億滋國際 (MDLZ) 2010 Q3 法說會逐字稿

Good day and welcome to Kraft Foods third quarter 2010 earnings conference call. Today's call is scheduled to last about one hour including remarks by Kraft management and the question-and-answer session. (Operator Instructions) I would now like to turn the call over to Mr. Chris Jakubik, Vice President of Investor Relations for Kraft. Please go ahead.

Good afternoon and thanks for joining us. With me are Irene Rosenfeld and Tim McLevish, chief financial officer. Earlier today we sent out our earnings release. The release, along with today's slides, are available on our website, www.kraftfoodscompany.com. As you know, during this call we'll make forward-looking statements about the company's performance. These statements are based on how we see things today. Actual results may differ materially due to risks and uncertainties. So please refer to the cautionary statements and risk factors contained in our 10-K and 10-Q filings for more details on our forward-looking statements. Some of today's prepared remarks will also include non-GAAP financial measures, and you can find the GAAP to non-GAAP reconciliations within our earnings release and at the back of the slide presentation. So let me now turn it over to Irene .

Thanks, Chris, and good afternoon. First off, we had another good quarter in a challenging environment. Every geography delivered solid results. In North America, we posted sequential improvement and top line performance despite weak consumer demand and less merchandising activity than the prior year. In Europe, we delivered another quarter of solid revenue growth despite soft categories. We also continued to grow our margins and have sustained them in the low teens. In developing markets, further investment in our Power Brands and in priority markets again drove strong revenue growth in Asia Pacific and Latin America.

Second, as we told you in August, we plan to reinvest our first-half earnings up side to build a stronger foundation for future growth and that's exactly what we did. We continued to increase our investments in advertising, including a double-digit increase in North America. This ensures that our brands are as strong as possible as the economy improves. We also normalized Cadbury's trade inventories in certain developing markets and, as expected, this tempered our top-line growth.

So overall, the third quarter played out essentially as we planned. A notable exception was that input costs, including dairy, coffee, and cocoa rose much more than we had expected. To offset these higher costs, we began to price in several categories and in several markets. This affected our results in two ways. Our top-line growth was driven more by price than by vol mix, and there was some pressure on gross margins because price realization trailed the increase in input costs. The gross margin pressure we experienced in Q3 should ease as price levels better align with input costs.

The key take-away is that the underlying momentum of our business remains strong. We're taking the necessary pricing actions despite a difficult consumer environment. That's a testament to our strength in brand equities and we continue to increase our advertising investments. This will further build our brand, stimulate our categories, and position us well as the economy recovers. Let me now turn it over to Tim to discuss our third quarter results in more detail.

Thanks, Irene, and good afternoon. As Irene just mentioned, we're pleased with our third quarter results. They came in largely in line with our expectations. Now let me provide some details.

I will start by discussing our top line, where pricing was the primary driver of organic revenue growth as we move quickly to offset higher input costs. Organic net revenue for the combined business grew 2.1% as focused investments drove continued growth in our Power Brands. In the Kraft base business organic revenues increased 2.5% including 2.3 points from pricing. In fact, net pricing was up in every one of our business units.

In the Cadbury business, organic revenue growth was essential flat but in line with our expectations. This is due in part to our decision to normalize trade inventories in certain markets. Doing so reduced Cadbury's top-line growth by about 2 points and reduced our combined revenue growth by approximately 0.5 percentage point. As you know, we're also comparing against a hard push by Cadbury in the second half of last year.

Now turning to profit, on a combined basis, our operating income margin excluding acquisition and integration costs was 13.6% and our Kraft base business operating income margin fell by 50 basis points to 13.9%. This is entirely due to our stepped up advertising investment which lowered margins by about 100 basis points. At the same time, we continued to make excellent progress in productivity and in reducing overhead costs.

For the Cadbury business margins were 12.4%. This reflected stepped up marketing investment and the impact of the trade inventory reductions we've already mentioned. Overall, we continue to demonstrate strong underlying momentum, but clearly there's more opportunity ahead.

Turning to EPS, two key drivers affected the comparison of third quarter earnings year on year. A lower tax rate in 2009 and, as we pointed out in August, we began to reinvest the $0.10 of earnings up side from the first half. Let me walk you through the bridge.

Starting with Q3 of 2009 we earned $0.55 with $0.03 of that coming from the divested pizza business. We also spent $0.01 on acquisition-related costs last year. So, from a year-ago base of $0.53, our operating EPS declined to $0.47. Our Kraft base business delivered $0.01 of operating gains while covering approximately $0.05 from significantly increased advertising investments. Cadbury contributed $0.12 of operating earnings in the quarter, and higher interest expense and a change shares outstanding lowered EPS by $0.11. So, as you can see, the decline in operating EPS can be accounted for by $0.06 of higher year on year taxes. This year on year increase in taxes was a function of timing with greater benefits from discrete items in the prior year quarter.

Below the operating EPS line, we incurred a net impact of $0.04 from integration program and acquisition-related costs resulting in a reported EPS of $0.43. On a year-to-date basis, improved vol mix, productivity and overhead cost savings have resulted in strong gains in operating earnings. We've done this while continuing to invest in our brands. And through the first nine months we've earned $1.56, leaving us well positioned to deliver our target of at least $2.00 for the year.

I'll take a few minutes now to share highlights of our business results by geography. In North America, we continued to make progress in a very difficult environment. We delivered sequential improvement in top-line growth. On a combined basis, organic net revenues were up 1% compared with the decline of 1.3% in the second quarter of this year. We continued to invest more behind our Power Brands, and they responded by growing 3% in the quarter. Chips Ahoy!, Velveeta and Kraft Mac and cheese, for example, grew double digits while Ritz, Starbucks and Oscar Meyer Deli Fresh grew high single digits. This solid progress, however, was partially offset by three things.

First, soft categories and less merchandising, especially in our snacks business. Second, tough comps, particularly in our Cadbury business. While Stride and Dentyne gum delivered strong growth, we were up against last year's highly successful launch of Trident Layers as well as strong shipments of Halls as customers stocked up in anticipation of an H1N1 flu season. Third, while pricing in response to higher input costs was a key driver in our top line growth, we did see pressure on vol mix. However, as we look forward we have solid programming in place and we anticipate more merchandising activity. Therefore, we expect further sequential improvement in organic growth across our North American portfolio in the fourth quarter.

Now let's look at profitability. On a combined basis, our operating income margin in North America was 17.3% and our Kraft base business OI margin declined to 16.9%. This is due primarily to a double-digit increase in advertising. These brand building investments were funded by continuing benefits from productivity and overhead cost reductions. While input costs spiked in the quarter, we moved quickly to price accordingly. In fact, we've implemented or announced price increases in about 40% of our North American portfolio. However, price realization will lag higher input costs, at least in the short term.

Our Cadbury business posted strong operating income margins of 22.9%. Productivity gains and improved product mix were partially offset by higher spending behind new products. In Europe, combined organic revenues increased 1.1% fueled by our Power Brands which collectively grew 3%. Across our Kraft base business, organic revenues grew 1.7% as vol mix gains resulted from increased focus and marketing support. The results were mixed across categories. Coffee and cheese both grew mid single digits. Yakult, (inaudible), Kenco and Tassimo drove solid volume mix gains in coffee and new product launches and a successful marketing campaign produced continued growth in Philadelphia cream cheese.

Chocolate revenues were flat. Continued strength of Fraya and Marabou in Scandinavia was offset by weak category performance in other parts of Europe. In biscuits, revenues declined slightly. Strong growth in Power Brands including Oreo and Velveeta was offset by the timing of promotional activity and weak category performance.

In our Cadbury business, organic net revenues declined by 0.4%. Soft markets in Continental Europe, especially in gum, offset solid growth in Britain and Ireland. Despite this, Cadbury brands are holding or gaining share across Europe. Operating income margins in Europe rose to 12.4% on a combined basis. In our Kraft base business OI margins improved by 140 basis points to 11.6%. This reflected continued productivity gains and lower overheads.

Advertising spending for the quarter was down in this region due to the timing of programming. I would note, however, that it's up on a year to date basis. In addition, we shifted some A&C spending from the base Kraft business to Cadbury. Our Cadbury business also made a solid profit contribution to the quarter. Product mix improved and we continued to realize the benefits of supply chain efficiencies. As in North America input costs are rising significantly and we're pricing accordingly. In fact, we've taken pricing or announced price increases on more than half of our European portfolio.

Turning now to developing markets, combined organic net revenue increased 4.8%. This is fueled by the continuing strength of our Power Brands which were up 12%. This drove double-digit growth in both Asia Pacific and Latin America. In contrast to North America and Europe, however, we're seeing a sequentially smaller contribution from pricing in this region because inflation is now lower in many countries. In our Kraft base business, organic revenues grew 7.4%. Specifically, in Asia Pacific, China and Indonesia led the way and Power Brands grew more than 30% propelled by Tang powdered beverage and Oreo cookies. In Latin America, Power Brands grew 18% led by Oreo and Club Social Biscuits and Lacta Chocolate. These gains were partially offset by category trends in [sema]. Despite this, we improved market shares in most markets.

In our Cadbury business, organic revenues rose just 0.7%. This was expected as our actions to normalized trade inventory reduced Cadbury's growth by about 4 percentage points. Cadbury growth was tempered by weakness in the gum category due to weak economic conditions. Our operating income margin in developing markets was 12.7%. Our base business profit margins declined to 13.1% as we stepped up advertising investments across the region. These investments more than offset gains in vol mix and overhead leverage. Profit performance in our Cadbury business also reflected incremental advertising as well as the impact of normalizing trade inventories. So, in sum, we delivered solid top and bottom line performance in every geography behind our Power Brands. Now, I would like to turn the call back to Irene who will discuss our outlook and provide an update on the Cadbury integration.

Thanks, Tim. As we look to the fourth quarter, despite the economic challenges, we anticipate a sequential increase in top-line growth. And we're well positioned to deliver combined organic revenue growth of 3% to 4% for the full year. This is a solid base from which we'll generate top tier growth in 2011 and beyond. As we've said, pricing will contribute more to our revenue growth than we anticipated at the start of the year. To back stop the pricing, we have solid Q4 programming in place, particularly in North America and Europe, which will accelerate growth and deliver our revenue guidance for the year. On the bottom line, as Tim said, we expect to deliver operating EPS of at least $2. At the same time, we'll fund increased A&C from about 7.5% last year to about 8% of net revenues in 2010.

Turning to the Cadbury integration, it continues to proceed smoothly. We're on track to generate cost synergies of at least $750 million in annual savings, about 15% of which will come this year. We're also on track to greatly improve our earnings growth trajectory. We're integrating Cadbury and driving the substantial savings and growth opportunities now available to us. As a result, our combined operating EPS by 2012 will surpass considerably what we could have achieved on our own. And we remain confident in our ability to deliver significantly higher long-term earnings growth of 9% to 11%. So, to sum up, our flywheel is turning and we're benefiting from a virtuous cycle of growth and focused reinvestment. We're setting growth objectives off a solid base. We're managing input costs by maintaining strong brand equities and pricing accordingly. We're driving gains in volume and mix through focused investments in Power Brands and key markets. We're driving productivity and reducing overhead costs to expand margins. And we're reinvesting a portion of our earnings up side to further strengthen our brands and lay an even stronger foundation for top tier performance in 2011. Now we'd be happy to take your questions.

(Operator Instructions). Your first question comes from Vincent Andrews of Morgan Stanley.

Thank you. Good afternoon, everyone. If I could just ask a question around the input environment, as well as the pricing environment, and I guess as we think back to the last time all this took place, prices went up, and if I remember correctly there was a lot of volume mix and share issues in the heritage Kraft business, and it looked like that is starting a little bit here. How confident are you really that you can shore that up so quickly?

Well, Vincent, there's no question there was rapid escalation of many, or most of our input costs starting late in second quarter and through the third quarter. One fundamental difference between last time this happened and this time is that our brands are much stronger than they were last time. At last time, we were a bit reluctant because of the relatively weak brand equities to price aggressively. We've come out of the shoot, and quickly responded with pricing. We're entering that into a generally a weak consumer environment, but so far we're quite pleased with the reaction from our customers, direct customers, retail partners, and the consumer response has been okay, as well.

And I guess just as a follow-up to that, or maybe two follow-ups, on the adaptive pricing in cheese, is that still the plan? And then also, obviously the other thing that's different about this time versus last time is there's a lot more promotional spending going on. Are you seeing your competitors act rationally from a promotional spending perspective, as you take pricing? Are they following you? Is private label following? That's all I have, thanks.

Chris, I'd say we feel very good that our adaptive pricing is working. I think it's particularly important in an environment of volatile commodity costs. And so being able to price closer to the market, I think, is serving us well, and I think we feel better about our cheese business than we have in a long time. So we feel pretty good about that.

Generally speaking, we have price, as Tim said, we moved rather quickly to be able to address the escalating input costs. Generally speaking, we have not yet seen much from our competition, and I think it's one of the reasons that our volume mix in the quarter was a little bit softer. But the reality is, costs are going up for everyone, and we would expect that price gaps will narrow as the fourth quarter progresses.

Thank you very much.

Thank you, Vincent.

Your next question comes from Andrew Lazar of Barclays Capital.

Good afternoon.

How are you doing, Andrew?

Well, thank you. Irene, a couple things. One, on some of the pricing moves you have taken, you mentioned quite a bit of pricing on some of the pass-through categories that are larger for you, whether it be coffee, cheese, what have you. Have you taken any pricing actions or even prospectively taken some that may not have flowed through results yet in some of the core non-pass-through sort of categories, whether that be biscuits or dressings, things of that nature?

The answer is yes. We've priced pretty broadly across our categories, and it's a combination of what you would call pass-through and others, not all of which has flowed through the P&L at this point. But as you can see in the contribution of pricing to our vol mix performance, to our revenue performance in the quarter, you can see the impact of much of the pricing so far.

In light of that, as you think out to the fourth quarter, and more importantly really, in 2011, the ongoing algorithm to get to sort of your organic top-line growth rate is typically, I think you said two-thirds volume and one-third price mix, in I assume a more normalized environment. Is that still the case, do you think, for the fourth quarter and next year, or should we really expect, in light of some of the pricing moves that you've taken and are going to take, that that kind of turns on its head a little bit and becomes -- maybe it's two-third price, one-third volume, or how should we think about that?

I think the dislocation was particularly acute in this quarter. So I think without a doubt, we certainly stand behind the belief that the long-term profile will be an equal mix, a balanced mix of vol mix and pricing. I think you will start to see some of that play through in the fourth quarter, and certainly into 2011.

The fact that it was more acute this quarter, particularly with all the brand spending that you've done over the last three years, were you surprised that the brands didn't maybe, particularly in North America, hold up somewhat better on the volume side with some of this pricing? Or was it really just that you led in a lot of areas, and the hope and expectation is that, clearly given the pressure everyone is facing, you are going to see everyone else come on board, and ultimately volume looks a little bit less sort of down less significantly?

As we said earlier, we moved a little more quickly than others in the market, and as we saw input costs going up, but the reality is those costs are going up for everyone, and so we would expect to see a narrowing of those gaps over the coming weeks and months, and I think that will be beneficial to our vol mix in many categories.

I would also point out that in the third quarter, we had difficult comps from last year. As I commented, we were comping against the Trident Layers launch, the strong Halls season with the H1N1 build in the retail trade. As we go into the fourth quarter -- or, I'm sorry, the third quarter also was the quarter, late in the quarter, when we kind of lapped the merchandising issue that we've talked about for the last several quarters, with one of our major retail customers. So going into the fourth quarter, we will have much better comps, and therefore, the year on year improvement in vol mix we would expect to see.

Okay, thanks. Last thing, only because all these headlines seem to be streaming across as we speak, this decision by Starbucks and the retail distribution in coffee with Kraft. Perhaps you can just fill us in a little bit on how significant that is, maybe what led to that, and sort of what the broader context of that is.

Yes, I'll start by giving a little context. We've had a strong partnership with Starbucks for their retail distribution of the Starbucks Seattle's Best coffee for the last 12 years, since about 1998. We've built that business, along with Starbucks, from a small $50 million compounded annual growth rate on top line of in excess of 20% per year. Today it's around a $500 million business. We think both parties have been well served by our partnership.

Starbucks, as you perhaps know, in recent times has expressed their desire to control their strategic brands, and we have had some discussions in recent weeks to that effect. They have not officially or formally announced their intent to dismantle the agreement, but we have had some discussions. The effect that -- as we get into it, we can't at this point speculate exactly how that may happen or when that may happen, but again, we respect their decision to consider ending the agreements, and we'll inform you as more developments come to pass.

I think they're talking about it on their conference call, perhaps as we speak, and that's where this is all coming from. To the extent that does happen, is that sort of inclusive in the way you're thinking about 2011 from a top and bottom line perspective, or would that meaningfully change the algorithm?

Andrew, it's really premature. We have not been at formal conversations, again with the deep and broad partnership over the years, we're in regular discussions about a variety of topics. We know that this has been on their mind, but we haven't entered into any specific conversations about the when or the why or the how, so it would be premature to speculate as to the impact it may have.

Thanks very much.

Sure.

Your next question comes from Robert Moskow of Credit Suisse.

Hi, thank you. I have a follow-up on the Starbucks question. Most licensing agreements, I would imagine, it's within the power of the licensor to decide whether or not the contract can be broken. I think General Mills has that in yogurt. Is this a different type of contract? Does Starbucks always have the right to exit this contract, or do you have any kind of recourse?

Well, we really don't want to get into the specifics of the contractual relationship we have with them. It is a perpetual agreement, and they do preserve some rights, but again until we get into specific conversations with them, we would prefer to reserve comment.

Let me ask you a different question then. For next year, mid-teens EPS growth would be the most robust EPS growth that Kraft has delivered. I'm just wondering, given what you've seen this year in the consumer environment, and also the fact that North America, it seems pretty clear, and I listened to Tony Vernon very carefully, that it's pretty early culturally at North America. They're not totally staffed the way they want to be yet. Maybe the marketing ideas aren't all there yet. Is it too soon to grow at this pace, 15% EPS, given that maybe half the business is still kind of in the early stages of a cultural turn around?

Rob, I would say we still stand behind our commitment to mid-teens growth in 2010 on top of this year's earnings of at least $2.00. The reality is, we have a lot of good stuff going on in the portfolio. There were some anomalies in our 2010 numbers that we've talked about. As we begin to restore some of our merchandising support, as we find ourselves ideally in a more stable commodity environment, I think there's a number of things, together with the very significant cost focus programs that we've been involved in over the last couple of years in procurement and manufacturing, in distribution, together with the synergies that come from the combination with Cadbury. So I would say as we look at the overall profile, the growth profile of the portfolio from a category standpoint, from a geographic footprint standpoint, together with the opportunities on the cost side, we feel quite comfortable with the forecast that we've laid out.

I would just elaborate on Irene's comments. She picked up on the synergies, but you may recall the phasing of synergies. We've said that in 2011, we expect to realize 70% of the $750 million of synergy on top of the 15% this year. So you can calculate the year on year difference will be a significant contributor to that growth into 2011.

I think the last point I would make, Rob, it should be clear to you we are doing everything we need to, to protect the business in the short term as well as stage it for the longer term. And I want to underscore the fact, the investments that we have made and we are planning to continue to make, are designed to ensure that this business is well positioned for long-term growth. And so I feel very good about the profile of the portfolio, as well as the investments that we have made and will continue to make over the course of 2011.

I appreciate the conviction. Thank you very much.

Your next question comes from Terry Bivens of JPMorgan.

Good afternoon, everybody.

How are you doing, Terry?

Very good, thank you. If Rob is after conviction, I suppose I'm after a little bit more comfort for the fourth quarter because, frankly, the organic growth rate came in a little bit lighter than I was expecting. Irene, what could you give us to give us a little bit more comfort around a better organic growth rate in the fourth quarter to get to your stated 3% to 4%?

That's a good question, Terry. I would tell you, do the math. To deliver 3% to 4% for the year, given our year to date performance, we have to do at least 4% in the fourth quarter. I'm quite confident that we will do that. I feel very good about our Q4 program. Tim talked about a number of the programs, and I'm pretty comfortable that we should end up somewhere in the middle of that range.

Obviously, exactly where we end up has a lot to do with how well the consumer responds to our programming, as well as the customer execution of our merchandising activity. But that's how you should feel quite comfortable, as we do, that we're clearly going to deliver in the 3% to 4% range as we've targeted.

Okay. Just a quick follow, kind of the same thing applied to Europe. The growth rates there were a bit slower than I expected. Were they slower than you expected, or had you expected a little bit of that deceleration from what we saw in Q2?

No, we actually -- the European performance was very much in line with our expectations. I think they are going to have a very strong year, and we feel very good about their performance, not only on the top line but we are very comfortably in the 12% double digit margin range, and they continue to make excellent progress on their margin expansion. So I think that business has good underlying momentum, without a doubt some geographic challenges given the economic situation, but I think they've done an excellent job of managing through it.

Okay. One quick thing. Our guys at (inaudible) now are beginning to get worried with grain prices going up, and they had forecasted dropping milk and cheese prices next year. If we get into a bad situation there, is there anything you can do to kind of protect yourself ahead of time, if cheese prices get a little wacky in 2011?

Most of our input costs, our major commodity input costs, we have a very active hedging program. As a major player in this industry, we have a pretty robust kind of a forecasting group that stays apprised of all of the developments, and crop cycles and those sort of things. So we have some visibility into what an expectation is directionally, and we have a very active hedging program, but the most important thing is, the hedging is only there until we're able to price. And so our expectation is with continued investment, the continued strength in brand equity, that we'll be able to price to offset any future changes in input costs.

Thank you very much.

Sure.

Your next question comes from Diane Geissler of CLSA.

Good afternoon.

Good afternoon, Diane.

I just wanted to ask about your goal that you stated at your analyst day, the $1 billion in revenue synergy. It sounds like from your commentary today that you feel like you've cleaned up the issue with regard to some of the excess inventory in the channel in the developing markets. Could you just talk about your expectations for the $1 billion over the next three years, how you expect that to flow, and even if you can give us some guidance on maybe through 2011, is that more back end loaded? Could you just talk about that a little?

Well, first of all, what we've laid out, Diane, was about $1 billion of revenue synergies that we see. About 0.5 of that would come from route to market, putting legacy Kraft products through the Cadbury infrastructure and vice versa. About a third of it comes from brand extension, simply taking some of the ideas on Cadbury, bringing it to Kraft products and vice versa. The rest of it comes from bringing products like dairy milk to new markets.

The opportunity, though, first of all, the pocket benefit of that will come a little bit later because most of those opportunities will require some investment. So when we talk about the $750 million of synergy, that is from cost synergy. We have not made a lot of assumptions in the near term of profit coming off of the revenue, but the top line benefit will come at the very least in late 2011, into 2012 and beyond. So it's going to take us a while to get some of those opportunities jump started to complete our integration, et cetera.

You will begin seeing next year, the benefits on the top line, but you won't see any bottom line benefit playing out until probably 2012, 2013. What profits we do generate next year, we'll just plow into building the next year's worth of top line growth.

Okay, so what I'm hearing, I just want to clarify, it's more of a benefit toward the back end of 2011, and that's really contingent upon continued integration of the two entities in the first half of 2011?

Yes, but it's back half into 2012. The real benefit from revenue synergies will really start to impact our top line more meaningfully beginning in 2012.

Okay, so then I guess to hit the 5% revenue target you have for 2011, it's really the base business itself?

It's the base business. We will pick up some of the revenue synergies in the back half of the year, as Irene just mentioned. The other thing I think important to point out is, as you know, every seven years or so in this industry there is a 53rd week, and so 2011 represents that year that we will have a 53rd week. If you do the simple arithmetic, it would suggest you have about 2%. The reality of it is you're adding a week of the year between Christmas and New Year, but we would expect that it's 1% to 1.5% worth of benefit associated with the calendar change and the associated 53rd week.

Okay. One quick housekeeping. Can you help me with the tax rate for 2010? What are your expectations there?

Pretty consistent. We started out the year with an expectation it was going to be a little bit above 30% in the second quarter, with some discrete items, some settlements, some audits, and so forth. We dropped that a little bit below 30%, and we don't have an update. We would still expect it to be -- the rate this quarter benefited by some discrete items, but that's reflected in our under 30% tax rate expectation for the year.

Just wanted to make sure there was no change there. Perfect, thank you.

Your next question comes from Bryan Spillane at Bank of America.

Hi, good evening.

Hi, Bryan.

Couple points of clarification. First, Tim, just your response to Diane's question just now. Does at least 5% organic revenue growth next year include the 53rd week, or is that excluding the 53rd week?

No, it's including the 53rd week. We will pick up a point or a point and a half from -- we have some 53rd week and some other miscellaneous calendar changes, and that would represent somewhere between 1% and 1.5%. That's included in our 5% plus.

Okay. So then it would be -- so, on an equal week basis, it would be 3.5% to 4% organic growth.

That would be fair, yes.

Okay, all right. And then in the quarter, just two items. There was a reversal, I think, of an accrual, a $9 million reversal of a restructuring accrual, and also looks like, were pension expenses also higher in the quarter? Can you just kind of talk through that, and also whether or not there will be more of that in the fourth quarter?

The pension expenses were no higher in the third quarter than in prior quarters. Typically, we'll determine the pension expense for the year based upon the assets and liability position, discount rate, et cetera, the end of the prior year. So there wouldn't be any changes in the course of the year. There were some miscellaneous clean-ups of accruals and so forth that happened in the quarter that often times do, but it's nothing material to worry about.

Okay, great. Thank you.

The next question comes from Jon Feeney of Janney.

Good afternoon. Thanks. I just wanted to dig in a little bit on -- for next year, maybe this is a nitpicky question for Tim, but it seems like the -- what would Kraft base businesses trends have been on a two-year basis reflected in that guidance? Because I see $750 million in cost synergies, and I guess I don't see a lot of other sort of earnings growth from what -- for the base business relative to that plan. Could you kind of talk a little bit about that? What roughly would that have been?

I think I'm picking up on the answer to your question. The $750 million of cost synergies we've identified relative to the Cadbury integration. We've said that 15% of that or so we would realize this year. We're tracking on that or ahead of that. We said that we would, in 2011, be about a 70% run rate. The differential would be 55%, so you're talking about, say, $400 million worth of year on year increase attributable to the synergies. That's probably half of the growth that we're expecting to see based upon our mid-teens growth. So the rest of it is base business growth.

Actually, let me be a little bit more clear. You did $2.02 in fiscal 2009, before acquiring Cadbury. So if you took out $0.05 for the pizza business, that would get you to $1.97. $750 million on a tax adjusted basis, I'm getting to something like in aggregate about $0.26, and if you do what you just said you're going to do, you're going to be doing about $2.30 to $2.40. So that would give me like $0.10 of EPS growth on a two year basis for the base business. Is that about right?

You're taking it back to 2009, to 2010 to 2011.

Yes.

We've walked through a bridge earlier in the year when we set out the guidance of 2009 to 2010, and we kind of showed how we kind of went from $2.00, to remained at $2.00 for the year with a variety of factors including a fair amount of investment back of some of the synergies, and building on some of the brand investments.

Jon, I think in terms of how you're doing your math, I think you're dropping 100% of the synergies. What we've said when we laid out the program, we said that you have integration synergy of $750 million, but we also said at the same time we probably reinvest about 25% of that back into the business. I think you have to be a little bit careful in terms of how you're doing your math, and how you're doing your attribution.

That makes sense. So I guess the question, the one follow-up I have, as far as the -- what kind of sign posts would you see six months out from now? I certainly get how you get to the numbers, and I understand it's been a surprising cost push environment, but would you expect, with the stronger brands, the brand investment you're making, where would that return on that investment sort of manifest itself? Would you expect to have like 2% or 3% volume by mid next year, or what would you point to, to say here's where we're getting the real return on that increase in advertising spending?

Let me answer that one, Jon, I think what you should look for is sequential improvement in top line. As we've suggested to you, you would begin to see this year and in North America, which has been one of our challenges, you are seeing that in the third quarter, and it will continue into the fourth quarter. And you will also see a better combination and contribution of pricing and vol mix to revenue growth. So as we said, as we get into a more normalized environment, and we get most of the pricing behind us, we should see a better balance between pricing and vol mix. And those would be the sign posts I'd look for, together with continued progress on margins for all the reasons that we've laid out.

Right. Great. That makes perfect sense. Thank you.

Thank you.

Your next question comes from David Driscoll of Citi investments.

Good evening, everyone. I want to focus on pricing, specifically on coffee, but this has nothing to do with Starbucks. Coffee has hit a 13-year high, and you and your competitors have all announced price increases. How are consumers responding to the August price hikes? And then I would note that recent Nielsen data was showing that volumes were slowing year on year even before the price hikes. So assuming that they're fully implemented, are you actually seeing material volume degradation, or do you expect to?

I think most of our coffee franchisers actually did quite well in the quarter. So we did see one of our businesses, our Maxwell House business, we shifted some of our promotional timing, and so you would see that would have had some impact on our third quarter results. That will come back in the fourth quarter. There's no question, as we take pricing, there is a consumer response, it takes awhile to adjust to new price levels, but we see nothing in the marketplace that would suggest that it's going to be an issue for us as we go forward.

Irene, just to follow up, coffee, it's a tough category for me to look at because there's somewhat of an addiction to the product, first off. And secondly, I think consumers might be somewhat trained to having very volatile prices. So I was just looking for any color on the elasticities that you expect. And then the 13-year high stuff, just caused me to be a little bit worried.

I think over time, that you have seen a fair amount of volatility, and it is pretty much a pass-through category, and the consumers I think are conditioned to that volatility in price. So I think there is pretty good price elasticity.

You really don't sound too worried about that one. Can you make one comment on the rate of inflation for 2011? What is your expectation at this point?

We're not going to provide specific guidance on inflation at this point. We believe the nature of our business, and the strengthening of our brands, we're able to respond to economic environments and cost environments. We feel pretty comfortable with that.

Will you do so on the fourth quarter conference call?

When we give 2011 guidance, we'll give you specifics on our expectation for Kraft, but we really don't forecast GDP, inflation rates, et cetera.

I understand. Thank you.

Thank you.

Your next question comes from Ed Aaron of RBC Capital.

Thanks for taking the question. I just wanted to ask a follow-up on the pricing environment in the third quarter. I'm just trying to understand what really changed so quickly in terms of the pricing for the quarter. I understand that the commodities obviously moved quickly, but you kind of indicated last quarter that you felt compelled to get maybe more aggressive in the quarter to defend share in response to what some of your competitors were doing. So it's not entirely intuitive to me why you would be moving actually faster than your peers seem to be.

I guess I would like to distinguish, Ed, between list pricing changes and promotional changes. We were very clear in our second quarter call, and I would say we remain committed to the fact that we are making significant investments in the equity of our brands, and we are not inclined to play around with short-term promotional pricing that doesn't really have a benefit for the long-term health of the business. So we still feel that way. The reality is, in many cases we were looking at costs that were up 20% and 30% versus prior year, and they're just significant, and we feel if we intend to continue to make the necessary investments in supporting our brands and in introducing new products, we need to make sure that we're able to cover those costs.

Okay, thanks. Then just on the 2011 outlook, I guess I'm accustomed to thinking about organic growth as excluding any differences in the number of weeks. Is there a fundamental reason why you wouldn't be comfortable with a 5% plus organic growth number kind of on a comparable weeks basis next year, kind of in line with your stated algorithm?

I think that with the recent integration of Cad, we feel very strongly that on a going forward basis, when we build our markets and so forth, with Cadbury we'd get the full integration done and so forth, that our portfolio will command a 5%plus. With the fragility of the consumer, with the high inflation we just talked about, with still a pretty early integration of the Cadbury, we're not quite ready to step up to the full 5% plus that we expect the portfolio to deliver on a going-forward basis, but again, we get the benefit of an extra shortened week in 2011. I think that 5% plus including that extra week is the right growth for us.

Understood, thank you.

The next question comes from Chris Growe of Stifel Nicolaus.

Hi, good afternoon. I have a couple of questions for you. The first one, in relation to your sales growth target for this year, you have a range of 3% to 4%, you've talked about the recovery at Wal-Mart, one of your key customers, and I just want to get maybe an update on how that's going, whether it's actionality or your merchandising efforts overall. To me, in walking the stores, it sure looks like you've picked up there quite a bit in terms of activity.

Yes, we certainly feel that in a number of their stores, we are beginning to see some of the merchandising come back. We've been working very actively with Wal-Mart to put back merchandising, particularly on products like our snacks products, and some of our grocery products that are particularly sensitive to the merchandising support. And as a result, we do expect to see sequential improvement in the fourth quarter versus the growth in the third quarter. The reality though is, given the speed with which some of this is being executed, and some of what's going on in the economic environment, I think the reality is that we're unlikely to see the full impact of those changes until next year.

Is that still a swing factor for your revenue growth this year?

Yes, it is.

Irene pointed out somewhere in the mid 3%s, so the middle part of that range, that was kind of the swing factor to determine where in that range.

Okay, and then do you still have further inventory changes to make at Cadbury, or are those all complete as of this quarter?

We have a little bit more to go in the fourth quarter. We're two-thirds to three-fourths finished with it, but the other 25%, 30% will come in the fourth quarter, then we'll be finished.

One final question for you on Cadbury. It's surprising to see it as a drag to your revenue, or a slower revenue growth versus base Kraft, and I know there's some reasons for that. I guess what I'm trying to understand, going forward, is it innovation, is it marketing? What are the things that are going to help you drive stronger revenue growth at Cadbury?

Let me say first of all, we continue to feel terrific about the Cadbury acquisition. It has -- it will have and is already having the transformational impact on our portfolio that we had hoped it would have. If you recall, their plan was front half loaded, reflecting a number of factors. The first is, as Tim referenced, a number of the new product launches, Trident Layers, the reality of having a very strong set of shipments in advance of the flu season, and there was a fairly significant push that they made in the second half of 2009. So we had expected to see a stronger performance from the business, front half versus back half, and then on top of it, we have -- did choose to normalize some of the inventories as we've described.

The business is generally delivering exactly as we had expected. We have some issues here and there. Gum is a little bit weaker in a number of markets in the world, but that is being offset by some chocolate strength in a number of markets in the world. So, net-net, we feel very good about the acquisition, and about the integration, and I think some of what we're seeing in the third quarter and the back half of the year was to be expected.

Thank you.

The next question comes from Judy Hong of Goldman Sachs.

Thanks. Just a few questions from me. Irene, the last time that the food manufacturers took pricing, you did see the element of consumers trading down to private labels, and as you think about the fragility of the consumers as you've called out, this time around, I'm wondering what you think about sort of the potential for trading down as the prices go up at the consumer level.

Well, I think the consumer is clearly sensitive to value, and I think the first point I would make is, there's so much focus on price, what we are seeing in so many of our categories, it's much more about value. And we have spent a lot of our investment money ensuring that our brands, that we have good healthy brand equity, and investing in our new product pipeline, and I think we are well positioned to be able to support the higher levels of pricing. Without a doubt there will be some pressure on our franchises, but I think we are well positioned. And what we continue to see is that it is the third and fourth brands in the category that are being most impacted by the private label performance, not so much our brands, and I think we will see that in the coming months.

Okay. And then, Tim, I know you're not giving us the inflation number for next year, but can you give us some perspective on your view of sort of what you think gross margins would do next year in terms of being flat, up or down. And then maybe more specifically the phasing of gross margin, because it sounds like you will take pricing, but you may not catch up to calls until maybe the back half of next year. So are we looking at first half margins down, and then picking up next year in the back half, or how should we think about that?

We've given guidance for OI margins, said that we will be mid-teens beginning in 2011. That reflects continued growth of our margins. It's driven by cost productivity, overhead reductions, procurement efficiencies, et cetera, as well as the leverage from volume growth. My expectation is, we can't predict precisely what's -- and I don't want to go out there and predict what's going to happen with input costs and so forth, but they are at a pretty high level. We are pricing to compensate for those currently. That will play out over the course of the fourth quarter, and probably into the first quarter, so I would expect those to be covered.

So I would expect a reasonably balanced over the course of the year margin. Maybe it will progressively improve some over the course of the year, just the normal seasonality as well as allowing our productivity and overhead reductions to kick in. But from a gross margin standpoint, I would expect it to be pretty balanced over the year.

Okay. Then the mid-teens earnings growth target for 2011 is on a currency neutral basis?

It reflects kind of the current exchange rates as they exist today. If there is material change to that, we'll have to discuss it, but I think we're able to manage that. Quite frankly, we have a very complex portfolio of currencies. So we are less impacted by just a decline in the value of the dollar or an appreciation of the dollar because we have a lot of our input costs. Our manufacturing is usually in the local countries. We source some of our costs by virtue of sourcing of cocoa is denominated in pounds, and coffee in dollars, et cetera. So we have a pretty balance, so we don't get as impacted by FX as one might assume.

Do you mean that at spot rates, there's pretty much neutral impact on 2011 from currency?

I would say our mid-teens would reflect currency exchange rates.

Thank you.

On balance this year, despite a fair amount of volatility in the value of the dollar and across currencies, we have had $0.01 or $0.02 maybe of favorability for the year.

Yes. Okay, thanks.

If we could take one more question.

Your final question comes from Eric Serotta of Wells Fargo.

Want to sneak in two questions here. First, if we could just beat the horse dead, in terms of pricing and elasticity. It seems to me that the 3% pricing in North America with the 2% volume trade-off was actually pretty good. It seems only going back a quarter or so that food companies were showing pricing down a couple of percentage points and volume down a couple of percentage points. Is that how you're looking at it, or is that -- is this largely in line with your elasticity models?

No, in fact, that's one of the reasons we feel quite good about the health of our brands. I'd also tell you certainly from a vol mix standpoint, we had some tough comps a year ago. So I really think that, as a result of all of the investments that we have made in our brands over these last couple of years, it's playing through in our ability to take pricing when we need to, in response to rising costs, as well as our ability to continue to support the brand.

So we were actually pleased with the sequential performance. We are not yet where we need to be in North America, but I think we've been clear about what we see as the challenges and what we're doing about them.

Great. And on a different subject, on slide number six, it looks like Cadbury was actually about $0.01 accretive to EPS in the quarter, and $0.02 dilutive for the year to date. I believe last quarter you said -- you reiterated that Cadbury would be about $0.16 dilutive for the full year. Is Cadbury coming in much stronger than that, or are you sticking by that $0.16 dilutive number? Doesn't really seem to make sense with your performance here to date.

Cadbury is coming in about as expected, and the dilution we would expect to be on about $0.16 for the year. What you are missing, and I apologize that by virtue of the proximity of the interest and the shares increase relative to the Cadbury operating income, would seem to imply that they're directly related, but you may recall that we had the proceeds from the pizza business that we said was going to benefit us by about $0.09. That is manifested in the shares outstanding dilution piece of it. And so consequently, you have to offset that element of it on the -- when you take your $0.12 and your $0.06 and your $0.05, you have to reflect that the shares would be the better part of $0.09 impact of that. Actually on a year-to-date basis, Cadbury is $0.10 or $0.11 dilutive, on the way to the $0.16 as we originally laid out.

Okay. Makes a lot more sense. Thanks a lot. I will pass it on.

This concludes the allotted time for today's question-and-answer session. I will now turn the floor back over to Mr. Chris Jakubik for any closing remarks.

Thanks, everybody, for joining us today. For anybody who has further questions, Mike Mitchell will be around to take your questions from the media, and Dexter and I will be around to take any follow-up questions from the analysts and the investors. So thanks again for joining us, and we'll speak to you soon. Thank you.

This concludes your conference. You may now disconnect.