億滋國際 (MDLZ) 2003 Q2 法說會逐字稿

Please stand by for the commencement of the Kraft Foods Earnings Conference Call .

Good afternoon ladies and gentlemen, welcome to the Kraft Foods 2003 second quarter conference call. At this time all participants have been placed on a listen only mode and the floor will be open for questions following the presentation. It is now my pleasure to turn the floor over to your host, Senior Vice President of Investor Relations and financial planning and analysis, Miss Marla Gottschalk. Ma'am, you may begin.

Good afternoon, and thanks for joining us for Kraft Foods second quarter 2003 Earnings Conference Call. I'm joined today by Kraft's Co-CEOs Betsy Holden and Roger Deromedi and Kraft's CFO, James Dollive. After a few brief opening comments, Betsy and Roger will take you through some prepared remarks and then we'll take your questions. For those of you listening on our website and media representatives, you are in a listen-only mode. Earlier today we issued our second quarter earnings release, which is available at WWW.Kraft.com. I remind you that our remarks today contain projections of future results and are made only as of today's date. Please refer to the Safe Harbor statement at the end of our release for a review of some of the factors that could cause actual results to differ from projections.

I also remind you that, as was the case in the first quarter, we will be discussing our financial results today only on a reported basis in accordance with Generally Accepted Accounting Principles. Items affecting year to year comparability of volume, net revenue and operating companies' incomes are summarized in the financial tables attached to our press release. I will now turn it over to Betsy and Roger for discussion of our second quarter results as well as an outlook for the full year.

Thanks, Marla. Roger and I will review our second quarter results and the implications going forward. In so doing we will address three matters in detail. We will start with a review of second quarter results, which were disappointing and below our internal expectations. Seconds, we will review the actions we will put in place to improve consumption and share trends. And third, we will explain our revised guide answer for 2003.

I'll start with a review of our second quarter, which was clearly a challenge. Second quarter diluted earnings per share were 55 cents, up 5.8% versus last year, driven largely by lower interest expense. Our operating income was up 0.6% on the quarter. Positive operating income growth drivers were volume growth, pricing, favorable net currencies and the absence of integration costs in 2002. These were largely offset by increased commodity and benefit costs, increased promotional spending to manage price gaps, costs associated with shortfalls on recent biscuit introductions and higher devaluation driven costs in Latin America. Operating income fell short of our expectations due to three main factors. First, we incurred higher promotional spending in certain categories, including cheese, coffee and coldcuts, to narrow price gaps versus private label and price-oriented competitors. Second, disappointing results on certain new biscuit items, including chips ahoy warm and chewy , generated significant product returns. And finally and most significantly, we expected our top line growth to be stronger and product mix to be favorable.

Looking at the top line in more detail, net revenues increased 4.4% in the quarter, 2.7 points faster than volume. Of this differential, two points were attributable to currencies, primarily the Euro, and 1.2 points were due to net pricing. These gains were partially offset by 0.9 points of adverse product mix. The volume increase of 1.7% was driven by 2.5% growth on ongoing businesses, partly offset by the impact of divestitures. Key growth drivers were news products, a shift in Easter timing, strong shipments in the beverage, desserts and cereal segments and solid growth in developing markets. Acquisitions contributed 0.2 points to volume growth. Looking at new products, most of our new items have performed on or ahead of our expectations thus far in 2003, including Capri Sun Sport , Altoid strips, lunchable fun fuel, Kraft Cheese cracker cups and flavored cheeses, ah-oh Oreos,Club Social integral crackers in Brazil and ten new flavors in several countries. We continue to project net revenues from new products of $1 billion in 2003. In terms of the impact of the Easter shift, the negative impact experienced in the first quarter reversed itself as expected in the second quarter. We estimate that the Easter ship provided over 1 point of benefit to volume growth in the second quarter versus last year. The beverages, desserts and cereal segment posted strong volume growth, part of it due to the Easter impact on coffee and desserts, but much of it due to continued strong performance from our ready to drink beverage business.

Finally, developing markets grew a solid 4.8% in the quarter, about one third of which was attributable to acquisition. Developing market growth was particularly strong in Brazil, China and Russia, though this growth was partly offset by declines in Argentina, Bulgaria and the Ukraine. While many volume drivers were in line with our expectations, volume growth in 2.5% from ongoing businesses was below expectations due to trade inventory reductions and soft consumption. As was the case in the first quarter several customers faced financial difficulties, which resulted in an accelerated pace of inventory reduction. Additionally, warehouse consolidations, store closings and the continued efforts by many retailers to reduce working capital also contributed to this acceleration. We estimate the trade inventory reductions by retailers in the U.S. impacted North American volume by about 1 percentage point in the second quarter.

Additionally, the reductions this quarter were skewed to higher margin product lines, adversely impacting product mix. Consumption softness across certain categories and countries also contributed to the volume shortfall versus expectations. Prolonged economic weakness in many parts of the world has resulted in weak category growth and led some consumers to trade down to lower price options. In certain categories and countries, the impact of this weakened consumer spending was magnified by higher price gaps on our products versus price-oriented and private label competitors. Looking further into this consumption softness, one of the issues we mentioned at the beginning of the year was the difficulty we would have evaluating our 2003 consumption results until we got through the second quarter, as the shift in Easter timing impacted year to year comparability. After a soft May, continued softness in June and a thorough assessment of consumer takeaway from the first six months of the year, we have determined that certain of our U.S. businesses, including cheese, coffee, coldcuts and biscuits, need incremental marketing spending to improve consumption and share trends and to restore a more robust growth profile. And due to heightened competitive activity from price competition in many international markets we plan to reinvest a portion of the currency favorability against our international franchises, as well.

Before looking specifically at our cheese, coffee, cold cuts and biscuit businesses, let me reinforce just a few of the reasons for our commitment to these categories. These categories have been strong performers for us over time and they continue to offer good growth potential. All of these categories enjoyed good margins and generate strong returns on capital invested. We believe incremental marketing spending is the right thing to do to reinvigorate growth in these franchises, have which have leading share positions and strong brands. Turning to the category specifics, you are aware of the competitive situation we have faced on cheese. We believe incremental marketing spending is the right thing to do to reinvigorate growth in these franchises, which have leading share positions and strong brands. Turning to the category specifics, you are aware of the competitive situation we have faced on Kiwi. We have continued to be challenged by price gaps at the higher end of and in certain categories above our targeted range.

While we have seen improvement in share trends over the past several quarters, we continue to face declining shares in several categories requiring a more significant response to both narrow the gaps as well as address some absolute price points. In categories where we have narrowed gaps to the lower end of our range, such as Kraft Singles we have gained share year to date. With regard to cheese commodity costs, barrel cheese is at $1.43 per pound as of today, up 26 cents over the last four weeks. While higher cheese costs will help to narrow gaps, we believe that in this difficult economic environment we need to move closer to the lower end of our ranges. Therefore, to improve cheese volume and share trends more broadly across categories, we will increase marketing spending behind both advertising and price gap management. Several of our key brands in these categories, such as Philadelphia cream cheese, generate some of our strongest returns in marketing investments. Additionally, we will continue to leverage our lineup of marketing innovations and new items which have performed well this year in market.

In coffee and coldcuts our price gaps have widened, versus regional and private label competitors and as a result we have seen our consumption and shares soften. To improve these trends, we are increasing our marketing spending to address price gaps and build our brand equity. In our biscuit business, we priced many of our products in the fourth quarter of last year to recover higher wheat and cocoa costs. As a result, our volume lists for merchandising have been lower than expected and both the category and our consumption have softened.

In addition, a few of our new Recent biscuit new product launches did not meet expectatios, although most are doing well. To improve consumption and share, we will be increasing marketing spending against the biscuit business with a focus on our core cookie and cracker brands. In totals, we are planning incremental spending in excess of $200 million in the balance of the year. We expect to see the majority of the impact on consumption and share trends in the fourth quarter. Over the years we have seen our brands respond well to the right combination of price and promotion along with effective consumer spending. Overall, looking forward we are confident that our action plans represent the right investments for the long-term health of our brands. I'll now turn it over to Roger for a review of our overall outlook for the year.

Thank you, Betsy. Turning now to our bull year outlook, volume growth from ongoing businesses projected to be around 2% while the incremental marketing spending that Betsy discussed will improve second half consumption, this gain is expected to be fully offset by reductions in customer inventories at a faster than historical pace. The incremental spending combined with softer than projected consumption and accelerated trade inventory reduction andadverse product mix are expected to yield full year diluted earnings per share of $2 to $2.05, which is 10 cents below our previous guidance. This guidance does reflect expectations of continued lower interest expense and favorable currency. Importantly, our cost reduction efforts remain on track to achieve targeted savings and the results in Latin America are projected to improve as we lap last year's devaluation driven cost increases and fully realize the benefits of our pricing actions.

Similiar to past communications we continue to review our non-core businesses for potential divestitures, such as the previously announced sale of our retail rights business in Germany. Our earnings guidance range does not account for the potential gain or loss on the possible sale of any businesses. Looking briefly at 2003 cash flows, discretionary cash flows to the second quarter was $1.1 billion, driven by higher earnings, partially offset by increased capital spending and working capital. For this full year we expect the discretionary cash flow to increase 10%-plus versus 2002, as we will offset the cash impact from the lower than expected earnings with improvements in working capital. Also built in this projection are capital expenditures for the year of approximately $1.1 billion. Importantly, we implemented a $2.5 billion short-term credit revolver that replaced our facility that expired earlier this week. There were no changes to the covenants in this revolver versus the firing facility.

Turning to 2004, we will be providing guidance in January, but current indications are that 2004 will likely be another difficult year. Challenges include global economic weakness, continued trade inventory reductions and significantly higher tension and other post--employment benefits costs. In addition, the investments planned in the second half of 2003 to enhance brand equity and growth prospects will increase in 2004, reflecting a full year of spending. To conclude, our second quarter earnings results were clearly disappointing and below our internal expectations. Based on our first half results, including weakening consumption share trends in the second quarter, we are putting incremental marketing programs in place on certain U.S. businesses to improve volume and share performance. As a result of this incremental spending, our expected full year diluted earnings per share is now $2 to $2.05. While this earnings guidance is disappointing we are confident that the investments we are making are an investment in long term interest in both the Kraft business and Kraft shareholder. And importantly with strong working capital management we continue to target delivery nof 10% plus growth in discretionary cash flow. That concludes our prepared remarks and we'd now be happy to take your questions.

The floor is now open for questions. If you do have a question, please press the number 1 followed by 4 on your touch-tone phone. To get out of line, just dial the pound sign. We ask that when you pick up your handset to provide optimum sound quality. Please hold while we poll for questions. Thank you. Our first question is from David Attleman of Morgan Stanley.

Good afternoon. I have a couple of questions.

Okay.

First, Betsy and Roger, do you think there's a bigger problem and that you need a bigger response, whether it's in terms of the geographies that the business is concentrated in, some of the businesses that you're in, the people that are operating them, because clearly you're underperforming your peers.

Well, David, let me answer in terms of we believe that we have the right magnitude of response to get the businesses back on track. We are investing $200 million behind cheese, coldcuts, coffee and biscuits to improve consumption and share trends in Q4, as we move into September in Q4, and we believe that we will see momentum turn. I think the other thing is we are in a challenging economic environment. We have seen our price gaps at the high end. We have seen -- we've seen on singles when we get things in line that we deliver share growth. So, we are confident that with this spending we will see momentum turn.

David, your question on businesses and geographies and people, we continue to examine our portfolio. We feel good about our portfolio and the businesses we're investing behind. We feel very good about those businesses. In terms of geographies,obviously we have global scope and continue to look for how we can expand ourselves, in developing markets, in particular. But more important, we think we have the right people to run the business. We have a very talented group and we have the right people.

Secondly, in some of these categories where you're seeing the pricing gaps too wide, you raised prices. Is private label just generically behaving differently through commodity cost cycles than it has been in the past?

As you said, we have raised our price in some of the categories. We have not seen price competition increase their pricing as we have in the past. In some cases, as we've seen in cheese, though, we are at very low commodities, and we are seeing them pass on those very low commodities. But in some of the categories, like coldcuts and coffee, we have not seen private labels pass on some of the commodity increases.

Last question. Couldn't you to an extent have planned better? The street certainly didn't think you could generate 3% volume growth in the first half. You highlighted that, Betsy, as one of the real reasons for the shortfall. Do you just need to take an approach that 3% long-term volume growth isn't achieveable and alter just the cost structure and the investment spending behind the business to drive better results in a challenging environment that may not get any better any time soon?

Well, clearly we will -- I mean, we always have been aggressive about looking at our cost base, and we will continue to aggressively look for ways to reduce costs. I think one of the challenges we saw in the quarter was not just the absolute level of volume, but the mix of the volume. And one of the key reasons why we're investing back behind these businesses is to deliver the volume and profit performance that we want. We need to jumpstart momentum on these high margin businesses.

Thanks.

Thanks, David.

Thank you.

Our next question is coming from Eric Katzman of Deutsche Bank.

Hi. Good evening.

Hi, Eric.

I guess my first question has to do with a kind of follow-up on Dave's question in terms of growth rates. I mean, you know, your systems are considered to be one of the best in the industry. Your, you know, control over the operating units and individual businesses. And yet, we've gone in two years from kind of a 15% target to an 8 to 10% target bottom line to, you know, now obviously to, you know, a year or two issue, but kind of low to mid single digits. And so, I guess, you know, big picture, what's kind of going wrong with the forecasting and why is it so difficult for you to get the numbers right

Well, Eric, I guess one of the things is as you go back over multiple years, the operating environment is very different. It really is the convergence of multiple things, the global economic slowdown, the retail environment that is very different now in terms of what the trade is doing with their inventories, and we had the convergence of increased costs at the same time. And as we talked about earlier in the year, the pinching costs and other post--employment benefit costs came together along with the Latin America crisis. So, we had many things come together at the same time. And I think in terms of our systems to know how we're running the business, I think we do have a good pulse of that. But the combination of those effects was greater than what we thought we could overcome and we want to do the right thing for the business for the long-term, and we determined that the right thing to do was spend back behind some of our businesses in this point in time.

Then the follow up, you know, I've been willing to kind of look beyond the reported earnings slowdown and kind of focus on the cash flow growth. But you know, working capital management is probably going to be a relatively short-term benefit. So, you know, is free cash flow growth of 10% this year likely to decline to more like mid single digit next year, or do you still think that free cash flow growth can grow at, you know, high single digits or low double digits?

Eric, we're not going to get any projections for 2004 and beyond on cash flow. But we do feel very good about 10%-plus growth we are projecting for this year. And would say that the whole organization is very focused on managing working capital, which is why despite this net earnings shortfall that we have versus previous guidance, we feel comfortable making a 10% flux.

Okay.

Last question, and then I'll pass it on. But you know, if I do the math correctly, Betsy, it sounds like, you know, 200 million on 15 billion or so in sales in the second half of incremental marketing, you know, 1.3% of sales, I mean, that doesn't sound like it's that significant. I mean, is that a bigger -- you know, am I not reading that correctly? I mean in the past have you had to spend a higher percentage than that? To jumpstart the business when private label has been an issue?

Well, again, our analysis would say at this time in light of the circumstances that this is the right amount to get consumption and share momentum up. This is something we will clearly monitor. And as we move through this year and as we look at next year, we will adjust our spending as we need to to insure that we deliver the volume and the share momentum.

And Eric again, to keep that 200 million investment in perspective, in the second half, we say, but it really starts to impact the market in September. If you did your math of 200 over $20 billion, the 20 billion is a full year, annual number. And as I said, in my comment our expectation is that the spending will be up in 2004, reflecting a full year of spending.

Okay. Thank you.

Thank you.

Thank you.

Our next question is coming from Chris Gallin of J. P. Morgan.

Good afternoon.

Hi, Chris.

Can you answer a question just on the portfolio? Does the disappointment you had this quarter and sort of the depressed outlook increase your need to perhaps go out and diversify away from some of the companies more commoditized type categories? And how do you feel about that with respect to acquisition? And also in the release you mentioned that you're going to be reviewing your non-core. Can you give a little more detail? That is that expanded in scope given what's going on?

We will continue to aggressively look at other businesses that are lower growth, lower margin, or where we're not leading, where it makes sense to divest, only if we can improve shareholder value in doing so. And we will continue to actively look for both tack on and larger acquisitions that can help accelerate our top line growth.

Okay. But is there a change because of the change in the outlook in terns of your wanting to be aggressive with respect to either of those two?

I guess, Chris, we've always been very aggressive in that.. Because we're selling our rights in Germany, I think you'll see actions coming in the future that reflects that continuous aggressive look at our portfolio. It's something that's been a characteristic of Kraft in the years past and you'll see it going forward.

Just going back to the cash flow, it's my understanding that the working capital has built up a little bit here largely because of inventory isn't it more difficult to reduce working capital given what's going on with the retail environment and the deloading on that side of the channel?

I again, as you say, working capital is up and it's -- I'll call it seasonly higher. We always see it go up this time of year, but in fact working capital is actually lower when compared to a year ago the increase we had versus the end of the year. One of the things--We're finding some new ways to come at working capital, and your comment is right about where the retail trade is but in the area of inventory, a key thing, we're putting a lot of systems in place to insure that we have accuracy and actually looking at the total inventory management pipeline. In many cases, you can look at silos or where your inventory is but when we take a total view theres increased progress in reducing your total inventories. And in terms of the biggest drivers is actual sales, forecasting accuracy, and we have many programs in place to insure that we're doing that well across the world. And finally in terms of on the receivable side is again making sure our invoices are accurate and making sure we're pursuing it appropriately with our customer. So, I think we have many programs in place that we can continue to drive improvements in working capital.

Okay. Thanks.

Thank you.

Our next question is coming from John McMillin of Prudential Securities.

Hello, everybody.

Hi, John.

$200 million sounds like a lot of money to me. What percentage of that 200 million will be spent on promotion versus advertising?

John, I'm not going to give you the specifics for competitive reasons. But we have modeled by category what the right balance of both price gap, absolute price points and advertising spending to make sure that we get momentum and trends improving.

The two and a half number that you cite in the quarter, does that include the small acquisitions that you've made?

Yes, it does. That was worth 2/10ths.

2/10ths. It was like a 2-3 numbers.

Right, acquisitions.

And you were shooting for something like a four number.

We said the first half would be in that 2 to 3% range. So yeah, you had to be in that sort of range to be given our results in the first quarter.

And I guess where you're most discouraged is that the myth on the volume was in some high profit margin item like Nabisco?

Yes. We're seeing -- part of why we're taking this action, John, is we're down about a point -- for the first half we're down about a point versus consumption where we were last year. And which is why we're spending money back against our higher margin items to help improve the mix.

I don't mean to relive -- you know, let bygones be bygones. But do you feel like management changes were made -- sometimes when you put a new head in charge at Nabisco, you have to start a new -- to what extent are marketing plans just being rethought out at Nabisco and new products plans? If you can talk about what impact management changes will have on it?

Well, Darryl Brewster I think as you know has been at Nabisco and has actually worked on all the different businesses that he is now responsible for. So, he has worked on biscuits, planters and confections. And clearly we're disappointed with Q2 results and we are aggressively looking at what are the things we need to change and improve to improve performance in the back half.

But in goes into David's question a little bit in terms of, you know, perhaps trying to get water from a rock. You've obviously made a statement on obesity, and at the same time, you know, you look around. It's hard for a lot of people in the United States to eat 3% more. I know part of it's population growth. But just to the extent you can kind of clarify, you know, the company's effort in that regard to achieving this volume increase. You're gonna try to grow your Volume 2 to 3% domestically, it's almost gotta make us fat.

I think you need to think about share of stomach, is what I would say. We are not even, I think, 7% of packaged foods, under 5% of packaged foods. So, there's a significant opportunity for us to improve share of stomach. And people clearly need to eat, and we provide a lot of products that provide very good nutrition and we provide a lot of products that provide alternatives, whether it's sugar-free, reduced fat, et cetera.

I see your point, if you see mine.

Yes.

Just in terms of shooting maybe a little bit too high. Jim, is there any kind of longer term guidance, there's no tax rate declines or anything in the '04 guidance, interest rate changes? I think what sets a lot of us back is just this feeling we'll be sitting here this time next year in another environment of trying to get to 5% quarterly earnings growth. There's just nothing built into the '04, the early '04 guidance that is kind of, let's say, non-operational?

Well, John, we really haven't given any specific '04 guidance.

Well, difficult is a word that gives some guidance.

Directionally, yes. The only -- so that -- we haven't gone through the assessment yet, looked at all the pieces on the tax rate and how that's gonna play into it. But I wouldn't be -- I wouldn't want to give any indication that we have or that any changes are built into the expectation. I think on the interest side, though, the one thing I would point out, and this is available in the information, we do have some debts that matures, some intercompany debt that matures later on in the year that will be refinanced. Right now our expectation is that we'll be refinanced in the public market. And that will have an implication on average interest rates.

Okay. Thanks for all that.

Thanks, John.

Our next question comes from Bill Leach of Banc of America Securities. j

good evening. Your forecast for the balance shows a slight decline in EPS year to year. Just as the starting point for 2004, given the higher marketing spending, is there any reason to believe that wouldn't continue in the first part of next year?

The higher marketing spending as we said will continue into next year. And as we said the $200m spent. It's basically in the last four months of this year, and then it will carry over and continue into 2004.

Are you going to have another 200 million over, next year? The higher spending level will continue, yes, on a full year basis. I know you don't want to qualify the word difficult, but can we [INAUDIBLE] earnings next year?

I won't give you precise guidance here. And part of the reason to not be precise is we want to first see how these new investments work in the marketplace and what impact they have. But there's a lot of other variables, too. We need to see what happens with trade inventories, which is one of the key variables we've been talking about here. Just as John was saying before what's going to happen on the tax rates, but importantly other indiginous things like interest rates and currencies and so forth. The reason I use the word "difficult," because as we've talked before, as we did our forecast this year, pension and post--retirement costs will continue on have an impact in 2004, even assuming the current same return on assets and the same discount rates. And as we've quantified, Cagney owes me 5 cents per share in 2004. And we also point out that every half a point of discount rate is worth $50 million, or about 2 cents, and every half a point of return assets $30m just over a penny. So, before we get to the end of the year to know where those things settle out, it's hard to give a great quantification out.. But we know that just holding the current assumptions, we'd have an impact there. And as I said, we will have a continued higher spending level to support businesses here in the U.S.

last question. Are you taking any specific list price reductions? You referred to time and again that your pricing was out of whacked with some of your competitors. Are you actually addressing that?

Well, again, I don't want to give specifics from a competitive standpoint, but we will manage narrowing the price gaps either through some specific price reductions on selects items or through promotional spending.

Okay. Thanks a lot.

Thanks.

Thank you.

Our next question is coming from Terry Bivens of Bear Sterns.

Good afternoon, everyone.

Hi, Terry. If you look at -- I mean, your big categories seem to be the ones that hurt you, Nabisco, cheese, coffee, coldcuts. And I think David pointed out those are categories you've raised pricing in. I mean, the question would be to what extent would you consider this quarter kind of a self-inflicted wound?

Well, on the pricing side, I mean, we were reflecting significantly higher costs this year, from commodities from packaging, from energy. So, our pricing -- you know, we price cost justified and price to cover costs like that. So, we were pricing to cover significant costs. And we did find some challenges this quarter in terms of realization, as we didn't see some of the price brands move as much as we would have expected. We did need to spend cut back some promotional spending and we did find some issues on some of the Nabisco return.

Okay. I don't know if this is a fair characterization, but it seems like everything was great when we had those Nabisco synergies and the earnings were clicking along. Would it be a fair characterization to say this is a company that needs those kinds of synergies and thus needs to do another acquisition, or do you think that once your medicine is applied here, that this again becomes a company that can grow at least in line with the peers? Do you think this energy thing is not the right way to look at it?

It's not the right way to think of it because I think as we talk about our business models as we talk about what that is, that is not assuming that we're having synergies. It's assuming driving our model of cutting back costs and expanding brands and new products and assuring the gaps are right to drive the top line growth. So, no, I don't think so it's tied into synergies. I think our business model challenges prime time given the environment that we're in and given the costs as Betsy talked about and the pricing and then the ability to deal with consumers who are actually doing a lot of down trading on us given the current economic environment, both in the U.S. but actually around the world, as well.

Well, if you take that view, isn't it implicit that perhaps the reason we're in this slowdown is that marketing was too light all along?

Well, coming back to your question, if you look at our performance from '95 to 2000 or '96 to 2000, which was without synergies or big acquisition, we clearly delivered against our underlying business model. And I think as we've talked about, we do model our spending very closely. And I think what we've seen is in this environment with the challenging economic environment and with higher gaps that we need to both reduce the gaps, narrow the gaps and increase our spending to build consumer equity.

Okay. And just one last thing. You know, obviously we've seen a nice pop in cheese prices, an abrupt pop at that. Shouldn't that result in materially better performance as we track through the second half? I've got to think that really cramps the economics on the private label guys.

That should help to narrow gaps, yes.

Okay. Well, thank you very much.

Thanks, Terry.

Thank you.

Our next question is coming from David Nelson of Credit Suisse First Boston.

Good afternoon.

Hi David.

I guess I'm questioning actually the increased marketing in an environment where there's little to no volume out there, first of all. I guess also related to the marketing is the 10% growth in discretionary cash flow before your increase in marketing spending?

I'll answer the second question first. No, it's included. That's the cash flow, our projection for the year, which includes this send back that we're doing.

So, the 10% is before increased marketing?

No, it's after. It's our cash flow projection for the year.

Okay. But on the marketing, so, we're really doing, I guess back to John McMillin's question, I've heard a lot of talk about price gaps here. If it's really to address price gaps, it's mainly promotion spending?

It's a combination of promotion spending and advertising. And I guess my response to your question would be there are a number of businesses, likes snacks, like pizza, like beverages, like confections, where we are seeing nice growth and we are seeing responsiveness. Again, we feel confident that as we get the marketing and the pricing in line, we'll see responsiveness.

All right. You note in your release working capital improvement, and I see a billion and a half sitting here in cash. Jim, what are you gonna do with all that money?

Well, David, obviously we took up our cash balances given the challenges we faced during the quarter on our ability to access the commercial paper market. We're now back into the commercial paper market. We've pretty much recovered balances there to where we were at the start of the quarter. And given that there still remains some uncertainty regarding, you know, our unfettered access to CP, we'll run with higher cash balances for a while 'cuz our intent is not to use the revolvers as a way -- as a means to meet our short-term cash needs. So, it's really to help balance and offset the credit, because if you look at the debt side, David, you'll see that the debt is actually up. When you look at debt net of cash, we're actually down.

Okay. And lastly, is your long-term volume growth target still 3%?

At this point, Dave, we're not changing our long-term business model. Clearly in this environment we're not going to be at 3%. This year we're saying 2%. But as we look at it over long term and we'll see how the actions this year play out, we still believe that 3% is the business model that we're projecting.

Okay. Thank you.

Our next question is coming from Andrew Lazar of Lehman Brothers.

Good afternoon.

Hi, Andrew.

I apologize for being somewhat maybe dense on this. I understand where the difficulties around price gaps would impact your more commodity-oriented businesses. I'm still not really clear on what's happening at Nabisco specifically. And I guess there's two things. One, when we spoke to Mike Polk even as recently as the annual meeting, I mean, he sounded incredibly confident about even the sort of current trends at that point in time, and you'd already taken some pricing at that point. Also, in this business you've taken pricing -- there were a number of sort of fall periods where you took pricing and led the industry. Others followed. And it might have slowed volume a bit, but clearly not as much as you've seen here. And I realize the operating environment, economic environment is a little different. But I guess in theory I'd like to believe that those companies that have truly dominant, branded portfolios, like Nabisco, can take some pricing when it's cost justified and not see this type of--sort of falloff. So, maybe if you could get in a little bit more. I'm not clear on what happened there.

Well, let me answer in terms of the biscuit division, they had a solid first quarter. And I think again until Easter, until we've gotten all the way through Easter and into May, they didn't have a read on how some of their new products were doing. And in second quarter, they were up against a very strong year ago with double delights and Creamwiches. And once theyn saw first quarter was pretty solid. As they came into second quarter, their new products significantly underperformed their expectations. So, we had sort of the double whammy of volume down because the products underperformed expectations, and then they had produced some significant inventory. We had to liquidate some product. We had to -- we've actually pulled warm and chewy from the marketplace. So, we had to pull it from the marketplace and had product returned. And in addition, they did see in soft May, soft June, did see some increased competitive activity and lower responsiveness from their merchandising. It's not to say, you know, that base pricing has gone through okay. It's really on the merchandising side that they've seen less responsiveness. And that's what we're addressing. But if you look at how we're going to solve it, we will selectively address merchandising price points to jumpstart momentum, we will strengthen our spending in the back half with a better balance between the base business, the core business and new products, we will clearly more carefully manage new products to make sure there are not those kinds of write-offs, and we'll also push for new products that are more incremental and help to expand our frame of reference better.

Okay. Were there any --

Andrew, I don't believe biscuit is in -- I mean, biscuit's issue is more new product execution and ideas and getting some merchandising price points right.

Okay. That was really the lead in to the next question, which is around execution. Have there been any -- you know, outside of obviously the change at the top, if you will, of Nabisco, have there been any changes around sales force or things that structurally -- would it sort of change the abilities of this more or less mp [inaudible] to get it done at the point of sale in store?

No. The DSD force continues to be very strong and do very well. There was probably a little bit more management churn within the biscuit marketing organization than one would have ideally planned. That was good career moves for different people where people were promoted to general managers role. But no, there's nothing structurally from a DSD standpoint. The issues here are on the marketing execution side.

And just lastly, one of the things I try and point to is when you operate in as many categories as you do in share positions to the magnitude that you do across a lot of these categories, you know, I like to believe that you can leverage that perhaps better than many of your peers with respect to retailers, particularly when things get tough, when the going gets tough. And I would have perhaps thought that maybe you could start to sort of leverage that a bit harder than it appears that you've been able to do versus some peers. And I -- and that's a general question, but it's one that I don't feel like has come through to the extent that maybe I would have considered. Is that still something that you consider an advantage, has that been pushed here you know the bundling sort of technique or is it just too many things to handle.

Well I think theres two separate issues here I think one is do we have good relationships and are we able to leverage the breadth of our portfolio with retailers to create excitement in store and merchandise and really cross-merchandising? I think that is very strong and will continue to be strong and we have not seen an impact there. We have seen some select categories where the gapts are out of line. And in today's challenging economic environments with unemployment the way it is, we have to narrow those gaps and increase spending to build our share in consumption. So, I don't think it's a retailer leverage or retailer relationship issue. I think it's consumer economic issue. And that's the steps we're taking to address.

Okay. Thanks a lot.

Thank you.

Our next question is coming from Chris Growe of A. G. Edwards.

Good evening. Just a couple questions still lingering here. For starters, I wonder if you could help me, Roger, in terms of the market share for your key categories and perhaps some of the key category growth in this quarter. Was there material attraction in say, your market share or in the growth of those categories?

The issue is the categories we're responding to are ones where we definitely had some significant market share declines of a point or more. So, where we're responding are where we had softness in consumption and softness in shares, that ,that's what our spending is intended to correct.

So, this quarter you could say there was a bit of a double whammy with both categories being down and your market share being down?

Yes, our consumption down, yes

And the other question would be relative to the increased spending both this year and next. I would assume there would be more of an immediate payoff on that spending given a lot of it is -- or some of it is price related. Is that a fair assumption, then?

Yes. And we are planning -- I mean, we're plan planning on a 1%, or two cents a share improvement from our investment so that we do see a 1% increase in consumption and share improvement in the back half.

Okay. And then on the price mix side, I know price generally was, I think you said, up 1.2. Mix, though, was negative. I had been looking for a number north of 1 for the combination there. Is that mix going to probably continue, the lower mix continue for the remainder of the year?

Well, our intention is with spending behind some of these core high profitable categories that we'll see mix improvement in the back half of the year.

Okay.

Chris, that is really a key thing that we're looking for in our spending behind these businesses. While the top line growth for the first half and the quarter was not that bad, the mix was not what we want it to be. And that was a key driver. So, spending is key to get that mix improvement.

Okay. And my last question would be on the working capital side, perhaps for Jim. I don't have the exact numbers from the release. It just gave sort of a -- I'm talking more inventory receivable and payables. But I know they were up pretty handily in the first quarter. I'm just curious if there is a bit of an issue there with working capital.

I wouldn't call it an issue in terms of working capital. Working capital is up. Some of it is going to be seasonly driven some of it is going to be currency driven simply because we've seen some strengthening of the international currencies. You also have to think about it relative to a year ago. On that basis it's far less of an increase because it takes up some of the seasonality. But as Roger mentioned in his earlier discussion, the place we're focused on the place we think we have the opportunities is managing down some of inventory balances.

Do you have the inventory receivables, payables numbers for this quarter.

Sure why don't I just give you--I'll give you rounded numbers here. Receivables will be about 3.3 billion, inventory to 3.6 billion, payables will be at 1.6 billion and the accrued liabilities at 3.3.

Okay. Thank you.

Thank you.

Our next question is coming from Leonard Tuttlebaum of Merrill Lynch.

Good evening.

Good evening.

Just a couple of things. I think most of it's gone through here. Can you quantify the -- I don't want to say the product recall, but the pulling of the Nabisco product off the market and the liquidation of the inventory? Can you give us some idea how that event alone --

Yes. It's about a penny a share.

Okay. Now, it's been a long time, I guess, since I've seen Nabisco not have a homerun every time they put a product out. Was there some basic thing that went different this time, or was it just one of those things that happened?

Just one of those things that happened. I mean, warm and chewy, which was -- it was actually in Canada. So, it was in the market place. We did bring it down here. We had to change some directions because of some safety issues with microwaving. And I think that impacted quality. And I think in the environment the price value just was not there.

Okay. I think this point has been beaten up pretty good, but if we presume, as I think others have, that in the $200 million increase in promotion, which will come off our gross sales and resetting some price points, is it fair to assume that we could have some difficult revenue comparisons in this next quarter and maybe even in the fourth quarter?

Well, again, we're not saying that all of the 200 million is in promotion that will come off of the revenue line. And we're not prepared to give you the exact level. It's a combination of both promotion and advertising.

And you're gonna reset some price points in your key categories, correct?

Yes, yes, we will.

So, Betsy, why wouldn't we assume at least going in that flat to marginally up would be the best we could look at for Q3 and maybe Q4? Is that too negative an outlook?

Yes. I mean, with the mix we would say that that would be too negative. Flat would be too negative.

And again, one of the other things to keep in mind as you look at total Kraft, you may talk about North America and what's going to happen there with the actions that are being put in place, you do see that revenues are dramatically higher in volume than on the international side. Obviously if you had taken pricing from inflation and other costs.

And what is your assumption on 4X for the balance of the year?

We haven't give that precisely. What we are assuming is roughly where we are today. Obviously it's been bouncing around. Obviously if you look at the Euro, it got up to 1.18 in quarter 2, and it was down to $1.11, and back up to $1.12 now. Obviously that's a ski wild card for us, but somewhere in that range is what we're assuming.

Thank you very much.

Reporter: Our next question

Our next question is coming from Romitha Mally from Goldman Sachs.

I guess as I'm listening to all of this I think I still struggle with the fact that yes, the economy is weak, we've had these issues. But why is Kraft hurting more than the peer group? And I guess one question, just following up on the inventory, is it possible that maybe a year ago your inventory levels were too high given that you were striving for the 3 to 4% volume growth last year?

No. I mean, the issues we're seeing relate to customers, relate to customers like Funding and K-Mart, et cetera.

Each quarter I think the volume is always the biggest focus on the quarter. Do you think that internally the metrics are right? Do you think that there's enough of a focus on profit and returns?

Yes.

Has there been any change?

Well we clearly in some people on volume, revenue, OCI and share, and it's clear that with product mix the way it is, there will be increased focus on insuring that people deliver against their most profitable volume.

And Rowina, as Betsy said before the, the focus is against categories that are high revenue, high margin categories. And I think that will drive the improvements that we expect to see.

And I guess -- just my final question, I know that just during the wave of consolidation, it was about scale, driving better top line growth as well as better bottom line growth. And clearly it's been a challenge. And my question to you is do you think that at this point maybe Kraft has just gotten too big and it's just too difficult with so many different brands, so many different products categories to manage the business and that some of the smaller businesses get lost as a result?

No. I think the challenges we're facing are economic. We've seen significant product costs. We've had to raise our price on some of these categories for the first time in five years, and in this environment I think we're going through some of the adjustment that happens with that. And I believe in spending back to address some of these price points and increase spending, we're doing just what we need to do to get them back on track.

In terms of the potential of noncore divestitures that you talked about, could these be relatively sizeable?

Again, we look at all of our business on a continuous basis. And the ones that we've now sent -- in Germany rice is not the largest thing in the world. but we can look at all of our businesses and as Betsy said before, we want to make sure that whatever we look at makes sense for us -- in terms of enhancing shareholder value, as well.

Thank you.

Thank you.

Thank you.

Our next question is coming from Evan Morris of UBS Warburg.

Hi. Good afternoon.

Hi.

Just a couple of quick questions. Just on that $200 million in spending, I know part of it's gonna be on promotion, but also part of it's gonna be on advertising, and I think you said it was gonna be spent behind some of the highest margin items. And I'm just trying to get a sense of how much of this came about because over the past few years we heard about marketing being either flat or down, getting a bigger bang for the buck. How much did you actually underinvest in these businesses, now that you look back? And I guess looking ahead, I know the spending is going to go up and move higher into the early part of '04, but given a lot of the challenges that you face in the food industry, should we expect this level of spending or this higher level of spending to continue, not even in '04, but even going forward which that in and of itself will put pressure on growth rates looking ahead?

Well, let me try to answer the multiple questions there. First of all, in terms of the past and targeting spending, as we said we do do very sophisticated modeling that helps us look at how we maximize bang for the buck on our spending. And if you look at our market shares I mean, Last year we were up in 60% of our market share, so we felt like we were getting good effectiveness for our spending. As we look at this year where prices have gone up ,we believe that we need to address again that same model edge would say we need to address the price gap issues, we need to increase our spending to bill brand value and our expectation would be that spending will be up in 2004 and that we will continue with those higher levels in the future.

And just another question, following on something you said to David Adelman earlier. You said that you were confident that you will see your momentum turn, but you used the term that you're looking for '04 to be another difficult year. So in terms of momentum turning, are you talking inflection point a year out from now, or if you could just kind of give a little color on that, when you expect momentum to turn and exactly how you're going to measure that given that the outlook certainly for the next balance of this year and into next year doesn't look particularly favorable?

Well, our expectation that we would clearly see consumption and share trends improvements as we move into Q4 and throughout 2004.

And so, with that expectation of improved consumption, but to some of the things I was pointing out, as it was pointed out before, things like the pension and post-retirement costs, that's a real issue, and that will be there in 2004. We're just trying to make sure everyone understands that and factors that into their thinking.

Right. And we knew that was gonna be there. So, is it safe to assume then when you talk about momentum turning and the spending you know resulting in share gains that your 3% volume number or your 3% volume targets, and I know you said you're not changing that now, but is there any reason to believe that that shouldn't be achieveable next year given this higher spending?

When we provide guidance in January, we'll give you a better sense. [INAUDIBLE] in January But we'll see how it's reading the latter part of this year and understand the effects.

Okay.

Thanks so much.

Thank you.

Thank you.

Our next question is coming from Tim Ramey of D.A. Davidson.

Good afternoon. I just wanted to probe on the mix question a little bit more. It wasn't obvious to me just looking at the business segment data and the weights of those various businesses, you know, what would drive the average product mix down 9/10ths of a percent. Are there issues within product segments that we need to focus on to understand the mix question a little better?

I'll answer that . A lot of growth in North America at least came from food service, from our beverage division. And some of our higher margin as we talked about, coffee, cheese, cookies and crackers, did not see the same level of growth.

And also, on the international side of the market, we have seen in the developoing markets, particularly those who have gone through some economic crisis, such as in Argentina, significant consumer downtrading, trading down from our premium brands into our more mainstream and value priced brands. We have seen within categories some mixed issues in some of those markets.

And when we talk about using promotion spending to kind of get back at that, why isn't that just a price cut for the industry? Why should we feel good that others won't just simply follow you down?

Well, again, in some cases they never moved up. So, in some of the price brands and private label, they didn't move their prices per se. And we're not saying that these are across the board list price declines. Their tactical strategic use of the money to address particular items, and particular markets, and particular merchandising price points to get the most bang for the buck.

Thank you.

Thank you.

Our next question is coming from Christine Mccracken of Midwest Research.

Good afternoon. I was just wondering, if you could, just comment a little bit more on the volumes at Oscar Mayer. Do you expect that with prices of meat going up that you'll actually see a stronger rebound with the incremental spending that you're putting behind these processed meats, or do you actually see a secular change away from your traditional Oscar Mayer brands and maybe more towards service deli, or, like, prepackaged meat at the front of the deli?

Well, again, usually when prices go up both of those groups go up fairly consistently, so you don't necessarily see a trade from packaged meat to deli as prices go up, because, as I said, usually they go up pretty consistently across the two groups. I think we have seen volume [INAUDIBLE] on Oscar Mayer cold cuts because of some of the price gap issues-- and we would expect to see those trends improve in the back half of this year and be growing as we move into 2004.

So, in both cheese and processed meats you're expecting a fairly sharp rebound, then, with the commodity price increases and incremental marketing spend?

Yes. Again, we're expecting a clear trends imovement from where we are today. Again, in Q4 and then into next year.

All right.

And secondly, just on new products, you'd mentioned that you anticipate hitting that billion dollar target despite the shortfalls in biscuits. Can you comment just on your pipeline do you feel comfortable with your new products that you're bringing out still in the second half?

Yes, we feel good about the pipeline we have in the second half.

And in biscuits, as well?

Yes.

Great. Thanks.

Once again, to ask a question, you may dial the numbers 1, then 4 on your touch phone at this time.

Our next question is coming from John McMillin of Prudential Securities.

Hello again.

Hi, John.

I don't mean to play international versus domestic, but is it safe to say that, you know, since your April guidance, your real miss here wasn't international, Roger. These numbers are largely in line in the second quarter with what you hoped three months earlier?

I would say, you know, we were below our expectations on volumes in quarter 2, just as we domestically had hoped for the Easter shift and have better consumption. And it's similar effects as Betsy's been talking about here in the U.S. As I mentioned before, we have seen consumer downtrading and lower price alternatives, particularly in some of the developing markets and increased price competition in western Europe. But what I do feel good about, we have seen great progress in key markets like Russia, China and Brazil. It's tremendous growth there. And the issue we've had is we've had some tough times in some areas, in Argentina and Spain, and so forth, as examples.. But all in all I think we are seeing a general effect in consumer downtrading in developing market which its popping our volume in quarter too.

And Betsy, I compliment you. At least you'll get one compliment today, for not blaming the weather: I know Kraft spends a lot of promotional dollars at memorial day promotions.

We did have a bad memorial day, John.

It did nothing but rain through half the country. And, you know, I guess I'm giving you the opportunity to blame the weather, if you want.

Well, it was clearly a contributing factor in Q2, and particularly in May, on that memorial daytiming. But it was clearly not the only factor.

Because I think what bothers people -- I don't know. I'll let other people speak for themselves, but to the extent it was only three months ago when you kind of -- you know, you felt like business was gonna pick up. And I guess a lot of us wondered for a company that even when it was just a division of Philip Morris, you know, had, as far as I could tell, had not missed many quarterly earnings numbers. And I just -- I guess I'm just trying to get an idea of to what extent the weather hurt or some other issues.

You know, John, as we said at the beginning of the year, we would not really know how things were with the switch in timing of Easter until we got into the second quarter. And you are right. In the first quarter we were on track. There were clearly some challenges through April. We felt pretty good about where we were. Again, we saw some challenges. May was extremely soft, and we saw both soft consumption, we saw some of the customer issues come through. We thought that it might turn around in June. June continued soft. You know, we're looking at six months of the year, and our shares up in only about not even 30% of our categories. And as we looked at consumption and share and the outlook for the year and the economic environment, we felt that we needed to do something bold enough to turn the momentum so that we get back to our sustainable business model. And as we looked at it, we did very detailed analysis and said we've got to get some of these price gaps, which are at the higher end or above our range in line and we've got to build equity through consumer spending. As you said, this is clearly not something we take lightly. We do have a history of doing what we say we're going to do. But as we looked at all the pieces, we need to do this for the long-term health of the business.

Okay. Well, good luck.

Thank you.

Ladies and gentlemen, there are no further questions. I turn the floor back over to you for any closing comments.

Well, there's all the time we had for questions. So, thanks for your participation this afternoon. Good night.

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time, and have a great day.