Kellogg Company 10-Q 2011
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
QUARTERLY REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended October 1, 2011
For the transition period from to
Commission file number 1-4171
One Kellogg Square, P.O. Box 3599, Battle Creek, MI 49016-3599
Registrants telephone number: 269-961-2000
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or shorter period that the registrant was required to submit and post such files).
Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨ No x
Common Stock outstanding as of October 29, 2011 359,150,227 shares
Item 1. Financial Statements.
CONSOLIDATED BALANCE SHEET
(millions, except per share data)
Refer to Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENT OF INCOME
(millions, except per share data)
Refer to Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENT OF EQUITY
Refer to Notes to Consolidated Financial Statements.
CONSOLIDATED STATEMENT OF CASH FLOWS
Refer to Notes to Consolidated Financial Statements.
for the quarter ended October 1, 2011 (unaudited)
Note 1 Accounting Policies
Basis of presentation
The unaudited interim financial information of Kellogg Company (the Company) included in this report reflects normal recurring adjustments that management believes are necessary for a fair statement of the results of operations, financial position, equity and cash flows for the periods presented. This interim information should be read in conjunction with the financial statements and accompanying notes contained on pages 27 to 57 of the Companys 2010 Annual Report on Form 10-K.
The condensed balance sheet data at January 1, 2011 was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States. The results of operations for the quarterly period ended October 1, 2011 are not necessarily indicative of the results to be expected for other interim periods or the full year.
Accounting standards to be adopted in future periods
In September 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2011-08, Testing Goodwill for Impairment, allowing entities the option to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Under ASU No. 2011-08, an entity would not be required to calculate the fair value of a reporting unit unless the entity determines, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. ASU No. 2011-08 is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. The Company will consider early adoption of ASU 2011-08 in connection with its annual goodwill impairment evaluation in the fourth quarter of 2011.
In June 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income, requiring most entities to present items of net income and other comprehensive income either in one continuous statement referred to as the statement of comprehensive income or in two separate, but consecutive, statements of net income and other comprehensive income. The update does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. ASU No. 2011-05 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011 and should be applied retrospectively. Early adoption is permitted. The Company will be adopting ASU 2011-05 at the beginning of its 2012 fiscal year.
Note 2 Goodwill and other intangible assets
Changes in the carrying amount of goodwill for the quarter ended October 1, 2011 are presented in the following table.
Carrying amount of goodwill
(a) Includes Australia, Asia and South Africa.
Intangible assets subject to amortization
For intangible assets in the preceding table, amortization was less than $1 million for each of the current and prior year comparable quarters. The currently estimated aggregate annual amortization expense for full-year 2011 and each of the four succeeding fiscal years is approximately $2 million.
Intangible assets not subject to amortization
Note 3 Exit or disposal activities
The Company views its continued spending on cost-reduction activities as part of its ongoing operating principles to provide greater visibility in achieving its long-term profit growth targets. Initiatives undertaken are currently expected to recover cash implementation costs within a five-year period of completion. Upon completion (or as each major stage is completed in the case of multi-year programs), the project begins to deliver cash savings and/or reduced depreciation.
During 2011, the Company incurred exit costs related to ongoing programs which will result in cost of goods sold (COGS) and selling, general and administrative (SGA) expense savings.
Total charges incurred during the quarter and year-to-date periods ended October 1, 2011 and October 2, 2010 were as follows:
Total program costs incurred through October 1, 2011 were as follows:
In 2009, the Company commenced various COGS related cost reduction programs. Refer to page 36 of the Companys 2010 Annual Report on Form 10-K for further information on these initiatives. Costs impacted the following operating segments during the quarter and year-to-date periods ended October 1, 2011 and October 2, 2010.
These costs represent employee severance and other cash costs associated with the elimination of hourly and salaried positions, as well as non-cash asset write offs at various global manufacturing facilities. To date, we have incurred $36 million in total exit costs for this program. The costs have impacted our operating segments, as follows (in millions): North America-$14; Europe-$21; and Asia Pacific-$1. Based on forecasted exchange rates, the Company currently expects to incur an additional $7 million in exit costs for this program during 2011.
In 2009, the Company commenced various SGA programs which resulted in an improvement in the efficiency and effectiveness of various support functions. Refer to page 37 of the Companys 2010 Annual Report on Form 10-K for further information on these initiatives. Costs for these programs impacted the following operating segments during the quarter and year-to-date periods ended October 1, 2011 and October 2, 2010 as follows:
These costs represent severance and other cash costs associated with the elimination of positions. To date, we have incurred $53 million in exit costs for these programs. The costs have impacted our operating segments as follows (in millions): North America-$34; Europe-$15; Asia Pacific-$3; and Latin America-$1. Based on forecasted exchange rates, the Company currently expects to incur an additional $1 million in exit costs for these programs during 2011.
Reserves for the COGS and SGA programs are primarily for employee severance and will be paid out by the end of 2011. The detail is as follows:
Note 4 Equity
Earnings per share
Basic earnings per share is determined by dividing net income attributable to Kellogg Company by the weighted average number of common shares outstanding during the period. Diluted earnings per share is similarly determined, except that the denominator is increased to include the number of additional common shares that would have been outstanding if all dilutive potential common shares had been issued. Dilutive potential common shares consist principally of employee stock options issued by the Company, and to a lesser extent, certain contingently issuable performance shares. Basic earnings per share is reconciled to diluted earnings per share in the following table. The total number of anti-dilutive potential common shares excluded from the reconciliation were 5 million and 4 million for the quarter and year-to-date periods ended October 1, 2011, respectively, and 9 million and 4 million for the quarter and year-to-date periods ended October 2, 2010, respectively.
Quarters ended October 1, 2011 and October 2, 2010:
Year-to-date period ended October 1, 2011 and October 2, 2010:
During the year-to-date period ended October 1, 2011, the Company issued 0.4 million shares to employees and directors under various benefit plans and stock purchase programs. Equity-based compensation is discussed further in Note 6.
On April 23, 2010, the Companys board of directors authorized a $2.5 billion three-year share repurchase program for 2010 through 2012. During the year-to-date period ended October 1, 2011, the Company repurchased 13 million shares of common stock for a total of $688 million. During the year-to-date period ended October 2, 2010, the Company repurchased 18 million shares of common stock for a total of $907 million.
Comprehensive income includes net income and all other changes in equity during a period except those resulting from investments by or distributions to shareholders. Other comprehensive income for all periods presented consists of foreign currency translation adjustments, fair value adjustments associated with cash flow hedges and adjustments for net experience losses and prior service cost related to employee benefit plans.
During the first quarter of 2010, the Company amended its U.S. postretirement healthcare benefit plan, which resulted in a $17 million decrease of a deferred tax asset.
Quarter ended October 1, 2011:
Year-to-date period ended October 1, 2011:
Year-to-date period ended October 2, 2010:
Accumulated other comprehensive income (loss) as of October 1, 2011 and January 1, 2011 consisted of the following:
Note 5 Debt
The following table presents the components of notes payable at October 1, 2011 and January 1, 2011:
In August 2011, the Company terminated interest rate swaps with notional amounts totaling $1.5 billion, which were designated as fair value hedges for (a) $750 million of its 4.25% fixed rate U.S. Dollar Notes due 2013 and (b) $750 million of its 5.125% fixed rate U.S. Dollar Notes due 2012 (collectively, the Notes). The interest rate swaps effectively converted the interest rate on the Notes from fixed to variable and the unrealized gain upon termination of $24 million will be amortized to interest expense over the remaining term of the Notes.
In May 2011, the Company issued $400 million of seven-year 3.25% fixed rate U.S. Dollar Notes, using the proceeds from these Notes for general corporate purposes including repayment of commercial paper. The Notes contain customary covenants that limit the ability of the Company and its restricted subsidiaries (as defined) to incur certain liens or enter into certain sale and lease-back transactions, as well as a change of control provision.
During the first quarter of 2011, the Company repaid its $946 million, ten-year 6.6% U.S. Dollar Notes at maturity with U.S. commercial paper.
In March 2011, the Company entered into an unsecured Four-Year Credit Agreement to replace its existing unsecured Five-Year Credit Agreement, which would have expired in November 2011. The Four-Year Credit Agreement allows the Company to borrow, on a revolving credit basis, up to $2.0 billion, to obtain letters of credit in an aggregate amount up to $75 million, U.S. swingline loans in an aggregate amount up to $200 million and European swingline loans in an aggregate amount up to $400 million and to provide a procedure for lenders to bid on short-term debt of the Company. The agreement contains customary covenants and warranties, including specified restrictions on indebtedness, liens, sale and leaseback transactions, and a specified interest coverage ratio. If an event of default occurs, then, to the extent permitted, the administrative agent may terminate the commitments under the credit facility, accelerate any outstanding loans under the agreement, and demand the deposit of cash collateral equal to the lenders letter of credit exposure plus interest.
Note 6 Stock compensation
The Company uses various equity-based compensation programs to provide long-term performance incentives for its global workforce. Currently, these incentives consist principally of stock options, and to a lesser extent, executive performance shares and restricted stock grants. Additionally, the Company awards restricted stock to its non-employee directors. The interim information below should be read in conjunction with the disclosures included on pages 41 to 44 of the Companys 2010 Annual Report on Form 10-K.
The Company classifies pre-tax stock compensation expense in SGA expense principally within its corporate operations. For the periods presented, compensation expense for all types of equity-based programs and the related income tax benefit recognized were as follows:
As of October 1, 2011, total stock-based compensation cost related to non-vested awards not yet recognized was $53 million and the weighted-average period over which this amount is expected to be recognized was 2 years.
During the year-to-date periods ended October 1, 2011 and October 2, 2010, the Company granted non-qualified stock options to eligible employees as presented in the following activity tables. Terms of these grants and the Companys methods for determining grant-date fair value of the awards were consistent with that described on pages 42 and 43 of the Companys 2010 Annual Report on Form 10-K.
Year-to-date period ended October 1, 2011:
Year-to-date period ended October 2, 2010:
The weighted-average fair value of options granted was $7.59 per share for the year-to-date period ended October 1, 2011 and $7.90 per share for the year-to-date period ended October 2, 2010. The fair value was estimated using the following assumptions:
The total intrinsic value of options exercised was $59 million for the year-to-date period ended October 1, 2011 and $40 million for the year-to-date period ended October 2, 2010.
In the first quarter of 2011, the Company granted performance shares to a limited number of senior executive-level employees, which entitle these employees to receive a specified number of shares of the Companys common stock on the vesting date, provided cumulative three-year operating profit and internal net sales growth targets are achieved.
The 2011 target grant currently corresponds to approximately 225,000 shares, with a grant-date fair value of $48 per share. The actual number of shares issued on the vesting date could range from 0 to 200% of target, depending on actual performance achieved. Based on the market price of the Companys common stock at October 1, 2011, the maximum future value that could be awarded to employees on the vesting date for all outstanding performance share awards was as follows:
The 2008 performance share award, payable in stock, was settled at 69% of target in February 2011 for a total dollar
equivalent of $6 million.
Note 7 Employee benefits
The Company sponsors a number of U.S. and foreign pension, other nonpension postretirement and postemployment plans to provide various benefits for its employees. These plans are described on pages 44 to 49 of the Companys 2010 Annual Report on Form 10-K. Components of Company plan benefit expense for the periods presented are included in the tables below.
Plan funding strategies may be modified in response to managements evaluation of tax deductibility, market conditions, and competing investment alternatives.
Note 8 Income taxes
The consolidated effective tax rate for the quarter ended October 1, 2011, of 27% was lower than the prior years rate of 30%. The consolidated effective tax rate for the year-to-date period ended October 1, 2011 was 28%, compared to the prior year-to-date period ended October 2, 2010 rate of 29%. The effective rate for the third quarter of 2011 benefited from a write off of an investment in a Latin America subsidiary as well as a decrease in the United Kingdoms statutory income tax rate.
As of October 1, 2011, the Company classified $12 million of unrecognized tax positions as a net current liability, representing several income tax positions under examination in various jurisdictions. Managements estimate of reasonably possible changes in unrecognized tax benefits during the next twelve months consists of the current liability balance, expected to be settled within one year, offset by $8 million of projected additions. Management is currently unaware of any issues under review that could result in significant additional payments, accruals or other material deviation in this estimate.
Following is a reconciliation of the Companys total gross unrecognized tax benefits for the year-to-date period ended October 1, 2011; $50 million of this total represents the amount that, if recognized, would affect the Companys effective income tax rate in future periods.
The Company had the following amounts of income tax related interest accrued as of January 1, 2011 and October 1, 2011.
Note 9 Derivative instruments and fair value measurements
The Company is exposed to certain market risks such as changes in interest rates, foreign currency exchange rates, and commodity prices, which exist as a part of its ongoing business operations. Management uses derivative financial and commodity instruments, including futures, options, and swaps, where appropriate, to manage these risks. Instruments used as hedges must be effective at reducing the risk associated with the exposure being hedged and must be designated as a hedge at the inception of the contract.
The Company designates derivatives as cash flow hedges, fair value hedges, net investment hedges, and uses other contracts to reduce volatility in interest rates, foreign currency and commodities. As a matter of policy, the Company does not engage in trading or speculative hedging transactions.
Total notional amounts of the Companys derivative instruments as of October 1, 2011 and January 1, 2011 were as follows:
Following is a description of each category in the fair value hierarchy and the financial assets and liabilities of the Company that were included in each category at October 1, 2011 and January 1, 2011, measured on a recurring basis.
Level 1 Financial assets and liabilities whose values are based on unadjusted quoted prices for identical assets or liabilities in an active market. For the Company, level 1 financial assets and liabilities consist primarily of commodity derivative contracts.
Level 2 Financial assets and liabilities whose values are based on quoted prices in markets that are not active or model inputs that are observable either directly or indirectly for substantially the full term of the asset or liability. For the Company, level 2 financial assets and liabilities consist of interest rate swaps and over-the-counter commodity and currency contracts.
The Companys calculation of the fair value of interest rate swaps is derived from a discounted cash flow analysis based on the terms of the contract and the interest rate curve. Over-the-counter commodity derivatives are valued using an income approach based on the commodity index prices less the contract rate multiplied by the notional amount. Foreign currency contracts are valued using an income approach based on forward rates less the contract rate multiplied by the notional amount. The Companys calculation of the fair value of level 2 financial assets and liabilities takes into consideration the risk of nonperformance, including counterparty credit risk.
Level 3 Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect managements own assumptions about the assumptions a market participant would use in pricing the asset or liability. The Company did not have any level 3 financial assets or liabilities as of October 1, 2011 or January 1, 2011.
The following table presents assets and liabilities that were measured at fair value in the Consolidated Balance Sheet on a recurring basis as of October 1, 2011 and January 1, 2011:
The fair value of non designated hedging instruments as of October 1, 2011 and January 1, 2011 was immaterial.
The effect of derivative instruments on the Consolidated Statement of Income for the quarters ended October 1, 2011 and October 2, 2010 was as follows:
The effect of derivative instruments on the Consolidated Statement of Income for the year-to-date periods ended October 1, 2011 and October 2, 2010 were as follows:
Contracts with certain of the Companys counterparties contain provisions requiring the Company to post collateral if the derivative instruments held with that counterparty are in a net liability position and the Companys credit rating falls below BB+ (S&P), or Ba1 (Moodys). The fair value of all derivative instruments with credit-risk-related contingent features in a net liability position on October 1, 2011 was $27 million. If the credit-risk-related contingent features were triggered as of October 1, 2011, the Company would be required to post collateral of $27 million. In addition, certain derivative instruments contain provisions that would be triggered in the event the Company defaults on its debt agreements. There were no collateral posting requirements as of October 1, 2011 triggered by credit-risk-related contingent features.
The carrying values of the Companys short-term items, including cash, cash equivalents, accounts receivable, accounts payable and notes payable approximate fair value. The fair value of the Companys long-term debt is calculated based on broker quotes and was as follows at October 1, 2011:
Counterparty credit risk concentration
The Company is exposed to credit loss in the event of nonperformance by counterparties on derivative financial and commodity contracts. Management believes a concentration of credit risk with respect to derivative counterparties is limited due to the credit ratings and use of master netting and reciprocal collateralization agreements with the counterparties and the use of exchange-traded commodity contracts.
Master netting agreements apply in situations where the Company executes multiple contracts with the same counterparty. There were no counterparties representing a concentration of credit risk to the Company at October 1, 2011.
For certain derivative contracts, reciprocal collateralization agreements with counterparties call for the posting of collateral in the form of cash, treasury securities or letters of credit if a fair value liability position to the Company or our counterparties exceeds a certain amount. There were no collateral balance requirements at October 1, 2011.
Management believes concentrations of credit risk with respect to accounts receivable is limited due to the generally high credit quality of the Companys major customers, as well as the large number and geographic dispersion of smaller customers. However, the Company conducts a disproportionate amount of business with a small number of large multinational grocery retailers, with the five largest accounts encompassing approximately 28% of consolidated trade receivables at October 1, 2011.
Note 10 Product recall
On June 25, 2010, the Company announced a recall of select packages of Kelloggs cereal in the U.S. due to an odor from waxy resins found in the package liner. Estimated customer returns and consumer rebates were recorded as a reduction of net sales; costs associated with returned product and the disposal and write-off of inventory were recorded as COGS; and other recall costs were recorded as SGA expenses. During the quarter ended October 2, 2010, the Company refined the estimated costs of the recall, which resulted in a reduction of $1 million, for a year-to-date expense through October 2, 2010 of $47 million, or $.09 per share on a diluted basis. In addition to the costs of the recall, the Company also lost sales of the impacted products in the second and third quarters of 2010.
Note 11 Operating segments
Kellogg Company is the worlds leading producer of cereal and a leading producer of convenience foods, including cookies, crackers, toaster pastries, cereal bars, fruit-flavored snacks, frozen waffles, and veggie foods. Kellogg products are manufactured and marketed globally. Principal markets for these products include the United States and United Kingdom. The Company currently manages its operations in four geographic operating segments, comprised of North America and the three International operating segments of Europe, Latin America, and Asia Pacific.
PART IFINANCIAL INFORMATION
Results of operations
For more than 100 years, consumers have counted on Kellogg for great-tasting, high-quality and nutritious foods. Kellogg Company is the worlds leading producer of cereal and a leading producer of convenience foods, including cookies, crackers, toaster pastries, cereal bars, fruit-flavored snacks, frozen waffles and veggie foods. Kellogg products are manufactured and marketed globally. We currently manage our operations in four geographic operating segments, consisting of North America and the three International operating segments of Europe, Latin America and Asia Pacific.
Our long term growth targets are 3 to 4% for internal net sales, mid single-digit (4 to 6%) for internal operating profit, and high single-digit (7 to 9%) for net earnings per diluted share (EPS) on a currency-neutral basis. Internal net sales and internal operating profit exclude the impact of foreign currency translation, acquisitions, dispositions and shipping day differences. See the Foreign currency translation section for an explanation of managements definition of currency neutral.
For the quarter ended October 1, 2011, our reported net sales increased 5% and internal net sales increased 3%. Consolidated operating profit decreased 14%, while internal operating profit decreased 16%. Diluted earnings per share (EPS) decreased 11% to $0.80, compared to $0.90 in the comparable prior year quarter. EPS on a currency-neutral basis was down 13%. Our performance was below our expectations for the quarter. While we experienced solid top-line growth, our operating profit was negatively impacted by the lapping of the significant reduction of incentive compensation costs in the third quarter of 2010 and the reinstatement of those costs in 2011 and our investments in our supply chain.
For the full year 2011, we still expect our internal net sales to increase by approximately 4 to 5%. We have lowered our outlook for internal operating profit and EPS on a currency-neutral basis to reflect the increased level of investment in our supply chain. We expect internal operating profit to be down 2 to 4%, with EPS on a currency-neutral basis to be approximately flat.
Preliminarily for 2012, we expect our internal net sales to be up 4 to 5%, above our long-term targets. We expect our operating profit to be flat to up slightly. This reflects investments to promote sustainable momentum for the long-term health of our business. The investments will focus on three key areas: increased brand-building, our supply chain, and the SAP reimplementation. EPS on a currency-neutral basis is expected to be up 2 to 4%.
Net sales and operating profit
The following table provides an analysis of net sales and operating profit performance for the third quarter of 2011 versus 2010: