter of 2005 which was the year's highest comp.

Year-to-date, category share is up 30 basis points in related measured channel data and was broadly flat in the third quarter.

We saw slightly higher inventories at the end of the Third Quarter which are coming out naturally in the Fourth Quarter.

Given the tough year ago comes, strong year competitor innovation and technical activity in Q3, we are pleased with these results.

The U.S. posted strong results driven by our adult portfolio, in fact 52 week sales of our Smart Start, Mini Wheat and Special K brands all increased to double digit rates in measured channels.

We'll continue to innovate behind these brands to drive momentum.

We have Special K chocolate and Rice Krispies Real Strawberry, a cinnamon raisin version of our popular Smart Start brand and a new variety of cocoa krispies all shipping in January of next year.

And finally, Kashi continued to do very well.

Sales growth continued at a double digit rate and our GoLean and Heart To Heart brands did well as a result of both strong based programs and innovation.

We gained category share again in Canada as a result of strong performance by existing brands and new products.

We recently introduced All-Bran Honey Nut and All-Bran Guardian which are both doing well and we supported their products with very effective programs, including an X-box impact promotion which has been extremely successful.

We're excited about this as many of our businesses will be running a similar promotion during Q4.

Now, let's turn to slide nine in our snacks business.

As you can see, snacks posted strong 11% growth in the quarter, considerably ahead of our long term target and building on 6% growth last year.

Year-to-date, our snacks business has posted 11% internal revenue growth.

As we've seen in previous quarters, this growth was again broad based across the categories as shown on slide ten.

Our Pop-Tarts toaster pastries business is having another good year.

We're gaining category share again in 2006 driven by some excellent advertising and great new flavors including mint chocolate chip and the launch of Go-Tarts.

Consumption in the quarter increased at a higher single digit rate while shipments were down slightly due to the timing of promotions, so expectations are for a positive Fourth Quarter.

We also saw strong growth in the crackers business in the quarter.

Cheez-It gained category share as both Cheez-It and innovation Cheez-It crisps did well.

Our Club and Town House brands also both did well as a result of this year's strong innovation and we continue to see solid growth in our cracker packs businesses.

We gained share again in the cookie category and Chips Deluxe, Fudge Shoppe, Sandies and Murray's Sugar Free all contributed and Famous Amos continues to show accelerated growth.

The wholesome snack business was also very strong in the third quarter.

New Crunchy Nut Sweet and Salty bars, Smart Start bars, base Rice Krispies treats and Special K bars all did exceptionally well.

In fact Special K snacks alone posted more than 30% sales growth in measured channels in the quarter.

In addition, our fruit snacks business, a category we entered less than three years ago, continues to do well.

For example, the popular new Yogos product that we launched earlier this year already holds a category share of more than 5% and is helping drive our overall category share towards 30% and in Canada, we introduced Fruit Loops Yogos fruit snacks, Nutri-Grain Munch ems in the third quarter and both are off to a good start.

Slide 11 shows that in combination, the frozen and Specialty Channels business posted internal sales growth of 8% in the quarter and year-to-date growth has been 7%.

Eggo, Morningstar Farms, and the Specialty Channels business all posted very good results.

Eggo posted double digit sales growth driven by new products and there's more to come at the start of next year.

We're introducing a couple of new waffles which will add to our already successful line.

Morningstar Farms and our new frozen entrees business also posted good growth.

The new Kashi entrees that we showed you last quarter are off to a great start.

Our Specialty Channels business also did well in the quarter.

This group of businesses continues to execute very well and achieve great results despite a difficult mid single digit comparison.

In fact, the foodservice, convenience and drug businesses all posted very strong rates of growth as a result of good innovation and execution.

Now let's turn to slide 12 and our international businesses.

Internal sales growth from an international businesses has been good all year and builds on growth throughout 2005.

As you can see, these businesses again posted internal growth of 5% and year-to-date growth is also 5%, both above our long term targets.

Now let's look at slide 13 which highlights growth by region.

In Europe, we posted internal sales growth of 6% behind excellent growth in many countries in the region including the UK, our largest.

The UK cereal business posted high single digit sales growth benefiting from strong innovation, including new Optivita, All-Bran Crunchy Oatbakes and Special K premium berry crunch.

The UK share grew 80 basis points in Q3 and is up 50 basis points year-to-date.

The snacks business posted solid mid single digit sales growth behind strong results from existing products such as Nutri-Grain and Rice Krispies squares and significant new innovation including Special K bliss bars, a great new product.

We're also pleased with our plans for brand building and innovation in the UK for Q4 in 2007.

Importantly, good growth was achieved outside the UK with France, Ireland, Spain, and the mediterranean all posting very strong growth.

In Latin America, we again posted good growth in both our cereal and snacks businesses.

In Mexico, we launched Special K with chocolate, and All-Bran with a fruit mix and we benefited from a seasonal Special K promotion.

In the snacks business, we gained share and introduced Nutri-Grain chocolate bars, and a new variety of Nutridea.

In addition, many other countries in the region posted strong growth in cereal and snacks.

The Caribbean posted strong growth driven by Zucaritis..

Venezuela posted very high double digit growth behind Special K and the introduction of snacks, and central America and Colombia posted good growth in both cereal and snacks.

And finally in Asia Pacific, we saw sales growth, consumption growth, and category share growth in our Australian cereal business.

This was driven by the introduction of Just Right berry apple and Corn Flakes honeycomb in the First Quarter of this year and Special K Honey Almond and a new variety of Muesli in the third quarter.

Our snacks business posted lower sales in the quarter due to an increase in competitive activity.

In Asia we saw growth in Japan driven by the introduction of All-Bran and my snacks during the quarter and we've got some great new products planned for introduction in early 2007.

In Korea, we gained share recently due to strength in grain story and Chex, driven by new Chex crunch and strong brand building.

As in many parts of the world, Asia will participate in our X -box promotion during the Fourth Quarter.

As we've said over the years, our goal is and will continue to be the delivery of dependable, sustainable growth across our businesses.

Realistic goals allow us to do what's right for the business , such as invest in our brands and our new products to drive our market shares around the world.

Given the commodity and energy cost pressures we've had to absorb this year, it highlights how our consistent focus on driving cost efficiency while also driving innovation and brand building continues to work for us.

These are the right ways to drive long term, consistent growth and shareholder value, which is really the underlying goal of our sustainable business model.

And with that, I'd like to turn it over to Jeff.

Thanks, David, and good morning everyone.

Slide 14 shows our gross margin performance over the past couple of years and a steady improvement we made since the significant acceleration and cost inflation which began in the second half of last year.

Gross margin in the quarter was 45.1%, a slight decline from last year's Third Quarter.

In fact, cost inflation from commodities, fuel, energy, and benefits decreased our gross margin by 140 basis points in the quarter alone, more than offsetting the benefit of having less impact from up front costs and also the offsetting positive impact that came from our cost efficiency projects and productivity initiatives.

Also, as we told you in the First Quarter, there was some margin impact on the growth that we've seen in certain new co-manufactured products this quarter.

These arrangements allow us to introduce innovative new products and test their popularity without initially committing capital.

As we said last quarter, we continue to expect full year gross margins to be down; however, in the Fourth Quarter, excluding the significantly greater amount of up front costs , we expect the gross margin to be up.

This improvement will be driven by three things: one) the effective pricing actions taken over the past year; two) easier comparison to cost inflation we saw in the Fourth Quarter of last year and also three) the ongoing benefit of our cost savings programs.

In addition, we continue to expect full year up front costs will be approximately $0.15 per share, right in line with our guidance.

Slide 15 shows the growth in internal operating profit in each of our geographic reporting areas.

This internal growth, which excludes the impact of currency translation.

In North America, internal operating profit growth was 4%.

This result was achieved despite the effect of significant cost inflation and a mid single digit increase in brand building investment.

In Europe, operating profit growth increased by 20% as a result of strong sales growth and gross margin expansion.

In Latin America, internal operating profit growth was 9%, driven by sales growth, and this excellent performance also included a high single digit increase in brand building investment.

And at Asia Pacific, we posted an internal operating profit decline of 11%, driven by difficult comparison to last year and strong double digit increases in brand building in Asia, due to the launch of snacks in Japan.

Our consolidated operating profit growth was significantly greater than our expectations due to good growth and positive momentum across many of our businesses and we expect this momentum to continue into the Fourth Quarter.

Below the operating profit line, interest expense increased due to higher debt as a result of share repurchase activity.

The tax rate in the third quarter was 32%, and note that we continue to expect that the full year tax rate will be around 32% in line with our original guidance.

Now, let's turn to slide 16 which shows the history of our core working capital measured as a percentage of sales.

This progression is important to us as it demonstrates our committment to the generation of cash flow and our ability to focus on the right metrics.

We're pleased with the progress that we've made again this quarter and the progress we've made over the years and we expect to maintain our industry leading position.

Now, let's turn to slide 17 and a more detailed discussion of cash flow.

Year-to-date, cash flow was $850 million versus $915 million last year.

The strength and expected timing of our cash flow performance throughout the year gives us additional confidence that we will meet full year guidance of between between and $975 million in 2006.

Our managed for cash operating principle remains extremely important throughout the organization, and we remain committed to providing strong rates of cash flow growth for our share owners.

And we've returned a significant amount of cash to our share owners.

We've increased our dividend again this year and year-to-date, we repurchased 580 million of our shares.

We expect to complete the remaining 70 million of our authorization in 2006 and in the last 12 months, we've repurchased nearly 1 billion of our shares.

We remain committed to a balanced use of cash flow.

We will continue to assess our dividend.

We will continue to repurchase our stock.

We will continue to focus on decreasing net debt and we will continue to invest in future growth initiatives which is helping to drive ROIC.

Now, let's look at slide 18 and our outlook for the remainder of the year.

Our guidance for strong, mid single digit net sales and operating profit growth hasn't changed.

Our expectations for operating profit continue to include significant incremental fuel, energy, and commodity costs.

Remember, we said that we expected that these costs would be much higher than original expectations.

We seen some recent benefits from fuel costs but as always, costs remain volatile and the entire industry has seen similar inflation.

While prices continue to move, we feel confident that we've got them covered while still increasing our brand building investment in the Fourth Quarter.

Our guidance also includes incremental benefit costs at the high end of our guidance range as we told you last quarter.

In addition, we now expect full year earnings per share to be in a range of $2.48-$2.50.

At the high end, this is three cents greater than the initial guidance we gave for 2006.

As I mentioned, we still expect up front costs to equal approximately $0.15 per share.

In addition, we now expect to absorb $0.11 from the effect of expensing stock options, up $0.01 per share from our previous guidance and we've also narrowed the range of our full year guidance by bringing up the lower end due to current momentum and excellent visibility into the balance of the year.

As Jim said, we have realistic targets and we're comfortable with the current range for 2006 given that we have even more investment planned for the Fourth Quarter than we originally expected.

This will support new and existing products and give us momentum for 2007.

Now let's turn to slide 19 and our 2007 guidance.

And it really should not be a surprise to anyone.

As usual, we expect low single digit internal net sales growth, mid single digit internal operating profit growth, giving us operating leverage and earnings per share of $2.67- $2.72 or high single digit growth, all right in line with our consistent commitments.

First, a word on the shape of the year, although we don't give quarterly guidance, I will say that we are expecting to have lower operating profit in the First Quarter due to significant reinvestment planned to support new product introductions and other brand building ideas.

As you know, we managed a business for the long term, and we can give you more color on the shape of the year on the Q4 Conference Call as we finalize our plans.

We expect gross margins to be broadly flat in 2007 as a result of pricing actions taken around the world and while current commodity Markets are highly volatile.

We don't expect the impact of commodity inflation to be worse than it has been this year, although it will be significant significant and right now, we are anticipating up front costs to be approximately equal to this years level.

If the amount is lower than we expect, we will either reinvest in future growth or we will drop the benefit to the bottom line.

We are budgeting for investment and brand building to increase at a rate greater than sales growth, also right in line with our long term targets, despite the fact that we are generating the efficiencies that Jim discussed earlier.

The investment will be skewed to advertising as we will focus even more on the efficiency of our investment and consumer promotion.

Below the operating profit line, we expect interest expense will increase by approximately 10% primarily due to higher floating rates, although a third of the increase will be offset by higher interest income, and we expect the tax rate will be between 31 and 32%, slightly lower than this year, however, at a level that we believe will be sustainable for the foreseeable future.

Cash flow is expected to increase at a rate approximately equal to net earnings growth, including capital expenditures totaling approximately 4% of sales about amounts similar to this year and with that I'd like to turn it over to Jim.

Thanks, Jeff.

We are confident 2006 will be another year of sustainable growth.

Last year at the same time, we expressed confidence in the coming year.

We have the same view now as we look at 2007.

Confidence in another year of sustainable performance.

With that, we'll take questions now.

[OPERATOR INSTRUCTIONS].

Our first question comes from Terry Bivens with Bear Stearns.

Good morning, everyone.

Good morning, Terry.

On the gross margin, Jeff, thanks for that detail.

I'm wondering, initially, I think we started off 06 if I recall, $0.20 of push from input inflation later went to $0.30.

How is your outlook?

What is Incorporated into '07 in terms of input inflation if you're prepared to give a cents number ?

Yeah, Terry, just a little bit.

We started 06 certainly with the $0.13 to $0.16 and we went up to $0.20 and we still see that range up to $0.30 but for '07, very similar position starting the year as we did in 06.

It's extremely volatile as you've seen on the weak market and some of the other commodities and there's a lot of speculation that we see in the marketplace, very high levels but broadly, basically in the same position as we started last year, probably a broad range of cost inflation that we see would be between $0.10 and $0.16 of EPS.

Okay.

That's built into our guidance for next year.

I know you traditionally were reluctant to say too much about hedging, but Incorporated in that, is there a need to go back into the market perhaps let's talk about wheat maybe , and some caution there as to when you might go back in, pricing at the time, etc?

Terry, from a competitive standpoint, we usually don't talk much about our hedging strategies, but certainly we have an active program.

Okay.

Thank you very much.

I'll adhere to the one question rule here.

Thanks.

We'll take our next question from Alexa Howard with Sanford Bernstein.

Hi.

Can you tell me a little bit about what your longer term plans are for Asia versus Latin America?

It seems to me that the latin American business is really an fire.

It's been doing well for awhile now and the margins out there are great and yet the business seems to be struggling more in Asia, particularly in terms of the top line growth and the operation margins.

Could you tell us a little bit about what drove the operations margins down in Asia this year and also what your plans are in terms of Resource allocation between the two regions?

We've been doing a lot of work, John Bryant and the and the team, working with the Asian team looking at what the opportunities could be in that area.

Clearly while cereal will remain a core part of our business , we are looking at how else could we participate and grow in Asia, and when and if we come up with some ideas we'll let you know, but it's an area of focus for us and really as you look at the Third Quarter, as Jeff said really, we did launch snacks into Japan, so we're using Japan as a if you like a bit of a test market for Asia with the snacks launch to see how that goes.

It started very well but it's very early days at this point.

And I know Latin America, I see that continue to be a focus.

Latin America continues to be our fastest growing region in the world and we'll do everything we can to continue that momentum.

They are doing an outstanding job and we see that continuing as well go forward.

Thank you very much.

And we'll take our next question from Jonathan Feeney with Wachovia.

Good morning.

Good morning.

Congratulations, finally, David.

Thank you, Jonathan.

You've been pulling a lot of productivity savings out of the business now for a few years particularly in the area of trade spending and I know you've wisely reinvested in that and brand building so I'm really not so worried about the margins as I am that are we coming to the end of a period of kind of optimizing that trade spending and we need to look for other areas of productivity growth or do you think there's still more to sort of reallocate in terms of the way you build your business as far as maybe pulling?

And deemphasizing the sort of trade spending and promotional stuff and emphasizing some of the advertising in longer term brand building?

I don't think it ever ends, Jonathan.

We're always obviously looking to optimize our investment and get better returns and sometimes it's not so much that the investment level has dropped as we're just driving different methodologies of deploying that money and getting better returns and better pay backs for the Company and that will be an ongoing cycle for us as we look at trade investment working with our retail partners to try and help them and help us get better value out of the money we do spend.

On consumer promotions, they remain a vital part of our business and really what we've been doing there over the last 12 months is working globally on how can we drive efficiencies, take some of the less effective programs out, optimize sharing around the world, and actually get a much much bigger bang for our buck and we've really done I think a great job in that and you're seeing some of that this year and you'll see more as we go into 2007 and even on media.

We're constantly our reviewing media buying practices and looking to drive efficiencies there and again, in 2006 and going into 2007, we'll see some real benefits coming through there as well, so I don't think Jonathan, it ever stops, and even if the level of absolute spend remains flat, then the focus is how do we get a better return for that investment.

Thanks and just as a follow-up to that, is there anything , I mean, there's been a lot of news about maybe Wal-Mart slowing their growth a little bit, some other retailers that have historically put up really tough comp numbers getting a heck of a lot better.

Is it becoming, maybe I don't want to say easier because it's never easy but more friendly, more partnership environment for optimizing trade spending/maximizing value and profit in these categories through pricing?

Yeah, we're not getting into any detail.

I think, the retail landscape has changed and I think many of our retail partners are talking to us and other companies about how they can more effectively engage their customer base and drive shoppers into their stores.

Okay, thanks very much.

Thanks.

[OPERATOR INSTRUCTIONS].

And we'll take our next question from Hernan Romero with Altima Advisors.

Thanks my question was covered.

Thank you.

And we'll take our next question from David Adelman with Morgan Stanley.

Hi, good morning, everyone.

Hi, David.

I had a question on the U.S. ready to eat cereal market and it's this: If these higher levels of competitive new product innovation persist, when you look out to '07 and longer term, do you think that Kellogg can continue to profitably gain market share in the market?

Yes, I think, David, our view is that the great benefit of the realistic targets we set as we think that's sustainable year after year, I think we look at the Third Quarter, we had a great Third Quarter against incredibly tough comps.

Our base business did very very well, a couple of our, of the major competitors in the category were a bit more aggressive on incremental price driven sales than we would like, but now I think to the extent that people are putting more into innovation and brand building, that will help the category and even if their share growth slows, we'll still be getting a reasonable growth level in what is a very big and mature category.

Thank you.

And we'll take our next question from Eric Katzman with Deutsche Bank.

Good morning, everybody.

Good morning, Eric.

Just one question, it's so tough.

I guess my question has to do with the mix issue in the business in that as cereal or if cereal slows a bit, if the market does become more competitive, I don't know whether your competition or any of them have followed the pricing move that you announced.

It doesn't sound like it, but and you put more capital behind the snack portfolio globally, and in the U.S.

For that matter, how do we think about the mix impact between cereal versus non-cereal and how does that kind of effect your gross margins over time?

I think, Eric, there is a potential if that mix was significant that over the next year or two, that could have a slight impact on a mix.

Our view is that hopefully we're going to keep growing our cereal business even if the rates of growth aren't at the same level and even on snacks and most of the other portfolio, the margins are very good so they could be a bit of a shift.

The margins are closer in the mature markets than they are in the developing markets so it really is a matter of where we're booming businesses, the margins are low in the first one to three years as those businesses mature, then that sort of effect will dissipate anyway.

Okay so it's kind of a combination of geography and product but you're pretty comfortable that it's manageable as long as cereal kind of keeps let's say slowly upticking?

Yes.

Okay.

And then just one follow-up.

Did you mention how much currency benefited you on the bottom line in the quarter and how does that factor in to the full year in '07?

Well, for the quarter, there was a very minor effect from the exchange rates and you know, normally, Eric, for next year, we would consider from a foreign exchange to be relatively flat with what we've seen this year.

We have certain currencies that kind of balance between each other.

Okay.

Thank you.

Our next question will come from Chris Growe with A.G. Edwards.

Hi, good morning.

Hi, Chris.

Just wanted to ask a quick follow-up to Eric's question and that is that your snack division within your international business, roughly how much of your sales of that constitute, is it around 15% of your sales for that division?

It's not a bad guess.

Okay.

And then my question really was for on the U.S. cereal business.

Have you said or could you say how much pricing benefited you this quarter in U.S.

Year quality, there for we seen some of that pricing coming through?

Yeah, in the quarter Kellogg's average price per pound was up above the category, which also grew.

Unfortunately, our two largest competitors price per pound was down really just reflects the heavy levels of price driven incremental sale.

And then the question on the cereal then is you mentioned that inventory levels were a little higher in the third quarter.

Is that a material level or something we should be worried about in the Fourth Quarter for our modeling?

No, Chris.

We manage most of our accounts on VMI, vendor managed inventory so we model inventories very closely.

As we looked at the end of our Third Quarter while our base business sales were strong, our incremental price driven sales were soft because of what the competition has been doing and inventory has drifted up a bit and as we look at it, it's probably less than a percent that we got in the third quarter that will come out in the fourth, so it's not material but it's, that's why we mentioned it.

Sure.

That's helpful.

Thank you.

Thanks.

[OPERATOR INSTRUCTIONS].

We'll take the next question from John McMillin with Prudential Equity Group.

David, congratulations.

Jim, I hope your ham string is better.

Thank you, John.

I did try your idea of realistic targets with my teenager.

I told him to shoot for Cs and it didn't work like it does in the cereal business.

It was a good try though.

We'll come back to you, John.

Simon, I just follow Simon!

You know, just, David, I don't know if you'll answer it so probably allow me another question, but every CEO changes something, and maybe you don't want to go into some of the details, but what do you think you can change or what are you thinking of changing organizationally or --

Well, John, what I can tell you is if we are repeat what was done the last five or six years even though we won't repeat it exactly the same, I think shareholders would be very happy with that, so the sort of, major changes you might be looking for, I think you'll be disappointed.

Well, and just since you didn't answer that one, I'll ask another one.

Just on a reference, I was going to Wal-Mart this week and I saw all of the Yogo products in the candy aisle.

It was put just in the cash register coming in.

Is that what you want it and, can you really kind of compete against the Hersheys, mars of the world?

Is that where you want the product?

Now, I think in most of our retail partners, it sits in the wholesome snacks aisle.

Some of them may be trying it in different parts of the stores, so we'll see what the results are, but that's not what currently exists in most of our trading partners.

Okay, thank you.

Thanks.

Next we'll go to Andrew Lazar with Lehman Brothers.

Good morning.

And to Dave, let me add my congratulations as well.

Thank you, Andrew.

I want to push I guess Jeff if I could just a little bit harder on the gross margin in the quarter.

I know you mentioned all of the various things that were headwinds and there certainly have been other things that were headwinds in the first two quarters as well.

Right.

But it just seems and maybe I'm just off here, it just seems like with the kind of sales growth that you've had that the operating leverage of your business, particularly given the margins around cereal should be allowing you perhaps some more gross margin flexibility, even understanding the cost that you've been pushing up against.

So I guess, are there any other notable things in the quarter that maybe impacted gross margins negatively that are kind of, I know you mentioned some of the co-packing things but is there maybe a way to quantify that to give a sense of what's impacting you because I'm having trouble understanding it.

Actually, we think our gross profit margin performance if you look at the chart is certainly improving quarter by quarter and we feel very good about the Q3 results only being down ten basis points with fuel, energy, commodity benefits.

That's a negative 140 basis points that we're trying to basically offset.

Some of that was offset by lower up front costs, probably around 50 basis points, so the net positive savings being about 70 basis points which we feel is a very good level, but there wasn't anything unusual certainly in the quarter.

It's just a story of commodities.

Okay.

That's helpful.

Thanks very much.

Thank you.

And Eric Serotta with Merrill Lynch has a question.

Good morning.

Following up on Andrew's question on gross margin, I know that you've cited over the past couple of quarters the impact of the co-packing arrangements you've had on new products.

Right.

With your very strong innovation pipeline, should we expect a continued sort of replacement or continuation of the trend as new products come as existing co-products, sorry, co-produced products come in house but new innovation go to co-manufacturers or should we expect some sort of margin benefit at some point from this volume coming in house?

Eric, I think that that depends.

We're taking a responsible view with some of the new products that we don't want to invest the capital until we have a degree of certainty about their likely success rate, so that could generate an opportunity in the future, but it does depend and if it hurts us a little bit in the short-term, we think that's a better way for us to manage the exposure putting capital in.

Okay.

And along the lines of some of these new products that you may not be sure of, the ultimate successes, you didn't mention some of the Special K extensions in the health and wellness area.

I know it's still very early, but could you give us a little bit of color as to how they've tracked versus your expectations on the Special K waters and the like?

Yeah.

It's a Special K protein beverage we call it.

Okay.

And the bars, well, you know, they've gone into most of the drug and pharmacy sections.

They wanted them in there early.

The actual major advertising launch doesn't start until January, so it really is too early to give you any sense of that.

I'd say by the end of the First Quarter next year we'll have , we'll start to get a reasonable sense for that, but we actually drove distribution in front of our launch program at the request of our customers.

Okay, thank you very much.

Thanks.

Thank you.

And next we'll go to David Driscoll with Citigroup.

Hello, this is Michael Avery for David.

Hi, Michael.

Congratulations.

Thank you.

Back to cereal for a minute, I know that the Nielsen data has it's reliability issues that you've mentioned in the past, but to the extent that it might be consistently unreliable, it has shown some more strength with an actual cereal decline for Kellogg of almost 3% in the period that correlates pretty closely to the quarter.

How do you see the cereal category for your business and what would drive the biggest difference between the shipments and the Nielsen data?

Is it the pipeline shipments or other channels or how do you break that down?

Well, I mean, we constantly have this debate, when you look at the overall market, even if you just take the category, the category looks like it's flattish and you'd need to add between two and three points to the category to get a true reflection of what's going on with the category and that's probably true across all of the players in the category and it can vary.

We've had up to a, I think a six or an eight point spread at certain times between ROI and our reported numbers and it's actually a little bit closer now with us up three and if we look at the ROI data really showing us sort of up a little bit relatively flat, but remember our year-to-date share is up 30 basis points.

We were broadly flat depending on which period you look at in the quarter and our base sales which is is really the thing that we focus on grew much faster than the category and our average price per pound was up.

Our two biggest competitors, their base sales grew lower than the category and their incremental was up higher than the category and their average price per pound both declined, so in that context, and up against an 11% year-ago comp, Michael we feel very good about our Third Quarter performance in cereal.

That's very helpful.

Thanks a lot.

And we'll take our next question from David Palmer with UBS.

Hi, guys, congratulations David and Jim.

Thank you.

I think I found a way to kind of combine several questions into kind of a big theme one.

That's a paragraph!

It seems that snack aisle has been particularly active with innovation and Kellogg has really pursued it very well with a variety of trademarks and extensions in there, but it does seem like the snack aisle has been getting kind of cluttered and I wonder if there is kind of a point in the evolution of that part of your business where the growth might begin to cool over time and the big picture is that you're perhaps hoping for other new things, you have the fruit snacks and the new weight Management products , and the big picture, that those will pick up the slack and as you perhaps in source those eventually that the margin swap might be fairly neutral.

Yeah, I think firstly on the whole some snacks category, it's clear that we are talking to our retail partners about potentially adding more space because it is under spaced relative to it's growth and it's return, not only to them but to the places and we would hope to see some expansion in some of the space allocated, and our view is that we'll grow in that category, we'll grow at about mid single digit and it will be slightly higher or above our low single digit but we think it will abate and it does go through cycles as we've seen before and normally what happens, David, is the clutter shakes out.

You remember when we had the low carb situation with a massive number of new products coming in, almost all of those have gone or are about to go, so we have very strong brands.

We continue to expect good performance as we go forward.

Thank you very much.

Thank you.

And we'll take the last question from Pablo Zuanic with JP Morgan.

Good morning, everyone.

Congratulations to Jim and David.

Thanks, Pablo.

It's good to see a Company that'll actually keeps the Chairman role and CEO role separate.

Just one question in terms of the cereal category, David, according to data, the category has really slowed and even including Wal-Mart in the last few months the category has actually been down and I'm just wondering s that true, is that are you seeing a decline in the category in terms of growth and we also get a sense that Wal-Mart is reducing the space to cereal because the growth of cereal at Wal-Mart has also slowed down so help me understand that and tell me also with cereal, what's next?

Omega three, we had fiber, we had whole grain, we had reduced cholesterol.

What's next to really, I guess, bring back excitement to a category in terms of innovative breakthroughs?

Actually, Pablo, as we look at the category in the third quarter, it was stronger than either the first or the second , and when you look at the Fourth Quarter last year, it was the weakest quarter, so our view is the category actually, the opposite picked up a little bit Third Quarter versus the first half.

Our view is that the cereal category will continue to do well.

As we've said if you blend the other channels, our view is it's growing two, maybe a little bit more than 2% and the extent to which we can continue to bring excitement to the category will keep growing the category and hopefully performing well.

I am not aware of a slowdown in any of our major customers and it remains a big focus for most of them because the category Management data that we have looked at indicates that anyone who buys cereal has a higher shopping basket than people who don't so it remains a destination category.

We have strong plans for innovation.

We are going to continue what we've been doing.

There are some exciting things in the future, but it's a bit early to really lay those out.

Again, just one follow-up if I may nor Jeff.

Jeff, you know when I look at the gross margins and EBIT margins, first of all to talk apples to apples we have to take out the option expense from SG&A and then we have to take out the charges which in this case were lower than last year and what I seen and bear with me here, I see gross margin from 2000-2004 increase and you actually were able to maintain your SG&A so we saw margin expansion.

In '05 as you guided, SG&A to sales increased because you were reinvesting in the business but in 2006 our model has really broken.

I mean, for the first three the quarters if you adjust, maybe these adjustments your gross margins have dropped and in fact in this quarter they fell two basis points and it seems to me you have founded some of that with lower SG&A again to sales.

So what I'm trying to understand if you're saying that brand building is up and I'm sure it is, where is the savings coming from and if they are coming from G & A, why didn't we see that before?

Because again in adjusted terms, SG&A to sales from 02- 05 was not declining like it has this year when you made a bigger emphasis on increasing brand building.

Help me understand that.

Certainly, you have to take in effect the up fronts and cost of goods sold in 05.

And when you look at our SG&a, certainly reported number you have to back off the stock option expense which the savings are really coming from our overhead area.

We look at overhead just like we do on cost of goods sold from an efficiency standpoint, so and you got to look also that our sales growth has been frankly at the high single digit level which when you look at a margin basis of SG&A and brand building as a part of that it's going up in line with that, it's not a little bit more.

So I think you got to look at the sales growth factor in line with the brand building growth factor.

Okay and if I may just last one David, I'm the last one on the Q, but in terms of i putting the business, you're saying keep doing what you're doing and I hear you, but what could you make to maybe Carlos's strategy in international business is it was really Mexico, Australia, UK, kind of and some business in other Markets, emerging Markets have been pretty much not explored, Asia and other Markets and I find that you left and obviously CBW get a hit starting in the emerging Markets.

Is that something that you plan to address in a different way or it's not really a big deal?

There's no hurry to worry about cereal consumption in China?

Help me understand that, your strategic division in regard.

I think we said at CAGNY that we were looking at the areas of the world where potentially your point, we backed off a bit when we did focus on the line.

We may be a little bit behind, but it doesn't make the opportunity any less significant.

Okay.

That's good.

Thank you.

Okay.

We're going to end the call now, Operator, if we may?

Yes, that does conclude today's Conference Call.

We do thank you for attending today and have a great day.