2005 2nd Quarter Earnings Release

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2005 2nd Quarter Earnings Release Powered By Docstoc
					2005 4th Quarter Earnings Release
January 31, 2006

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 Fourth 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. Thanks for joining us for a review of our 2005 fourth quarter and full year results, and for some discussion regarding 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. We must point out that certain statements made today, such as projections for Kellogg Company’s future performance, including earnings per share, net sales, 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.

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A replay of today’s conference call will be available by ‘phone through Friday evening, by dialing 888-203-1112 in the U.S. and 719-4570820 from international locations; the passcode for both numbers is #3185746. 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. 2006 marks the 100th anniversary of the Kellogg Company. We have every confidence that it will be another excellent year of sustainable and dependable performance, but more on that later. My message at the start of last year was all about staying on track. Staying on track    with our overarching focus on sustainable performance defined by our long-term targets. with our grow cereal, expand snacks, and pursue selected growth opportunities focused strategy. with our Volume to Value and Manage for Cash operating principles. Staying on track     to increase effective brand building at a rate greater than sales growth. executing cost-saving initiatives. driving visibility beyond 2005 for innovation, brandbuilding, pricing actions, and cost-saving initiatives. And leveraging the continuity of our strong operating management and the momentum of the last three years. Staying on track is exactly what Kellogg Company did. 2005 was our strongest performance since we implemented our focused strategy. Strong results were delivered across business units and geographies and we invested to set up a winning 2006.

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The same operating team that implemented the focused strategy remained in place and delivered, again: David as president and COO, John Bryant running Kellogg International, Jeff Montie running Kellogg North America, and Alan Harris in Global Marketing. In the U.S., our leading ready-to-eat cereal market share in measured channels increased for the sixth year in a row. Our 52-week share gap versus the nearest competitor more than doubled in 2005… more than doubled, from 1.6 to 3.6 share points and this gap broadened as we closed the year. The quality of this share performance dramatizes our commitment to sustainable growth and doing the right things for the longterm. Our 2005 ready-to-eat cereal base business grew as a result of effective brand building and a very strong share of innovation, well above our total category share. Outside the U.S., we grew or held share in 9 out of 10 of our top businesses including the U.K., Canada, and Mexico. These nine countries account for more than 80% of our net sales and operating profit. These are regions in which we have an average 50% share. Our internal net sales growth of 6.4% is the fourth year in a row of strong increases. This increase is the fastest growth we’ve seen since the adoption of our focused strategy. Price, mix, and volume all contributed to this increase. Gross margin performance was strong in 2005. Significant headwinds were offset which totalled more than 70 basis points of margin for the year. And don’t forget, in COGS, we also had an additional 45 basis points of incremental up-front cost initiatives. Our internal operating profit growth was 5%, right in line with our long-term guidance and we’re pleased with the quality of this growth as it would have been much higher had we not absorbed significant inflationary costs and significantly increased our investment in Volume to Value through brand building and innovation for the long-term.

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Our tax initiatives worked and generated millions of dollars in savings in 2005 alone. This is a result of our continued investment in cost-saving initiatives that help drive sustainable growth. And earnings per share increased at a double-digit rate for the fourth consecutive year. We remained focused on Manage for Cash, lowered our industry-leading level of working capital, and again generated strong cash flow. We then used this cash wisely: we completed a significant share repurchase that benefited our share holders and drove additional value; and this all led to our fourth consecutive year of improvement in ROIC; and we increased the dividend for the first time in four years. Once again, our approach to planning using realistic goals set up this continued strong delivery while driving the right behaviours for sustainable growth into the future. Now, let’s look at our results in more detail. Slide 4 gives you a summary of our key financial results. Reported Net sales increased by 6%, due to continued very strong internal growth of 6%; a slight favorable impact from foreign exchange was more than offset by the fact that we had a 53rd week last year. Internal net sales growth in the fourth quarter was also a strong 6 percent. Internal operating profit growth was 5% in 2005; reported operating profit increased by 4 percent. We’re pleased with this given the significantly higher investment we made for sustainability and the dramatically higher fuel, energy, and benefit costs which affected the entire industry. This is the power of Volume to Value and Manage for Cash in action. Earnings per share for the full year increased by 10%, driven by the strong sales growth and helped by lower interest expense which resulted from our focus on Manage for Cash. We also had a lower tax rate due to tax planning initiatives and fewer shares outstanding as a result of our more aggressive share repurchase program. EPS for the fourth quarter

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was $0.47, or 4.4% growth, despite the effect of last year’s 53rd week. We delivered this performance and still made a contribution to our corporate citizenship fund of 2¢ per share. Full-year cash flow reached $769 million including strong contributions to benefit plans of approximately $400 million, or $200 million more than in 2004. Slide five is our Volume to Value wheel. We achieved strong performance across this sustainable-growth model, maintained gross profit margin despite significant inflationary headwinds, and funded incremental up-front cost initiatives, invested in double-digit increases in brand building, improved price/mix, delivered excellent innovation sales performance and a very strong top line. Let’s look at each of the metrics in more detail. Slide 6 shows our net sales growth. For the full year, internal net sales growth was 6.4 percent. Price/mix, and tonnage growth again contributed to our internal sales growth result. Those of you familiar with Volume to Value recognize that it is all about generating profitable and sustainable revenue growth. We are not driving tonnage growth through price cuts, and you can see this in the price/mix improvement in these results and public category data. Rather, tonnage growth is being driven by consumer pull as a result of effective brand-building programs and successful innovation. Tonnage growth in our more profitable brands, along with price/mix improvement is good. Our revenue growth momentum continued right through the fourth quarter. Foreign currency translation and 2004’s 53rd week impacted both fourth quarter and full-year results. Let’s turn now to slide 7. Our long-term target is to increase investment in brand building at a rate faster than sales growth each year. We achieved this in recent years and again posted double-digit growth in 2005. Investment in brand building is a principal driver of the profitable and sustainable revenue growth that is the goal of Volume to Value.

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Heavy trade discounting provides temporary, rented share gains, but it doesn’t build brands. In 2005, we delivered operating profit growth in line with our long-term target of mid single-digit growth… and make no mistake, we made significant investment in brand building and innovation during the fourth quarter and full year. We will not under-invest in the business and we certainly didn’t do this in 2005. In 2006, we will continue to target dependable rates of sales growth and will invest to achieve them over the long-term. Now, Jeff will walk you through more of our financial results. Thanks, Jim. Let’s turn to slide 8. We maintained our gross profit margin for the full year of 2005 at 44.9 percent. The performance in 2005 was primarily the result of uncontrollable, weather-related increases in fuel and energy costs of $60 million and a $12 million charge for the conclusion of a collective bargaining agreement in the fourth quarter; these factors reduced full-year gross margin by 70 basis points alone. In addition, incremental up-front costs for cost-saving initiatives reduced gross margin by another 45 basis points in 2005 vs. 2004. Gross margin for the quarter declined by 130 basis points due to the headwinds having a proportionately greater effect in the fourth quarter. The Company expects its gross profit margin to expand in 2006 as the result of price increases taken in 2005 and cost saving from prior investments. So, our gross margin performance was strong given the serious headwinds: fuel and energy costs increased in 2005, on top of commodity cost inflation of approximately 15¢ in both 2003 and 2004. Cost-saving projects have helped us overcome these headwinds, and we plan to overcome them again in 2006. This is exactly what sustainability is all about. Slide 9 shows our internal operating profit growth for the full year and fourth quarter by region; this internal growth excludes the benefit of currency translation and 2004’s 53rd week.

J. Boromisa:

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Internal operating profit growth was 5.2% for the full year, right in line with our long-term target. Internal operating profit increased by 3.5% in the fourth quarter even with increased investment in brand building and cost pressures on gross profit that I just mentioned. In North America, internal operating profit increased by 2.4% for the full year, but decreased by 11.1% in the fourth quarter. North American results included all $90 million of this year’s up-front costs and significant increases in brand building. Both of these items had a significant effect on fourth quarter results as well. Remember though, that these are investments for the future. Internal operating profit in Europe increased by 14.9% for the full year and by 284% in the fourth quarter. We also made significant investment in brand building as full-year investment increased at a strong double-digit rate. Remember, too, that most of the up-front costs in the fourth quarter of 2004 were in Europe, which resulted in this year’s large profit gain. In Latin America, internal operating profit growth was 6.6% for the full year and 18.5% in the fourth quarter. We achieved this excellent full-year result despite an increase in investment in brand building of more than 25 percent. And internal operating profit in Asia Pacific increased by 7.4% for the full year and declined by 11.7% in the fourth quarter. We achieved this excellent full-year result even with our increased investment in brand building. The fourth quarter result was affected by comparisons to the fourth quarter of 2004 when operating profit more than doubled. Our full-year tax rate was 31.2% which was broadly in-line with our expectations. Slide 10 shows the improvement in working capital we’ve made in recent years. This is core working capital measured as receivables plus inventories, less trade payables, divided by our last 12-month sales. As

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we’ve mentioned before, this does not include customer trade liabilities, which would artificially improve this measure. We believe that there is room to improve further as was demonstrated again in the fourth quarter of 2005. We will continue to spread best-practices around the world, even from our industry-leading position. We remain focused on the generation of cash flow as you can see on slide eleven. As you know, cash flow of $769 million in 2005 was in line with our expectations and included total contributions to benefit plans of approximately $400 million and included a $300 million contribution in the fourth quarter alone; these contributions totaled approximately $200 million greater than 2004’s total. Capex was 3.7% of sales in 2005 and, as we previously announced, it should be about 4% in 2006, right in line with the peer-group average. This capacity was made necessary by the success of Volume to Value, our sustainable growth model. Our value-added innovation and brandbuilding programs have been so successful that we need to add the capacity to meet sales demand. Just to put this into perspective, since 2002, our sales have grown by $1.9 billion, essentially the size of our European business. Mini-Wheats alone posted measured channel sales growth of approximately 18% last year and, as you know, our Eggo business posted double-digit sales growth in each of the last two years. We remain as careful and disciplined about capex as ever, while serving our customers and driving incremental mix and return. Looking now at slide 12 and our debt level. Our debt remains at about the same level as last year. Debt increased in the latest quarter primarily as a result of a share repurchase of approximately $400 million and benefit plan contributions completed in the fourth quarter. We remain committed to the continued long-term repayment of net debt, or reducing total debt less cash, and the financial flexibility it brings.

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As we mentioned, we repurchased $400 million worth of shares in the fourth quarter from the W.K. Kellogg Foundation Trust and repurchased $664 million over the course of the year. We have a $650 million authorization for 2006 and expect to complete the full amount by year-end. Return on invested capital improved significantly in 2005, after three years of strong growth, as shown in slide thirteen. Our 70 basis point improvement is the result of our focus on Volume to Value and Manage for Cash. You can see, based on the slide, the effect this focus has had in recent years. Slide 14 details our outlook for 2006. We continue to expect low single-digit internal revenue growth, mid single-digit operating profit growth, and earnings per share of $2.43 to $2.48 per share, which includes the impact of expensing employee stock options. We now expect that the impact of the options will total 9¢ per share, in line with 2005, rather than the 8¢ we told you last quarter, largely due to share repurchase activity late in 2005. The earnings guidance range of $2.52-2.57, without the effect of the options, is an increase from previous guidance of $0.02 per share. Included in our guidance is the expectation that benefit costs will increase by $0.03 to $0.07 for the full year, and that total fuel and energy costs will increase between $0.13 and $0.16 per share. Changes in fuel and energy prices in the fourth quarter confirm that the estimates we gave you last quarter appear reasonable for 2006. However, this still represents a significant amount of cost inflation after two years of $0.15 per share in incremental commodity costs. We have also included in our guidance cost-saving projects that will cost approximately $0.15 this year. These projects have a high return, which we will use in future periods to increase our investment in brand building and R&D. Remember, this investment is part of Volume to Value, our sustainable growth model, and helps us provide sustainable,

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consistent rates of growth for the long-term, as we have demonstrated. As a result, we have also included in our guidance an increase in brandbuilding investment greater than our expected sales growth rate. We expect gross profit margin expansion in 2006 and that some operating margin expansion will provide mid single-digit operating profit growth, right in line with our long-term target. We also continue to expect some leverage below the operating profit line. Interest expense will be lower than in 2005 and the tax rate should be between 31 and 32 percent. So, the lower interest expense, tax rate, and fewer shares outstanding, should lead to high single-digit earnings per share growth for the full year. While we don’t give quarterly guidance, I do want to give you a sense of the shape of the year. As you will remember, the operating profit in the first half of 2005 was very strong. Brand-building investment will certainly be significant in the first half of 2006, effectively balancing out operating profit across the year. We continue to have confidence in our full-year guidance and the dependability of our business model. We again expect to meet our longterm targets in 2006. It is because of the strength of our operating principles, and how we run our business for sustainability, that we can achieve this result in this environment, while continuing to increase our investment in brand building and future sales growth. Now, I’ll turn it over to David for a review of our operations.

D. Mackay:

Thanks, Jeff. Slide 15 shows the North American internal sales growth for the full year and for the fourth quarter. Full-year growth of 8% built on strong growth of 5% in 2004 and fourth quarter growth of 8% also built on 5% growth in 2004. This is comparable growth as it excludes the effect of currency translation and the 53rd week which fell in the fourth quarter of 2004.

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This growth was the result of price, mix, and volume improvement and we’re carrying good momentum into 2006. While each of the components of revenue growth should remain strong this year, we are budgeting for price/mix to contribute about half of our 2006 top-line growth. Let’s look at North American Retail Cereal in more detail on slide 16 which shows the quarterly growth and full-year results for 2005. Our strong momentum continued in the fourth quarter as we posted 8% internal growth. Consequently, full-year growth was also 8 percent. This is an outstanding performance resulting from increased category share and growth in non-measured channels. In the U.S., new products introduced during the year, some of which are pictured on the slide, performed very well and helped drive growth. As we discussed last quarter, we are maintaining the pressure in 2006 with significant new product introductions and brand-building programs. Very strong brand-building programs also added to 2005’s results. We had effective advertising behind many of our brands including the health-oriented messaging behind Smart Start Healthy Heart, Mini-Wheats fiber messaging, and the popular Raisin Bran Crunch programs. Kashi posted another year of double-digit growth. Kashi is a highly credible brand in the important natural and organic channel. And, in addition to strong results in the U.S., our Canadian business also had an excellent 2005 after a difficult start to the year. After no growth in the first quarter as the result of a very competitive and promotional environment, we posted internal sales growth of more than 6% for the year and we also grew category share. Slide 17 shows the increase we’ve seen in U.S. ready-to-eat-cereal category share in recent years. This is comparable year-over-year growth… and we’re very pleased that we increased category share by 40

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basis points again in 2005 after a similar increase in 2004. In fact, this is our sixth consecutive year of category share gains. Our fourth quarter was strong with 12-week share growing 90 basis points primarily as a result of strong growth in our base business. Slide 18 shows continued growth in the North American snacks business, which had another excellent year. In fact, our growth of 7% was above our long-term target and we remain confident that our investment behind core brands like Cheez-It and Special K bars, along with our outstanding innovation plans, will continue to drive growth in this business. And as many of you might know, we increased our prices on cookies and crackers late in the fourth quarter of last year to help offset some of the cost inflation we’ve seen. Let’s turn to Slide 19 which details the North American Retail Snacks results by category. For the year, toaster pastries, crackers, and wholesome snacks all posted internal net sales growth. Pop-Tarts had another very good year posting category share growth of 1.8 points. Pop-Tarts is a powerful brand and we continued successful innovation in 2005 and we have more exciting products planned for introduction in 2006. Our Cracker business also had another very good year with high single-digit sales growth. Club Sticks has been a very successful introduction which also helped the base brand post high-single digit sales growth and Cheez-It, our largest brand posted exceptional growth; even the Cheez-It base business was up at a double-digit rate. We also have a lot of innovation being introduced right now in crackers, including CheezIt Crisps and Club Multi-Grain. Cookie internal net sales increased significantly in the fourth quarter as a result of strong innovation. As expected, total net internal cookie sales were down slightly for the year. We proved that it is innovation that drives this category and our core brands posted solid

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single-digit net sales growth. New products in 2006 include new Fudge Shoppe Filled varieties and new Murray Sugar Free cookies. Finally, our Wholesome snacks business had another exceptional year, with double-digit growth. Base Nutri-Grain, and Rice Krispies Treats performed well as did Special K bars and All-Bran bars. Fruit snacks continued to do well as a result of innovation and we now have close to 25% category share after only two years. Wholesome snacks will continue to be a focus for us and we have some great new products hitting the shelves right now including Special K Snack Bites and granola Munch ‘Ems. Our snacks business posted excellent results over the last three years and we have confidence that we can continue to grow in 2006. Slide 20 shows the results posted by our North America Frozen & Specialty Channels product group over the course of the year. Internal sales increased by an exceptional 8% for the full year, and by 8% in the fourth quarter. This above-target growth continued all year long and resulted from strong performance across the businesses. Eggo had an excellent year posting double-digit internal sales growth, building on double-digit growth in 2004 and share of the waffle category increased by 2.1 points. New pancakes are doing extremely well as are French Toast Sticks and Flip-Flop Waffles. Morningstar posted good mid single-digit internal sales growth for both the quarter and the full year and our Specialty Channels businesses had an excellent year. Foodservice, vending, convenience, and drug all posted strong growth and we saw very good share performance as well. This strong performance continued into the fourth quarter, as did our excellent execution, which is of primary importance in these channels. We have excellent visibility into new product introductions and brand-building programs for 2006 and we are confident that our Frozen and Specialty Channels businesses will continue to post very good results. Slide 21 shows reported and internal sales growth for Kellogg International during 2005. Internal and reported sales growth was 4% for

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the year. In fact internal growth was solid all year despite competitive conditions in certain regions. For the fourth quarter, internal growth was 3% and reported growth was -4% due to the stronger U.S. dollar and the impact of last year’s 53rd week. Importantly, Europe, Latin America, and Asia Pacific all posted internal growth for the year… and much of the growth came from our core brands and innovation within those core brands. Special K, Coco-Pops, and All-Bran were all significant contributors. Now let’s look at each area in more detail. Slide 22 shows the full year and fourth quarter internal net sales growth of each of our three international areas. In Europe, both cereal and snacks posted growth for the full year and the fourth quarter. We’re very pleased with this industry-leading performance given the difficult environment experienced in Europe this year. Across Europe, Special K again posted solid sales growth in the fourth quarter and both Coco Pops and Nutri-Grain saw double-digit growth. In the U.K., where we’d seen some weakness earlier in the year, we also posted good growth in both cereal and snacks and we increased our share of the ready-to-eat cereal category in the 12-week and 52-week periods. As you’ll remember, our innovation was timed to be introduced in the third quarter of the year and we’ve started to see the benefits. We also increased share in Spain and France/Benelux for the year. Latin America posted internal growth of 14% in the fourth quarter and 11% for the full year and we grew share in both Mexico and the Caribbean. In Mexico, Corn Pops, Froot Loops, Zucaritas, and Special K cereal all posted high single or low double-digit sales growth as a result of strong brand building. Innovation launched in the fourth quarter included the new Go! brand, a coffee-flavored cereal, two new varieties of AllBran, Raisin Bran Crunch, Nutri Día Amaranth bars and Nutri Día Flaxseed bars. Other markets in our Latin American region, Columbia, Venezuela, Brazil, Argentina, the Caribbean, and Central America all posted double-digit internal sales growth in the fourth quarter.

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Asia posted good growth in the fourth quarter and full year as a result of strong innovation which launched later in the year. In the fourth quarter, our South Korean business posted double-digit sales growth after last year’s weakness and Japan posted strong mid single-digit growth as a result of strength in our adult brands including 2005’s launch of Special K and we also increased our category share in Japan in 2005. India grew at a double-digit rate again in the fourth quarter driven by category growth and innovation and we have more planned for 2006. In Australia, we posted a slight decline in internal sales growth for the full year, comparing to strong mid-single-digit growth in 2004. We posted a decline in internal sales in the fourth quarter due to very difficult double-digit comparisons, as well as the timing of innovation, and adverse competitive activity. Importantly, cereal share rebounded at the end of the quarter as All-Bran, Be Natural, Guardian, Just Right, and Sultana Bran all posted share gains. Reflecting on 2005 across the globe, we are very pleased with our top-line growth and share gains. Our innovation and brand building were strong and we invested across the business globally to build sustainable results and keep our momentum. In 2006, we will continue our focus on driving for sustainable growth in an environment of tough energy and commodity inflation. Pricing actions in late 2005 in a number of markets, plus our continued drive to reduce cost and improve efficiency in our business, gives us great confidence that we can sustain our recent performance into 2006 and beyond. And with that I’ll hand it over to Jim for a summary.

J. Jenness:

We stayed on track in 2005. We delivered the strongest year of performance since we embarked on our focused strategy, and we invested to drive sustainable rates of growth. We have visibility for our innovation and brand-building plans as well as additional, high-value, cost-saving initiatives.

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Our confidence in delivering another strong year in 2006 is high and reflected in the fact that we raised our EPS guidance early in the year. We have momentum coming out of 2005 with a seasoned management team and a proven strategy. Our EPS growth will be driven by our profitable sales and balanced use of cash. As we enter our 100th year, I’d like to take the opportunity to thank our 25,000 employees for their hard work and commitment to our Company. And with that, I’ll open it up for questions.
Operator: Thank you. Once again, if you would like to ask a question please do so by pressing the * key followed by the digit 1 on your touch tone telephone. Also, if you are using a speaker phone please make sure your mute function is off to allow your signal to reach our equipment. Once again please press *1 to ask a question. Additionally, please limit yourself to one question. Our first question comes from David Palmer with UBS Securities.

D. Palmer:

Heading into 2005, you forecasted low single-digit internal sales growth and obviously you handily beat that with a plus 6% number. The concern is, against these tough comparisons, the same guidance looks a little bit tougher to beat. Obviously the US led things this year. Could you perhaps give us some general view as to where upside may be – whether it’s within the US, whether its outside the US, whether it’s certain categories within the domestic business that you see taking the lead. Perhaps you can give us some granularity there.

J. Jenness:

First of all, the performance of the company this year has really been across our geographies and the business units. And the momentum we see there, in terms of where incremental growth is going to come from next year, it’s going to come from a similar profile. That’s what we’re expecting. The plans and the budgets and the ideas that we’ve seen certainly give us the confidence for that. Our talk about sustainability is that it drives our actions. And as we saw the strong topline coming in, we

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clearly invested against the business to set up continuation of that performance into 2006. So, we expect the incremental growth in 2006 to come from across our business units. The plan that we have in place and the visibility around our innovation gives us confidence in that. So we’re feeling real good about 2006.

D. Palmer:

In your overall cost guidance you had energy 13 to16 [cents] and then your overall commodity costs have been at least, for 2 years now, around 15 cents incremental each year. Is that right? Yes, that’s correct. The last 2 years we’ve had commodity unfavorability of about 15 cents each year. Next year, we’re seeing 13 to 16 cents in the energy / fuel area. In addition to that we are also seeing between 3 to 7 cents related to benefit costs. But that’s all in our guidance and we’re still looking forward to 2006. I think the big story here is that even with those headwinds we’re able to increase our gross profit margin for 2006.

J. Boromisa:

D. Palmer:

And then the volatility within the segment operating margins we saw in the 4th quarter – I realize some of the charges for the 4th quarter of 2004 were reversed for Europe— but it did seem like the North American margin swing was bigger than the $12MM settlement was. Could you give some color as to that 400+ basis points change in the US?

J. Boromisa:

When you look at the operating profit performance in North America, particularly in the 4th quarter, we had that collective bargaining agreement charge of $12MM – that was totally in North America. And also, the upfront costs of this year were all in North America. And for the quarter, that was around 3 cents of EPS. So those two factors are what caused the operating profit delivery, but it’s right in line with what we were expecting to do with the up-front costs.

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Operator:

Our next question comes from David Nelson with Credit Suisse First Boston.

D. Nelson:

Congratulations. Hard to find any problems here, so maybe I’ll ask about cookies. Obviously you had better performance in cookies in the 4th quarter and you’ve got news for 2006, but over the last four years your share in cookies has gone down. Is there something in the Volume to Value program that it doesn’t work as well in the cookie category as it does in cereal and crackers? You’ve heard us focusing very much on crackers and wholesome snacks. We have not in any way given up on cookies. And our performance has been relatively flat, down a little bit over the last couple of years. We are looking at innovation as being a key driver. As we said earlier, our core brands all grew in 2005 and our 4th quarter performance was very pleasing, even though you didn’t see it in the IRI data. And that was a combination of things, including the fact that in non-measured channels we did very well. And across cookies, crackers and wholesome snacks we had lower price-based spend in the 4th quarter and we also did a great job in DSD in lowering our unsaleables, which is a big factor in a DSD system. The team did an outstanding job of pulling unsaleables down in the 4th quarter. Going forward on cookies, I think if we continue to innovate we’re in a reasonable position. We’re going to continue to bat away and I think the strength of our execution in-store is going to help us. We feel pretty good about our position.

D. Mackay:

Operator:

Thank you. Our next question comes from Ken Zaslow with Harris Nesbittt.

K. Zaslow:

In terms of the competitive environment in US cereal, do you think that your products continue to differentiate relative to the competition? If you think back a couple years ago when you came out with the berries, that

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was something that was really something very different from everybody had in the market. Now, more and more companies are coming out with the yogurt chips or other products that are a little more similar. Can you just speak to that as a product differentiation issue?

J. Jenness:

The strength of our business in the States and the brands, as you can see from the share improvement and the programs around innovation, is outstanding and the differentiation is what we are all about. The investment in brand building at a rate greater than our net sales is what’s behind it all as is the quality of the innovation. And you think of brands like Smart Start Healthy Heart – the position around that; All-Bran digestive health positioning; Special K positioning around weight maintenance. These brands sit on top of extremely relevant consumer needs that are in fact becoming even more interesting to consumers now. And we have the power to continue to drive those – with our communications and food improvements. You look at our results and the strengths of our brands, you see a lot of our strength coming around our base businesses that we’ve really grown over time. This, I think, is an opportunity for us going forward not only across our base brands, but you see how we performed on innovation. And our share of innovation over the last 3 years and the investment we’ve made in this area to continue it is an area of strength for the company and an area of opportunity.

Operator:

Thank you. We will take our next question from Jon Feeney with Wachovia Securities.

J. Feeney:

Congratulations. In Cereal, when you look at the 8 percent on net sales growth, could you approximately break that down between pricing and volume? And then just comment on, when you look at price gaps and market share gains and the health of some of your competitors in the category, how sustainable are these continued share gains, in your view? Is it getting harder to take share away from branded and perhaps private 19

label competitors given what appears to be consistent dollar share gains over the last two years that are coming out of somebody’s hide?

D. Mackay:

There are a couple of questions in there. First, just to respond to the difference between reported internal and IRI data that you’re probably looking at, fairly consistent with what we’ve been saying on an ongoing basis. Just so you know, our inventories are broadly in line with year-ago and down from the third quarter, so it wasn’t inventory driven. We had about 3 or 4 percent incremental growth versus IRI coming out of alternate channels which has been relatively consistent for the last year or so. And we had greater than 2% benefit from lower Q4 price activity versus yearago from a Kellogg perspective. I think the great thing, if we look at our business in the fourth quarter, Kellogg grew total sales and we grew base sales. We were the only branded player to grow our total sales and our base sales. Coming to your question about can we continue to gain share – I think the bar goes up every year we perform as we’ve been performing. But execution is critical. As Jim mentioned, innovation is going to be critical. We continue to gain quality merch as our sales force does an outstanding job. And I think the strength of our innovation and valueadded promotions continue to drive good support from our retail partners. And the third part of your question, probably poking a little at private label, I think we mentioned that our expectation was that private label growth would slow in the back half. We’re seeing exactly that happen. Private label is up over 7% for the year, just over 3% for the 4th quarter and up 1% for the latest month of the year. They haven’t taken pricing, it doesn’t appear. And we feel good about what we can do going forward. We’re just going to keep driving very, very hard. Regarding breaking out the 8% between price/mix and volume, if you look at IRI it’s just short of 1 %. If you take 3-4% in alternate channels and you take more than 2% for lower trade that’s basically it.

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Operator:

Thank you. Next we will take a question from David Adelman with Morgan Stanley Equity Research.

D. Adelman:

Can you comment on the outlook for the first quarter earnings? Do you expect to have higher earnings in the first quarter, and I ask that because you obviously had two dynamite consecutive Q1s in 2005 and 2004. We don’t normally give quarter-by-quarter guidance, but for the first half of 2006, looking at our delivery of operating profit last year which was very strong in Q1 and Q2, we see certainly a strong investment in brand building happening in 2006. We expect our operating profit delivery to be pretty consistent by quarter. Right now, that’s about all the guidance we’d give on a quarter-by-quarter basis.

J. Boromisa:

D. Adelman:

Okay. And just to be clear, that 2 cent collective bargaining agreement is not included in the 4th quarter in the up-front costs you’ve referenced, is that correct? That’s correct.
Thank you. Our next question comes from Eric Larson with Piper Jaffray.

J. Boromisa:

Operator:

E. Larson:

Congratulations everyone. You’re stock option expensing – is it fair to assume that those expenses will be spread evenly across the quarters, like about 2 cents throughout 2006? Yes, that’s a good assumption to make. And then also on tax rate. You did get quite a bit of benefit in the 4th quarter. I’m assuming that’s from things you put in place over the last couple of years. Is that a sustainable tax rate for 2006 as well?

J. Boromisa:

E. Larson:

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J. Boromisa:

That is. And we’re looking at a 2006 tax rate of around 31 – 32% and we do believe that’s ongoing. We’ve done a lot of work with our tax planning initiatives around the world and we’re seeing some good dividends coming from that. Q4, specifically, was impacted by our country mix around the world and we did have some discrete items that were unexpected tax resolution items.

Operator:

Thank you. Our next question comes from Michael Avery with Citigroup.

M. Avery:

You demonstrate about as well as anybody the value of the consumer spending and the advertising, but at some point, wouldn’t it be fair to think that that could level off a little bit? You’re describing 2006 as increases above the rate of sales. Is that a deceleration from the double-digits? Are you reaching a point where your increases can decelerate because of the base being so big?

J. Jenness:

Our long term guidance is all around having our brand building running ahead of our net sales. We’re not just investing brand building against laying it on top of same programs. We have a whole menu of opportunities to invest against, whether it’s line extensions to our current brands or additional innovation. And as we see our business momentum growing it is absolutely critical for us and our commitment to sustainability to invest against those opportunities. So we want to keep driving our brand building. The teams are outstanding at that in terms of building brand value and getting on top of consumer benefits that are extremely relevant in today’s world. So our commitment to brand building around our long-term guidance is above our net sales. But if we see an opportunity to invest against incrementally as the business develops, against opportunities and visibility we have, we’re going to do it.

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M. Avery:

That helps and I think the benefit is very clear – you really do have a lot of believers in the value of that spend. But would the increases, perhaps, be lessening over time so that you’re basically getting some operating leverage maybe? It sounds like the double-digit increases from the last couple of years might not be quite the increase that we’ll see going forward. Is that fair?

J. Jenness:

I think the best way, Michael, to think about that is our long-term guidance. And that is we’re going to invest ahead of net sales, and that’s in our whole Volume to Value model and how we go about it.

Operator:

Thank you. Our next question comes from Chris Growe with AG Edwards.

C. Growe:

I know Asia had some tough comparisons year-over-year, but there was some weaker internal growth than what I expected in the quarter. Is that expected to ease in 2006 and we should expect to see better growth throughout the year, is the first half going to be a little weaker? Can you talk about that in more detail? If you’re looking at 2006, we’d expect their growth to be relatively balanced. I don’t have right at hand exactly what we did quarter-byquarter, but no major ups or downs expected. There could be some; if there are we’ll report them. We’re expecting low single digit across the year, Chris.

D. Mackay:

C. Growe:

Then a general question on pricing and volume. You seem to show a better balance this quarter and obviously across the year. Are there pricing actions that you’ve taken that, say, internationally we’re not aware of? I know cookie/cracker in the US, but what other pricing activities have you taken that will help 2006?

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D. Mackay:

We’ve taken a number of price increases late in 2005 that we believe will clearly have a positive impact on our price/mix for 2006. While we’ve taken a number, they only help us offset some of the energy and cost inflation we’re seeing. The only one we’ve taken in the US, which we’ve mentioned, has been in cookies and crackers and that was very light in 2005 as well.

C. Growe:

So were there international markets you can mention where you took pricing?

D. Mackay:

The United Kingdom, Mexico and a couple of others late in 2005.

C. Growe:

Generally, as you see the pricing environment here in the US, and I really refer to cereal, private label prices have at least been creeping up. Would you regard the environment for US cereal pricing as positive today given private labels movement of late? We don’t comment on future pricing. I think everyone recognizes the current inflation environment we’re in, given energy and some of the other costs. But I wouldn’t like to comment on that at this stage.

D. Mackay:

Operator:

Our next question comes from Terry Bivens of Bear Stearns.

T. Bivens:

As you look at the P&L, we just finished the second year where the growth of operating income is less than the growth of sales, which is not in your algorithm, of course. Now, I know you project that to reverse next year and clearly there are two big drivers of that – all these commodity and ingredient costs and then the up-front costs. We’ve had roughly 15 cents in up-front costs now for three years and project it to be the same for 2006. How long do we keep seeing that? Isn’t there a point…I mean know various people have tried to take a look at the paybacks on

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those…but is there a point in your mind where those begin to fall off in a significant way?

J. Jenness:

A critical part of our whole sustainability model is the constant exploration and finding of high-value cost saving initiatives that we can invest against that help us in future years. So the answer to your question is this is an ongoing part of how we go about doing business. If there’s any dramatization about the appropriateness of this for the business it’s the results of 2005 given all the headwinds that we faced. And even more impressively, as we look at it, is how we’re setting up 2006. And it’s because of how the company has been run around Volume to Value and Manage for Cash for the last four years and the logic underneath that that we feel we’re in a position to be able to stay on our long-term guidance, deliver our fourth year of topline growth, fourth year of double digit EPS growth and with that, very impressively, seeing the strong share growth in the US continuing and the strong share growth we’ve had in 9 out of our 10 top markets, which accounts for over 80% of our business. That’s the power of all this working. So cost savings initiatives are critical to our model going forward and you’re going to continue to see them. Okay and I didn’t mean to imply anything negative by that. But it’s a tough one for us to forecast and you have to acknowledge it is kind of a big piece. So your view is that it’s more or less a sustainable part of the P&L as we look forward into the foreseeable future, is that correct?

T. Bivens:

J. Jenness:

Yes, and we certainly want to drive visibility around what those actions are. And if you think about it in the context of just the food industry, we would much prefer to be going at this on a continuing smooth basis to find these things versus having it where all of a sudden the rubber band breaks and you’ve gotta go major restructuring. And the reason for that has to do with the behaviors in the company and driving the right kind of behaviors

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for the long term on a continuing basis so you don’t have to disrupt the company through a major shot. And that’s what we’re really trying to work against. And we will take the heat, and I certainly will take the heat, for sustainability and driving it. But that’s the course this company is on and we’re going to stay on it. That’s a good point, and a timely one. Thank you.
Our next question comes from Tim Ramey of DA Davidson.

T. Bivens:

Operator:

T. Ramey:

David, you mentioned innovation a couple of times and there was the press release on low-linolenic soybean oil, a little over a year ago I think there was some news on Omega-3. Can you give us any more detail about how prominently ‘good for you’ products and new health stories will be featured in 2006?

D. Mackay:

I think the whole health and wellness trend is clearly very strong. Lowlinolenic oil is our response to try to remove trans-fats from our products that have them. There are no trans-fats in cereal, as you’re aware, but where we do have them we’re trying to remove them but keep the total oil at or below the current level. You mentioned Omega 3. Clearly there’s work going along on that and at the appropriate time we’ll tell you what we’re doing. You’ll probably hear more about health and wellness, not only from Kellogg, but from many companies. But rather than try over the conference call to preview something that we may do, we’ll leave it to the appropriate time.

S. Burton:

We have time for one more question.
Thank you, we will take our final question from Eric Katzman from Deutsche Bank.

Operator:

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E. Katzman:

The 15 cents of one-time items, Jeff. Are those supposed to spread evenly across the year as well.

J. Boromisa:

For 2006, I would say probably more towards the back half of the year. Currently, we have the big initiative that’s going on with the closure of two plants in the snacks business. That will finish up in Q1 and then you’ll see things pick up in the second half.

E. Katzman:

I’ve been harping on you over time about cash flow having kind of flattened out. We can argue about the contributions to the pension fund and how that’s affected the free cash flow numbers. So after a $400MM payment in 2005, what kind of pension contribution do you think you’ll have to make in 2006? And, correct me if I’m wrong, regardless of that pension contribution payment you’ve got about $1B of net income, $400MM of depreciation/amortization offset by roughly the same amount of capex. Deferred taxes was a use, so maybe that swings to being a source given the pension contribution. So it seems to me that your cash flow, after kind of flat to downish the last two years, off of the 2005 base should swing up quite a bit. Is there anything wrong there and can you kind answer the cash contribution question?

J. Boromisa:

Yes, maybe just a little clarification, Eric. If you look at 2006, our guidance on cash flow is $875 – $975MM. On the benefits side, certainly this year in 2005, we did a tremendous amount – the $400MM. We see minimal benefit contributions next year, probably more in the $50 – $75MM range. Capex, as we talked about, will be about 4% of sales. And when you look at that, our absolute cash flow delivery versus income is very good. Where you’re off a little bit is on your assumption on depreciation versus capex. There’s probably a gap of probably $80 – $100MM, versus where you called them even.

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E. Katzman:

You reported $392MM of D&A in 2005.

J. Boromisa:

Yes, in 2005. And certainly depreciation in 2006 will be lower because our capex spending over the last 3 – 4 years has been fairly low, so our depreciation level’s coming down. And then increasing our capex because of our growth, coming up you’ll see that now more around an $80 – $100MM gap versus where they probably were at par before. Okay. So even including the $80MM of D&A difference and let’s say the other stuff is a wash, you’re spending a little bit more on capex and then, either way, even if you get to like $950MM, off of an equivalent base you’re talking 23% growth in year-over-year free cash flow.

E. Katzman:

J. Boromisa:

Absolutely.
Thank you. That does conclude the question-and-answer session today. Mr. Burton, I would like to turn the conference back over to you for any additional or closing remarks.

Operator:

S. Burton:

We’d like to thank everyone for joining this call and we look forward to seeing you at CAGNY.

Operator:

Thank you. That concludes today’s conference. Thank you for your participation. You may now disconnect.

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