家樂氏 (K) 2015 Q2 法說會逐字稿

Good morning.

Welcome to the Kellogg Company second quarter 2015 earnings call.

(Operator Instructions)

Please note, this event is being recorded.

Thank you.

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

Mr. Burton, you may begin your conference call.

Thanks, Gary, and good morning.

And thank you, everyone, for joining us for a review of our second-quarter 2015 results.

I'm joined today by John Bryant, Chairman and CEO, Ron Dissinger, Chief Financial Officer, and Paul Norman, President of Kellogg North America.

The press release and slides that support our remarks this morning are posted on our website at www.kelloggcompany.com.

As you're aware, certain statements made today, such as projections for Kellogg Company's future performance, including earnings per share, net sales, margin, operating profit, interest expense, tax rate, cash flow, brand building, up front costs, investments and inflation 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.

As a reminder, a replay of today's conference call will be available by phone through Tuesday, August 11.

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

Now I'll turn it over to John.

Thanks, Simon, and thank you, everyone, for joining us.

Results for earnings were in line with our expectations for the second quarter.

Comparable sales were approximately flat to last year, and comparable earnings were $0.92 per share.

The better performance we saw in the US cereal business in the first quarter continued in the second quarter.

And we again saw a good performance across the international regions as well.

The benefits we have seen from our initial investment in Project K have continued, and we expect it to continue to build momentum in the second half of the year.

We are on track to meet our guidance for the full year.

Specifically, we expect approximately flat currency-neutral comparable sales, a decline in currency-neutral comparable operating profit of between 2% and 4%.

Including a negative impact of 3 to 4 points from rebasing of incentive compensation, and currency-neutral comparable earnings per share to be between flat and down 2% also impacted by compensation.

Our performance in 2015 represents a significant improvement from 2014, and we believe that we are building a foundation for better results in the future.

As a result, our improving momentum and increasing visibility into productivity programs are driving our confidence that we will achieve our long-term targets for sales and operating profit growth in 2016.

So with that in mind, I would now like to talk about some of the things that give us that confidence.

First, let's turn to slide 4 and a discussion of our momentum.

Paul and the team have done a great job of improving the performance of our US cereal business this year.

And while we definitely have more to do to improve category performance, we're confident we're focusing our investment on the right drivers of sales growth to continue recent trends.

We're improving our food.

We have invested in our sales force, and we are improving the effectiveness of our brand building.

In addition, as you've seen in recent quarters, our international businesses have been performing well.

We are pursuing some better results in a difficult environment, and growth has been good in Latin America and in Asia.

Secondly, our investment in Project K has helped to drive the improved momentum.

It has provided us with the funds to invest in the Kashi organization, and a significant number of new sales reps in both our warehouse and DC sales forces in the US, and in our coverage of high frequency stores largely in emerging markets.

These investments have already had an impact, and will help to drive even better results next year.

Finally, we have made some significant structural changes to our business.

Paul will bring his experience and knowledge to running the North American business.

Also, we have recently hired Craig Bahner to run our morning business, and we've also hired Deanie Elsner, who was most recently CMO at Kraft Foods to run our US snacks business.

I believe that our Management team is now the best we have had in years, and represents the right mix of experienced industry professionals from outside the organization, and talented long-term Kellogg employees.

With that, I would like to turn it over to Ron.

Thanks, John, and good morning.

Slide 5 shows the financial results for the second quarter.

As you have likely seen, our reported results include a re-measurement of our Venezuelan business to the sumadi rate of VEF198 to the US dollar.

Venezuela is a volatile market, and our circumstances changed in the second quarter.

We experienced disruption in our business operations, driven by reduced access to US dollars for inputs to support production.

As a result, we re-measured our business accordingly.

The financial impact of this re-measurement is disclosed in detail in the appendices to our presentation materials.

Reported net sales declined by 5.1%, due to the devaluation of international currencies.

Currency-neutral comparable net sales were essentially flat, in line with our guidance for the year.

We saw strong broad-based growth in Latin America and Asia Pacific, and in addition, our US frozen foods business grew as did our Canadian business.

Reported quarterly operating profit was $412 million.

And included Project K execution costs, and the impacted re-measurement of the Venezuelan business.

Quarterly currency-neutral comparable operating profit decreased by 6.8%, in our line with our expectations.

The decline was due to timing of manufacturing costs and higher distribution costs, as well as the impact of resetting incentive compensation.

Comparable earnings per share, which exclude integration costs, mark-to-market adjustments, Project K costs, $0.37 per share from the re-measurement of the Venezuelan business and other items that affect comparability were $0.92 per share in the first quarter.

These results include $0.05 of currency headwind, as a result, currency-neutral comparable earnings were $0.97 per share.

Slide 6 shows details regarding the second-quarter sales growth.

Comparable revenues for the quarter increased 0.1%, a slight improvement from the first quarter, and included a 0.5% increase in price mix driven by our Latin America business.

We saw good volume growth in Asia Pacific and Latin America driven by growth in cereal, and several of our North American businesses grew volume as well.

The slight decline of 0.4% is primarily due to cereal in developed markets.

But as Paul will discuss later, we are seeing improving trends in US cereal.

Currency has lowered reported net sales by 5.5%, driven mostly by the euro, the peso, the Canadian dollar and the pound.

Slide 7 shows our year-to-date currency-neutral comparable gross profit and gross margin.

Year-to-date, gross margin was broadly in line with last year and with our guidance for the full year.

While we have recognized lower material costs and we continue to generate strong productivity improvements across our supply chain, we are seeing higher inflation and distribution costs.

And as I mentioned earlier, some timing on our manufacturing costs versus prior year.

In addition, we are investing in our food across the globe.

Recall that we mentioned that some of the Project K related savings would be invested in our food.

This includes the renovation of Kashi and Special K, as well as the launch of granolas and mueslis in a number of countries.

Slide 8 shows the quarterly currency-neutral comparable operating profit performance for each of the regions.

North America's operating profit decreased by 13%.

This was the result of sales declines, increased distributions costs, the timing of costs in our factories and the resetting of incentive compensation levels.

We do expect the results to improve as we progress through the balance of the year.

Europe's operating profit increased by 6% in the quarter.

Driven by broad-based improvement in cost of goods sold, including Project K savings, and the timing of brand-building investments which are weighted more to the second half of the year.

Quarterly operating profit increased by 9% on Latin America, as a result of strong sales growth.

This quarter's growth included a significant increase in investment and brand building.

Operating profit increased by 76% in the Asia Pacific region.

This was the result of double digit sales growth in Asia and South Africa, lower cost of goods sold and comparisons to last year.

In addition, the region saw some benefit due to the timing of brand building between the second quarter and the third quarter.

The growth in operating profit also included continued investment in capabilities in the region.

Slide 9 shows our year-to-date cash flow.

Year-to-date operating cash flow after capital expenditure was $323 million.

Cash flow in the second quarter was $311 million, which represented an improvement of more than $50 million from the second quarter of last year.

We saw a good performance in our core working capital, as I'll discuss in a minute.

We continue to expect full year cash flow of approximately $1 billion.

Our cash requirements for Project K are the highest in 2015, and this is impacting our year-to-date position.

But we remain on track to meet our outlook for the year.

And of course, returning cash to share owners remains a priority for us.

In total, we have returned more than $2 billion to share owners over the last two years through dividends and share repurchases.

Slide 10 shows our core working capital as a percentage of net sales.

As you can see, our performance had flattened out over the past several years.

But we have made a lot of progress improving our position recently, and have best-in-class levels of working capital.

We have said that we would improve performance further to unlock cash flow after the acquisition of Pringles, and to help us fund cash requirements for Project K. And our supplier financing initiative has contributed significantly to this improvement.

Slide 11 details our currency-neutral comparable guidance for 2015, which has not changed.

We continue to expect that net sales will be approximately flat for the year.

We now expect a relatively neutral balance between inflation and a combination of productivity improvements and Project K savings.

We've seen slightly more costs come through on materials and distribution, but we have been able to manage the impact in our outlook.

Our materials are more than 90% covered.

And as a result, we expect gross margin for the year to be flat to up slightly.

We expect that operating profit will decline by between 2% and 4%.

We also still expect that currency-neutral comparable earnings will be between $3.74 and $3.82 per share, or in a range between flat and down 2%.

Guidance for both operating profit and earnings per share include the impact of resetting incentive compensation.

The expectations for sales, operating profit and earnings per share exclude the impact of last year's 53rd week.

The impact of the re-measurement to the Venezuelan business, and the impact of currency translation.

Our expectation for the impact of foreign currency translation is now approximately $0.29 a share, up from the $0.24 per share we expected last quarter.

This includes our estimate that the currency headwind from translating future 2015 earnings for our Venezuela business at the sumadi rate will be approximately $0.10 per share.

This will offset some improvement we have seen in other currencies.

Our tax rate is still expected to be between 27% and 28%.

And interest expense is expected to be between $215 million and $225 million.

We continue to anticipate that cash flow after capital spending will be approximately $1 billion, as I mentioned.

And this includes total incremental cash costs of $350 million for project K. Partially offset by benefits from our supplier financing initiative, and other cash flow initiatives.

Total capital spending should be in a range between 4% and 5% of sales.

Including approximately 1 point of sales for incremental capital associated with Project K. And our current plan is that we will repurchase between $700 million and $750 million of shares in 2015.

Slide 12 shows our full year earnings per share walk.

Costs for the integration of Pringles and Bisco Misr in Egypt are still expected to be between $0.04 and $0.06 per share.

Project K's pretax P&L costs are anticipated to be between $400 million and $450 million, or approximately $0.80 to $0.90 per share for the year.

75% of which will be in cost of goods sold.

And the impact of the re-measurement of Venezuela, in addition to the translation impact of $0.10 per share, is expected to be approximately $0.43 per share in total.

A small amount of the re-measurement will impact our second half of the year.

Incremental savings from Project K are still expected to be between $90 million to $100 million for the full year.

And approximately two-thirds of this will come from cost of goods sold.

For the remainder of the year, we expect comparable earnings-per-share delivery, including the impact of foreign exchange to be approximately evenly split across the next two quarters.

Our foreign currency headwind is much greater in the third quarter, as currencies had already begun to devalue in the fourth quarter of last year.

And with that, I'll turn it over to Paul for a discussion of our North America business.

Thanks, Ron, and good morning, everyone.

Let's first turn to the performance of the businesses within the North America segment.

Let's start with the morning foods business.

As you may have seen in public consumption data, the performance of the cereal category has improved this year.

Total consumption across all channels was approximately flat in the second quarter.

And importantly, Kellogg branded sales were essentially flat too, with our six largest cereal brands collectively growing sales and share in the quarter.

This performance was driven in part by the good performance of the Special K brand.

One of our main areas of focus over the last year.

I'll talk more about this and morning foods in a minute.

Moving onto US snacks.

We saw mixed results in the second quarter, with sales down 1.8%.

Pringles grew nicely.

Consumption trends in crackers and cookies improved, but we experienced continued weakness in wholesome snacks.

In crackers, our Cheez-It brand grew sales and a full point of share in the quarter.

In fact, excluding Special K Cracker Chips, our total cracker business grew sales and share.

On Special K cracker chips, velocities are improving.

However, prior losses of distribution continue to weigh heavily on our year-over-year performance.

In cookies, consumption and share trends also improved in the quarter.

With our Fudge Shop, Sandies and Simply Made brands all showing consumption growth.

In both crackers and cookies, our innovation is weighted to the back half.

With new items such as Cheez-It Extra Toasty, Town House Focaccia, Chips Deluxe Peanut Butter with M&Ms and Simply Made Sandwich Creams amongst the numerous launches coming to market now.

Whilst Pringles, crackers and cookies all showed positive signs in Q2, wholesome snacks continued to under perform.

Rice Krispy treats and our base Nutri-Grain foods performed quite well.

However, distribution losses on prior innovation have impacted our business this year.

We are committed to improving the performance of US snacks, and this will be an area of focus for me in coming months.

Moving onto the specialty channels business.

Sales declined by approximately 1% in the second quarter, although our business improved as the quarter progressed.

In the Convenience channel, we saw share growth in five of the seven categories in which we compete.

Although we did see some weakness in food service, partially due to the exit from some unprofitable business.

We are confident that our Specialty channels business will grow in the second half.

The final business is the North America other segment.

This is the combination of frozen foods, the Canadian and the Kashi businesses.

Frozen foods posted currency-neutral, comparable net sales growth, driven by strong results from the Eggo brand.

Eggo waffles saw momentum in consumption, increased share, increased base sales, and gains in penetration and buy rate.

In addition, Eggo hand held breakfast sandwiches continue to do really well in their first year.

We also saw good sales growth in the Canadian business.

As cereal, frozen food and snacks all posted growth, with sales of Pringles up at a high teen rate.

As expected, sales of the Kashi business declined in the second quarter, which led to a decline in total North America other segment sales of about 1.3%.

While sales were down, the trend improved as the team began to launch new products and reestablish distribution.

I'll come back to Kashi in a minute.

And now, over the next few slides, I'd like to focus on the US cereal business and some of the progress we have made.

Let's start with slide 15.

Over the past nine months, we have made good progress on the agenda we set out.

And I've seen a stabilization of our Kelloggs' branded business.

This is illustrated by our improving top line performance and Kelloggs' branded share being up year to date.

Back at CAGNY, We spoke about four critical elements to returning cereal to growth, as illustrated on this slide.

These were focusing on wellness, investing in our foods, engaging with consumers in new ways, and dialing up the fun and executing with impact.

Slide 16 focuses on the first of these, wellness in today's world.

One of our biggest challenges has been to return the Special K brand to growth.

We have moved the focus of the brand away from diet towards wellness.

In the past few months, we have launched a new protein offering and introduced a gluten free Special K.

We have also launched taste renovation binding more berries to our largest variant, Special K Red Berries.

And we have improved our Special K Vanilla Almond food too.

We have introduced new packaging, and new communication to support all of this.

I'm pleased to say, we have seen steady improvement in performance over the past few months as you can see on the slide.

In fact, consumption increased by 2.4% in the latest public data.

We also have more news to come in August, with the launch of new Special K Apple Cinnamon Harvest.

Now let's turn to slide 17.

Our other challenge has been Kashi.

Whilst we have yet to see the kind of turn around we have seen on Special K, we are seeing distribution losses subside, and velocities begin to stabilize.

The team is making good progress on renovation and innovation plans.

And we expect to see the fruits of these efforts begin to come through in improving trends over the coming months and as we enter the 2016.

You can see on the slide some of the Kashi innovation we have launched recently, all have coming soon.

Including overnight mueslis, granolas, gluten-free waffles, organic chewy granola seed bars, and Sprouted Grain and Sweet Potato Sunshine Organic Promise cereals.

As you know, we have made a specific investment in the Kashi team and organization, and we believe we have the right structure in place.

The team is focused on delivering on trend food to holistics, and will leverage the Kelloggs' Company's infrastructure to the degree that it helps them achieve that objective.

Earlier in the year, I also mentioned the launch of Kellogg's Origins, which you can see pictured on slide 18.

This is a range of cereals, granola, and mueslis made with simple ingredients and designed to meet evolving consumer needs.

The brand is now launched, and early acceptance has been good.

The second critical element to returning cereal to growth is investing more in our food.

Our work on Kashi, Special K and Origins all demonstrate actions to invest more in our foods.

You can see on slide 19 that this year, we have also launched new and improved Froot Loops and Apple Jacks with lower sugar.

And as we look forward, we will continue to renovate our core offerings to give consumers more of what they want in the way of nutritional benefits.

Such as protein, gluten-free choices and simpler ingredient lists.

We know consumers are looking for foods with simpler ingredients, and work is well underway to answer that call.

Already in North America, 75% of our cereals are made without artificial colors, and more than half are made without artificial flavors.

Further, we have been working to remove artificial colors and flavors across Kelloggs' branded cereals and a variety of Kelloggs' branded snack bars, as well as Eggo frozen goods.

Our goal is to complete this transition by the end of 2018.

The cereal category is and always has been a repertoire category.

Offering health, taste, and importantly, fun too.

We believe getting this blend right is as important today as it has ever been.

You can see on slide 20 that keeping our category vibrant and on trend, also means bringing fun to life on pack and into store in impactful ways.

We have seen good results behind our Disney Frozen cereal this year, and also strong in-market performance behind our in-pack Avengers promotion, an event in April.

Looking forward, we believe initiatives like these are just as important as what we do on the health and nutrition front to drive category engagement.

The final area I wanted to mention is in-store execution on slide 21.

With our dedicated sales force, including field sales reps, back in place, we are seeing tangible improvements come through in the area of assortment gains, in-stock performance, and merchandising behind the initiatives I outlined earlier.

So in summary on slide 22, whilst we still have plenty to do, we are pleased with the progress we are making on our cereal business.

Behind better core brand performance, relevant innovation and renovation, and better execution through the path to purchase.

In fact, sales are on trend to be flat to up in 2016, a great improvement.

Finally, I would like to thank the entire morning foods team who have done an incredible job over the past year, improving all parts of our plan.

With that, I'll turn you back to John.

Thanks, Paul.

And now let's turn to slide 23 and detail regarding our European business.

The Pringles business in Europe had another great quarter.

And delivered mid single digit currency-neutral comparable sales growth on a difficult double-digit comparison last year.

The business in the UK posted double-digit growth and share gains, partially as a result of increased distribution.

In addition, the launch of Pringles Tortilla made an important contribution to sales, although only launched recently.

We have a significant Pringles business in Germany as well.

And we saw high single-digit sales growth there as a result of distribution gains and increased commercial activity.

Consumption trends improved in our wholesome snacks business in the second quarter.

We have re-staged Special K bars in the region, which is helping the brand's performance.

This and the renovation of some of our foods will continue to contribute, and we expect the wholesome snack business to return to growth by the end of the year.

Total comparable net sales in the region decreased by 2.5% in the quarter, as the cereal category continue to be a challenge.

We re-staged our Special K cereals in July, and had other activity launching at the same time.

In addition, we're introducing new Special K cereals on the continent in the second half.

We have introduces mueslis in Germany, and are expanding they're direction to other parts of the region.

Slide 24 shows some detail regarding our Latin American business.

Total currency-neutral comparable net sales in the region increased by 14.5% in the second quarter, driven by growth in both cereal and snacks.

Sales in the cereal business were ahead of our expectations, and included both volume growth and improvement in price mix.

In addition, we gained category share across our key businesses.

And we increased investment in brand building at a double-digit rate in the quarter.

Specifically, we saw good growth in our portfolio of kids cereals, and a benefit from the parent brand products we have launched this year.

Sales in the snack business increase at a high single-digit rate, largely driven by new products and go-to-market programs.

In addition, underlying consumption growth in Pringles was good.

All of which led to increased year-to-date share gains in the Mexican, Brazilian and Columbian businesses.

As we discussed on last quarter's conference call, we executed the Copa America Soccer related initiative in the second quarter, and it was a huge success.

It had the highest customer engagement ever from a program in Latin America, and has helped to drive the sales growth we saw in both Pringles and cereal.

Also as we discussed last quarter, we have started investing in high-frequency stores in the region.

This initiative is relatively, new but is already driving distribution gains and sales growth, and we see significant opportunity for further gains as we expand our efforts.

The team in Latin America has done a great job with new products, investing in growth, and executing the plans, and the results this quarter reflect all of its effort.

Let's turn to slide 25 and our Asia Pacific business.

Currency-neutral comparable net sales in Asia and sub-Saharan Africa increased at a double-digit rate in the quarter, due to broad-based growth.

The Indian business also grew at a double-digit rate, and [grocers] show that cross brands for some our new packaging initiatives driving results.

The business in Japan also grew at a double-digit rate, due to the continued popularity of granolas and strong growth from All Bran.

New advertising and innovation helped drive sales of the Special K brand, up significantly in South Korea, and we saw good growth in southeast Asia.

The Pringles business also posted strong net sales growth in the quarter.

And consumption increased at a double-digit rate, due to graphic expansion and the success of a music campaign, similar as to the one we ran in Europe.

Sales declined in the Australian business, which led to total quarterly sales growth for the region of 6.8%.

While we expect the environment in Australia to remain challenging, we have plans for improvement.

Which include new product introductions, support which stresses the nutritional benefits of our food, and a focus on increasing distribution.

The first half of the year has been strong for the Asia Pacific segment.

And we expect that the team will continue to execute well for the remainder of the year.

Let's turn to the summary on page 26.

We are on track to meet our expectations for 2015.

And importantly, this performance will represent progress over 2014.

As I mentioned earlier, we're building momentum.

We're seeing improvement in our US cereal business, improvement in our European business, and good growth in both the Latin American and Asian businesses.

And we're confident that this improvement will continue into 2016.

We've invested savings from Project K, and have seen the benefits.

And this investment will continue to increase next year.

We have a talented management team that will drive the results of the individual segments.

We have a well-defined strategy that we are continuing to execute.

And we're starting an aggressive zero-based budgeting program which we expect will generate significant savings in addition to the savings flowing from Project K. These two programs will allow us to invest in the business, while also driving improvement in operating margin.

All of this gives us confidence that we will achieve our long-term targets for comparable sales and operating profit growth in 2016.

We're planning an investment day in November, and we'll give you more detail then regarding our plans for next year.

With that, I would like to end by thanking our employees around the world for all of their hard work.

Now we'll open up for questions.

(Operator Instructions)

The first question comes from Alexia Howard with Sanford Bernstein, please go ahead.

Good morning, everybody.

Good morning, Alexia.

Can I ask, just in terms of the improvement in profitability in the second half, just to help me understand that a little better.

It was obviously down quite a bit this quarter, I think 6.8%.

Did that include roughly a 6% headwind from incentive comps that basically goes away from here on out?

Because you started taking guidance down in the second half of last year?

If we could just run through that, and then I have a follow up.

Sure, Alexia.

A couple of things on that.

First of all, we do have an expectation that sales will improve over the second half of the year.

We have seen improvement from the first quarter to the second quarter, and we expect that to improve as we go into the second half.

We did have some incentive compensation headwind in the second quarter.

It's a couple of points impact to operating profit.

We do have some of that impact going into the third and fourth quarter as well, though, so that isn't the primary driver.

Really it's the sales performance.

And then from a productivity standpoint within cost of goods sold, we are seeing our savings ramp up a little bit as we go through the balance of year.

That will help both gross margin, as well as operating profit performance.

Okay.

Thank you for that.

And then the North American operating profit trends, you're expecting to get back onto your long-term earnings growth algorithm in 2016.

Does that mean that operating profit growth in North America should pull around very quickly here, certainly within the next two or three quarters?

As I mentioned, we do expect improving trends in operating profit in the back half for North America.

And as we move into 2016, as you would expect, we do anticipate growth in North American operating profit.

Okay.

So, very early in the year.

Thank you very much, I'll pass it on.

The next question comes from Andrew Lazar with Barclays, please go ahead.

Morning, everybody.

Morning, Andrew.

Just following on that, this is, I guess is as early in the year that I can remember in quite some time where Kellogg discussed at least preliminarily their view for the out year.

In this case, 2016.

So again, I'm just trying to get a sense of maybe why the -- what drives the timing of that to be this early in the year to talk about next year?

And I think as you discussed earlier, it does require morning foods to certainly be more stable and really into modest growth mode.

So is this just really a thought around your confidence level of that happening, sooner than later, and really what's driving that?

Good question, Andrew.

I think it's, as you say, very early in 2015 to give guidance for 2016.

What we're essentially doing is letting investors know that we expect to be on our long-term top line and operating profit growth goals for 2016.

And the reason we're doing that, as we look at the performance in 2015, we believe that we're building momentum,.

It's a significant improvement from where we were in 2014.

We expect that momentum to build into 2016.

What's driving that momentum is the returns on our Project K investments, so whether that be the global category teams and rapidly transferring ideas around the world; the Kashi team, and the stronger innovation pipeline we see coming from that business; investing back in in-store execution; feet on the street in our US cereal business; and the investments in our emerging market capability, such as high-frequency stores.

Also we have excellent productivity programs into 2016.

We have additional savings from Project K. We have our underlying continuous improvement programs, and on top of that, we have the zero-based budgeting initiative.

So, while it's too early to give specific guidance for 2016, we want to give investors a sense as we go into 2016, we do expect to be back on our long-term goals.

We could obviously, hold for the third quarter call or the fourth quarter call to do that, but we have given a commitment to investors to get back on those goals as quickly as possible.

And we wanted to get that out there that we see that happening in 2016.

Thank you.

The next question comes from David Palmer with RBC Capital Markets, please go ahead.

Good morning, and thanks for the deep dive on North America.

And just wanted to ask, Paul, if we were to use the Special K extensions and snacks as a case study as to what you're trying to do with Special K; you have made some progress with Special K in cereal.

And it seems to be a little bit more slow to recover in the snack side, and you're talking about feet on the street investments there.

Could you perhaps talk about what the issues are between execution, reformulation or other with that side?

Thanks.

Hello, David.

I would say we're probably -- we have been a little ahead on some of the work we have been doing on cereal, and we have touched all parts of the brand.

If you take Special K where it plays in snacks on crackers, on the Special K Cracker Chips, we are seeing some improving velocity through the renovated foods we put back in market.

However, we are lapping some pretty significant distribution losses.

So the biggest issue there is recapturing lost distribution to be able to get that part of the business back on trend.

As you go towards wholesome, we did do some renovation on our core bars earlier in the year, and they're holding steady.

We're just launching, as we speak, Special K chewy nut bars, which is a step change in food, and that's just entering the market as we speak mid year.

So we'll be watching that closely as we look forward on Special K.

So the work is coming, the innovation is there, the renovation is there.

It's a little behind in wholesome, relative to where it was in the cereal business.

And if I could just follow up on that, just the reinvestments that were made in the DSD, the feet on the street, I think that began last year.

How has that reinvestment there or investment there progressed over the last couple years?

And if there's any sort of detail you can give us about how that's going.

Thanks.

We did add some additional reps to the DSD system back, I think it was early last year.

And we've had some impact from that.

I think what we have seen on the morning foods side of the business that even more impact where we've put the feet on the street back on the warehouse side.

And as a proportion of the change, the impact to the warehouse is much bigger than the impact would be to the DSD system.

Thank you.

Thank you.

The next question comes from Bryan Spillane with Bank of America, please go ahead.

Hello, good morning.

Morning, Bryan.

A question about the zero-based budgeting.

If I recall correctly, where we left off last was that you were watching and what was happening at perhaps at Kraft or some other companies, and were going to look at it closely.

So I guess we could talk about maybe what's changed in the last three months that caused you to think about or caused you to go further down that path on zero-based budgeting.

And then connected to that, will you consider any change in the way that you change incentive compensation related to it?

Just simply because it's such an investment for the employee base, and it's a little bit long-term in terms of driving value.

So those two things, what's changed in terms of adopting it, and will it come with a change in the way you calculate or look at incentive comp?

Hello, Bryan, this is Ron.

Hey, first in terms of our zero-based budgeting initiative that John mentioned, timing is absolutely right for us at this point in time.

Remember a couple of years ago, we undertook Project K, big initiative for us, touching all parts of the globe.

That project is progressing very well.

It's on track at this point in time, both from an operational execution standpoint as well as the financial elements of the program.

The fact is, we already ran some pilots on zero-based budgeting back in 2014, so we have learned from those pilots.

We have determined now the application is right.

We're going to begin in North America, and actually that gives us some support for confidence in growing profit in North America next year.

So we'll roll it into North America end of 2015 and into 2016, and then cascade it across the globe after that.

Little bit early for us to talk about savings estimates at this point in time, but it does give us more confidence, as I said, in our 2016 outlook.

And on the incentive compensation.

I wouldn't see us changing our macro plan design, but I could see us working to ensure we incentivize the savings for the people who are driving that program.

Thank you.

The next question comes from Jason English with Goldman Sachs, please go ahead.

Good morning, folks, thanks for the question.

Morning, Jason.

I guess I was a little surprised in terms of your gross margin outlook, where you talked about inflation and productivity and now neutral for the year.

And it sounds like there's some incremental costs rolling through the P&L.

Can you give us a breakdown of what that is?

And also, any incremental color you can add in terms of the magnitude of investment that you're absorbing in gross margin with regards to the product quality and rejuvenation efforts there?

Sure, Jason.

In terms of our output on our input, so our productivity and then input costs, there has been a little bit of a change.

Remember when we started the year, we said that all up with the productivity savings, the input inflation, and then Project K savings, we may be net a little bit deflationary.

Well as we have come through the front part of the this year, we have encountered avian influenza.

That is having an impact on our [A] costs, and it's relatively significant for us.

So it's having and impact particularly on our back half cost structure.

So we're expecting it to be relatively neutral now.

We do believe our gross margin will be flat, though, to up slightly.

Well, it's difficult for us to tease out the additional costs of renovating our foods.

Certainly, there are additional costs in this year from doing that, and there will be meaningful costs over the next couple of the years from continually evolving and improving our foods.

And we will fund those through a variety of productivity programs within the Company to absorb those costs.

Got it.

That's helpful.

And one more, if I may.

Question for you Paul, in terms of North America cereal.

Can you give us a sense of how much capacity you have taken out of the cereal market in the US?

And how much, from where you sit, you think has come out of the industry?

And as we look at some of the scanner data, it is encouraging to see that the amount of volume that's being sold on promotion has been steadily eroding.

Do you think that we're seeing more rational behavior in terms of discipline on promotion and price investment, and do you think there's any relation to the capacity reductions that have happened?

Obviously, we did close a facility last year in Canada, so that came out of the Kellogg business.

I can't talk to all the stuff that's going on with our competitors, but I know they're making moves as well.

I think the marketplace is pretty rational at the moment.

We're seeing a little bit of price realization.

We're putting our money, as I said, back into our food.

We're investing back into our core brands.

We're renovating, innovating and trying to drive those sales fundamentals right through to the store.

And I think that's where we'll get the benefit.

I don't think there's going to be a lot more heavy promotion, per se.

I think the category dynamics are pretty good at the moment.

Thanks a lot guys.

I'll pass it on.

The next question comes from Kenneth Zaslow with BMO Capital Markets, please go ahead.

Hello, this is [Michelle Patel] in for Ken.

I just had a question on the recent agreement with the union that you announced over the weekend.

You're not reducing work force as a result.

Is that a fair statement?

Yes, Michelle, I think if you look at our cereal network, as Paul mentioned, we closed a fairly meaningful facility last year in London, Canada that's reduced the size of our footprint in North America.

The contract that was signed with the union I think is a very good contract.

It enables us to be more cost competitive.

It gives us operational flexibility going forward.

So it has us holding the number of cereal plants we have today open, but we have flexibility within that to change the scheduling and the production based upon what we need to produce for the category.

Great.

Thank you.

The next question comes from David Driscoll with Citi, please go ahead.

Hello, this is Alexis Borden in for David this morning.

Morning.

Question, so comparing Special K with Kashi.

So basically, so you have been seeing Special K trends improve, and the retail scanner data shows this.

But when you look at Kashi, it's struggling with double-digit sales declines.

Can you maybe tell us what's going right in Special K, and why it's being harder to turn around Kashi.

How do you see that progressing?

Okay.

As I spoke through in the prepared notes, I think we are a little ahead on Special K again versus where we were on Kashi.

We have innovated with on-trend food.

We have reinvested in some of our core SKUs.

We have migrated the positioning of the brand more to wellness from diet, and we have invested and activated heavily.

Kashi, we have a bit of a lag, because we have had to do quite a lot of renovation to tour foods, including Go Lean, for example, which I'm pleased to say in Q3 15 will be now be non GMO project certified, the rest of the portfolio will go that way in Q1 2016.

So we have more or less got through the renovation phase of our work on Kashi.

We also moved to put a team back in place in Kashi, back in California.

That team now is fully functional and in place, and we're beginning to see the benefits of the renovation and innovation work they have been doing coming through.

So I think you'll see Kashi trends improving in the back half of this year into the beginning of next year.

We are seeing distribution losses, which were a big driver of those declines subside, and velocity stabilizing.

So I think the recipe, all the ingredients are coming together for Kashi to start to get back into growth as we finish this year, and move into next year.

So I think you'll see sequential improvement from now on with Kashi.

Okay.

Thank you.

The next question comes from Robert Moskow with Credit Suisse, please go ahead.

Hello.

Just a follow up on the zero-based budgeting question that Bryan asked.

My understanding is that Kellogg had done this benchmarking work in the past, and found that like in North America, ex the DSD costs that SG&A and admin expenses were pretty much in line with its peers.

Am I mistaken in that assumption?

So what did you find in that pilot last year?

Did you find opportunities, and if so, in what areas?

Yes, Rob, so when we look at benchmarking our SG&A costs.

And let's set aside the advertising costs and other brand building costs, and just get to pure overhead.

We do find that we tend to benchmark pretty well, but [peers] are moving on us as well.

We believe there's opportunity by executing a zero-based budgeting initiative, starting, as I said, in North America, and then cascading it across the globe.

So we see it as an opportunity for us to be more competitive, and perhaps unlock some funds for reinvestment into the business or to drop to the bottom line.

Okay.

So it was just a function of everyone else is cutting, so you think the bar keeps going -- keeps getting higher so to speak.

I think, again, we have run a couple of trials, some projects internally, and we found some savings.

Some of the savings have been in areas that we would not have anticipated, such as non people-related overhead costs.

And we're also going to apply the ZBB tools into the brand-building element as well, which we have.

We are finding significant efficiencies even this year whether it be in agency fees, media buying, point of sale materials, all those sorts of elements as well

Thanks, John.

Thank you.

The next question comes from Eric Katzman with Deutsche Bank, please go ahead.

Good morning, this is Mario Contreras on for Eric.

Good morning.

I had a couple questions on a couple of the adjustments you had this quarter.

First on the VIE deconsolidation, can you talk a little bit about what that business was and what led to that decision?

And then second, on the Venezuela currency adjustments.

Obviously, that's been a pretty volatile economy for a good amount of time now.

So can you just talk about what got worse this quarter that led you guys to make the decision to change that accounting?

Sure.

So first on this variable interest entity, we recognized a gain due to deconsolidating this third-party business.

This is a co-manufacturer that was making food for our US snacks business.

It was consolidated into our results over the past several years based on the accounting rules.

In this quarter, the business sold itself to a third party, and that triggered a change in our accounting.

If you look at our 10-Q, it's been disclosed in the past, and you'll see it disclosed again, obviously, in the impact.

It's a one-time non-cash item that we have excluded from our comparable results.

Now if we move on to Venezuela, our situation did change in the second quarter in Venezuela.

As I've mentioned in the past, we buy a small amount of inputs from outside of Venezuela to manufacture product in the country, and we typically get access to US dollars to be able to do that.

In the first quarter, we got access to those US dollars.

In the second quarter, we had no access to US dollars.

And in fact, the government has indicated that it is going to slow payments going forward.

This created a disruption to our business in the second quarter, so we've reevaluated the matter and we determined that the best rate for us to measure the business at was a [sumadi] rate of VEF198 to the US dollar.

Well if we still remain a priority industry within Venezuela, we do expect to continue to manufacture and to conserve our consumers.

We have a good business there, and we have a great team that's managing in a very difficult environment.

Okay.

Great.

Thanks for the time.

The next question comes from Ken Goldman with JPMorgan.

Please go ahead.

Good morning, everyone.

On cereal, one of your top customers has spoken about, in general, not promoting as often across food.

Maybe going back a little bit toward EDLP.

And I guess that would lead to displaced base for promotion, in general, reverting to a more normal level.

And bear with me here, but I'm just wondering if this has benefited cereal in any way.

Because I think of cereal as a product that maybe relies on successful promotions to succeed.

And if there is less competition for display space, if consumers are no longer seeing displays all over the board, but they're seeing the legacy ones like cereal.

Has that helped that category at all, or is that not really taking place in your mind?

Thanks for the question, Ken.

Obviously, I cannot talk about specific customers.

If I focus on our cereal business, I think what we're seeing is the good return on our focus on driving our core brands better with better innovation, promotions, renovation, ideas and really focusing through the path to purchase with impactful sales execution.

And that's driving display.

If you look at the data from Nielson, and I think you're seeing a lot more display necessary.

We are getting more impact and quality merchandising, because we're leveraging the scale of these events and bringing fun and news through to the point of purchase.

So I don't see any relation to the theory you put forward.

I think we focus on delivering our business and executing and exciting consumers in every retail environment.

If I could add to that too, Ken.

I think if you look beyond the US, we have seen the Canadian cereal category get a lot better as well.

And we're also seeing improving category trends, although they're not quite where we would like them to be in the UK and Australia as well.

So I think you're seeing cereal get a stronger footing in some of these large cereal markets, and even on a global basis, we actually grew our cereal sales globally in the first quarter and in the second quarter.

Thank, John.

That's helpful.

Thank you.

The next question comes from David Hayes with Nomura, please go ahead.

Hello, gentlemen, thank you.

I think this is for Paul, this question.

Just in terms of this encouraging [events] among the US cereal, and obviously, this impressive array of innovation.

I guess if I was being concerned or nervous about the ongoing trend, the question would be, can you give us some kind of indication of your confidence that there isn't any channel ;pipe feel] from the innovations in these numbers?

And I guess more importantly in some ways, the consumer pull through or the consumer repeat purchasing.

In the sense of people trying it because it's new, and then you don't get it pulled through.

If you can give us some kind of indication, idea to quantitatively, in terms of focus group feedback and repeat purchase information.

Just to give us that feel that this is actually ongoing business rather than people trying and then we got to wait to see what happens in the next six to twelve months in terms of pull through.

Thanks.

Hello, David.

Two points to probably go towards.

One is, the data I was quoting is consumption data, so it's actually purchased data, total categories flat.

Our biggest six brands are growing consumption dollars and share, so this is being pushed -- pulled through.

This isn't us pushing into the market.

We have no inventory issues within the US.

Special K is interesting because the brand was up.

Base sales as the quarter progressed went into progression as well.

So when you've got base movement off the shelf, this isn't purely incrementally driven through display and price promotion.

It's actually good fundamentals coming through in terms of base consumption.

So we know that consumers want nothing more than more goodies in their food when it comes to red berries.

And giving them more of what they want, we're seeing them buy more from the shelf, importantly.

So I think the underlying trends are positive, that's why I feel positive about the future.

This isn't a share rental or overly pushing the business.

This is good consumer demand coming through.

Thanks, Paul.

(Operator Instructions)

The next question comes from Matt Grainger with Morgan Stanley, please go ahead.

Hello, good morning, thanks for the question.

Morning, Matt.

John, just coming back around to the 2016 outlook.

You gave us a number of factors that give you confidence in the achievability of those targets, and willingness to talk about them today.

Just curious here what you see as the biggest challenges or areas of uncertainty, or areas where you're pushing the employee base to work harder to make sure you actually do deliver on those targets.

And, Ron, I know this essentially is asking for guidance.

But is there any incremental color you can give us on the phasing of Project K savings you're looking for next year?

Not necessarily an absolute, but maybe relative to what we're seeing this year.

If I answer your question first on 2016, I think the important thing to remember is we are building momentum.

In 2014, a tough year for us, we're building momentum in 2015 and we see that continuing into 2016.

You're seeing it with continued strong Pringles growth around the world.

You're seeing it with the largest cereal businesses starting to perform better, particularly the US and Canada so far.

You're seeing very strong emerging market growth.

We grew cereal double digits across Latin America and Asia, and so that's helping our results as well.

And we're seeing those overall trends put us in a better position when we go into 2016.

I think what really helps give visibility to 2016 is the excellent cost and productivity outlook that we have for 2016.

Obviously, we'll have Project K savings come through, we'll have continuous improvement programs, and we'll have zero-based budgeting also start to help in 2016.

So clearly, I'd like to get the top line growth in place.

But even if the top line growth is lower than we would like, we still have good productivity, visibility for next year.

And, Matt, in terms of Project K savings.

Recall our guidance for 2015 is that we expect savings in the range of $90 million to $100 million, and we're tracking in line with that.

Remember, we always said that our savings would ramp up as we went through the years.

As we look at 2016, at this point in time, and it's early to provide guidance on Project K savings, but we expect savings to be north of $100 million.

Great.

That's helpful.

Thanks.

This concludes our question-and-answer session.

I would like to turn the conference back over to Simon Burton for any closing remarks.

Thanks, everyone, for joining us today.

We'll be around for the next day or two for follow-up questions.

Look forward to talking to you then, thanks.

The conference is now concluded.

Thank you for attending today's presentation.

You may now disconnect.