億滋國際 (MDLZ) 2005 Q3 法說會逐字稿

Good afternoon, and welcome to the Kraft Foods third-quarter 2005 earnings conference call. Today's call is scheduled to last about one hour, including remarks by Kraft Foods management and the question-and-answer session. [OPERATOR INSTRUCTIONS] I will now turn the call over to Mr. Mark Magnesen, Vice President of Investor Relations for Kraft. Please go ahead, sir.

Thank you. Good afternoon, everyone. And welcome to Kraft Foods' third-quarter earnings call. Joining me on the call today are Kraft's Chief Executive Officer, Roger Deromedi; and Chief Financial Officer, Jim Dollive. During our planned remarks today, we will reference slides that are available on our website at www.kraft.com. Our comments and presentation will contain projections of future results and are made only as of today's date.

About an hour ago we issued a press release with our results and updated full-year outlook. And this release is also available on our website. Both the presentation and release contain our Safe Harbor statement which reviews some of the factors that could cause actual results to differ materially from our projections. Jim will take you through a review of our third-quarter results as well as our outlook for the remainder of 2005. Then Roger, Jim, and I will open it up for questions. At this point, I'll turn it over to our CFO, Jim Dollive.

Thanks, Mark, and good afternoon, everyone. Our third-quarter results reflect improved top-line momentum driven by balanced contributions from volume gains, positive mix, and pricing. New products are performing well and we delivered double-digit growth in developing markets. Additionally, our cost restructuring program remained on track and we made further progress on simplifying our business to the organizational changes announced last week. Despite this progress, our earnings declined as the impact of our pricing actions lagged the significant increases in our commodity costs, particularly in energy and packaging, and we chose in certain categories to maintain competitive prices. Given that this higher cost environment does not appear likely to lessen in the near future, we are exploring additional pricing actions.

Looking at the specifics of our third quarter, top-line momentum accelerated versus our first-half results. Net revenues were up 4.4%, including 1.5 points benefit from currency and a negative seven-tenths of a point impact from divestitures. Excluding these items, third quarter ongoing constant currency revenues were up 3.6%, bringing our year-to-date growth to 3%. Third-quarter revenue drivers reflect solid contributions from volume growth of 1.3 points, positive mix of 1.4 points, and pricing of nine-tenths of a point.

We are pleased that our volume growth improved in the third quarter after a decline in Q2 when many of our pricing actions affected consumer take-away. Growth was broad based with ongoing constant currency revenues up in all seven segments this quarter. North America revenues were up 3.2%, which was consistent with first-half growth while the international revenues grew 4.5% bringing their year-to-date growth up to 2.6%. Trends in Europe, Middle East, and Africa improved as strong results continued in many eastern European markets like Russia and Ukraine. In Germany the rate of revenue -- the rate of revenue declined moderated to low single digits although this reflects the impact of increased prices offset by a volume decline.

Year-to-date revenues were up in six of seven segments with particularly strong growth in the beverages and the snacks and cereals segments. Consistent with the first half we delivered positive mix across most of our segments. Five of seven segments reported positive mix in Q3 and six of seven are positive year to date. Mix was particularly strong in Europe, Middle East, and Africa due to solid growth in coffee in the UK and France and U.S. convenient meals behind growth in Oscar Mayer deli shaped meats and new California Pizza Kitchen items and in U.S. snacks due to good results on our new cookie and cracker bar products. The mix impact was negative in U.S. beverages in the quarter due to strong volume growth in ready-to-drink beverages which outpaced solid growth in our powdered beverages and good mix within our coffee portfolio. Mix was also negative in US grocery due primarily to a decline in sugar-free desserts as this brand lapsed prior-year benefit from low carb trends.

Our improved mix also reflects good momentum from our new product initiatives. On our new South Beach Diet product line, distribution levels have exceeded our expectations, repeat purchase rates are strong, and after seven months in market, revenues have already exceeded $100 million. We are also pleased that this brand has quickly risen to the number two share position in the growing breakfast bars category. South Beach Diet is a great example of our scale capabilities and we plan to expand the line with additional products in early 2006.

In Europe, we continued the rollout of our new Tassimo hot beverage system to new geographies. In France, our lead market for Tassimo, consumer processes of brewer machines have continued to build with over 300,000 units sold since our launch last year. We have learned much on consumer behavior and product usage in France, as well as the effectiveness of our marketing programs. In late September we entered the German market as well as the U.S. through specialty retailers and on-line. For the year, we expect Tassimo revenues to reach $50 million. We continue to be encouraged by both the retail and consumer reaction to Tassimo and look forward to additional geographic and product line expansions in 2006.

In pizza we expanded our thin crust platform to the California Pizza Kitchen brand. Revenues on this brand doubled in the quarter versus last year and are now tracking at $70 million annually. Our innovation within the pizza category this year has been strong, and has driven overall dollar consumption growth of 7%, and a dollar share gain of eight-tenths of a point year to date. In our desserts business, we introduced two new items earlier this year, sugar-free ready to eat Jell-O pudding snacks and Jell-O Sunday Toppers pudding that have both performed very well. Together, these items are tracking to achieve $75 million in sales in their first year.

Finally, in the third quarter we introduced our new line of Kraft branded processed cheeses for developing markets into Russia as a lead market. Early response from distributors and retailers have be positive and we expect to expand this growth platform to additional developing markets in 2006. The aggregate gross revenues for these and other new products are expected to exceed $1.5 billion this year. When compared to recent years, this step-up in new product revenues reflects our focus on leveraging growth platforms on a global basis. Additionally, as mentioned earlier, new products have played a key role in improving our revenue mix, as the revenue per pound index on new items relative to our base business has improved significantly in the past two years.

Our third-quarter volume growth also benefited from improved U.S. category growth rates versus the second quarter. According to Nielsen data including Wal-Mart across our top 25 U.S. categories, category growth in pounds increased 0.6% in the quarter versus a decline of 1.1% in the second quarter. On a dollar basis, third-quarter growth was 2.3%, similar to second-quarter growth of 2.4% as lower cheese prices offset the improvement in pound growth. We are encouraged that our categories appear to have rebounded as expected from consumers' reactions to higher retail prices that impacted take-away in the second quarter.

On our U.S. market share, we held our aggregate market share at a weighted average basis across our top 25 categories in both the quarter and year-to-date despite increased prices in many categories. In these same 25 categories, private label has increased its share by three-tenths of a point year to date while all other branded manufacturers lost three-tenths of a point. We're encouraged that we are maintaining and building the value of our brands in the face of more value conscious consumers.

Another top-line growth driver was developing markets. Ongoing constant currency revenues in developing markets were up 10% in the quarter, following 9% growth in the first half. Growth was particularly strong in Eastern Europe, led by significant gains in Russia and Ukraine, and across most Latin American markets. As I indicated earlier, our improved top-line growth did not translate into increased earnings as we continued to face significant commodity cost challenges. On a continuing basis EPS was $0.40 in the third quarter, down $0.05 or 11% versus 2004. This quarter brings our year-to-date EPS to $1.26, up $0.10 or 8.6% versus prior year. Third-quarter earnings in both years were impacted by $0.02 per share of restructuring charges, and year-to-date we have incurred $0.10 per share in restructuring and impairment charges.

Through the third quarter we remain on track to achieve our targets on a three -- remain on track to achieve our targets on our three-year restructuring program. Thus far, we've announced the planned closure of 16 facilities versus a three-year target of up to 20 and the elimination of almost 4,600 positions versus the target of 6,000. We have incurred charges of approximately 810 million to date, while capturing $225 million in ongoing savings. This keeps us on track to deliver $400 million in ongoing savings by the end of next year.

Already in the fourth quarter we advanced our simplification efforts further with last week's announcement of additional organizational streamlining. In North America we are eliminating the division layer and more fully integrating our Canadian organization into our U.S. teams. We are also making related changes in our global functions to align with the new North American structure. As a result of these moves we'll eliminate approximately 600 positions bringing our cumulative total to around 5,200 since the announcement of our restructuring program. We see several benefits arising from these moves including improved focus on consumers and faster decision-making. The cost in savings associated with these changes are included in our original projections.

We are also making good progress towards simplifying our business through SKU reductions. We are on track to take out over 20% of our SKUs over a two-year period. While these reductions have impacted our volume growth this year, they have increased our operational efficiency and contributed to our lower inventory levels versus last year. Continuing to abridge our year-over-year earnings, our third-quarter comparison is impacted unfavorably by a one-time tax event in the prior year. As a reported -- as reported last third quarter, we settled an outstanding tax claim for $76 million or the equivalent of $0.04 per share. Aside from this one-time event, our base tax rate in 2005 was slightly below last year, which generated a $0.01 benefit. The net result is that taxes represent a $0.03 negative impact year-over-year. On a year-to-date basis, taxes remain favorable to prior year by $0.04 per share.

On our year-to-date -- our year-to-date tax rate is 30.4% and we project a full-year rate of approximately 31% in 2005. The remaining $0.02 decline in our third-quarter earnings result from the change in all other operations. This impact includes higher commodity costs net of pricing which represented $0.05, an increased postemployment benefits in restricted stock expenses which together represented $0.03, partially offset by volume growth, positive mix and our cost reduction efforts, which together contributed $0.06 to earnings growth.

Higher commodity costs remain our most-significant challenge. We are up approximately $200 million in the quarter, bringing our year-to-date increase to approximately $600 million on top of a $900 million increase last year. Looking at specific commodities in the quarter, coffee, nuts, energy, and packaging remain substantially higher than prior year. We are incurring higher direct energy costs to operate our facilities and ship our products, but the more significant energy impact has been on higher packaging costs. Plastic packaging is our second-largest input cost in dollars trailing only cheese and the underlying PET resins were up substantially in the quarter. Our long-term contracts have shielded us from some of the increases in the third quarter, but the sustained higher energy costs are now starting to roll through on packaging.

During the quarter, a few commodities declined with barrel cheese down 2%. In the case of cheese, this decline was not as large as we had projected. With the consistent strong increases in U.S. milk supply this year we had expected cheese prices to move lower throughout 2005. Through September, cheese prices have remained fairly flat as export demand coupled with solid domestic growth absorbed the higher milk supply. But with milk supply continuing to be strong, we expect cheese prices to decline seasonally as we move through the fourth quarter.

On PET resins for packaging, costs began rising in 2004 and spike began in recent periods as crude oil and natural gas prices rose. These costs will continue to be a watchout for us next year given the nature of the packaging material industry and their input costs. These higher costs were only partially offset by increased prices in the quarter. While pricing contributed 1.4 points to revenue growth in the first half of the year, this contribution declined to nine-tenths of a point in Q3. The lower impact in Q3 is the result of less pricing benefit in North America, which was essentially flat in the third quarter, partially offset by higher pricing in our international business. In North America, the flat pricing in Q3 was the result of a 14% increase in coffee prices, offset by declines in cheese of about 2% and foodservice of about 4%. Price declines in these businesses reflected lower commodity costs.

In the remainder of our North American businesses, net pricing was flat in the quarter after being up 0.7% in the first half when we benefited from prior-year price increases on our meat and pizza businesses. In our international business, the pricing acceleration is driven in large part by coffee price increases in Germany, but also reflects price adjustments in many other markets. The net result of these higher costs and lag pricing impacts was lower operating margins in the quarter. On a reported basis, our margin was 14.2%, down 1.8 points from the prior year. Margin from operations was down 2 points in the quarter, with higher commodity costs net of pricing, the main driver at 1.9 points. Higher pensions and restricted stock costs also impacted margins by nine-tenths of a point. These impacts were partially offset by the positive contributions from mix, productivity, and cost restructuring savings.

Turning briefly to cash flow. Our year-to-date discretionary cash flow plus divestiture proceeds was $2.9 billion, including $1.6 billion in gross proceeds from divestitures. Year-to-date discretionary cash flow or cash from operating activities less capital expenditures was $1.3 billion, down $660 million from last year. The key drivers of the decline are a tax payment of $359 million related to the sale of the sugar confectionery business, $210 million in higher capital spending, and increased cash spending against the restructuring program. Importantly, we continued to manage our working capital effectively with a net seven-day reduction in our overall cash conversion cycle versus September of last year. Through the third quarter, 62% of our cash has gone to dividends and share repurchases. In August we announced a 12.2% increase in our annualized dividend to $0.92 per share. We have also bought back about $800 million worth of our shares through September and have utilized over half of the $1.5 billion two-year program authorized by our Board in December of '04. Finally, the remainder of our cash flow reduced debt.

Turning now to our outlook for the balance of the year. On the top line, we narrowed our range for ongoing constant currency revenue growth to 4.5 to 5% on a 53-week basis, or 3 to 3.5% on a comparable 52-week basis. With year-to-date growth at 3%, and our 52-week guidance of 3 to 3.5% this implies fourth quarter growth of 3 to 4.5% excluding the extra week. The key factors that would help us achieve this fourth-quarter growth are continued new-product momentum, increased marketing support, and the impact of pricing actions.

In addition to the new products I mentioned earlier, there are few other new items that -- that we've announced for the balance of the year. Across our biscuit portfolio we introduced several new items that leverage whole grains, including whole grain Chips Ahoy! cookies and Wheat Thin chips in the U.S. as well as the expansion of Ritz chips into Canada, Brazil, and China. We've also launched a new brand of health and wellness oriented bars called Velveeta into several markets including Poland, Indonesia, the Middle East, and Austria. We have several new chocolate and biscuit items in the U.S., with Oreo Choco Sticks and Nutter Butter Choco Sticks that leverage the agacencies between the cookie and chocolate categories. We will also continue to expand our successful Milka N-Joy chocolate tabbets with our entry into Russia. Finally, we recently announced the launch of Kraft Super Mac and Cheese dinners in the U.S. with more vitamins and whole grains than our current macaroni and cheese product.

On earnings per share we've lowered our guidance to $1.68 to $1.71 per share on a continuing basis, versus our previous $1.73 to $1.78 guidance. Consistent with our past practice, this range includes an estimated $0.22 in restructuring impairment charges and $0.04 from gains on sales of businesses. It does not include any possible impacts from potential divestitures for the balance of this year.

The main driver of our guidance reduction is higher commodity costs, particularly for energy packaging and dairy. Earlier this year, we indicated that we projected full-year commodity costs to increase by $600 million, given this sustained higher energy costs and related impacts on packaging materials, as well as a smaller than anticipated decline in dairy costs, our current projection is for commodities to increase by around $800 million. On cash flow, we continued to project discretionary cash flow plus divestiture proceeds of around $4.3 billion, including net divestiture proceeds of 1.2 billion. Our priorities for the use of cash remain the same, which are to fund acquisitions, return cash to shareholders through dividends and share repurchases, and lastly to reduce debt.

To briefly sum up before moving to questions. We continued to make good progress in several areas this quarter. Our top-line growth improved, with a good balance of growth drivers. Our cost restructuring program remains on track and we took additional steps to simplify our business. But our pricing continued to lag the significant increases in our commodity costs and earnings and margins were impacted. Given that many of these costs appear likely to remain higher for the foreseeable future, we are currently exploring additional pricing actions to offset these higher costs and improve our earnings and margin profile. With that, Roger, Mark, and I will open it up for your questions .

Operator. Can we open it up for questions, please.

Thank you. [OPERATOR INSTRUCTIONS] Our first question is coming from Chris Growe of A.G. Edwards.

Hi, Chris, how are you.

Hi, good evening. Thanks. Just two quick questions. For starters you gave some information on -- I know it was IRI related but your category's being up around 0.6% in pounds and your volume being up around 1.9 excluding divestitures. Is there any sort of shipment in advance -- that is with new products that maybe plays a role in the stronger volume this quarter?

No. It's actually -- as you look at the aggregate volumes, pretty much in line with what we -- you see as you look at the overall categories, nothing is really dramatically swinging what we've seen in the other category trend.

Okay. And was the flat market share in the quarter also a surprise or was that something that we should be looking for going forward?

No. We had anticipated back when you look at where we were in quarter two we were down about a tenth in quarter two. That as we were going through these price increases, we would probably see that basically flat share performance. As the consumers have gotten used to the higher prices and as we continue to invest in our marketing and actually there was a phasing of new products in the activity between quarter three and quarter four as well. We would expect that we will continue to sort of build our share as we go into quarter four in 2006.

Okay.

But again it's -- we've always said Chris -- the tens may not sound like a lot but in the size and scale of our business we count the tens.

Absolutely. And then just one final one, that is regarding the pricing actions that may or may not occur going forward as a result of commodity cost increases, is that related to a fear of -- sort of the consumer reaction, downtrading? Is private label likely to follow in your opinion? Would you have any general comments on that?

Again, I can't comment on any specific pricing actions but as we look at -- the key thing we obviously have been watching is have there been structural changes in our costs because obviously we go up and down in prices for commodities whether it be coffee or cheese or meat and so forth. But what we have seen is the higher oil prices have, as Jim said not only impacting our own manufacturing and transportation, but very importantly on packaging, and given that we see that as a very structural change and everyone can take their own guess for where oil prices are going to be but again, much of that higher costing this year will be so into even more so next year given our contracts we have with packaging suppliers and so I think -- to your comment is are many of these common industry costs? Certainly they are. Everyone is being impacted by higher energy and packaging costs but again it will vary by category, because as we said cheese costs, barrel costs were down 2% in quarter three and we expect obviously the higher milk production for -- seasonally for them to decline in quarter four. So it will vary by category and what we end up doing as we examine and explore pricing but there is some structural change in terms of higher costs for the whole industry.

Thank you.

Thanks, Chris.

Thank you. Our next question is coming from David Adelman of Morgan Stanley.

Hi, David.

Good morning -- good evening. Rodger, I want to go back to the issue of market share in the U.S. The question is this -- Over the last two years you've obviously significantly invested in marketing, brand building, narrowing pricing gaps, and then on top of that, the financial results clearly demonstrate that you have tactically elected to lag your pricing vis-a-vis where the commodity costs are. So with those two factors as a backdrop, shouldn't you be gaining market share?

As we look at it, the intention as we build our brand value we will be gaining market share over time. But I will tell you the environment is such given where consumers are that it is a more challenging consumer environment and I think importantly, as Jim commented, while we're flat, other branded competitors in the quarter were down three-tenths and Private label was up three-tenths. Anyway as you look at it cumulatively, Private Label is gaining share modestly across all of our categories and we are holding or modestly gaining and competitors are losing. So it is a more challenging consumer environment and so versus where we were a couple of years ago when we initiated this Sustainable Growth Plan it's probably a more challenging consumer environment which is why it goes back to as we continue to stare at our cost structure, and we continue to look for more ways to continue drive costs out of our system, to make sure that our brand value equations need to be where they are. So have we been cautious about taking pricing given the consumer environment and that's again driving us as a consumer environment, we've -- yes, we have been, but again we're committed to make sure that we build the brand value for the longer term and continue to build our top-line momentum which is a key driver for us over time.

With respect to the consumer environment, with the recent spike in gas prices, has that translated when you look at more granular data to a slowdown in some of your category growth rates more recently, Roger?

It varies. And in fact it's interesting in talking to some of our largest customers you see a combination of shoppers making less-frequent trips but higher rings on each of those trips and some doing closer driving trips and making smaller rings. But there is less disposable income for consumers as they have to spend more on gasoline so there's some pressure in terms of gee, can they -- or they make trade-offs in what they're going to purchase and why we're very sensitive to make sure we keep our brand value equations right versus a competitive environment and in many cases that is Private Label.

Last question, can you give us a preliminary view where you think the tax rate will be. It's obviously come in low this year and you've even brought down your outlook in conjunction with this year with the release of these results where might it be next year?

I'll let Jim answer that.

As I said we're at -- this year our forecast is 32%.

32 or 31, Jim? I thought the release says 31.

31%. And for next year we haven't got an official rate yet, but I do expect it to move up 2 to 3 percentage points, somewhere in that range.

Okay. Thank you.

Thanks, David.

Thank you. We have our next question coming from Andrew Lazar of Lehman Brothers.

Good afternoon.

Good evening, Andrew.

How are you?

All right.

Focusing for a minute on your cost structure as you just brought up before. How soon will you be able to talk about sort of the magnitude of further savings opportunities? And where do you see the most incremental opportunities lying for Kraft? I mean is it still manufacturing capacity or other areas? Because I see as you talked about balancing volume and pricing, I wonder what that does to kind of fix cost absorption which gets me back to kind of the cost structure question.

Sure. And that's -- the challenge for all of us in the industry is to get a more value conscious consumer we've got to make sure the benefits we deliver equate to the price we want to charge versus other alternatives. And so this is where we're working hard to continue to look at our cost structure, the things we announced last Friday on the organizational streamlining, was just a continuation of what we do as we look at the organization, and it's going to yet save us money as we eliminate some headcount, but importantly, it's going to make us a more efficient and effective organization so we're continuing to look at our organization structure and how we can be more efficient there.

But importantly, as we keep talking about SKU rationalization and we're doing a lot of things as we say to decomplex our business system, and as you noted our cash conversion cycle improves our days of inventory on hand are being reduced as we simplify in our entire business system, and while we've announced that -- 20 plants in the restructuring we announced back in January of last year, and we continue to find opportunities to streamline lines and consolidate there and so I think you'll find that folks in a lot of the cost reduction opportunities and how do we simplify the organization and how do we continue to decomplex our manufacturing in business system.

And then your earlier comment around being sensitive to the consumers' reaction.

Yes.

Pricing and price gaps. In your -- in your conversations or top to tops with -- more important I guess your retail customers.

Yes.

What is the execution risk associated with additional pricing in a lot of your categories from a retailer perspective? In other words is there risk that Kraft gets kind of frozen out of certain key merchandising events with respect to those retailers -- or how proactive can you be ahead of some of these things with those key partners?

Well, this is where -- I can't comment specifically on any pricing -- any customers per se but as the previous question that David had, we're -- everyone in this industry's been incurring higher costs and so it's not as if what we're talking about here is as we explore additional pricing actions. Is it because we are doing something that is not being incurred from a cost point of view by our competitors or by Private Label as well. And so when there's an understanding of the cost pressures that are there, you have that as part of your discussions that you deal with to your retail customers.

And your sense is that they are--?

They are incurring similar cost increases themselves and whether it be energy or packaging as they're dealing with their suppliers themselves, or their own private label. So I think it's -- these are all -- what we're talking about on energy and packaging and so forth is common in the industry.

Thank you.

Okay. Thanks Andrew. Take care.

Thank you. Our next question is coming from Rob Campagnino of Prudential.

Afternoon gentlemen, how are you doing?

Good.

Roger, you had the opportunity to maybe modify your guidance back in September. At that point I think that you probably hadn't fully integrated the impact of Hurricane Katrina into your forecast. Was that really the primary swing factor or did something else happen in September?

It's two things. One is we were having an environment of higher costs from energy happening prior to Katrina and Rita. Obviously that's accelerated that and will maintain obviously those oil prices at higher levels. And so, yes, the key driver was one is energy, and importantly as we saw that flowing through on packaging costs, and what we'd anticipate future on packaging costs. Interesting, trucking costs and transportation is also up dramatically, somewhat exacerbated by the hurricanes in terms of availability of trucks. But also as Jim mentioned in his opening remarks, we have not seen the decline in cheese costs that we would have anticipated given the strength of the milk production and that's another key one since the meeting in early September that's different as we went through the months.

Okay. And just -- I guess just sort of a different way of asking some of the questions the other gentlemen asked.

Yes.

But there -- there hasn't been any sort of fundamental shift in consumer behavior that you've seen sort of in September, and maybe through October?

No. And -- no, it's not been a great fundamental shift. It's just we're cognizant and watchful of the consumers' spending power as they're having to spend more on filling up their tanks of gasoline and interesting as you meet with retailers and talk about what they're doing is some of their most successful promotions are to save $0.10 on a gallon of gas when you buy $100 worth of groceries. So there's a lot of sensitivity about gas prices, consumers obviously make different trade-offs and important thing for us is to maintain and continue to build the value they see in our brands in face of these other pressures as households are having -- in the United States on what they are going to do with their spending power.

Okay. Thanks for your time this evening.

Great. Thanks, Rob.

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

Good evening, David.

Hello?

Hi, David.

Yes, actually, this is Gerry Gallagher. I have a couple of questions. Regarding the supply chain, what are you guys looking to do to reduce your supply chain cost overall by establishing better collaboration with your suppliers?

I think as -- we talked about before and actually back in May when we had our investor meeting had Brian Driscoll who's head of sales in the United States talk a lot about these things so I can reprise them for you. Obviously we are doing a lot more vendor managed inventory, a lot more CPFR, collaborative planning and forecasting. Importantly one of the things -- in fact I just had a meeting on it this morning is improving our own forecasting accuracy and we're doing a lot of work in terms of working with our customers to better understand the promotional lift we'll get and building that back into our supply chain all the way back to make sure we have the right products that satisfy promotional needs, but at the same time not having to carry too much inventory in those non-peak periods of time. So it comes down to a collaboration and talking back and forth between us and our customers and planning it and then having, I'll call it the planning systems and information systems within our company to truly affect the production planning inventories that we have.

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

Hi. Good evening.

Hi, Eric.

I got a few questions. I guess the first one, Jim, if I take the extra 200 million in commodity costs I think that's about whatever, $0.07, $0.08 a share.

About $0.08, yes.

And then your interest expense came in surprisingly low. I'd like an explanation there. But if that let's say is running $0.04 below at least what I was projecting for the year. It looks like the taxes for the second half are going to be maybe $0.03 better. So you kind of have the tax rate and the interest expense offsetting the commodities and yet the numbers are coming in lower. So what isn't coming through versus what you had forecast? And is that basically pricing?

Well, obviously, as we went through the earlier conversation, our pricing has lagged the magnitude of the cost increases we had and that is the primary driver. Regarding the other components, I'm pleased to say that the interest expense is favorable to where it was prior year. And a lot of that has to do with the fact that we've -- our debt levels have come down over $1 billion. In conjunction with that, we had a couple of bonds that redeemed earlier in the year and those were higher coupon Nabisco bonds. So there were -- that helped bring down the average interest on our portfolio. I am not sure that the magnitude of the changes is on par with what you indicated so I don't know if I can bridge to that. And then we have brought down -- we just brought down the tax rate a slight amount, 0.5% or so on the year.

Okay. So--.

The other thing, Eric, that drove down the interest expense was the use of divestiture proceeds which came in at the very end of the quarter -- second quarter. So that was a full quarter worth of pay down there.

I see. Okay. So the difference, then, is -- okay. Well, all right. Let me move on. The -- with the rising -- I mean with the expect -- with the Philip Morris and Altria gaining a relatively good ruling and a likelihood that the spin occurs sooner rather than later, you I think pay Altria 2, $300 million in shared services. Is any of that tied to -- like a joint -- purchases on energy or packaging where -- if you become a stand-alone or when you become a stand-alone company that that is a step up?

Actually, we've been -- obviously any decision about spin will be made by Altria, but obviously we have the responsibility -- if they were to decide to spin us that we'd be ready to be a stand-alone company. And what's in those shared services relate to things like the information services, treasury services, sort of other sort of higher level staff functions. From a procurement point of view, on procuring oil or procuring energy or packaging and so forth, that's very much done by ourselves. But we may sometimes talk to the scale of -- total Altria Group, we always do separate contracts than what we do with our suppliers. And so this is where as we continue to evolve the organization and -- in terms of readiness, if the -- Altria were to decide to spin us and again would not expect any dramatic change in terms of our cost structure versus what we're getting today as a services agreement with Altria. The one that we have been getting a benefit from has been the tax-sharing agreement, and obviously that's something we continue to explore in terms of how to make sure -- if we were a stand-alone company we'd be managing our tax situation.

Okay. And then last, and then I'll -- the last question and I'll pass it on. You -- in the last announcement you made about some changes in the job -- jobs and the management lines, I'm not, Roger, exactly clear. So is -- like, let's say the person who is running cookies.

Right.

Like, are they--.

If they were in cookies, yes.

Well, okay, but the way the press release read, it seemed as if there -- that that position was almost as if that was gone and not reporting up to the north -- I guess I just don't understand the press release relative to what you're doing.

Let me make it -- see if I can say this in a way that is clear because I'm sure others may have the same question. If you go back to -- again, two years ago almost when we created the logo Kraft, prior to that Kraft Foods North America and the segments that you use to study and analyze our business were aggregations of categories that were based on the historical acquisitions. On the call we used to have a segment called cheese, meals, and enhancers another one called beverages, desserts, and cereals and then back in January of 2004 we changed those to be our -- I'll call it consumer centric sectors. Beverages, convenient meals, cheese and dairy, grocery, et cetera. And then what we had within each of those sectors and that's -- one of the things importantly as we did these changes in North America last Friday, none of those sector heads have changed. And you've met many of them if not all of them over the past few years. None of the sector heads changed. Kevin Ponticelli still runs Cheese. Rick Searer still runs convenient meals, et cetera.

What we had then in some of our sectors underneath that were divisions. So for instance, in -- since you were talking about cookies as an example, within our snacks and cereal sector that Daryl Brewster runs, we had a, quote, Biscuit Division. Within the Business Division were three categories, basically, three major categories, cookies, crackers, and salted snacks. What we've done is -- and then in the case -- there was another category, is -- we used to have confectionery there. What we've done is eliminated that Biscuit Division and just now have the head of cookies reporting directly into Daryl. And the head of crackers reporting directly into Daryl.

Okay.

And so we basically eliminated a layer in the organization because now that these sectors are more oriented around the consumer, it's a more natural grouping to have the sector -- I mean the category heads report directly into the sector head.

Okay. So whoever's running cookies now reports directly to the sector head.

That's exactly right.

Okay. All right.

So I got rid of that sort of span-breaking division -- and you needed those division heads when you had these segments that were just odd conglomerations of cheese, meals and enhancer, but now that you have them oriented around the consumer -- because everything we're trying to do from an organizational design point of view is get closer to the consumer in what we do and it's even down to the categories and as I always -- as I said, it's for instance to Rick Searer, I said Rick you're in charge of U.S. convenient meals whether it comes frozen, dry, or refrigerated and that's your consumer space so he has now the categories of, yes, the Pizza but he also then has meat and he has Lunchables and this South Beach Diet and so forth reporting directly into him now.

Okay. Thanks.

Thank you. Our next question is coming from David Driscoll of Citigroup.

Hi. Good evening, gentlemen.

Good evening, David.

I'd like to talk to you a little bit here about the energy, oil, and packaging side. My understanding of this, and you -- quite frankly you made it sound differently in your prepared comments is that the third quarter was really not -- in my opinion it shouldn't have been where the full brunt of these higher energy prices have been felt given the fact that the hurricane, the first one there, Katrina didn't hit until August well into the third quarter. My question here is -- is -- what am I missing? Or am I precisely correct in that the negative impact from packaging costs and energy costs will in fact accelerate in the fourth quarter?

You are correct. In fact, as you look within quarter three, where we actually came in in terms of EPS was slightly below our expectations, obviously we -- as you know don't provide guidance by quarter. And we knew exactly what was going to happen on taxes and what our expectations were. As we talk about energy and packaging, you're going to find that cost accelerating as you go into quarter four. As we get the flow-through from packaging suppliers into their costs. And it will actually carry over into 2006 as well. Given the contracts we have with packaging suppliers. But importantly within quarter three there were higher costs as the dairy curve did not come down as much as we had anticipated.

So those are some of the dynamics between quarter three and quarter four. But you're right about quarter four which is why as we talk about what we're looking at in terms of our cost structure as we look at energy and packaging, it is very structural and it's going to continue for a while because even as we look at 2006, these higher energy costs are going to carry through into packaging well into 2006 as well.

Roger, I just get the impression, though, from reading the press release and from listening to the comments that it was sort of the unexpected move in energy costs that affected the third quarter. But it's not the read that I've had on the quarter for the entire sector. My thought here was that we really were not going to see the impact of what happened from the hurricanes until next quarter, and so then it really stands to reason then that your comments on cheese -- I'd make a quick comment here as well that as I understand from prior comments you guys have made, cheese inventories are built up quite a bit in advance. And so if recent milk prices have not declined as fast as you wanted, that's a recent event that would affect future inventory that would eventually flow through the sales line. However, the inventory that you sold during the third quarter were built up at a prior period and so i.e. when you were giving us guidance back in July, I feel like you guys probably should have known all of these pieces. Am I thinking wrong on this or what am I missing?

The only thing I would disagree with you on that is that the cheese costs do flow through the P&L more quickly than you're anticipating. While we do hold some fairly high levels of inventory on cheese for aging purposes, there's still an awful lot of cheese -- because it is our largest single commodity that we buy on a short-term basis and that does impact the overall profile.

But again as you look at the change again, the guidance that we had given was on an annual basis and not in quarter three, you guys all did your forecast for quarter three, the change in our guidance is driven by the -- primarily in quarter four. So understand your analysis is right, it's not that different than -- versus where we were in quarter three versus our expectations of ups and downs on some various lines but the greatest impact in the change of our full-year guidance is in quarter four.

Let me bring this to the final ultimate question then is 2006. It stands to reason then if we're going to have an acceleration of the increased costs in Q4 and then if we assume that -- I don't know where oil is going and I'm just going to assume that packaging is going to be high, this appears to be remarkably negative for 2006. What can you do to offset this or should I just go ahead and make the assumption that your long-term earnings guidance for '06 is just -- excuse me, your long-term earnings guidance would not be achievable for '06?

Again--.

It seems very tough right now.

Again, we're not providing specific guidance today as -- and we will do that in January. But one of the things that -- within our control and obviously we don't control the oil price is one, the momentum we can create on the top line but importantly what we can do with other costs in our business system. And that's why we're aggressively -- to the previous questions, that we can do on both plants and in terms of the organization structuring themselves and so this is where we will continue to drive hard on those costs and see what we can do to reduce costs across our business system. And importantly that's why we've made the point that we're exploring additional pricing because as these costs are appearing to be more structural in nature than just one quarter, and partially that's -- as we -- you don't want to overprice too soon but when you see more -- I'll call it resistance or structural cost changes, we are exploring additional pricing that will be common in the industry that is very important that -- as you look at these costs you improve the margin structure going forward.

My only comment to that would be a 200 basis points decline on operating margins certainly sounds like a rationale enough for price increases.

I'm glad you look at the P&L like we do.

One final question then I'll pass it on. Can you give us interest expense guidance for the remaining portion of the year, i.e. I think Eric was getting at this but maybe I just didn't hear the answer. Do you expect this -- the number of -- the interest expense number that you posted in the third quarter to be the ongoing run rate?

It should be very similar. The only thing I would point out is there is an extra week in the fourth quarter and we'd have to -- you'd have to take that into consideration. Obviously, we'll continue to bring down I think some of our debt level just as we saw a big decline at the very end of Q2. But that would -- so it's going to be similar adjusted for the extra week.

Okay. Super. Thanks a lot, everyone.

Okay. Thanks, David.

Thanks David.

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

Good evening, can you hear me this time.

This time can I hear you, it was someone different last time so.

Yes, I don't know. Maybe that's the guy that got me on the TSA do not let fly list. Anyway, first of all, you had what seemed to be a pretty good top line here. You're talking about maintaining your expectations, delivering 1.5 billion in new products this year, but you're lowering at least the top end of your sales forecast. What do we have here? Is it more cannibalization than expected, less pricing than expected, more elasticity than expected?

It's actually -- no, the new products are tracking where we thought and also in terms of incrementality, there's no change in our expectations and incrementality. And something that we've been very focused on is increasing the incrementality as you know, David, as we've been doing this fewer bigger better and what we're seeing on the things that we're doing so there's really not a change there. As we got in a year-to-date run rate at 3%, it's -- when we were at -- that 3 to 4.5, obviously you would do the math on year-to-date and year to go and say well you can't be at that same run rate. And so as you look at sort of what we had in the previously -- it's slightly lower and some of the pricing realization as we've said are our pricing has lagged some of the higher costs but it's slightly lower on the pricing realization, and obviously as we -- have good growth in developing markets slightly less on the revenue realization there so this is back to slightly lower mix than we may have had before so it's a little minor little things here and there so it's nothing anything dramatically versus what our expectations were but they've come up so we don't want to have an expectation full year that doesn't make sense relative to the year-to-date.

Understand. And I guess also on pricing, relative to commodity costs, is it mostly a organizational issue in terms of nimbleness you're not able to get the pricing through fast enough, maybe -- obviously the costs have rose very rapidly. Or more a competitive issue, you don't have enough incrementality, to use your word, innovation or brand power.

I'd say it's the third issue, which is back to just sensitivity and don't want to get ahead of the curve and you can say well, gee, your margin is down and as it was down in quarter three. But maybe it's our own sensitivity to we don't want repeats and the mistakes that we had in early 2003 as you'll remember.

Right.

Where we priced and basically had significant share declines and got ourselves in a spiral downward. We've been making good consistent progress in getting all the cylinders working in terms of the top-line momentum and we are just being very -- making good conscious decisions when we see -- permanent structural changes in that costs, yes, we need to price for those but we don't want to get ahead of that as we take pricing.

All right. Just lastly. Is there an update on your adaptive distribution system rollout?

Continues to be testing and we're continuing to see good success. The various highlights we've been doing have been working well for us. And we'll be rolling out more pilots at the beginning of next year. So no, I've actually been very pleased as a comment before it takes a lot of work in the back room to make sure that as you put warehouse items through DSD you have the systems that making sure that works right. So we continue to make progress and are continue -- encouraged by it.

Great. Thank you very much.

Thanks David.

Thanks David.

Thank you our next question is coming from Terry Bivens of Bear Stearns.

Good afternoon, gentlemen.

Hello Terry.

Hi, Terry.

I don't understand this -- your cheese and dairy cost. I mean I'm looking at -- it looks like in the fourth quarter -- and again I'm looking at Barrel Cheese, understanding there may be some difference there with the other. But it looks to be down according to the figures I look at by about $0.09 in the fourth quarter, 7% average next year. So I -- where was it -- just, and maybe Roger this gets back to your forecasting accuracy comment, but you anticipated it to be much lower, is that the problem?

In quarter three we anticipate it to be lower and actually at this point in time in barrel cheese price as of today, the market was 1.42.

Okay.

A pound and at this point in time given the milk production that we've seen you would expect to be lower than that, given the seasonality of cheese costs and that's part of -- that's why we included the curve so you can see the long-term history and the seasonality of it and our expectation as you go through quarter four it will come down but almost think of it as it's trending the right direction. It's come down from the 1.50s where we were earlier in quarter three, but it has been tracking just -- at a higher level than what we would have expected given the 4.5% milk increases. So it's the shape of the curve and well, yes, we expect it to go down in quarter four with whatever forecast you're looking at. Do we expect it to go down in quarter four? Certainly we do. But it's coming off from a higher level and it's just tracking above the line that we were expecting.

Well, I guess that begs the question for '06, then, how are you looking at '06 in terms of your dairy cost?

Again, I won't give you an exact forecast but one of the things that impacted dairy this year in the United States was strong demand out of Asia. Do I expect that to go away? No I don't. But we also had weak production in Australia and New Zealand and that should start to recover as we always know that milk sort of flows with the money and when prices are higher, there will be more output. And importantly, with the output in the United States, everything we're seeing continues to be strong, there's no reason why it won't be strong. So we don't expect any unusual structural things that would change it if those things were to continue and I think we'll see a seasonality in cheese continuing next year. So nothing unusual should drift down in quarter four, do its normal seasonal rise as we get into the summertime and after the flush in the spring.

Okay. Looking just at the fourth quarter and bearing in mind the risk of going through all the puts and takes. It looks to us like basically you're looking at a fourth quarter that's somewhere around, $0.56, $0.57, $0.58, which is better than the $0.53 consensus I am looking at. First of all, do you think my math is right? And secondly, if it is why would you think your view of Q4 is a little bit more rosy than the consensus?

I'll let Jim go through that. I mean it's--.

Well.

I don't want to bog you down in too much--.

That's okay.

That's okay but no it's important that--.

Well, Terry, we did give guidance, 1.68, $1.71. And we are year to date $1.26. So on that basis you could just back into the $0.42 to $0.45. We also gave guidance on the restructuring charges of $0.22 year-to-date and we're -- excuse me, for the year and we're $0.10 year to date, so $0.42 to $0.45 on the fourth quarter with about a $0.12 restructuring impact. So you can do the arithmetic on that. Year ago, we were $0.37 and there was about $0.11 of structural costs in that quarter. The thing to remember in our fourth quarter, we have a 53rd week and we said that's worth about $0.04 for us.

Okay.

That'll be an impact in that even despite that we are looking for some positive momentum given the guidance that we've provided.

Okay. So maybe I should have added the extra week back in that maybe you weren't doing that?

Yes, I think some people may have placed it entirely in Q4 and I think others may have sort of spread it throughout the year if you will.

Okay. Lastly, I guess just on one of the operating divisions. As you look at beverages, frankly, I was surprised on the volume was very nice, the revenues even better. But yet you posted I think an 11% decline in the operating income. And I guess this gets back in a way to David Driscoll's comment. I wouldn't have expected the packaging cost to be as high uniformly through the quarter. Did you shoulder more benefit cost in that division? What was going on that you did report such a fall-off in operating income yet the top-line was so robust?

All right. Well, let's start with the top-line because you had for the North American beverages just about 11% revenue increase and importantly it was strong in both powder beverages, which were up in high single digits and also in the ready to drink which again also in the -- above the double digits but I will tell you our coffee business in terms of revenues was up in the mid-teens. Again, that reflects somewhat of a volume decline as obviously a lot of pricing's going through and as Jim commented in his remarks, so some good mix improvement there. It is one, though, where we've seen a disproportionate level of packaging costs flowing through as you think about our Veryfine business and our Capri Sun business, an awful lot of packaging there.

And this is one where we've been very judicious probably about our pricing in terms of what we have taken in the marketplace and the competitive actions there. Because we've had -- have seen some softening of the category where we actually saw the ready to drink category as you look at Nielsen down 4%. And so we've been cautious about consumers and as we mentioned last quarter, we've seen some switching from our aseptic pouches and our bottled drinks into water. And so that's -- it's a tale of two cities there, while we may have some impact on the category trends in our ready to drink. On the flip side the category and powder beverages is up in double digits. So it's a tale of two cities there. But the biggest driver from the earnings point of view is it's in packaging, just the PET impact on packaging.

Okay. All right. Thanks very much.

Great. Thanks, Terry.

Thank you, our next question is coming from David Palmer of UBS.

Hi, David.

Hi, Roger. Using the numbers you've given for planned closures and layoffs it looks like you're roughly 75% through the planned restructuring and your planned savings, if they come in as planned you should get another 150 million or so in incremental savings over the next year or so.

Yes.

Using these data points it looks like -- it paints a picture like you're nearing the end of a restructuring journey with increasing cost benefits. So with that as kind of a lead-in I just wanted to know if you could give us your thoughts about a timetable when the potential distractions from this restructuring might diminish, and the better costs and organizational structure that leads to more profitable growth can start, when does that virtuous cycle begin?

This is where -- I'll start with the virtuous cycle on the top line and I guess I feel very good already that we've got better top-line momentum going already and that's been one of the focal points of what we've been doing, and again as I said in the early 2000s we were less than 2% in terms of constant currency revenue growth and now we're at 3% and driving higher as we go forward. And so I think we're -- we are getting the marketing mix better we're getting the brand value equations right. As we are driving that.

You mentioned the distraction on -- sort of ending. I guess one of the things we talk about organizationally is change is a constant and -- because our environment is constantly changing. And even as we evolved the organization last Friday, it's how do we get close to our consumers as we organize ourselves. But also create some efficiencies in our nimbleness and how we do it. Do I see continuous or more organization things as our environment changes? Certainly I do. So it's not a steady state there.

Also as I mentioned earlier, as we look at our global supply chain of manufacturing and logistics and so forth, that one will continue to evolve as well. We will continue to find opportunities and if they're good financial decisions to do additional closures we'll do those because it makes sense to continue to drive out costs and I think as we mentioned, the commodity environment of energy and so forth next year, is going to be critical that we continue that -- those cost drives. And so I guess I don't view it as ever ending it's how we deal with that going forward is something we'll have to sort of manage but it's one of those where we will see continuous cost change.

Okay. Thank you.

Great. Thanks, David.

Thank you. We have our next question coming from Pablo Zuanic of J.P. Morgan.

Good evening.

Hi Pablo.

Would you try to grade or rank your five U.S. North American divisions. In terms of when I think of brand-value equation and I combine that with the sustainability of your EBIT margins relative to your competition, I would argue that in some cases you probably have more flexibility to increase prices than in other cases. At the end of the day the cost increases are pretty similar for some of your competitors. The only reason why you could not increase prices, -- the only reason why your competitors would not increase prices and you would have to is because they have -- they can operate with lower margins or your margins are too high. So when we think about it in those terms brand value equation, sustainability of EBIT margins, and you look at your five U.S., North American divisions how would you rank them? I mean who -- which one has a well-balanced brand value equation and which ones may be lagging right now?

Sure I'll give you some perspective as I walk through the five sectors in North America. Anyway, within each one there will be some pluses or minuses which is why you just can't say which sector's all in one place or another. As I mentioned in talking just a moment ago to Terry on beverages, powder beverages, we have actually seen some share pressures from private label but the category's very strong. Sugar-free powder beverages are selling very well, the thick format's doing very well for us but all in all we feel very good about powder beverages and the innovation stream we have there. But on the -- the aseptic side there's some challenges in terms of the cannibalization of the category from water, but again we have been gaining share on a year-to-date basis in that category as we have over the past few years so we feel good about our brand value equations. The sensitivity there is some switching into some adjacent categories.

As you get into the -- I'm sorry, I didn't want to miss coffee, excuse me. Coffee actually has been one where we've been challenged and this is one where we are having to make a lot of investments to strengthen our coffee business. For anyone obviously following us, it's been a challenge of us versus our main branded competitor, but actually of late it's been as we've -- as prices have risen because the higher commodity costs although it has been a decline of late, the gain has actually been with Private Label. And so this is where we are aggressively investing in our marketing. We feel great about our improved ad awareness we have in our house campaign but that's one where I'll tell you our brand value equation has been weak but we're taking a lot of actions to strengthen it and thinks like [INAUDIBLE] are going to be innovations that will be key there. So that one we are very sensitive to given our share loss that we have seen over the last few years in the coffee business.

When you talk about our snacks business, we continue to fare well in cookies and crackers. Sometimes it's cookies doing better. Sometimes it's crackers doing better. Depends on the phasing of what we're doing. Actually quarter three in crackers was probably a little bit less than we would have anticipated but we've been phasing things like the Cheese Nips re-stage into quarter four and some of the new chips products. A category that historically has been a real challenge for us has been our cereal business, and again, we know we're number three in that category, but our revenues were strong in ready-to-eat cereals in the high single digits, basically holding share for the quarter and year to date with our share up and so that's one where I think it's -- we've been doing a better job in building our brand value equation. But again given our position in that category, we understand the challenges there.

And then interestingly, when you get into the world of cheese and this is one where you talk a lot about cheese and we've made some very -- important choices last year, not overpricing when we had the record-high commodity costs but the group consistently has been able to maintain and build their share in the cheese category which continues to grow nicely in the United States. When you include all the segments in which cheese is sold and so, this is one where we have to be probably the most vigilant on our pricing and our price gaps, but again it's the one that the group does a superb job of managing and is very sensitive to and working it through.

And then you get into the convenient meal side and this is where there's some that we feel very good about and some that we're challenged on in there. The group's done well in cold cuts. In fact, in quarter three our share was up over a couple points with very strong revenue growth. And hot dogs and bacon about even. Importantly Lunchables is coming back for us. As we've been doing the reformulations and introducing our new chicken varieties. And pizza continues to do well for us as we've been innovating with microwave and then California Pizza Kitchen as Jim talked about. But in that sector we've had a struggle in our dry dinners business, our macaroni and cheese. We need to do some of our own reinvention of that category. And bring some innovations and that's where personally I'm very excited about our new Super Mac that's just being introduced now which is the noodles made with whole grain and added vitamins and minerals and it tastes, yum, my kids think it does and our taste tests they taste just like the base product. And so I think we need to bring some more innovation to that dry dinners business and bring some -- and you'll see more innovations coming in quarter one next year.

Then lastly you get to the assorted grocery and this one again is sort of a mixed bag. We've had some challenges in the dry package desserts or the dried gelatins and puddings. Both from a category point of view, as we're lapping over the sugar-frees, but importantly we've also been maintaining our share but where we've been doing very well is in the ready-to-eat and so this is where we're sensitive on the dry side, but feel very good on the -- on the ready side. Interesting in the dressings area whether it be on the spoonable dressings as they call the Miracle Whip and mayonnaise we've been faring pretty well here. Our innovation in the packaging on Kraft mayonnaise has done well, but we've got some challenges in salad dressing from some regional players. So I've rattled through a lot of categories and--.

That's very helpful, Roger.

Pablo, no more essay questions.

That's very helpful.

But again--.

Just one last quick one.

Which is why when I -- somebody asked the question at the very beginning, how do you think about pricing? It's not a -- yes, we've all got higher oil and commodity cost increases on packaging, but every one of our decisions will be category by category depending on the strength of where we are. But in aggregate, as we look at tracking numbers both on imagery, awareness, as we look within diary panels on frequency of use and so forth, we have stronger franchises now than we did a couple years ago.

That's very good. Thank you very much. And just to follow-up on the coffee foodservice side and this is mostly from looking at Sara Lee. What's happening in that category? Just seems that foodservice, coffee sales for the industry are down. It seems that you or someone else is taking share from Sara Lee. Any insights there would be helpful. On the foodservice side, coffee.

Yes. This is where, again as we have a large foodservice both here in the United States and also in Europe, it's been one where our business is up slightly. There's been just a lot of competitive activity in the foodservice side. It's also one where innovations will be critical in terms of how you deal with particularly the -- what we call the OCS office coffee service operators. And so importantly, I think it's been a matter of, not so much between maybe I'll call it more branded retailer -- retail manufacturers but a lot of competition from some of the smaller players in the coffee market.

Okay. That's good. Thank you very much.

Okay. Thank you, Pablo.

Thank you. We have our next question coming from Christine McCracken of FTN Midwest.

Good afternoon.

Hi, Christine.

Hi, Christine.

Roger, you talked about some structural issues that you were looking at relative to your commodity outlook and clearly you mentioned a number of factors that affected the dairy markets, but if I'm not mistaken, the producer led buyout in support for dairy exports has also had an impact and they've done it multiple times. Is this something that you expect to see going forward and how significant is that to the dairy cost outlook?

Well, this is one where, yes, there's been some changes in those structural aspects and even to the point of discussions going into [Dohaul Round] and the upcoming discussions that are happening now between Europe and the United States and between common agricultural policy in Europe and what we have here in support programs in the United States. I think you will see over time a -- an opening up more of global markets on these things. It's a particularly sensitive subject between the developed and developing countries and so I think you will see greater globalization of commodities that may not have been that way before. That's where it varies by different commodities and in certain ones have been very global and when you talk about soy beans, there's crops in the U.S., there's crops in Latin America that can offset each other depending on weather and so forth. But on some of the ones like on dairy and so forth I think you will see some of those regulatory structural changes continue to have some impacts and then so you'll hear us where we used to only talk about U.S. milk and its impact on cheese and so forth you'll hear us talk about more global impacts in that category.

And then just if you could give us a little bit of insight on your packaging exposure. How often do you contract or negotiate prices? Is that something that you can talk about relative to -- is that a market-based exposure or is it -- or is it a negotiated rate? And are these contracts expiring? Is that part of the issue relative to the timing or is it kind of an ongoing process?

It's -- and I -- without being too specific, we have a wide range of types of contracts and some are fixed for a period of time, some are fixed for long periods of time, some have the underlying commodities as a pricing mechanism within those contracts. Some have a lag within the contracts and when those commodity costs will be flowing through. Which probably is the most typical of the contracts we have. And so that's part of what we're saying, is in some cases you'll -- in many cases on these packaging contracts you'll see those costs flowing through in quarter four or even the beginning of 2006. Given the higher oil prices and PET resin prices the packaging suppliers have had.

And so that's where -- a lot of varieties of contracts and it depends on the supplier that we're dealing with and the terms to deal with that. So I don't want to get more specific than that but, yes, your assumption is correct that there's been some sheltering and I say some because some has flown through in some regards and there have been some surcharges and so forth happening in some cases and in some categories and -- of raw materials, but more will keep flowing through on the impact of oil.

At what point do you consider alternative packaging? Is that -- I'm sure you're always looking at that, but given the outlook for oil, is it possible that you probably put an increased emphasis on looking at alternatives?

We constantly, as you know, have a hard look on productivity as we drive 3.5 to 4% on the ongoing put aside what we do on restructuring. But, no, this is back to -- we look at alternatives and yes, as costs rise up on more petroleum-based packaging on plastic and so forth if you look at other alternatives you can -- on a bit more corrugated and so forth certainly are and that's part of what we're doing as we look at our 2006 productivity programs and packaging's a key component of that.

All right. Thanks.

Thanks, Christine.

Thank you. We do have our final question coming from Filippe Goossens of Credit Suisse First Boston.

Yes. Good afternoon, gentlemen. Two questions for Jim and one for Roger if I may today. Jim, the first one in terms of packaging and PET, is the issue more one of pricing rather than limited supplies as a result of the hurricanes?

It is. Right now it's the passthrough of the resin costs under the contracts in terms that Roger broadly outlined previously.

Okay. So there's not an issue in terms of any supply constraint.

Well, we're very conscious of that because there have been some instances in the industry where supply has been constrained, but right now that has not affected us.

Okay. Then my second question, Jim. If the current commodity environment were to remain as negative as it is and the rating agencies were to take a somewhat more cautious view on the packaged foods sector, would you be willing if need to change somewhat your priorities in terms of free cash flow going forward in order to protect that current rating you have today?

Well, I -- we'd have to have a separate discussion on how I feel about our current rating.

Ha ha.

But -- but that aside, I am not sure I see the need to do that because we are continuing to generate some fairly strong cash within our business. We've been using the working capital gains to offset some of the other activities such that the cash flow continues to stay at a fairly strong level. So I am not sure I accept the premise on which you are making this suggestion. And if the costs were to get that outrageous, we'd have to look at all other things, including the magnitude of the pricing mechanism that we're talking about.

Obviously if something positive happens which we all expect with Altria, obviously that should positively impact your ratings so I'm sure you have quite a buffer. But I'm just trying to see what if the rating agencies were all of a sudden to come very negative on the sector. So fair enough. Roger a question for you. In Europe we have seen some household products companies start to make some progress with the hard discounters to carry branded product. Do you see that as an opportunity as well for you in the packaged food sector perhaps?

And this is where, in some of the cases wherever there's been reports of -- that we would call soft discounters carrying some of the products from home and personal care companies. In many and most if not all -- I think all of those soft discounters whether it be in Germany or up into the Nordic countries and in Spain and so forth our products have been available in those markets. So I guess as I've read some of those reports it was a little bit of -- and soft discounters our products have been available.

In the case of, I'll call it hard discounters which have even if not a handful but very limited brands in their array of products, that's something we look at, but it's something we're very cautious about in terms of ensuring that you have your pricing to the marketplace ensuring it's sort of properly fair and equal amongst the different channels. And so we explore it, we have some controlled brands that we do. That is another tool that we do and that's brands that we have that are specific for those hard discounter channels. But we continue to look at it and from the hard discounter side. But, no, we've been an active participate in the soft discounter channel for years.

And then maybe just as a follow-up, Roger. In terms of some players, like let's say [Cairo Four] in France, have been lowering pricing in order to gain market share. Have you seen any change in terms of some of these players perhaps putting a little bit more pressure on you to give them better terms and have -- and try to shield or kind of spread some of the margin pressure that they are experiencing themselves?

I think, Filippe, as you know, Europe is always a market where there's -- I should say tough negotiations between retailers and manufacturers. I think the French situation is just particularly confusing right now because we've left [speaking French] and moved onto [French] and what that means in terms of the price declines that have been occurring in that market place. But so much of it is the back margin and how the laws allow that back margin to flow into prices under costs and so forth, the mechanisms are much more complicated than just as simple as, gee, I'm dropping my prices and I want you to fund this. And so I think we've been very good about what we've been doing there. But I will tell you it's been a very competitive market in France we've had to be -- we've been pleased at this year and -- I mean this quarter in France. We actually had a very good revenue increase in the mid-single digits. But that's really driven by the fact that -- driven by strong volume growth. But we've had to be very cautious on pricing there given the change that we're seeing in the trade environment, particularly some focus by some of the large retailers on their private label brands as they're trying to be competitive with the discounter growth in that country.

Great. Thanks very much, Roger.

Very good. Thanks, Filippe.

Thank you. At this time we have no further questions. I turn the floor back over to management for any closing remarks.

Okay. Well, thank you all again for participating on the call with us this afternoon. And have a good evening.

Thank you. This concludes today's teleconference. You may disconnect all lines at this time and have a great day.