Kellogg Co.
/K
/Q1 2007 Earnings Call
/Apr. 30, 2007
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/Ticker▲
/ Event Type▲ /Date▲
MANAGEMENT DISCUSSION SECTION
Operator: Good morning and welcome to the Kellogg Company 2007 First Quarter Earnings Call. [Operator Instructions]. At this time, I would like to turn the call over to Simon Burton, Kellogg’s Vice President of Investor Relations. Mr. Burton, you may begin your conference.
Simon D. Burton, Vice President, Investor Relations and Global Corporate Planning
Thank you, Sara and good morning everyone and thanks for joining us for a review of our first quarter results and for some discussion regarding our strategy and outlook. With me here in Battle Creek are David Mackay, President and CEO; John Bryant, CFO; and Gary Pilnick, General Counsel. We must point out that certain statements made today such as projections for Kellogg Company’s future performance, including earnings per share, net sales, margins, operating profit, interest expense, tax rate, cash flow, 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 Thursday evening by dialing 888-203-1112 in the US, and 719-457-0820 from international locations. The passcode for both numbers is 6714942. The call will also be available via webcast, which will be archived for 90 days.
And now let me turn it over to David.
A.D. David Mackay, President and Chief Executive Officer
Thank you, Simon, and good morning, everyone. We are obviously pleased to announce our first quarter results and an increased level of confidence for the year that comes from such a strong start in Q1. As you can see, last year’s momentum continued into the first quarter and sales growth increased faster than our target. We exceeded our expectations for operating profit growth and we did this while absorbing significant cost inflation and while making investment in the business to drive growth.
Both our net sales and operating profit results were achieved against tough year-ago comps, and reported earnings per share growth was greater than our high-single digit target. Results across the P&L were strong and we delivered sales and operating profit growth across most of our global businesses. This shows the strength of our operating principles and the benefit of our commitment to invest in future growth through brand building and innovation. We are entering the second quarter with greater confidence that we will meet our long-term targets in 2007. Given this great start to the year and our continued business momentum, we’re raising our guidance to mid-single digit revenue growth and we are also raising earnings guidance again to a range between $2.70 and $2.74 per share.
Slide 4 highlights our financial performance this quarter. Reported net sales increased by 9% building on 6% growth in the first quarter of last year. Internal sales growth, which excludes the effect of foreign exchange, was 7% and builds on 7% internal growth last year. Reported operating profit increased by 6% and internal growth was 3%. As you will remember, we had budgeted for internal operating profit to be down in the first quarter, so we are pleased with this better than expected performance. Earnings per share increased by 18% due to the strong sales and operating profit growth, lower interest expense and a lower tax rate. This was timing related, which John will discuss later. Note too that EPS included upfront costs of 1 penny inline with last year’s first quarter. And finally, cash flow in the first quarter was 289 million, an increase of 188 million from the first quarter of last year.
Let’s look at each of these results in more detail, and slide 5 shows our net sales growth. Internal net sales growth in the first quarter was 7%, and as with previous quarters, this was driven by a relatively balanced contribution from price mix and tonnage growth. Clearly, the sales momentum we carried through 2006 continued into the first quarter, which is why we’ve raised our guidance for full year internal net sales to mid-single digit growth. Tonnage and price mix were both driven by strong innovation and excellent brand building programs. In fact, I’m sure you’ve all seen the strong pricing benefit that is showing through in the recent US measured channel category data. And finally, as you can see, the effect of foreign currency translation had an impact of less than 2% on the first quarter’s reported results. We remain committed to our realistic targets and believe they provide us the basis for our strong performance. We want to provide you, our shareowners, with consistent, dependable rates of growth, and we know that constant reinvestment and strong execution are essential to our continued success.
Now let’s turn to Slide 6, which provides detail regarding our increased investment in advertising. The slide shows the significant increase we made in this investment during the first quarter of 2007 and for the full-year 2006, and the double-digit growth posted in the first quarter built on mid-single digit growth in the first quarter of last year. Remember that we said previously that we expected brand building support to be strong in the first quarter, as we continue to invest in the growth of our current brands and support our new introductions. We had a significant amount of new product activity in the first quarter and as you can see, we certainly invested as we had planned behind these initiatives. We remain committed to both advertising and consumer promotion as the means of building our brands and driving profitable sales growth. We will continue to leverage our scale across our different regions and businesses throughout 2007, with programs such as Shrek 3, Pirates of the Caribbean III, and Xbox.
And now, I’d like to turn it over to John for an overview of our financial performance.
John A. Bryant, Executive Vice President and Chief Financial Officer, Kellogg Company, President – Kellogg International
Thanks David and good morning everyone. Slide 7 shows our first quarter gross margin performance. Gross margin was lower in the first quarter, in line with our budget and the guidance we gave you. The decrease resulted from the impact of incremental commodity cost inflation which accounted for the majority of the decline. As you know, we have seen a lot of volatility from commodity, fuel, benefits and energy costs over the last few years, and as we told you last quarter 2007 is forecast to be no exception. In fact we continue to expect that these incremental costs be between 0.18 and $0.22 of EPS in 2007, which could lead to a gross margin decline of approximately 50 basis points for the full year.
The year-on-year increase is somewhat front-loaded as we lap higher costs in the back half of 2006. In Q1 we incurred approximately $0.06 of additional commodity, fuel, benefits and energy inflation versus the first quarter of 2006. We also had some discrete items in cost of goods which negatively impacted gross margin by 40 basis points. This included items such as $5 million lease termination charge. As I mentioned at CAGNY, however, we banked almost no margin and we generated almost $70 million of incremental gross profit in the first quarter. This in turn helped fund our increase investment in the business.
If you look at slide 8 you will see a slide we showed you at CAGNY. This shows the effect of the introduction of higher priced products can sometimes have. For example, in our international business, our snacks have a sales price per kilo that is 152% of international average. Gross dollars that are 141% of the average, but gross margin is 92% of the average. So margin is down while the absolute gross dollars generated up dramatically. Obviously, gross margin is important to us, but as I said dollars are what we invest in future growth.
Now let’s turn to slide 9, the discussion of operating profit. The slide shows a growth in internal operating profit in each of our geographic reporting areas. In North America, first quarter internal operating profit growth increased by 3% despite a significant increase in investment in advertising. In Europe 6% internal net sales growth drove 18% profit growth. We do not have the same kind of commodity issues in Europe. We have the benefit of significant cost saving programs and you can see the leverage in our P&L when we do not face unusual inflation pressure. In Latin America, quarterly internal operating profit declined by 15% resulting from cost inflation and the timing of expenses including investment in brand building. Obviously, we will continue to invest heavily in this excellent business throughout the year and we expect that inflation will remain high. Consequently, we expect approximately flat operating profit from our Latin American business for the full year. And finally in Asia Pacific, internal operating profit increased by 4% inline with our long-term targets.
For the quarter, consolidated internal operating profit growth was 3% which as David said earlier was greater than our expectations. This resulted from relatively broad-based sales growth across our businesses and was achieved despite strong investment and continued cost pressures. Relative to operating profit line, interest expense increased for the quarter by $3 million and the tax rate was lower at 24%. While the timing was uncertain, you’ll remember that we said previously our expectations for the full year tax rate would include the effect of certain discrete items and as you can see these flow through in the first quarter. This effect was simply one of timing.
Now let’s turn to slide 10 and a more detailed discussion of cash flow. You can see that we posted strong cash flow $289 million in the first quarter of 2007, which was largely driven by better working capital management. Both inventories and payables made significant contributions to cash flow in the quarter and obviously we will remain very focused on this important metric in the future. We continue to expect that full year cash flow will be between $950 million and $1.025 billion.
Now finally I’d like to discuss guidance for remainder of the year on slide 11. You can see that we now expect mid-single digit internal revenue growth, an increase from the guidance we gave you last quarter at CAGNY. We still expect that operating profit will increase at a mid-single digit range, but we now expect that earnings will be in a range between $2.70 to $2.74 per share. Remember too that our previous guidance was an increase of $0.01 from our initial guidance. New guidance includes our estimate for total incremental fuel, energy, benefits, and commodity costs of between 18 and $0.22 per share unchanged from last quarter. This inflation remains a considerable headwind, so we are very pleased to be able to absorb these costs and still increase our earnings guidance. And we continue to expect that upfront costs for the full year will total $0.14 of EPS, approximately equal to last year’s level of investment. Obviously we expect some leverage below the operating profit line in 2007. For the year we expect approximately flat net interest expense and we expect that the tax rate could be between 30 and 31%, slightly lower than our recent guidance.
I am sure that many of you are wondering why given our stronger than expected first quarter performance we have not raised our EPS guidance even more for the full year. While we significantly increased investment in advertising in the first quarter, there was a benefit to operating income from the timing of programs and an addition we will continue to invest in the business given our increase flexibility. So you can see we have momentum and our goals haven’t changed, so we should post another year of dependable results in 2007 while following our operating principles and investing in long-term sustainable growth.
Now I’ll turn it back over to David for a review of our business.
A.D. David Mackay, President and Chief Executive Officer
Thanks, John. Some of the themes you’ll be seeing throughout the remainder of the presentation are outlined on slide 12. We continue to invest aggressively behind innovation. We have a balance between line extensions such as Special K Chocolate, usage occasions such as Right Bites cookies, and new platforms such as Special K beverages. We’ll also continue to reinvest behind our brands to drive long-term sustainable growth. We leverage our global scale to quickly share ideas around the world and it is our strong execution that allows us to fully leverage our innovation programs, brand-building initiatives, and price mix gains to help us deliver dependable sales growth.
Now let’s turn to slide 13 which shows internal growth posted by our North American businesses in the first quarter, and we’re pleased with the performance, as sales growth continued to be strong across these businesses. Let’s look at each of them in a bit more detail; and if you look at slide 14, it shows the sales growth we have posted in North American cereals in the recent quarter. And as you can see, the first quarter strong 4% growth builds on 6% growth posted in the first quarter of 2006, the year’s most difficult comp. Our base sales increased by 4% in measured channels in the quarter and price per pound increased by 5%. And both were driven by successful innovation and strong brand building programs. Special K Chocolate, Rice Krispies with Strawberries and Kashi GOLEAN Honey Almond Flax, all of which were introduced within the last year, are doing very well and all contributed to our strong results. We are constantly looking for creative ways to bring innovative foods to consumers, and as you would imagine, we’ve got more introductions planned, including our cereal straws product and Mini-Wheats Cinnamon Streusel. Kashi posted strong sales and share growth in the quarter, as GOLEAN and Organic Promise did well, and we are launching two versions of Kashi Granola, which are great tasting additions to the Kashi franchise. Our Canadian business posted mid-single digit sales growth as a result of All-Bran Guardian and Buds, Mini-Wheats Strawberry and Special K Chocolate, all performing well.
Slide 15 shows our snacks business and the stronger 11% growth posted in the first quarter. This continues the strong momentum that these businesses built up in 2006 and builds on a 12% comp. Let’s look at more detail on slide 16. Our Pop-Tarts Toaster Pastries business posted essentially flat sales on a difficult comp from the introduction of Go Tarts last year. Despite this, category share in measured channels was 87 – 86% in the quarter, and we continue to expect another solid year from this great brand. Our cracker business posted high-single digit sales growth and strong consumption growth in measured channels. Cheez-It, Club, and Town House all had a good quarter and Portable Snacks continued to do well. And we’ve got great new innovation about to launch with Club Puffed Crackers.
We also saw high single digit sales growth in the store-door cookies business and posted increased consumption gains and share gain. Our portable products such as Rite Bites and Gripz had a great quarter. We’re about to introduce a new variety of Sandies in the second half after a strong lineup of innovation in the first half. Our wholesome snack business also had an excellent quarter posting double-digit sales growth behind innovation and continued growth in Special K bars, Rice Krispies Treats, Nutri-Grain and Sweet & Salty Bars. And our fruit snacks business continued to post excellent sales growth, consumption growth and share gains. Yogos is doing well and we’ve got more products planned for introduction in the months to come. And finally, in Canada, we also saw a high-single digit sales growth as a result of innovation including All-Bran Snack Bites, Nutri-Grain Sweet & Salty bars, Munch’ems and Froot Loops Yogos.
If you’ll turn to slide 17, you will see that our Frozen and Specialty Channels businesses posted 5% growth on 5% growth last year. Our two frozen brands, Eggo and Morningstar both contributed and both gained share in the quarter. The Eggo business saw continued growth from innovation, pancakes continued to do well, and we’ve got new blueberry Eggo pancakes launching in a couple of months. Morningstar posted high-single digit sales growth, also as a result of good innovation. Products such as Veggie Bites posted significant growth. Our Kashi frozen entrees have six of the top ten natural and organic entrees ranked by sales. Kashi entrees have also grown the category and are doing very well to-date, and as you may know, we are introducing three versions of Kashi frozen pizza in the second half. Finally, our specialty channels businesses had another good quarter. Our execution on these channels has been excellent and we expect another strong year from this very important business.