億滋國際 (MDLZ) 2009 Q2 法說會逐字稿

Good day, and welcome to Kraft Foods second quarter 2009 earnings conference call. Today's call is scheduled to last about one hour, including remarks by Kraft's management and the question-and-answer session. (Operator Instructions). I'd now to to turn the call over to Mr. Chris Jakubik, Vice President, Investor Relations for Kraft. Please go ahead, sir.

Thank you, and good afternoon. Thanks for joining us on our conference call. With me are Irene Rosenfeld, our Chairman and CEO, and Tim McLevish, our Chief Financial Officer. Our earnings release was sent out earlier today and is available on our website, KraftFoodsCompany.com. It is also made available on our website a set of slides that we will refer to during our prepared remarks.

As you know, during this call we may make forward-looking statements about the company's performance. These statements are based on how we see things today so they contain an element of uncertainty. Actual results may differ materially due to risks and uncertainties so please refer to the cautionary statements and risk factors contained in the company's 10-K and 10-Q filings for a more detailed explanations of the inherent limitations of such forward-looking statements. Some of today's prepared remarks will include non-GAAP financial measures and you can find these GAAP to non-GAAP reconciliations within our news release.

So with that out of the way, I'll hand it off to Irene.

Thanks, Chris. Good afternoon. I hope you're enjoying not having to wake up quite so early to hear our results. I know we are happier.

Earlier today we reported strong second quarter results, results that built on our solid first quarter. Our performance was broad based, across our businesses, and around the world. And the results played through on both the top and bottom lines. As we have said, our Q2 results began to reflect the transition from growth based on price to growth based on volume mix. As we begin to lap the significant pricing actions we took last year, contribution from pricing has moderated, and as a result of our targeted incremental investments, we are seeing sequentially improving vol/mix.

Specifically in North America and Europe our focus brands are growing in the mid single digits, and in developing markets, our focus brands continue to grow at strong double-digit rates. Of course, we also benefited from the Easter shift into the second quarter. But this benefit was more than offset by our decision last year to discontinue a number of less profitable product lines. On the bottom line, our profitability increased substantially, despite the year-ago benefits from certain hedging gains and a value added tax credit.

Importantly, margins expanded across all geographies. Gross margin rose by 30 basis points driven primarily by improved vol/mix and operating income margin increased by 190 basis points. The completion of our restructuring program certainly contributed to the OI margin gains, but improved vol/mix was an important driver as well.

Looking ahead, this strong operating momentum will continue. For the full year despite a challenging economic environment and significantly lower dairy costs, we are maintaining our target for organic revenue growth of about 3%. Pricing will be less of a factor, and vol/mix in priority categories, core brands and key markets will continue to improve as the year progresses. And although we are seeing weakening category consumption trends in certain European and developing markets, we are offsetting much of that with gains in market share.

At the EPS line, we are raising our full-year forecast to at least $1.93 from $1.88. This represents double-digit growth on a constant currency basis versus 2008. This forecast not only reflects our strong year-to-date performance, but it also includes increased investments in marketing and cost savings initiatives. In particular, we are increasing our A NC spending to grow our share of voice. As a result, we expect 2009 ANC to increase as a percentage of net revenue, even though advertising rates have come down considerably.

In addition, we are accelerating some cost savings initiatives to stage our earnings growth in 2010 and beyond. We now expect to spend at least $50 million more on these initiatives in the current year. That's in addition to the approximately $200 million we announced in the first quarter. These incremental investments will accelerate margin growth and provide more funds to reinvest in driving our top line.

Looking at these results within the context of our three-year turnaround, I would say we are now in the home stretch. We have clearly hit our stride and have staged the business for sustainable profitable growth. Our forecast for 2009 builds on the success of the past two years. We will again grow both the top and bottom lines while expanding margins and improving market share. Equally important, though, we have made progress in a number of areas. Rebuilding our brand equities, increasing our pricing power, strengthening our innovation pipeline and identifying additional areas for future cost savings.

As a result, we are poised to deliver profit margins at or above industry benchmarks and to consistently deliver against our long-term earnings target of 7 to 9% growth. We are finalizing our strategic plan right now and in the coming weeks we will share more specifics with you about our cost savings pipeline and about our game plan to deliver significant margin expansion in the next two years. Now I'll turn the call over to Tim.

Thanks, Irene and good afternoon.

Let me start by saying that our Q2 results provided further evidence that our financial turnaround is on track. Our top and bottom line trends continue to move in the right direction. We are beating the expectations we established at the beginning of this year, and we have zeroed in on the specific levers that will deliver the growth we laid out in our long term plan.

On the top line, we achieved solid organic revenue growth. As you can see in this chart, organic growth in the quarter was 2.9%, including a modest but positive contribution from vol/mix. Higher pricing drove 2.7 points of revenue growth, but that included a 70 basis point hit from lower dairy prices. Additionally, Q2 organic growth was negatively impacted by about 40 basis points from a value-added tax credit in the year-ago quarter. Excluding these factors, organic growth would have been closer to 4%.

Going forward, we expect vol/mix to become the primary driver of organic revenue growth and a significant contributor to higher earnings and profit margins. This change signals a more balanced growth profile on the top line for the full year and one that's more consistent with our long-term model. Here's what we foresee. Pricing plus productivity will cover our input costs, while volume growth and stronger product mix leverage our overhead costs to increased profit margins. As Irene mentioned, the Easter shift benefited us by about one percentage point in Q2, but again, this is more than offset by planned discontinuations of less profitable product lines announced last year. As you know, this lessens our volume and revenue growth but the net effect is a positive to both mix and profit margins, which you see playing through in our results.

Turning now to the drivers of earnings per share. As you look at this chart, there are two things I'd like to highlight. First, our year on year improvement from operations in Q2 was $0.05, mainly from improved vol/mix and soft savings, but this included $0.02 of headwinds due to certain realized hedging games last year.

Second, on a year-to-date basis, gains from operations were $0.10, this also includes the $0.02 headwinds from the hedging gains I just mentioned. Importantly, this operating improvement came while offsetting more than $550 million of higher input costs to a combination of pricing and productivity. The key takeaway is this, we are growing our earnings in a very high quality manner, specifically, our top line growth is becoming more balanced between pricing and vol/mix. Margin gains reflect a strong contribution from improved vol/mix. That's a function of both investing behind priority brands and walking away from unprofitable volume. We continue to fund higher marketing spend to fuel future growth. And we are carefully managing our overheads to further enhance our bottom line.

As a result, we are comfortable in raising our EPS guidance to at least $1.93 for the year while making further incremental investments in marketing and cost savings initiatives to set the stage for next year. We are also making excellent progress on cash flow. As you know, we have been very focused on improving this important financial metric. These efforts have certainly intensified since the financial crisis hit, and we entered into cash preservation mode. The benefits from our actions are now showing up in a stronger cash flow outlook driven by contributions from earnings, lower capital expenditures and working capital improvements.

As a result, we expect our 2009 discretionary cash flow to be higher than originally anticipated, approximately $2.6 billion in total. On an apples to apples basis, that would be up from $2.4 billion in 2008. That also represents good progress towards our target of $3 billion of annual discretionary cash flow by 2011.

I'll take a few minutes now to share some highlights of our business segment results starting with North America. Overall, we turned in solid growth in a difficult economic environment. As you can see, organic revenue growth was 1.8% including 0.8 points from pricing. It's worth noting that the impact of lower dairy prices in the quarter reduced North American revenue growth by about 1.5 percentage points. In our priority categories, revenue is up 5%. This demonstrates once again that our focused investments in product quality, innovation and marketing are working.

On a bottom line, North America delivered a 170 basis point increase in operating margins to 18.5%. Operating gains from favorable vol/mix and lower overheads contributed 110 basis points of that margin improvement. Going forward in the second half of the year, we expect vol/mix to drive growth as segment pricing turns negative in Q3. This primarily reflects the impact of our adaptive pricing model in natural cheese.

Before we get to individual North America segments, let's take a look at US market share. As you can see on this slide, our 52 week share trends are beginning to stabilize and improve. About 41% of our US retail revenue gained or held share. Clearly we are not satisfied with our US share performance, but it does reflect stabilization of market trends as consumers adjust to the significant cost driven pricing in 2008. Going forward, we see further market share improvements as we lap the pricing actions and declining consumer sentiment in the back half of last year.

Now let's take a look at results by segment. In US beverages, strong vol/mix drove organic revenue growth of 6%, specifically, the restage of Capri Sun with a lower sugar formula drove double-digit revenue gains in our ready-to-drink category. In addition, solid performance by Maxwell House in response to our quality improvements drove double-digit growth in mainstream coffee as well. OI margins rose 60 basis points to 17.7%, overhead leverage and the completion of our restructuring program contributed to the margin upside. And we continued to invest in incremental marketing behind our priority brands. As we look ahead, we expect year-over-year improvements in vol/mix to continue and the second half will benefit from new products and marketing programs in both powdered beverages and coffee.

In US cheese, our Q2 profile demonstrates our adaptive pricing model at work. Organic revenues fell 8.7%, almost entirely due to lower pricing, as dairy input costs have fallen dramatically. At the same time, volumes have stabilized. More importantly, we achieved a 16% increase in operating income, which reflects pricing that's better aligned with our input costs.

In the second half, we expect vol/mix to turn positive as we focus incremental marketing investments behind advantage categories such as Kraft Singles and Philadelphia Cream Cheese. At the same time, barrel cheese costs have stayed close to government support levels longer than we would have anticipated. and therefore the impact of lower prices will be a greater drag on second half revenue growth. This will not, however, impact our profit stream. Our adaptive pricing approach for natural cheese is now enabling us to reduce volatility in our income stream. That will enable our US cheese business to be a more consistent contributor to our overall growth.

Now let's move onto US convenient meals. Where consistent gains continue. Our focused investments in quality and innovation drove improvements in vol/mix. This in turn contributed to strong revenue growth and margin gains. On the top line, organic revenues grew 7.1%. DiGiorno Pizza and Oscar Mayer Deli Fresh each grew 20% or more in the quarter. Oscar Mayer Deli Creations also grew strongly. As a profit line, operating margins jumped 260 basis points to 12.1%, higher pricing and better vol/mix drove the improvement. overcoming input cost inflation and incremental marketing investment. Going forward, we expect the momentum we have established in convenient meals to continue beyond strong revenue growth and further cost savings.

Onto US grocery, where we delivered solid gains on both the top and the bottom lines. Organic revenues were up 6.7% as carryover pricing actions drove strong growth. Kraft Macaroni & Cheese was up double digits as it continued to benefit from value oriented marketing, new formats and flavor extensions. Operating margin rose 120 basis point to 34.8%, margin benefited from better price cost alignment and overhead leverage that offset higher marketing costs.

Now let's look at US snacks. Organic revenues rose 1.3% in the quarter, due to pricing and vol/mix gains. Biscuits had a strong quarter with revenue up about 5%, driven by solid performance of our top five brands. The strength in biscuits, however, was largely offset by a decline in nuts and bars. We expect these businesses to recover as the year progresses. At the profit line, margin fell by 160 basis points. However, this included a headwind of more than 300 basis points due to significant realized gains on certain commodity hedging activities last year.

Excluding the impact of hedging gains, margins would have been up strongly from improved vol/mix especially in biscuits and overhead leverage. As we move forward, we have new marketing campaigns and new products planned for the second half of the year. And we expect these activities to drive solid top-line growth and deliver margin upside.

Turning to Canada and North America food service, our business in Canada continued to perform well, delivering strong organic revenue growth. This was driven by higher price levels and continued vol/mix improvements fueled by marketing investments and improved customer programs. However, declines in food service, reflecting an industrywide slowdown into casual dining traffic, more than offset the gains in Canada. In addition, the discontinuation of a less profitable product line negatively impacted revenues by about two percentage points. Operating margin rose by 260 basis points, this is driven by three things, growth in Canada, overhead leverage, as we have taken steps to offset weak trends in the food service industry, and lower costs from the completion of the restructuring program.

Now I'll turn to our businesses outside North America. In Europe, revenues rose modestly as we grew share in a very difficult economic environment. The 0.4% increase in organic revenue included two points of contribution from pricing. We are pleased that our investments in brand equity enabled our volume to hold up well in the face of strong pricing and a weakening economic environment.

However, vol/mix declined by 1.6 points in the quarter, largely due to our decision to forgo unprofitable volume. At the profit line, operating margins more than doubled to 10%, despite additional investments in cost savings initiatives and higher marketing costs. This margin expansion was largely a result of improved pricing, favorable vol/mix and lower manufacturing costs as well as the completion of our restructuring program and lower divesture-related losses.

In developing markets, our focus on priority categories, core brands and key markets continues to drive strong growth. Organic revenues grew 9.3%, with double-digit gains in priority brands, for example, in Asia-Pacific, Oreo cookies grew more than 40%. In Latin America, Lacta chocolates were up more than 30%. In CEMA, Jakob's Coffee grossed top 10%, and Tang Parter beverages grew strong double digits across each developing market region.

Operating margins increased strongly, 160 basis points to 13.3% and this came despite the absence of a $40 million Brazilian value added tax credit a year ago. The economic environment remains challenging, and we continue to see weakening consumption trends, particularly in central and eastern Europe. Nonetheless, we remain cautiously optimistic about performance in the second half, as our investments behind priority brands continue to drive top and bottom line results.

With that, I'll hand it back to Irene for some closing comments.

Thanks, Tim. So I'll sum up our year-to-date very simply, we continue to deliver strong results across all geographies. We have raised our full-year outlook to at least $1.93, while increasing our investments in the business. As a result, in the next two years, we are poised to deliver profit margins at or above industry averages and to consistently deliver against our long-term earnings target of 7 to 9% growth. Now we'd be happy to take your questions.

(Operator Instructions). We will pause for just a moment to compile the Q&A roster. Your first question comes from Robert Moskow of Credit Suisse.

Hi. Good afternoon.

Good afternoon, Robert.

Hello.

I wanted to know about the revenue growth. It was just a little bit lighter than what we had expected and I guess it must have been due to the discontinuation. Was Easter originally supposed to be 200 basis points of a shift instead of 100?

No..

No. We essentially expected it to be about a hundred and as we mentioned, it was offset by the discontinuation of some of our less profitable product lines.

Okay.

We actually felt quite good about our revenue performance in the quarter, particularly in light of the fact that dairy was considerably lower than we had expected it to be.

Yes. Rob, I think what you're getting confused is was in the first quarter there was a about 200 basis point drag but that was a combination of the Easter shift as well as the discontinuation of certain product lines.

Okay. So that was both of those things. I got it.

Yes.

All right. And then on the gross profit margin it's up 30 bips from a year ago, I think a lot of other companies are showing some big margin gains. Did the discontinuation of these items help your margin and if so, was that in that 30 bips?

Yes. I mean, the net impact is positive from a margin standpoint. It's a little bit of a drag on revenue as we said, and it certainly is an enhancer to our bottom line operating margins as well as our operating income.

Okay. So then -- but gross margin up 30 basis points for the year, was that in line with your expectations?

Well, actually, it was probably a little bit ahead of our expectations because keep in mind some of the factors that come through that would have enhanced the gross margin last quarter that we have talked about in prior meetings, such as the benefit from the realized hedging gains, et cetera, so the fact that it was out -- up actually overcame a number of pretty significant headwinds.

That must have been it, then, the hedging. Okay. Thank you very much.

Your next question is from Eric Katzman of Deutsche Bank.

Good afternoon, Eric.

I guess a few specific questions first. Did you mention how much advertising and promotional spending was either up or down in the quarter?

Well, we are actually not going to give you a number for the quarter. What I did say is that we expect it will be up on the year. It was in fact up on the quarter despite the fact that the costs have come down so we feel very good about the investment that we have made to increase our share of voice.

Okay. Thank you for that. And then the corporate expense like was a lot higher even though I thought, Tim, that -- I mean, you had recognized a fair amount of pension expense in the first quarter. Is there anything in one particular thing that's driving that up so much from sequentially quarter to quarter?

No. The pension -- the pension contribution should have been about the same as the first quarter. Mark to market gains and losses run through corporate until they are realized so there was some impact from that that may have been the delta you're seeing.

Certainly year on year it would have been up pretty significantly.

Okay. And then just more from a -- I guess a conceptual and strategic standpoint, Irene, the -- I understand that you're now managing the cheese business to reflect more of the pass-through and focusing on the higher margin pieces, but should -- I mean, with the pricing down 8% in this past quarter and volume still not really recovering, in fact, probably a little bit weaker because you had the benefit of Easter in there, I mean, why shouldn't we have seen more of a recovery in volume within the quarter?

Well, Eric, I think you will see a progressive improvement in the performance. There's a number of factors that are at work in the second quarter numbers. We benefited from Easter certainly on our cream cheese business. It doesn't have much of an impact on the other forms but the facts are we are continuing to deemphasize some of our lower margin businesses and so the net of that puts a little bit of pressure in the short term on the vol/mix line. You will see improvement, though, as that works its way through and I think certainly we have good visibility to our share performance as we start to look out into the current quarters as well as the out quarters and we are feeling quite good about the performance of that business. Most importantly, though, as Tim mentioned, we feel very good about our ability to manage the volatility of the earnings on the business as a consequence of the approaches that we have taken on adaptive pricing.

Okay. I'll pass it on. Thank you.

Thank you.

Your next question is from Terry Bivens of JPMorgan.

Good afternoon, everyone.

Hello, Terry.

Irene, on Europe, granted there was some nice improvement there but I think you might agree with me that 10% operating margins are probably not where you want to be. Can you just give us a little color on how you see European margins evolving? I know you have a new person in there and presumably we will hear some more from that person, but kind of what's your two-year goal there to improve Europe?

Well, Terry, we have been pretty clear that we are targeting to get ourselves closer to peer margins in that geography as we are elsewhere in the world, and the reality is as you look at the performance in the second quarter, our operating income is up over 90%, despite an almost 30% currency hit, so we actually feel quite good about the progress that they are making. Without a doubt 10% is not our end goal, but it's a significant improvement year over year and I think we have got the programming in place to continue to make progress on our margins in Europe as well as elsewhere.

We are very focused on the extent of that equation and we will talk a little bit more about that at the back-to-school conference coming up next month.

As we look at, we should perhaps look at European food companies to get kind of a barometer of where you think that might go?

Yes.

Very good and one quick thing and I'll pass it on. Tim, you mentioned $550 million in input cost, if I heard that correctly.

Yes.

What period was that over?

$550 million is year to date.

Year to date. Okay. Thank you very much.

Okay.

Your next question is from David Palmer of UBS.

Thanks. Hi, everybody. Question for you, just on promotions and the effectiveness around promotions these days in certain categories in 2009 versus maybe previous years where promotions and activity in store may not have made as much sense, for instance, is there an increase right now, are you thinking about dedicating more resources in store behind convenient meal categories, some of your categories within grocery that may be more just pure and simple meals for the family and there's a better ROI attached to that than what you have seen before and was there a higher impact on to your pricing from increased promotions in this last quarter? Thanks.

Well, we really feel very good that as a result of the investments we have made in our businesses, we are in a much stronger position to be able to market these businesses and to essentially grow them with a variety of tactics and so particularly our value oriented businesses, our value meals, products like Mac & Cheese, products like frozen pizza, beverages like Kool-Aid and Crystal Light and Country Time, those kinds of products are doing exceptionally well with value messaging and we don't necessarily have to spend a lot more to promote them at this point in time.

We have got very strong brand equities that we have been able to leverage quite successfully. The reality, though, is given the volatility of input costs, we have invested more in the short term in promotions because it's been our mechanism to adjust pricing while we wait to see how the markets shake out. But our intent long term is continuing to shift our mix from more short-term promotional tactics to longer term equity building tactics like marketing and innovation.

Thank you very much.

The next question is from Alexia Howard of Sanford Bernstein.

Hello, everybody.

Hello.

A couple of quick ones. Just on the commodity input cost pressures, do you have a full-year number that you talked about? I think at one point it was $200 million as the estimate for the full year. Has that gone up substantially?

Yes, it's gone up a little bit as probably a three year, a little over $300 million is our expectation today.

But it's been three -- it's been 550 million year to date so this is the point where it actually starts to turn negative?

We will see it turn the other direction the second half.

Okay. Great. And then you talk about increasing or I guess since the last quarter I think you talked about increasing your investment in marketing and cost savings in the back half of the year. Can you give us some sort of number on how much that's been raised since we last spoke.

Well, none of the increase. We talked about probably a couple of pennies of additional restructuring and a couple pennies of additional ANC investment, neither of which were in our prior guidance or expectation.

Okay. That's great. And then finally, is there -- in the upper division of guidance, is there any foreign exchange movement in there? Because that seems to have turned a little bit more favorable over the last couple of months, or is that completely foreign exchange neutral?

Yes, if you kind of sequence it, as you know, in January we talked about $0.16 of year-over-year pressure from FX. What happened by the end of the first quarter, we had about another $0.05 worth of additional pressure and we thought we would be able to cover that with operational improvements, so we kind of held our guidance at that point. But as FX has essentially come back to about $0.16 level that we originally started, now we let that 5 cents worth of operational improvements flow through.

Right. Thank you very much. I'll toss it on.

Sure.

Your next question comes from Ken Zaslow of BMO Capital Markets.

Good afternoon, everyone.

Hello, Ken.

Hello, Ken.

First question, in the categories that you expect to gain market share that you haven't gained market share, can you talk about specific examples to what you're going to do to gain share?

Well, I guess I start with the cheese, the situation in cheese. We will see progressively improved market share in our cheese businesses as we continue to focus our marketing efforts and our dollars on our advantage categories particularly singles and cream cheese. In a number of our other categories, I would remind you, Ken, that we have about 10% of our revenue that is losing share, but they are in categories like Mac & Cheese, hot dogs, Velveeta, for example, where we have very strong market share positions, and we are growing very nicely at high single digit rates. It just happens that the category is growing a little bit faster. So we really see a number of our categories continuing to improve as the year progresses, both through a combination of increased marketing support as well as the fact that a number of our innovations will hit in the back half.

Okay. The second question I have is in terms of your hedge positions, how much are you incrementally more hedged this quarter versus last quarter and does that preclude you from -- or does that actually enable you to have more margin expansion in 2010 as they roll off?

No. Our hedge position is a pretty stable program. We are always essentially hedging until our ability to price to reflect changes in the underlying costs but our position, hedged position has not changed appreciably from quarter to quarter.

Great. Thank you.

Yes.

Your next question comes from Tim Ramey of DA Davidson.

Good afternoon. Just a -- first a quick follow-up on Ken's question there. Does that mean that your hedges don't extend into fiscal 2010 at this point?

There may be a couple of them that would extend into 2010, but that would be more derivative products. We may have a little bit of oil hedged out into 2010 because that's a little bit less direct impact on our business, but it affects our fuel for our logistics and it also affects some of our packaging materials and the films so we may extend a couple -- a little bit out of that out into 2010 but there really shouldn't be any direct input costs that would be hedged into 2010.

Got it. And the volume recovery is very impressive or heartening and talk about improved volume in the second half is great. Can you be more specific about what you think volume might do and just my vote that mixing volume and mix together is not at all intuitive to me?

Well, as we have told you, our expectation, Tim, is that we will see the contribution of vol/mix driving our revenue growth in the back half of the year as we lap the pricing actions that we took, and we are quite confident that we have -- that we will be able to deliver that because we have been focusing our resources on those categories and those brands and those geographies where we have the greatest potential for revenue growth as well as the greatest profit potential, and we are seeing that play through in each of our core geographies, in North America, our focus brands are growing about 5%, in Europe similarly, and in developing markets our priority businesses are growing about 19% so I feel quite comfortable that the focus that we have got and the investments that we are making in these core brands and categories and markets will be a good driver and a key driver of our performance in the back half of the year.

Thanks.

Your next question is from Judy Hong of Goldman Sachs.

Thanks. Hi, everyone.

Hi, Judy.

Can you maybe give us a little bit more color in terms of your margin expansion opportunities as you're finalizing your strategic initiatives just curious as to what buckets of cost savings really are out there for you guys to achieve and if you sort of look back two years ago and you had the cost savings initiatives, it sounds like a lot of that sort of went back towards brand investments to improve your brand equity and improve your market share performance and it sounds like maybe going forward, more of the cost savings really flow to the bottom line because you feel pretty good about your brands' strength at this point. Am I thinking about this in the right way?

Very much so, Judy. The reality is productivity has always been a hall mark of Kraft. Over the last couple of years given the rise in input costs we have been using a lot of that to offset costs. Now that we have stronger brand equities, we are able to use pricing much more effectively and as we look forward, we are going to spend quite a bit of time at the back-to-school conference talking about our cost initiatives but I would tell you that we are expecting to see margin expansion from a couple of sources. One is just the vol/mix improvement that will continue to play through as a consequence of our stronger brand equities.

The second is we will give you a lot more visibility to our end to end productivity. We talked a little bit about this at Cagney. We have got some very specific programming in a couple of areas including procurement, manufacturing and logistics and we will talk some more about that as well as a continued focus on managing our overhead costs. So that's what gives us great confidence that we can achieve at or above peer margins in the next two years.

And is it still your intention to include these costs as part of your EPS and --

Absolutely, absolutely.

That's absolutely correct.

And just a quick follow-up on the mix component of it. A lot of the companies are more realistic of mix not being as beneficial just given the consumers are under more pressure and could remain so for the foreseeable future. How does that sort of play into your growth algorithm, the mix components specifically?

In some cases, there was a point where a number of us thought about mix in terms of trading customers up, in our case it's just about not chasing less profitable volume and so what what you're seeing, a lot of our businesses whether it's Mac & Cheese or powder drinks for example have very attractive margin, so as we continue to market those businesses, particularly in the current environment, we are benefiting from the mix and we are getting a mix benefit as a result. So we feel quite comfortable that mix will continue to be a benefit to us and in fact as we now lap a number of the more significant discontinuations that we made in the first half of last year, we will start to see stronger flow-through in our vol/mix component.

Okay. Thank you.

You're welcome.

Next question comes from Jonathan Feeney of Janney.

Good afternoon. Thank you.

Hi, Jonathan.

Jonathan.

Irene a few companies have kind of proceeded down this path of sort of parsing their categories between, certain focus brands and certain focus categories and others that are a little bit less profitable and getting less focus. I think the risk as I see it anyway is that communicating that to customers directly and indirectly tends to have an impact and maybe can get a little out of control. I mean, how have you dealt with retailers in categories where you're maybe putting a little bit less investment and I guess how are you managing that risk that maybe those categories decline a little bit more than you planned?

Let me be clear. When we talk about focus, these are categories that are getting incremental investment. The balance is just getting investment that's essentially in line with the company average. So we are not talking about walking away from businesses. What we are talking about, though, is disproportionately investing incrementally in businesses that we feel have greater growth potentials. So it's not a difficult conversation with our customers. They are as anxious to grow some of these core categories as we are, but the businesses that are not part of our focus categories are still receiving support, and in fact they are some of the businesses that benefited from the investments that we have made over the last couple of years. We are just not looking to invest any further incrementally in those businesses -- we feel quite comfortable that the level of support they have today is adequate.

Thanks. And just one other one if you wouldn't mind. You mentioned in your opening remarks, you're thinking about margins and productivity, in line with industry benchmarks. Can you give us a sense of what those benchmarks are? Are we talking about operating margin and industry averages or just any color you can give us around what your internal benchmarks are from that long-term perspective?

Well as we mentioned, we will be giving a lot more color on how we are thinking about it and more specifics, but the margins as we are thinking about them are operating margins and as we have said before, we have set our sights on getting ourselves back at least to peer average margins, which we would define to be global food and beverage margins and we see those in the mid-teens, and so that's the target that we have set for ourselves, and as a result of the good work that we have done on a number of the cost initiatives that I mentioned a moment ago, we have much better visibility to the impact of those kinds of initiatives, but we will talk a lot more about that at the back-to-school conference.

Okay. Thanks very much.

You're welcome.

Your next question comes from Bryan Spillane of Banc of America.

Hi. Thanks for taking the call. Just a couple of quick follow-ups. First, Tim, on the -- on the inflation -- input inflation outlook for the year, going up from 200 to 300 million, what moved against you that caused it to go up for the year?

It's not really -- I mean, it's -- I mean, it's a variety of factors there. I can't point to one specific input cost that has changed but that's kind of our latest view of the overall impact.

Okay. Trying to get a sense for whether there is something that we should be watching that could move that. How much volatility might we expect in that in the back half of the year I guess is what I'm after.

We feel pretty good about that number. It's maybe a little bit more than the 300 level, maybe closing in on $400 million for the whole year but again that reflects a decline in the second half of the year of some $150 million.

Okay.

Bryan, just to clarify, I think Alexia said our original forecast was $200 million. That would be incorrect. In fact our forecast at the beginning of the year was higher, it actually comes down a bit to that $300 million range.

I thought it was $200 million at the end of the first quarter for some reason I had that written down too, but in any event, the other question, I guess, in terms of getting back to the mid-teens operating profit margin targets over the next two years, if you guys hit your organic revenue assumptions, and you hit that target, it seems like EPS would grow faster than the 7 to 9%. Is that -- am I thinking about that right?

Yes. I mean, it would be at the upper end of the range. There's a little bit of variation in all of that but I would say you're right, it would drive an EPS at the upper end of that 7 to 9% target range.

Okay. Great. Thanks.

As we enhance that considerably.

Okay. Great. Thank you.

Your next question comes from Andrew Lazar of Kraft Foods.

Good evening.

Hey, Andrew.

You joining us, Andrew. Did you join the company?

I'm sorry?

If you're one of the staffers, we are proud to have you.

Quick follow-up. I know you'll get into a lot of this in the coming weeks but again as we think about sort of how you get ultimately to sort of the margin goals that you want to, just thinking about your North American margins versus those overseas, the bigger opportunity right from a margin perspective is overseas, it would seem like that's where sort of outsized margin gains and improvements really need to come from. Is that where you've identified I guess disproportionate amounts of cost synergies relative to North America as a percent of sales, or --

Disproportionate I would say is accurate. A big piece of it as we talked a little bit earlier about Europe, developing markets has margin enhancement opportunity but they are really the growth driver. EU has margin improvement opportunity and there's still some room in North America. We have said before that the 21, 22% is not a sustainable level, and that is very much reflected very high North American. We don't think it's healthy to go back to those levels, but clearly we think there's upside across all of our geographies, probably the biggest opportunities in Europe and then developing markets, and then you're right, North America still sound but it's not the preponderance of it.

And in thinking about the 3% organic rate of sales growth this year with -- you had mentioned kind of dairy obviously was a bigger hit to the downside to that organic growth rate, maybe than you had thought at the beginning of the year. So is it accurate to say therefore, that I guess the operating side of organic top line growth outside of that dairy piece is better to make up for that to keep the 3% organic growth for the year?

Exactly right, that the rest of if is filled in a little bit better than we had originally anticipated to make up for the shortfall in the cheese as a result of the dairy cost.

Got it. One last quick one. Your vol/mix went from minus 3-4 in the first quarter to plus 0.2 this quarter and without I guess getting into specific components, I mean, which -- is there a way to say which one drove the majority of that improvement? I mean, was it primarily mix that drove that? Was volume at least sequentially better if not positive in the quarter?

Yes. Again, we -- I will reiterate, I know that some of you don't particularly care for combining the two, but we think it's a really a more accurate reflection because there are inherent trade-offs between vol/mix that become actually misleading if you look at them individually, but in the first quarter vol was about 2.3% of the 3.4 and this quarter vol was essentially flat so we picked up 0.2 from mix in this quarter and 1.2 from mix in the first quarter.

Thanks very much.

Sure.

Your next question comes from David Driscoll of Citi Investment Research.

Good afternoon.

Hi, David.

Question on the second half of 2009. So year to date you earned $1 a share, that leaves $0.93 for the back half of the year. I believe that you've said that commodities will be a significant tail wind and I think the computation is somewhere around a $200 million benefit in terms of commodity deflation, something we haven't seen in a very long time. Why then are the second half earnings at just $0.93 and below that first half? I've gone back and looked at the pattern and there really is no significant seasonality pattern over many, many years at Kraft. Can you go into factors here? Is it just being conservative?

There's a couple of things. You're right when you go back to the seasonal patterns at Kraft, you have a fair number of moving parts with restructuring reserves and charges and all those sort of things. On balance, it's front half, back half I would say an average is probably 50/50, a little bit maybe more weighted to the second half by a couple percentage, but on balance, about the same. The dairy costs -- or the input costs going down in the second half of the year will also come with it some expectation as we talked about adaptive pricing in cheese or natural cheese, you'll see some of the pricing come down as well. We are in fact anticipating that pricing in the second half of the year will actually be a negative contributor to revenues.

We do have a number as we talked about as well of things we have got about $0.02 worth of cost savings initiatives that weren't in our prior forecast that with the strong performance we would have, that we are taking the opportunity to accelerate some of the cost savings initiatives, so we have picked up about $50 million and we originally came out with somewhere between $150 million and $200 million that we are investing in cost savings initiatives. We have kicked that up by about $0.02 or $50 million and also as we mentioned earlier we are increasing our investment in brand building and increasing our ANC by about $0.02 or $50 million. That makes up substantially the difference in first half, second half. I won't consider it -- I think it's a realistic expectation considering the environment out there and we feel pretty good about it quite frankly.

Bigger picture here on the commodity side. Over the last four years by my calculations, the commodity inflation hit to Kraft Foods has been just over $4 billion, gross margins are down about 385 basis points ended 2008. So the lower -- I mean I think there's a wide expectation out there that a deflation in commodities is a significant positive for Kraft. Is that one of the fundamental drivers, Irene, in your comments about the margin goals and really I think you're leading us to the conclusion that at this upcoming conference you're going to spell out these margin goals in the next two years and it would seem that a deflation necessary environment would be a key component of it. Am I reading that correctly?

No, I wouldn't say that, David. I think -- I talked earlier about what we see as the key drivers of the margin expansion and we will give you a lot more detail on that in a couple of weeks. But I feel particularly good that we have staged the business for long-term growth because of the investments that we have made in our brand equities, the pricing power that we have been able to demonstrate, the fact that we have got a much stronger innovation pipeline, all of which make us feel quite comfortable that the vol/mix expectations that we have, which will be the key driver of margin expansion, are quite realistic, and then we are going to basically add to that some of the good work that has gone on in some creative ideas in end to end productivity as well as some of the actions we will continue to take to manage overhead costs. So it's really the combination of those three areas, the end to end productivity, the vol/mix improvement, and managing our overhead costs tightly that is what will drive our margin expansion.

All of the margin expansion we have talked about and we will talk more about that coming weeks is attributable to operational improvements, none of it is forecasting an expectation that we are going to see a tailwind from input costs to deflation.

If I were just to restate what you're trying to say, then, is that the things that are under your control are really the basis for the margin forecast. If I or any one of us were to take the view that commodities were deflationary, and the view that this is a benefit to Kraft, would you agree that that it would be additive to what you all are doing?

I would say that anything that we have guided or set expectations is purely operational, they are under our control and we are committed to deliver them. To the extent that there's changes in the input costs, some of that will play through if you had a dramatic change, for instance, a downward change in dairy prices again, some of that presumably would have to be given back in pricing, but again, we have built the strength of our brands, we have innovative new products we think we have pricing power but we'd have to see exactly how that would play out in the environment if you saw a material change in some of those input costs.

I understand. And thanks for all the color.

Sure.

Your next question comes from Eric Serotta of Consumer Edge Research.

Good afternoon.

Hello, Eric.

A couple quick housekeeping questions and then a broader question. First, it looks like you have about $26 million or so of asset impairment and exit costs this quarter. If I remember correctly, there were about $25 million of restructuring-type costs that were embedded in the P&L in the first quarter. Were there additional costs, restructuring costs embedded this quarter or should we expect now $200 million or so in the second half?

Yes. Actually, I think the $26 million you're seeing is actually a credit of $26 million.

Okay.

It's attributable to some charges we took last year under the program and we found a better means of accomplishing that. We essentially sold the business rather than shut it down or a manufacturing plant and so we took back the net as $26 million worth of restructuring. So that was a credit. Embedded within the second quarter is about 40, $45 million worth of restructuring costs. You won't see it broken out on the P&L because it's embedded within the individual lines. As we have talked about moving away from X items reporting and carving out restructuring, it's embedded, but there's about 40, $45 million worth of costs in the second quarter and a similar amount in the first quarter, so year to date, we are about $90 million and we are expecting that to step up in the second half, we had originally said 150, $200 million so that would kind of normalize that but now we have stepped that up about $50 million additionally as we see opportunity to accelerate some of that restructuring.

Okay. And then to follow up on the commodity outlook for the second half, could you give a rough feeling as to -- or a rough guidance as to how much of the commodity deflation you expect to come from lower cheese costs, which would obviously be passed on given your adaptive pricing model, is that the bulk of the $250 million delta in commodities or if you could give us some order of magnitude there.

I mean it's a big piece of it, as you know, dairy prices have come down pretty dramatically from the last half of this year to where they are at today. There's been some recent shifts in that as the regulatory environment has made some changes but I would say other of the input costs, some of them are moving upward a little bit, some of them moving downward. On balance I would say the cheese thing and that is the primary driver of it.

Okay. And --

Go ahead.

And then on -- in terms of your priority brand versus the rest of the portfolio, if I remember correctly, the priority brands represent something like 45, 50% of the US business at least. It seems like you're showing some very solid mixed single digit top line growth from those. Does the current -- do your current targets and does the current model work if the other 50% or so of the portfolio does not improve in terms of performance from current levels or is there some expectation that the nonpriority or nonfocus part of the portfolio is going to start to improve from these levels built into your expectations?

No. Again, our major assumption here, Eric, is that these priority brands will be the key drivers of our aggregate performance, as they have been so far. So, again, if we look at our aggregate results in North America, for example, where our priority brands grew about 5%, they represent, as you said, over half of our revenue and then similarly, we are seeing disproportionate contribution from these brands in the other regions of the world. So we are counting on continued strong performance from these focused businesses, because that's where we are putting our incremental investment, and essentially sustained performance from the balance of the portfolio, which is quite consistent with what we have seen so far.

Okay. Thanks. I'll pass it on.

Okay.

Your next question comes from Chris Growe of Stifel, Nicolaus.

A couple of quick follow-ups for you. First off on the cost savings you're expecting for the year, you've taken the charge up a little bit. Are we still looking for around $200 million for the cost savings for the year?

Yes, there's -- I mean, that's from the last restructuring program that we finished last year, kind of the full year 2009 effective at is about $200 million. The cost savings initiatives that we are undertaking in the back half of the year that we talked about, the additional $200 million, $200 plus million dollars is new programs that will benefit us in subsequent years.

Okay. Okay. And then again a quick follow-up on the cheese price increase we have seen recently. It's moved up pretty quickly obviously. Does that temper your comment about the negative pricing in the third quarter? We see that flow through in the third quarter? Is that more about a fourth quarter shift for you in terms of retail pricing?

I would say where the cheese pricing is today is pretty consistent with our forecasts so the increase that we have seen really was reflected in our expectations.

Okay. Sure. And then last question I had just as a bigger picture question regarding trade promotion, IRI data at least says that you're -- and a lot of of your categories are seeing increased levels of promotion and I wonder if you can make a general comment about that across your business and maybe competitively if you're seeing increased levels of promotion and price promotion in your categories, and I guess I should say ex cheese because I think we see that happening in cheese pretty clearly.

Chris as I mentioned we are seeing some increases in some respects because of the volatility of input costs, we have been using promotion tactically to adjust pricing and so we are seeing some impact in a number of our categories and occasionally we are seeing some sporadic aggressive price points that are really being funded by our customers as well. So there has been some activity but it is our long-term expectation that as the dust settles and we see input costs stabilize, that we will continue to move our spending from short-term tactical spending to more longer-term equity building investments.

Okay. So is that a drive on your overall price realization in the quarter?

Well, not really because net-net we have essentially -- we spent a little bit more in promotion, some cases we actually used that rather than take a list price reduction, we actually used the trade promotion to adjust prices so our -- essentially our net price was essentially where we expected it to be.

Okay. Thank you.

You're welcome.

Your next question comes from Vincent Andrews of Morgan Stanley.

Thank you. Tim if I ask you, if I look out to next year now, it looks to me like you have input cost inflation of at least 3%, and maybe as high as 5% and that probably would be pretty manageable from a cost activity perspective but is that similar to what you would see at this point?

It's a bit early to be giving any indication or guidance on 2010 or future. I'd rather not make those prognostications at this point.

Irene, from a vol/mix perspective, where are we in the pruning process? Are you done pruning and we are just going to be a few more quarters before we lap the effort that you've already gotten underway or is there more to come?

No. I would tell you the heavy lifting is pretty much behind us and as we exit the third quarter, we will have lapped most of the significant reductions that we have made. We will continue on an ongoing basis to do some pruning but we took out some significant product lines in a number of our businesses and we would not expect that to be replicated.

And then maybe the last question I would ask, Irene, is at what point does the growth in the nonmeasured channels at what point do the comps get tough because it seems like there is pretty good growth coming out of the channels and when will it get difficult?

I think certain some of the trends that are fueling the growth of these other channels, the value orientation and just the shopper traffic, we expect will be something that we will continue to see for the foreseen future and it's one of the reasons that we have continued to make sure that we are appropriately represented there.

Thank you very much.

You're welcome.

Operator, perhaps one more question.

Okay. Our final question comes from Christine McCracken of Cleveland Research.

Sorry. Thanks for taking the question. Just not to get too specific, but would it be fair to assume the commodities cost favorability you're expecting in the second half should be heavily concentrated in North America with the dairy and protein cost outlook and not in Europe where cocoa sugar and coffee are moving higher.

That's fair. We have much heavier -- I mean our cheese business and pizza business is more heavily weighted towards dairy input costs and you're right, we are continuing to see a little bit higher cocoa costs and sugar and so forth so I would say that's fair that North America would be most impacted.

Separately, on DiGiorno and Deli Fresh, those seem to be more premium products that might be benefiting from the shipped away from food service (inaudible) well known that that's happening but when you look at the launch of new products that you're going to be coming out here with in the second half are you tailoring that innovation at all to kind of hit those same trends or are you expecting thinking kind of longer term when you're rolling those out?

No. I would tell you that we have certainly -- we have a number of items in our pipeline that would be more premium kinds of offerings than we have chosen to just hold those in abeyance while we wait for the economy to recover. So I would say the focus of our near term innovation pipeline is on snacking, it's on health and wellness products and continued focus on value.

And just on the frozen area, there hasn't been any noticeable kind of shift down in sales trends there. We have been picking that up here in the last couple of weeks. Just wanted to follow up with that.

No. We have had -- I think it's our seventh straight quarter of double-digit revenue growth on our pizza business and we are quite optimistic about the outlook.

Great. Thanks. I'll leave it there.

You're welcome.

This concludes the question and answer portion of the conference. I will now turn the call back over to Chris Jakubik for closing remarks.

Thanks very much. Thanks, everybody, for joining us this evening and for those people in the media who have further questions, Mike Mitchell will be available to you, and for any analysts who have follow-ups, myself and Dexter Convoy will be around for a while to take your questions. Thanks very much, and we will speak to you all soon.

This concludes today's Kraft Foods second quarter 2009 earnings conference call. Thank you for your participation. You may now disconnect.