2005 1st Quarter Earnings Release
April 28, 2005
Speaking on behalf of Kellogg:
Jim Jenness, Chairman and CEO
David Mackay, President and COO
Jeff Boromisa, CFO
Simon Burton, Director, Investor Relations
Operator: Good morning and welcome to the Kellogg Company 2005 First Quarter Earnings Call. This call is being recorded. All lines have been placed on mute to prevent background noise. After the speaker’s remarks there will be a question and answer period. If you would like to ask a question during this time, simply press * and the number 1 on your telephone keypad. If you would like to withdraw your question, please press the # key. Also, please limit yourself to one question during the Q&A session. Thank you. At this time I would like to turn the conference over to Mr. Simon Burton, Kellogg Company Director of Investor Relations. Mr. Burton you may begin your conference.
S. Burton: Good morning, everyone. Thank you for joining us for a review of our first quarter results and for some discussion about our strategy and outlook. With me here in Battle Creek are Jim Jenness, our chairman and CEO, David Mackay, president and COO; Jeff Boromisa, CFO; and Gary Pilnick, general counsel. By now you should have received the press release by e-mail, and the slides that accompany today’s presentation are available on-line at www.kelloggcompany.com on the Investors page.
We must point out that certain statements made today, such as projections for Kellogg Company’s future performance, including earnings per share, net sales, gross margin, brand building, operating profit, innovation, costs, interest expense, tax rate, cash flow, working capital, share repurchases, and debt reduction are forward-looking statements. Actual results could be materially different from those projected. For further information concerning factors that could cause these results to differ, please refer to the second slide of this presentation, as well as to our public SEC filings. A replay of today’s conference call will be available by ‘phone through Tuesday evening, by dialing 888-203-1112 in the U.S. and 719-457-0820 from international locations; the passcode for both numbers is #2469078. The call will also be available via webcast, which will be archived for 90 days. Now let me turn it over to Jim Jenness, chairman and chief executive officer.
J. Jenness: Thank you, Simon, and good morning, everyone. We are obviously very pleased to report another positive quarter driven by broad-based growth across our businesses. This performance in the first quarter is even more impressive considering 2004’s very difficult comps. By almost any metric this was another excellent quarter.
We posted much stronger than expected sales growth. Reported net sales grew by 7.6%, which built on significant 11% growth last year. Internal net sales growth, which as always excludes the impact of foreign exchange, acquisitions, divestitures, and differences in the number of shipping days, was 6.3%, and built on excellent 6.5% growth in the first quarter of 2004.
Our gross margin expanded by 90 basis points. We continued to drive price and mix, which were significant contributors to the margin expansion and we managed this despite continued high energy and fuel prices and increased benefits costs. And as always, we took that margin expansion and invested it into the business.
We continued to invest in cost-reduction projects and we significantly increased investment in brand building during the quarter. Remember, these two things are simply investment in the future of our Company. In fact, it is because we made this kind of investment in previous quarters that we were able to drive the excellent growth we are reporting today.
Our goal is to generate dependable, sustainable growth. And 2005 now looks like it will be more front-end loaded than we originally anticipated, which should give you added confidence in our ability to meet our targets for the year.
In fact, even with recent significant increases in our estimate for up-front costs in 2005 to 15¢ a share from the original estimate of approximately 5¢ per share, the first quarter’s business momentum gives us confidence that earnings for the full year will now fall at the high end of the previous range of $2.28 to $2.32 per share. By any measure this was an excellent quarter.
Slide 4 details some of the key financial highlights. Net sales increased by 7.6% as a result of broad-based strength across our markets and some favorable impact from currency translation. Internal sales growth, which excludes the effect of foreign exchange, was 6.3 percent and represents significant growth over last year. Operating profit increased by 11% and internal growth was 10 percent. We managed this despite:
§ a mid single-digit increase in investment in brand building,
§ the significant cost headwinds faced by the entire industry, and
§ the absorption of approximately 4¢ of up-front costs, which was an increase from our initial expectation for less than 3¢ per share.
Earnings per share grew by 15 percent after increasing by 33 percent in the first quarter of 2004. This quarter’s performance was also helped by both a lower tax rate and slightly lower interest expense.
Cash flow for the quarter was $169 million, which was lower than last year’s $211 million, because of the timing of an interest payment. Jeff will discuss this in more detail in a minute, but remember, too, that last year’s cash flow growth was also 33 percent. Let’s look at the results in more detail.
Slide 5 shows our net sales growth in its various components. Reported sales growth was 7.6% in the first quarter, driven by broad-based internal growth and a contribution from currency translation, as the dollar remained relatively weak against various currencies.
Internal net sales growth was a strong 6.3% and built on growth of 6.5% last year. This internal growth again came from both price/mix improvements and tonnage growth. In fact, the price/mix increase of 2.3% was driven by improvements in mix and price, partially as a result of last year’s U.S. cereal price increase. Mix improvement is an important part of the Volume to Value operating principle and we are encouraged by these continued strong results. In addition, tonnage increased by 4 percent. The growth that we saw earlier in the quarter continued in March and was broad-based across our businesses.
Slide 6 details our investment in brand building for the first quarter of 2005 and the full year 2004. Our strategy is to increase investment in brand building at a rate greater than sales growth. As you can, see, we achieved this in 2004 and posted a double-digit increase in investment. But we didn’t quite meet our target during the first quarter of 2005 due to the better than expected sales growth and the timing of certain programs. Our expectation is that we will still meet this goal for the full year.
We are often asked how long we can continue to increase our investment in brand building at such a strong rate. We’re a branded food company and investment, through innovation and brand building is our lifeblood. Product news and promotions, such as the Special K two-week challenge, are an essential part of the way we operate our business. Consequently, we are committed to continuing this investment in our brands and driving future growth and we still have a long way to go. Also keep in mind that our definition of brand building does not include trade promotion, just advertising and consumer promotion.
In a moment, David will review each of our businesses in more detail. But first, let me turn it over to Jeff Boromisa, who will walk you through our financial results.
J. Boromisa: Thank you, Jim. Good morning everyone. The sales growth Jim discussed, and the continued effect of Volume to Value, drove our gross profit margin for the first quarter as is shown in slide 7. In fact, our gross margin improved by 90 basis points, higher than our long-term target.
The improvement in price/mix that Jim mentioned earlier, along with productivity savings from previous cost initiatives and operating leverage, offset various negative factors, such as higher fuel, energy, and benefit costs. In addition, we invested a total of 4¢ in up-front costs, all of which was recognized in cost of goods sold. We expect that the incremental full-year effect of higher benefit costs will be up to 10¢ per share and that commodity costs will neither benefit nor hurt us. As you know, some commodity costs are lower this year than last, but others, such as energy, are much higher. In addition, we have hedged many of our input costs for this year.
Lower costs for package inserts accounted for less than half of the gross margin expansion. Inserts and other consumer promotions are an excellent form of brand building. Remember that these consumer promotions are accounted for in cost of goods sold.
Our long-term target is for gross margin expansion to equal approximately 50 basis points a year and 2005 is off to a great start. We expect that continued mix improvement, operating leverage, and productivity savings will more than offset continued negative cost pressures.
Now let’s turn to operating profit growth by business. Slide 8 details this growth by each of our geographic reporting areas in the first quarter… and, as always, internal growth excludes the benefit of currency translation. As you can see, our broad-based growth also extended to operating profit, as each of our segments posted strong growth.
In North America, internal operating profit growth was 11.6 percent. We are pleased with this growth given our investment during the quarter. In addition, all of the first quarter’s up-front costs were recognized in North America and are reflected in the operating margin.
Internal profit growth was 9.2% in Europe where we also increased brand-building investment at a double-digit rate.
We increased our investment in brand building at a double-digit rate in Latin America, and saw internal operating profit growth of 4.8 percent.
And in Asia/Pacific, where internal operating profit growth was 9%, we also increased brand-building investment at a double-digit rate.
So, you can see that each of the reporting areas contributed to this quarter’s growth and our investment in the business just adds to the quality of the results.
Below the operating profit line, earnings were helped by a lower tax rate of approximately 32% and slightly lower year-over-year interest expense due to our continued focus on the Manage for Cash principle. These benefits were partially offset by an asset write down and a charitable contribution that totaled approximately 2¢ per share. We continue to expect that the full-year tax rate will be approximately 33% and that total interest expense for the full year will be only slightly lower than last year due to the timing of bond maturities.
Slide 9 shows our continued improvement in working capital. This is core working capital measured as receivables plus inventories, less traditional trade payables, which excludes customer trade liabilities… divided by our last 12-month sales. This was our fifteenth quarter of improvement in core working capital and we are proud to be the industry leader.
As you know, this improvement has been a good source of cash for us over the last couple of years and we are very pleased to have achieved this result while improving our levels of customer service. In the future, we expect additional improvement in core working capital as a percentage of sales, but expect it to be neither a source of or use of cash.
Slide 10 shows our strong cash flow performance for the first quarter. This was a decrease of 20% from last year’s very strong $211 million. This was due to the timing of an interest payment of $112 million during this quarter; the comparable payment fell in the second quarter of last year. Remember also, that last year’s result represented 33% growth from 2003.
This year’s cash flow was driven by strong earnings and continued discipline with capital expenditure. This is a good start to the year and gives us confidence that we will achieve our full-year cash flow target of between $950 million and $1.025 billion.
Slide 11 shows the progress we have made on the reduction of debt since the acquisition of Keebler and our long-term target is to reduce debt by approximately $300 million a year. As you know, our Board of Directors has approved a $400 million share repurchase authorization for 2005 and we completed $260 million of this amount during the first quarter.
Now let’s look at slide 12 and the progress we’ve made with return on invested capital in recent years. Our operating principles ensure that we maintain capital discipline while focusing on return. We understand the importance of improving our return and are confident that we will continue to do so over time.
Finally, let me discuss our outlook for the remainder of 2005, which is detailed on slide 13. As you can see, the strength of the first quarter’s results gives us confidence that we will now reach the high end of our previous earnings guidance range of $2.28 to $2.32 per share.
While we are pleased that we achieved such strong results in the first quarter, it wouldn’t be prudent for us to expect that we would maintain that level of growth. So, we continue to expect internal sales growth more in line with our long-term target of a low single-digit rate.
As we said in the March press release, the planned closure of two snacks’ bakeries will bring up-front costs for the full year to approximately 15¢ per share. This is an increase from our previous guidance for 8-10¢ per share and our original estimate of 5¢ per share. Essentially all of these costs will be recognized in North America and in COGS. Timing is often hard to predict, but we expect the distribution to be relatively uniform across the quarters.