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Mondelez International, Inc. 10-Q 2007
Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

 

  x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2007

OR

 

  ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                 to

Commission file number 1-16483

Kraft Foods Inc.

(Exact name of registrant as specified in its charter)

 

Virginia   52-2284372

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

Three Lakes Drive,

Northfield, Illinois

  60093
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code: (847) 646-2000

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer x   Accelerated filer ¨   Non-accelerated filer ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨   No x

At September 30, 2007, there were 1,547,195,209 shares of the registrant’s common stock outstanding.

 



KRAFT FOODS INC.

TABLE OF CONTENTS

 

               Page No.

PART I –

   FINANCIAL INFORMATION      

Item 1.

   Financial Statements (Unaudited)      
  

Condensed Consolidated Balance Sheets at
September 30, 2007 and December 31, 2006

      3
  

Condensed Consolidated Statements of Earnings for the
Three Months Ended September 30, 2007 and 2006 and the
Nine Months Ended September 30, 2007 and 2006

      4
  

Condensed Consolidated Statements of Shareholders’
Equity for the Year Ended December 31, 2006 and the
Nine Months Ended September 30, 2007

      5
  

Condensed Consolidated Statements of Cash Flows for the
Nine Months Ended September 30, 2007 and 2006

      6
   Notes to Condensed Consolidated Financial Statements       7-22

Item 2.

  

Management’s Discussion and Analysis of Financial
Condition and Results of Operations

      22-39

Item 3.

   Quantitative and Qualitative Disclosures about Market Risk       39

Item 4.

   Controls and Procedures       40

PART II –

   OTHER INFORMATION      

Item 1.

   Legal Proceedings       41

Item 1A.

   Risk Factors       41

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds       42

Item 6.

   Exhibits       43

Signature

         44

 

In this report, “Kraft,” “we,” “us” and “our” refers to Kraft Foods Inc. and subsidiaries, and “Common Stock” refers to Kraft’s Class A common stock.

 

2


PART I - FINANCIAL INFORMATION

Item 1.  Financial Statements.

Kraft Foods Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(in millions of dollars)

(Unaudited)

 

     September 30,
2007
    December 31,
2006
 

ASSETS

    

Cash and cash equivalents

   $ 498     $ 239  

Receivables (less allowances of $80 in 2007 and $84 in 2006)

     3,942       3,869  

Inventories:

    

Raw materials

     1,754       1,389  

Finished product

     2,621       2,117  
                

Total inventories

     4,375       3,506  

Deferred income taxes

     386       387  

Other current assets

     343       253  
                

Total current assets

     9,544       8,254  

Property, plant and equipment, at cost

     18,358       17,050  

Less accumulated depreciation

     8,391       7,357  
                

Property, plant and equipment, net

     9,967       9,693  

Goodwill

     25,768       25,553  

Other intangible assets, net

     9,992       10,177  

Prepaid pension assets

     1,270       1,168  

Other assets

     818       729  
                

TOTAL ASSETS

   $                   57,359     $                   55,574  
                

LIABILITIES

    

Short-term borrowings

   $ 2,836     $ 1,715  

Current portion of long-term debt

     20       1,418  

Due to Altria Group, Inc. and affiliates

           607  

Accounts payable

     2,908       2,602  

Accrued liabilities:

    

Marketing

     1,614       1,626  

Employment costs

     746       750  

Dividends payable

     423       45  

Other

     1,566       1,559  

Income taxes

     81       151  
                

Total current liabilities

     10,194       10,473  

Long-term debt

     10,600       7,081  

Deferred income taxes

     3,837       3,930  

Accrued pension costs

     1,032       1,022  

Accrued postretirement health care costs

     2,914       3,014  

Other liabilities

     1,900       1,499  
                

TOTAL LIABILITIES

     30,477       27,019  

Contingencies (Note 8)

    

SHAREHOLDERS’ EQUITY

    

Class A common stock, no par value (1,735,000,000 shares issued in 2007 and 555,000,000
shares issued and outstanding in 2006)

    

Class B common stock, no par value (1,180,000,000 shares issued and outstanding in 2006)

    

Additional paid-in capital

     23,388       23,626  

Retained earnings

     12,058       11,128  

Accumulated other comprehensive losses

     (2,496 )     (3,069 )

Treasury stock, at cost

     (6,068 )     (3,130 )
                

TOTAL SHAREHOLDERS’ EQUITY

     26,882       28,555  
                

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

   $ 57,359     $ 55,574  
                

See notes to condensed consolidated financial statements.

 

3


Kraft Foods Inc. and Subsidiaries

Condensed Consolidated Statements of Earnings

(in millions of dollars, except per share data)

(Unaudited)

 

   

For the Three Months

Ended

September 30,

   

For the Nine Months

Ended

September 30,

     
    2007     2006     2007     2006      

Net revenues

  $           9,054     $           8,243     $         26,845     $         24,985    

Cost of sales

    5,995       5,243       17,475       15,869    
                                 

Gross profit

    3,059       3,000       9,370       9,116    

Marketing, administration and research costs

    1,901       1,767       5,742       5,246    

Asset impairment and exit costs

    174       125       348       553    

Gain on redemption of United Biscuits investment

          (251 )           (251 )  

(Gains) / losses on sales of businesses, net

          3       (20 )     14    

Amortization of intangibles

    3       1       9       6    
                                 

Operating income

    981       1,355       3,291       3,548    

Interest and other debt expense, net

    165       134       378       377    
                                 

Earnings before income taxes

    816       1,221       2,913       3,171    

Provision for income taxes

    220       473       908       735    
                                 

Net earnings

  $ 596     $ 748     $ 2,005     $ 2,436    
                                 

Per share data:

         

Basic earnings per share

  $ 0.38     $ 0.46     $ 1.26     $ 1.48    
                                 

Diluted earnings per share

  $ 0.38     $ 0.45     $ 1.25     $ 1.47    
                                 

Dividends declared

  $ 0.27     $ 0.25     $ 0.77     $ 0.71    
                                 

See notes to condensed consolidated financial statements.

 

4


Kraft Foods Inc. and Subsidiaries

Condensed Consolidated Statements of Shareholders’ Equity

(in millions of dollars, except per share data)

(Unaudited)

 

    

Class

A and B
  Common  
Stock

   Additional
Paid-in
Capital
    Retained
Earnings
    Accumulated
Other
Comprehensive
Losses
    Treasury
Stock
    Total
Shareholders’
Equity
 

Balances at January 1, 2006

   $                    –    $           23,835     $             9,453     $         (1,663)     $         (2,032)     $            29,593  

Comprehensive earnings:

             

Net earnings

                3,060                   3,060  

Other comprehensive earnings, net of
income taxes

                      645             645  
                   

Total comprehensive earnings *

                3,705  
                   

Initial adoption of FASB Statement No. 158,
net of income taxes

                      (2,051 )           (2,051 )

Exercise of stock options and issuance
of other stock awards

          (209 )     202             152       145  

Cash dividends declared ($0.96 per share)

                (1,587 )                 (1,587 )

Common Stock repurchased

                            (1,250 )     (1,250 )
                                               

Balances at December 31, 2006

          23,626       11,128       (3,069 )     (3,130 )     28,555  

Comprehensive earnings:

             

Net earnings

                2,005                   2,005  

Other comprehensive earnings, net of
income taxes

                      573             573  
                   

Total comprehensive earnings *

                2,578  
                   

Initial adoption of FIN 48 (Note 15)

                213                   213  

Exercise of stock options and issuance
of other stock awards

          (24 )     (60 )           248       164  

Net settlement of employee stock awards
with Altria Group, Inc. (Note 6)

          (179 )                       (179 )

Cash dividends declared ($0.77 per share)

                (1,228 )                 (1,228 )

Common Stock repurchased

                            (3,186 )     (3,186 )

Other

          (35 )                       (35 )
                                               

Balances at September 30, 2007

   $    $ 23,388     $ 12,058     $ (2,496 )   $ (6,068 )   $ 26,882  
                                               

 

* Total comprehensive earnings were $774 million for the quarter ended September 30, 2007, $697 million for the quarter ended September 30, 2006 and $2,843 million for the nine months ended September 30, 2006.

See notes to condensed consolidated financial statements.

 

5


Kraft Foods Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(in millions of dollars)

(Unaudited)

 

     For the Nine Months Ended
September 30,
 
     2007     2006  

CASH PROVIDED BY / (USED IN) OPERATING ACTIVITIES

    

Net earnings

   $               2,005     $               2,436  

Adjustments to reconcile net earnings to operating cash flows:

    

Depreciation and amortization

     662       654  

Deferred income tax benefit

     (214 )     (29 )

Gain on redemption of United Biscuits investment

           (251 )

(Gains) / losses on sales of businesses

     (20 )     14  

Asset impairment and exit costs, net of cash paid

     171       389  

Change in assets and liabilities, excluding the effects of acquisitions
and divestitures:

    

Receivables, net

     96       38  

Inventories

     (739 )     (526 )

Accounts payable

     36       84  

Income taxes

     13       130  

Amounts due to Altria Group, Inc. and affiliates

     (93 )     (214 )

Other working capital items

     (268 )     (139 )

Change in pension assets and postretirement liabilities, net

     128       75  

Other

     503       135  
                

Net cash provided by operating activities

     2,280       2,796  
                

CASH PROVIDED BY / (USED IN) INVESTING ACTIVITIES

    

Capital expenditures

     (858 )     (687 )

Proceeds from sales of businesses

     203       674  

Other

     15       82  
                

Net cash (used in) / provided by investing activities

     (640 )     69  
                

CASH PROVIDED BY / (USED IN) FINANCING ACTIVITIES

    

Net issuance / (repayment) of short-term borrowings

     1,102       (317 )

Long-term debt proceeds

     3,550       49  

Long-term debt repayments

     (1,454 )     (57 )

(Decrease) / increase in amounts due to Altria Group, Inc. and affiliates

     (149 )     9  

Repurchase of Common Stock

     (3,171 )     (943 )

Dividends paid

     (1,214 )     (1,150 )

Other

     (67 )     (147 )
                

Net cash used in financing activities

     (1,403 )     (2,556 )
                

Effect of exchange rate changes on cash and cash equivalents

     22       30  
                

Cash and cash equivalents:

    

Increase

     259       339  

Balance at beginning of period

     239       316  
                

Balance at end of period

   $ 498     $ 655  
                

See notes to condensed consolidated financial statements.

 

6


Kraft Foods Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 1.  Accounting Policies:

Basis of Presentation:

Our interim condensed consolidated financial statements are unaudited. We prepared the condensed consolidated financial statements following the requirements of the SEC for interim reporting. As permitted under those rules, a number of footnotes or other financial information that are normally required by accounting principles generally accepted in the United States of America have been condensed or omitted. It is management’s opinion that these financial statements include all normal and recurring adjustments necessary for a fair presentation of our financial position and operating results. Net revenues and net earnings for any interim period are not necessarily indicative of annual results.

You should read these statements in conjunction with our consolidated financial statements and related notes in our Annual Report on Form 10-K for the year ended December 31, 2006.

In the first quarter of 2007, Altria Group, Inc. (“Altria”) spun off its entire interest (89.0%) in Kraft on a pro rata basis to Altria stockholders in a tax-free transaction. Effective as of the close of business on March 30, 2007, all Kraft shares owned by Altria were distributed to Altria’s stockholders, and our separation from Altria was completed (the “Distribution”). Before the Distribution, Altria converted all of its Class B shares of Kraft common stock into Class A shares of Kraft common stock. The Distribution ratio was calculated by dividing the number of shares of Kraft Common Stock held by Altria by the number of Altria shares outstanding on the date of record, March 16, 2007. Based on the calculation, the distribution ratio was 0.692024 shares of Kraft Common Stock for every share of Altria common stock outstanding. Following the Distribution, we only have Class A common stock outstanding.

New Accounting Pronouncements:

In September 2006, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value Measurements. The provisions are effective for Kraft as of January 1, 2008. This statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. We do not expect the adoption of this statement to have a material impact on our financial statements.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115. The provisions are effective for Kraft as of January 1, 2008. This statement permits entities to choose to measure many financial instruments and certain other items at fair value and report unrealized gains and losses on these instruments in earnings. We do not expect the adoption of this statement to have a material impact on our financial statements.

Reclassification:

We reclassified minority interest in earnings in the prior year statement of earnings from a separate line item into general corporate expenses within marketing, administration and research costs to conform with the current year’s presentation. Additionally, we reclassified dividends payable in the prior year balance sheet from other accrued liabilities to a separate line item to conform with the current year’s presentation.

 

7


Note 2.  Asset Impairment, Exit and Implementation Costs:

Restructuring Program

In January 2004, we announced a three-year restructuring program (the “Restructuring Program”) and, in January 2006, extended it through 2008. The objectives of this program are to leverage our global scale, realign and lower our cost structure, and optimize capacity. As part of the Restructuring Program we anticipate:

 

   

incurring approximately $3.0 billion in pre-tax charges reflecting asset disposals, severance and implementation costs, including approximately $500 million in 2007;

   

closing up to 40 facilities and eliminating approximately 14,000 positions; and

   

using cash to pay for approximately $1.9 billion of the $3.0 billion in charges.

We have incurred $1.9 billion in charges since the inception of the Restructuring Program, including $326 million during the nine months ended September 30, 2007.

In September 2007, we announced that we are implementing a new operating structure built on three core elements: accountable business units; shared services that leverage the scale of our global portfolio; and a streamlined corporate staff. We expect to complete the roll-out of this new structure by early 2008. The primary objective of this initiative is improved effectiveness. As a result, we expect some job eliminations as we streamline our headquarter functions.

During the second quarter of 2006, we entered into a seven-year, $1.7 billion agreement to receive information technology services from Electronic Data Systems (“EDS”). On June 1, 2006, we began using EDS’s data centers, and EDS started providing us with web hosting, telecommunications and IT workplace services. During the nine months ended September 30, 2007, we reversed $7 million in restructuring costs because our severance costs were lower than originally anticipated, and we incurred implementation costs of $42 million related to the EDS transition. These amounts are included in the total Restructuring Program charges discussed above.

Restructuring Costs:

Under the Restructuring Program, we recorded asset impairment and exit costs of $54 million during the three months and $228 million during the nine months ended September 30, 2007. We announced the closure of two plants during the first nine months of 2007; we have now announced the closure of 29 facilities since the program began in 2004. We expect to pay cash for approximately $171 million of the charges that we incurred during the first nine months of 2007.

Restructuring liability activity for the nine months ended September 30, 2007 was as follows:

 

    Severance     Asset
Write-downs
    Other     Total  
    (in millions)  

Liability balance, January 1, 2007

  $           165     $               –     $             32     $           197  

Charges

    104       67       57       228  

Cash spent

    (108 )     4       (73 )     (177 )

Charges against assets

    (19 )     (74 )     (1 )     (94 )

Currency

    7       3             10  
                               

Liability balance, September 30, 2007

  $ 149     $     $ 15     $ 164  
                               

Severance costs include the cost of benefits received by terminated employees. We expect to eliminate approximately 10,800 positions in connection with initiatives announced since 2004. As of September 30, 2007, we had eliminated approximately 10,400 of these positions. Severance charges against assets primarily relate to incremental pension costs, which reduce prepaid pension assets. Asset write-downs relate to the impairment of assets caused by plant closings and related activity. We incurred other costs related primarily to the renegotiation of supplier contract costs, workforce reductions associated with the plant closings and the termination of leasing agreements.

 

8


Implementation Costs:

We recorded implementation costs associated with the Restructuring Program of $27 million during the three months and $98 million during the nine months ended September 30, 2007. These costs primarily include incremental expenses related to the closure of facilities and the EDS transition discussed above. Substantially all implementation costs incurred in 2007 will require cash payments. We recorded these costs on the condensed consolidated statements of earnings as follows:

 

          For the Three Months Ended
September 30,
   For the Nine Months Ended
September 30,
    
          2007    2006            2007                    2006             
          (in millions)    (in millions)     
  

Cost of sales

   $                 17    $                  2    $                47    $                 13   
  

Marketing, administration and
research costs

     10      21      51      40   
                                 
  

Total implementation costs

   $ 27    $ 23    $ 98    $ 53   
                                 

 

Asset Impairment Charges

 

In October 2007, we announced and closed the sale of our flavored water and juice brand assets and related trademarks, including Veryfine and Fruit2O. In recognition of the anticipated sale, we recorded a $120 million asset impairment charge for these assets in the third quarter. The charge, which included the write-off of the associated goodwill, intangible assets and property, plant and equipment, was recorded as asset impairment and exit costs on the condensed consolidated statement of earnings.

 

During the first quarter of 2007, we sold our hot cereal assets and trademarks for a pre-tax gain of $12 million. We previously incurred an asset impairment charge of $69 million in the fourth quarter of 2006 in connection with this sale. The charge included the write-off of a portion of the associated goodwill, intangible assets and property, plant and equipment. We recorded the charge as asset impairment and exit costs on the 2006 consolidated statement of earnings, and no further charges were incurred in 2007 for this divestiture.

 

During the first quarter of 2007, we completed our annual review of goodwill and intangible assets. No impairments resulted from this review.

 

Total – Asset Impairment, Exit and Implementation Costs

 

We included the asset impairment, exit and implementation costs discussed above, for the three and nine months ended September 30, 2007 and 2006 in segment operating income as follows:

 

          For the Three Months Ended September 30, 2007
          Restructuring
Costs
   Asset
Impairment
   Total Asset
Impairment
and Exit Costs
   Implementation
Costs
   Total
          (in millions)
  

North America Beverages

   $                   2    $                 120    $               122    $                   –    $                 122
  

North America Cheese &
Foodservice

     12           12      4      16
  

North America Convenient Meals

     6           6      5      11
  

North America Grocery

     3           3      2      5
  

North America Snacks & Cereals

     7           7      3      10
  

European Union

     14           14      10      24
  

Developing Markets (1)

     10           10      3      13
                                     
  

Total

   $ 54    $ 120    $ 174    $ 27    $ 201
                                     

 

9


    For the Three Months Ended September 30, 2006
   

Restructuring

Costs

  

Asset

Impairment

   Total Asset
Impairment
and Exit Costs
   Implementation
Costs
   Total
    (in millions)

North America Beverages

  $ 8    $    $ 8    $ 2    $ 10

North America Cheese &
Foodservice

    14           14      6      20

North America Convenient Meals

    22           22      5      27

North America Grocery

    5           5      3      8

North America Snacks & Cereals

    13           13      5      18

European Union

    62           62      2      64

Developing Markets (1)

    1           1           1
                                 

Total

  $             125    $                 –    $             125    $           23    $             148
                                 
    For the Nine Months Ended September 30, 2007
   

Restructuring

Costs

  

Asset

Impairment

   Total Asset
Impairment
and Exit Costs
   Implementation
Costs
   Total
    (in millions)

North America Beverages

  $ 9    $ 120    $ 129    $ 4    $ 133

North America Cheese &
Foodservice

    53           53      22      75

North America Convenient Meals

    17           17      12      29

North America Grocery

    20           20      5      25

North America Snacks & Cereals

    13           13      13      26

European Union

    91           91      32      123

Developing Markets (1)

    25           25      10      35
                                 

Total

  $ 228    $ 120    $ 348    $ 98    $ 446
                                 
    For the Nine Months Ended September 30, 2006
   

Restructuring

Costs

  

Asset

Impairment

   Total Asset
Impairment
and Exit Costs
   Implementation
Costs
   Total
    (in millions)

North America Beverages

  $ 17    $    $ 17    $ 6    $ 23

North America Cheese &
Foodservice

    80           80      7      87

North America Convenient Meals

    74           74      9      83

North America Grocery

    18           18      7      25

North America Snacks & Cereals

    28      99      127      9      136

European Union

    161           161      11      172

Developing Markets (1)

    65      11      76      4      80
                                 

Total

  $ 443    $ 110    $ 553    $ 53    $ 606
                                 

 

  (1) This segment was formerly known as Developing Markets, Oceania & North Asia

 

10


Note 3.  Transactions with Altria Group, Inc.:

On March 30, 2007, we entered into a post-spin Transition Services Agreement with Altria’s subsidiary, Altria Corporate Services, Inc. (“ALCS”). Under the agreement, ALCS is providing information technology services to Kraft during the EDS transition. In the first quarter of 2007, ALCS provided pre-spin administrative services to us under a separate Corporate Services agreement that expired on March 30, 2007. Billings for all services were $4 million for the three months and $27 million for the nine months ended September 30, 2007. The remaining services provided by ALCS will cease by the end of the year.

On March 30, 2007, we also entered into Employee Matters and Tax Sharing Agreements with Altria. The Employee Matters Agreement sets out each company’s obligations for employee transfers, equity compensation and other employee benefits matters for individuals moving, or who previously moved between companies. The Tax Sharing Agreement identifies Altria’s and Kraft’s rights, responsibilities and obligations with respect to our income taxes following the Distribution. It also places certain restrictions on us, including a 2-year limit on share repurchases of no more than 20% of our Common Stock outstanding at the time of the Distribution.

At March 31, 2007, we had short-term amounts payable to Altria of $449 million, including $364 million of accrued dividends, which we paid in April 2007.

In the first quarter 2007, we repurchased 1.4 million shares of our Common Stock from Altria at a cost of $46.5 million. We paid $32.085 per share, which was the average of the high and the low price of Kraft Common Stock as reported on the NYSE on March 1, 2007. This repurchase was in accordance with the Distribution agreement.

Note 4.  Acquisitions:

On October 29, 2007, we announced that we have signed final agreements to acquire the global biscuit business of Groupe Danone S.A. (“Danone Biscuit”) for €5.3 billion (approximately $7.5 billion) in cash subject to purchase price adjustments. This follows the announcement of our binding offer in July which, according to French law, was subject to consultation with Groupe Danone S.A.’s works councils. The recent conclusion of these consultations has allowed the Group Danone S.A. Board of Directors to approve the transaction and both parties to sign the final sale agreement. Danone Biscuit generated global revenues of approximately $2.7 billion during 2006. Completion of this transaction is subject to customary closing conditions, including regulatory approval. We expect the transaction to close by the end of the year.

In September 2006, we acquired the Spanish and Portuguese operations of United Biscuits (“UB”) for approximately $1.1 billion. The non-cash acquisition was financed by our assumption of $541 million of debt issued by the acquired business immediately prior to the acquisition, as well as $530 million of value for the redemption of our outstanding investment in UB, primarily deep-discount securities. As part of the transaction, we also recovered the rights to all Nabisco trademarks in the European Union, Eastern Europe, the Middle East and Africa, which UB had held since 2000. These businesses contributed net revenues of approximately $129 million during the three months and $344 million during the nine months ended September 30, 2007. Due to the timing of closing of the acquisition, our financial statements for the period ended September 30, 2006, do not reflect results from these operations, the amounts of which were not material.

Note 5.  Divestitures:

During the second quarter of 2007, we sold sugar confectionery assets in Romania and related trademarks. During the first quarter of 2007, we sold our hot cereal assets and trademarks. In aggregate, we received $203 million in proceeds, and recorded pre-tax gains of $20 million on these sales. The aggregate operating results of these divestitures were not material to our financial statements in any of the periods presented.

In October 2007, we announced and closed the sale of our flavored water and juice brand assets and related trademarks.

Note 6.  Stock Plans:

On May 3, 2007, our Board of Directors approved a stock option grant to Irene Rosenfeld to recognize her election as our Chairman. Ms. Rosenfeld received 300,000 stock options under the 2005 Performance Incentive Plan, which vest under varying market and service conditions and expire ten years after the grant date.

 

11


At Distribution, as described in Note 1, Accounting Policies, Altria stock awards were modified through the issuance of Kraft stock awards, and accordingly the Altria stock awards were split into two instruments. Holders of Altria stock options received: 1) a new Kraft option to acquire shares of Kraft Common Stock; and 2) an adjusted Altria stock option for the same number of shares of Altria common stock previously held, but with a proportionally reduced exercise price. For each employee stock option outstanding, the aggregate intrinsic value immediately after the Distribution was not greater than the aggregate intrinsic value immediately prior to the Distribution. Holders of Altria restricted stock or stock rights awarded before January 31, 2007, retained their existing awards and received restricted stock or stock rights in Kraft Common Stock. Recipients of Altria restricted stock or stock rights awarded on or after January 31, 2007, did not receive Kraft restricted stock or stock rights because Altria had announced the Distribution at that time. We reimbursed Altria $179 million for net settlement of the employee stock awards as detailed below. We determined the fair value of the stock options using the Black-Scholes option valuation model; and adjusted the fair value of the restricted stock and stock rights by the value of projected forfeitures.

In April 2007, we paid the following to Altria (in millions):

 

Kraft stock options received by Altria employees

   $                 240    

Altria stock options received by Kraft employees

     (440 )  

Kraft stock awards received by holders of Altria stock awards

     33    

Altria stock awards received by holders of Kraft stock awards

     (12 )  
          

Net payment to Altria

   $ (179 )  
          

Based upon the number of Altria stock awards outstanding at Distribution, we granted stock options for approximately 24.1 million shares of Kraft Common Stock at a weighted-average price of $15.75. The options expire between 2007 and 2012. In addition, we issued approximately 3.0 million shares of restricted stock and stock rights. The market value per restricted share or right was $31.66 on the date of grant. Restrictions on the majority of these restricted stock and stock rights lapse in the first quarter of either 2008 or 2009.

In January 2007, we issued approximately 5.2 million shares of restricted stock and stock rights to eligible U.S. and non-U.S. employees as part of our annual incentive program. Restrictions on these shares and rights lapse in the first quarter of 2010. The market value per restricted share or right was $34.655 on the date of grant. Additionally, in the normal course of business we issued approximately 0.1 million shares of restricted stock and stock rights during the nine months ended September 30, 2007. The weighted-average market value per restricted share or right was $32.987 on the date of grant. The total number of restricted shares and rights issued in the nine months ended September 30, 2007 was 8.3 million, including those issued as a result of the Distribution.

During the nine months ended September 30, 2007, approximately 4.5 million shares of restricted stock and stock rights vested at a market value of $151 million.

The total intrinsic value of the 0.9 million Kraft stock options exercised during the third quarter of 2007 was $12.4 million. The total intrinsic value of the 4.9 million Kraft stock options exercised during the first nine months of 2007 was $68.2 million.

 

12


Note 7.  Earnings Per Share:

Basic and diluted EPS were calculated as follows:

 

         For the Three Months Ended
September 30,
   For the Nine Months Ended
September 30,
      
         2007    2006    2007    2006       
         (in millions, except per share data)       
 

Net earnings

   $       596    $         748    $       2,005    $       2,436     
                                  
 

Weighted average shares for basic EPS

     1,557      1,638      1,590      1,648     
 

Plus incremental shares from assumed
conversions of stock options,
restricted stock and stock rights

     19      10      18      10     
                                  
 

Weighted average shares for diluted EPS

     1,576      1,648      1,608      1,658     
                                  
 

Basic earnings per share

   $ 0.38    $ 0.46    $ 1.26    $ 1.48     
                                  
 

Diluted earnings per share

   $ 0.38    $ 0.45    $ 1.25    $ 1.47     
                                  
                  

 

For the three and nine months ended September 30, 2007 and 2006, we excluded an insignificant number of Kraft stock options from the calculation of weighted average shares for diluted EPS, because they were antidilutive.

 

Note 8.  Contingencies:

 

Legal Proceedings: We are defendants in a variety of legal proceedings. Plaintiffs in a few of those cases seek substantial damages. We cannot predict with certainty the results of these proceedings. However, we believe that the final outcome of these proceedings will not materially affect our financial results.

 

Third-Party Guarantees: We have third-party guarantees because of our acquisition, divestiture and construction activities. As part of those transactions, we guarantee that third parties will make contractual payments or achieve performance measures. At September 30, 2007, our third-party guarantees were approximately $30 million, of which approximately $7 million have no specified expiration dates. Substantially all of the remainder expire at various times through 2016. We had a liability of $24 million on our condensed consolidated balance sheet at September 30, 2007, relating to these guarantees.

 

Note 9. Goodwill and Other Intangible Assets, Net:

 

Goodwill by reportable segment was as follows:

 

         September 30,
2007
   December 31,
2006
                
         (in millions)                 
 

North America Beverages

   $       1,370    $       1,372           
 

North America Cheese & Foodservice

     4,210      4,218           
 

North America Convenient Meals

     2,171      2,167           
 

North America Grocery

     3,053      3,058           
 

North America Snacks & Cereals

     8,599      8,696           
 

European Union

     5,280      5,004           
 

Developing Markets

     1,085      1,038           
                          
 

Total goodwill

   $ 25,768    $ 25,553           
                          

 

13


Other intangible assets were as follows:

 

         September 30, 2007      December 31, 2006     
         Intangible
Assets, at cost
     Accumulated
Amortization
     Intangible
Assets, at cost
   Accumulated
Amortization
    
       (in millions)        (in millions)   
 

Non-amortizable intangible assets

   $ 9,864      $      $ 10,150    $   
 

Amortizable intangible assets

     186        58        94      67   
                                    
 

Total other intangible assets

   $           10,050      $               58      $         10,244    $             67   
                                    
                

 

Non-amortizable intangible assets consist substantially of brand names purchased through the Nabisco Holdings Corp. and UB acquisitions. Amortizable intangible assets consist primarily of trademark licenses and non-compete agreements. We made the following significant adjustments to goodwill and intangible assets during the nine months ended September 30, 2007:

 

•      reduced goodwill by $85 million upon the adoption of FIN 48 (see Note 15, Income Taxes, for further details) and increased goodwill by $28 million in connection with the UB acquisition (included within other below);

 

•      reduced goodwill by $45 million and intangible assets by $132 million primarily due to the divestiture our hot cereal assets and trademarks;

 

•      recorded an asset impairment charge of $70 million to intangible assets in anticipation of our flavored water and juice brand assets and related trademarks sale;

 

•      completed the purchase price allocation and reclassified $101 million from non-amortizable to amortizable intangible assets as part of the UB acquisition; and

 

•      removed a fully amortized intangible asset for $18 million.

 

The movement in goodwill and intangible assets from December 31, 2006 is as follows:

 

         Goodwill      Intangible
Assets, at cost
                
         (in millions)                 
 

Balance at December 31, 2006

   $         25,553      $         10,244           
 

Changes due to:

              
 

Currency

     317        26           
 

Divestitures

     (45 )      (132 )         
 

Asset Impairment

     (3 )      (70 )         
 

Other

     (54 )      (18 )         
                            
 

Balance at September 30, 2007

   $ 25,768      $ 10,050           
                            

Amortization expense for intangible assets was $3 million in the third quarter of 2007 and $9 million in the first nine months of 2007. We currently estimate amortization expense for each of the next five years to be approximately $11 million or less.

 

14


Note 10. Debt and Borrowing Arrangements:

On August 13, 2007, we issued $3.5 billion of senior unsecured notes, which was the remaining amount available under our shelf registration. We used the net proceeds ($3,462 million) from the sale of the offered securities for general corporate purposes, including the repayment of outstanding commercial paper. The $3.5 billion of notes bear the following general terms:

 

   

$250,000,000 total principal notes due August 11, 2010 at a fixed, annual interest rate of 5.625%. Interest is payable semiannually beginning February 11, 2008.

 

   

$750,000,000 total principal notes due February 11, 2013 at a fixed, annual interest rate of 6.000%. Interest is payable semiannually beginning February 11, 2008.

 

   

$1,500,000,000 total principal notes due August 11, 2017 at a fixed, annual interest rate of 6.500%. Interest is payable semiannually beginning February 11, 2008.

 

   

$750,000,000 total principal notes due August 11, 2037 at a fixed, annual interest rate of 7.000%. Interest is payable semiannually beginning February 11, 2008.

 

   

$250,000,000 total principal notes due August 11, 2010 at a floating, annual interest rate of LIBOR plus 50 basis points that resets quarterly. The rate as of September 30, 2007 was 6.000%. Interest on the floating rate notes is payable quarterly, beginning on November 13, 2007.

Each of these notes contain covenants that restrict our ability to incur debt secured by liens, and engage in sale/leaseback transactions. If we experience a “change in control” triggering event, which results in below investment grade credit ratings by the three major rating agencies, we may be required to offer to purchase the notes from holders.

On October 12, 2007, we entered into a 364-day bridge facility agreement for €5.3 billion (approximately $7.5 billion) for our pending acquisition of Danone Biscuit. We intend to reduce borrowings or commitments under this facility with proceeds from the issuance of investment grade bonds or other securities. According to the credit agreement, the commitment of the lenders or drawings under the facility will be reduced by the proceeds from equity offerings and by the net cash proceeds in excess of $1.0 billion from aggregate debt offerings having a maturity of greater than one year. Additionally, drawings under this facility may be reduced by the proceeds in excess of $1.0 billion from the aggregate sale or divestiture of assets. This facility replaces a commitment letter we entered into upon the announcement of the Danone Biscuit acquisition.

On May 24, 2007, we entered into a $1.5 billion, 364-day revolving credit agreement. According to the terms of this credit agreement, it was terminated upon the issuance of the $3.5 billion of senior unsecured notes in August 2007.

At September 30, 2007 and December 31, 2006, our long-term debt consisted of the following:

 

     2007     2006  
     (in millions)  

Notes, 4.00% to 7.55% (average effective rate 5.87%), due through 2037

   $         10,392     $         8,290  

7% Debenture (effective rate 11.32%), $200 million face amount, due 2011

     174       170  

Foreign currency obligations

     15       15  

Other

     39       24  
                

Total long-term debt

     10,620       8,499  

Less current portion of long-term debt

     (20 )     (1,418 )
                

Long-term debt

   $ 10,600     $ 7,081  
                

Aggregate maturities of long-term debt for the years ended September 30, are as follows (in millions):

 

2008

       $               20   

2009

   707   

2010

   1,256   

2011

   203   

2012

   3,502   

Thereafter

   4,966   

 

15


Based on market quotes, where available, or interest rates currently available to us for issuance of debt with similar terms and remaining maturities, the aggregate fair value of our long-term debt, including the current portion of long-term debt, was $10,788 million at September 30, 2007.

Note 11. Accumulated Other Comprehensive Losses:

The components of accumulated other comprehensive losses are as follows:

 

     Currency
Translation
Adjustments
    Pension and
Other Benefits
    Derivatives
Accounted for
as Hedges
    Total  
     (in millions)  

Balances at December 31, 2006

   $ (723 )   $ (2,342 )   $ (4 )   $ (3,069 )

Other comprehensive earnings/ (losses),
net of income taxes:

        

Currency translation adjustments

     367       (54 )           313  

Amortization of experience losses
and prior service costs

           150             150  

Valuation update

           75             75  

Change in fair value of derivatives accounted for as hedges

                 35       35  
              

Total other comprehensive earnings

           573  
                                

Balances at September 30, 2007

   $                 (356 )   $               (2,171 )   $                     31     $               (2,496 )
                                

Note 12. Segment Reporting:

Kraft manufactures and markets packaged food products, including beverages, cheese, snacks, convenient meals and various packaged grocery products. We manage and report operating results through two commercial units, Kraft North America and Kraft International. We manage Kraft North America’s operations by product category, and its reportable segments are North America Beverages; North America Cheese & Foodservice; North America Convenient Meals; North America Grocery; and North America Snacks & Cereals. We manage Kraft International’s operations by geographic location, and its reportable segments are European Union and Developing Markets (formerly known as Developing Markets, Oceania & North Asia).

In September 2007 we announced that we are implementing a new operating structure effective in early 2008. We expect to finalize our new reporting structure thereafter.

Management uses segment operating income to evaluate segment performance and allocate resources. Segment operating income excludes unallocated general corporate expenses and amortization of intangibles. Management believes it is appropriate to disclose this measure to help investors analyze segment performance and trends. We centrally manage interest and other debt expense and the provision for income taxes. Accordingly, we do not present these items by segment because they are excluded from the segment profitability measure that management reviews. Our assets are principally located in the U.S. and Europe and are managed geographically.

 

16


Segment data were as follows:

 

     For the Three Months Ended
September 30,
    For the Nine Months Ended
September 30,
 
     2007     2006     2007     2006  
     (in millions)     (in millions)  

Net revenues:

        

North America Beverages

   $ 773     $ 731     $ 2,453     $ 2,345  

North America Cheese & Foodservice

     1,537       1,446       4,545       4,410  

North America Convenient Meals

     1,311       1,232       3,831       3,676  

North America Grocery

     602       597       2,001       2,019  

North America Snacks & Cereals

     1,655       1,585       4,812       4,729  

European Union

     1,855       1,544       5,446       4,550  

Developing Markets

     1,321       1,108       3,757       3,256  
                                

Net revenues

   $           9,054     $           8,243     $         26,845     $         24,985  
                                
     For the Three Months Ended
September 30,
   

For the Nine Months Ended

September 30,

 
     2007     2006     2007     2006  
     (in millions)     (in millions)  

Earnings before income taxes:

        

Operating income:

        

Segment operating income:

        

North America Beverages

   $ (4 )   $ 83     $ 269     $ 345  

North America Cheese & Foodservice

     159       233       501       615  

North America Convenient Meals

     185       183       526       568  

North America Grocery

     184       176       651       674  

North America Snacks & Cereals

     240       255       754       666  

European Union

     129       347       372       562  

Developing Markets

     137       122       366       255  

General corporate expenses

     (46 )     (43 )     (139 )     (131 )

Amortization of intangibles

     (3 )     (1 )     (9 )     (6 )
                                

Operating income

     981       1,355       3,291       3,548  

Interest and other debt expense, net

     (165 )     (134 )     (378 )     (377 )
                                

Earnings before income taxes

   $ 816     $ 1,221     $ 2,913     $ 3,171  
                                

We incurred asset impairment, exit and implementation costs of $201 million during the three months and $446 million during the nine months ended September 30, 2007. Refer to Note 2, Asset Impairment, Exit and Implementation Costs, for a breakout of charges by segment.

During the second quarter of 2007, we sold sugar confectionery assets in Romania and related trademarks and recorded a pre-tax gain of $8 million. We included this gain in the segment operating income of the Developing Markets segment. During the first quarter of 2007, we sold our hot cereal assets and trademarks and recorded a pre-tax gain of $12 million. We included this gain in the segment operating income of the North America Snacks & Cereals segment.

 

17


Net revenues by consumer sector, which includes the separation of Foodservice and Kraft International into sector components and Cereals into the Grocery sector, were as follows:

 

    

For the Three Months Ended

September 30, 2007

  

For the Three Months Ended

September 30, 2006

     Kraft North
America
   Kraft
International
   Total    Kraft North
America
   Kraft
International
   Total
     (in millions)    (in millions)

Snacks

   $ 1,439    $ 1,296    $ 2,735    $ 1,372    $ 994    $ 2,366

Beverages

     840      1,084      1,924      795      955      1,750

Cheese & Dairy

     1,231      436      1,667      1,142      391      1,533

Grocery

     995      239      1,234      981      202      1,183

Convenient Meals

     1,373      121      1,494      1,301      110      1,411
                                         

Total net revenues

   $         5,878    $         3,176    $         9,054    $         5,591    $         2,652    $         8,243
                                         
    

For the Nine Months Ended

September 30, 2007

  

For the Nine Months Ended

September 30, 2006

     Kraft North
America
   Kraft
International
   Total    Kraft North
America
   Kraft
International
   Total
     (in millions)    (in millions)

Snacks

   $ 4,146    $ 3,767    $ 7,913    $ 3,994    $ 2,988    $ 6,982

Beverages

     2,648      3,201      5,849      2,539      2,823      5,362

Cheese & Dairy

     3,648      1,228      4,876      3,485      1,135      4,620

Grocery

     3,184      670      3,854      3,276      571      3,847

Convenient Meals

     4,016      337      4,353      3,885      289      4,174
                                         

Total net revenues

   $ 17,642    $ 9,203    $ 26,845    $ 17,179    $ 7,806    $ 24,985
                                         

Note 13. Financial Instruments:

Kraft is exposed to price risk related to forecasted purchases of certain commodities that we primarily use as raw materials. Accordingly, we use commodity forward contracts as cash flow hedges, primarily for coffee, milk, sugar and cocoa. Commodity forward contracts generally qualify for the normal purchase exception under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, (“SFAS 133”) and are, therefore, not subject to its provisions. We also use commodity futures and options to hedge the price of certain commodities, including cheese, milk, coffee, cocoa, wheat, corn, sugar, soybean oil and natural gas. Net unrealized gains on all of our commodity positions were insignificant at September 30, 2007 and December 31, 2006. Some of these derivative instruments are highly effective and qualify for hedge accounting under SFAS 133. We defer the effective portion of the unrealized gains and losses on commodity futures and option contracts as a component of accumulated other comprehensive earnings / (losses). We recognize the deferred portion as a component of cost of sales in our condensed consolidated statement of earnings when the related inventory is sold. We expect to transfer an insignificant amount of unrealized gains / (losses) to earnings during the next 12 months, and recognized an insignificant amount during the three and nine months ended September 30, 2007. Ineffectiveness is recorded as a component of interest and other debt expense in our condensed consolidated statement of earnings, and it was insignificant during the three and nine months ended September 30, 2007. For the derivative instruments that we considered economic hedges but did not designate for hedge accounting under SFAS 133, we recognized net gains of $13 million during the three months and $29 million during the nine months ended September 30, 2007 directly as a component of cost of sales in our condensed consolidated statement of earnings. In aggregate, we had net long commodity positions of $497 million at September 30, 2007, and $533 million at December 31, 2006. As of September 30, 2007, we had hedged forecasted commodity transactions for periods not exceeding the next 18 months.

 

18


We also use various financial instruments to mitigate our exposure to changes in exchange rates from third-party and intercompany actual and forecasted transactions. Based on the size and location of our businesses, the primary currencies we are exposed to include the euro, Swiss franc, British pound and Canadian dollar. These instruments include forward foreign exchange contracts, foreign currency swaps and foreign currency options. Net unrealized losses on all of our foreign currency positions were approximately $196 million at September 30, 2007, and net unrealized gains were insignificant at December 31, 2006. Substantially all of these derivative instruments are highly effective and qualify for hedge accounting under SFAS 133. We defer the effective portion of unrealized gains and losses associated with forward, swap and option contracts as a component of accumulated other comprehensive earnings / (losses) until the underlying hedged transactions are reported in our condensed consolidated statement of earnings. We recognize the deferred portion as a component of cost of sales in our condensed consolidated statement of earnings when the related inventory is sold or as foreign currency translation gain or loss for our hedges of intercompany loans when the payments are made. We expect to transfer an insignificant amount of unrealized gains / (losses) to earnings during the next 12 months, and recognized an insignificant amount during the three and nine months ended September 30, 2007. Ineffectiveness is recorded as a component of interest and other debt expense in our condensed consolidated statement of earnings, and it was insignificant during the three and nine months ended September 30, 2007. For the derivative instruments that we consider economic hedges but do not designate for hedge accounting under SFAS 133, we recognize gains and losses directly as a component of cost of sales or foreign currency translation loss in our condensed consolidated statement of earnings, depending on the nature of the underlying transaction. For these derivative instruments, we recognized net losses of $129 million during the three months and $90 million during the nine months ended September 30, 2007 in our condensed consolidated statement of earnings. The majority of these losses were attributable to intercompany loans with offsetting foreign currency gains from the intercompany receivable. In aggregate, we had forward foreign exchange contracts, foreign currency swaps and foreign exchange options with aggregate notional amounts of $5.6 billion at September 30, 2007, and $2.6 billion at December 31, 2006. As of September 30, 2007, we had hedged forecasted foreign currency transactions for periods not exceeding the next 51 months. During the first quarter of 2007, we hedged currency exposure related to new, longer term intercompany loans with foreign subsidiaries. Excluding these intercompany loans, we had hedged forecasted foreign currency transactions for periods not exceeding the next nine months.

Hedging activities affected accumulated other comprehensive losses, net of income taxes, as follows:

 

     For the Three Months Ended
September 30,
    For the Nine Months Ended
September 30,
 
     2007     2006     2007     2006  
     (in millions)     (in millions)  

Accumulated gain / (loss) at beginning of period

   $           28     $            (3 )   $            (4 )   $            (4 )

Transfer of realized (gains) / losses in fair value to earnings

     (4 )     (3 )     (7 )     7  

Unrealized gain / (loss) in fair value

     7       (32 )     42       (41 )
                                

Accumulated gain / (loss) at September 30

   $ 31     $ (38 )   $ 31     $ (38 )
                                

Note 14. Benefit Plans:

We sponsor noncontributory defined benefit pension plans covering most U.S. employees. As appropriate, we provide pension coverage for employees of our non-U.S. subsidiaries through separate plans. Local statutory requirements govern many of these plans. In addition, our U.S. and Canadian subsidiaries provide health care and other benefits to most retired employees. Local government plans generally cover health care benefits for retirees outside the U.S. and Canada.

 

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Pension Plans:

Components of Net Periodic Pension Cost

Net periodic pension cost consisted of the following for the three and nine months ended September 30, 2007 and 2006:

 

         U.S. Plans      Non-U.S. Plans         
         For the Three Months Ended
September 30,
     For the Three Months Ended
September 30,
        
         2007      2006      2007      2006         
         (in millions)      (in millions)         
 

Service cost

   $ 40      $ 42      $ 25      $ 24       
 

Interest cost

     91        89        49        42       
 

Expected return on plan assets

     (131 )      (126 )      (64 )      (50 )     
 

Amortization:

                
 

Net loss from experience differences

     35        50        18        20       
 

Prior service cost

     1        1        2        2       
 

Other expense

     19                      2       
                                          
 

Net periodic pension cost

   $              55      $              56      $              30      $              40       
                                          
         U.S. Plans      Non-U.S. Plans         
        

For the Nine Months Ended

September 30,

     For the Nine Months Ended
September 30,
        
         2007      2006      2007      2006         
         (in millions)      (in millions)         
 

Service cost

   $ 119      $ 127      $ 73      $ 70       
 

Interest cost

     273        266        142        125       
 

Expected return on plan assets

     (393 )      (378 )      (184 )      (149 )     
 

Amortization:

                
 

Net loss from experience differences

     105        149        50        54       
 

Prior service cost

     4        4        6        6       
 

Other expense

     53                      2       
                                          
 

Net periodic pension cost

   $ 161      $ 168      $ 87      $ 108       
                                          

Employees left Kraft under workforce reduction initiatives, resulting in settlement losses for the U.S. plans of $4 million in the third quarter of 2007 and $19 million in the nine months ended September 30, 2007. In addition, retiring employees elected lump-sum payments, resulting in settlement losses for U.S. plans of $15 million in the third quarter of 2007 and $34 million in the nine months ended September 30, 2007. These costs are included in other expense, above.

Employer Contributions

We make contributions to our U.S. and non-U.S. pension plans to the extent that they are tax deductible and do not generate an excise tax liability. During the nine months ended September 30, 2007, we contributed $14 million to our U.S. plans and $113 million to our non-U.S. plans. We currently plan to make additional contributions of approximately $2 million to our U.S. plans and approximately $44 million to our non-U.S. plans during the remainder of 2007. However, our actual contributions may be different due to many factors. Those factors include changes in tax and other benefit laws, pension asset performance that differs significantly from the expected performance, or significant changes in interest rates.

 

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Postretirement Benefit Plans:

Net postretirement health care costs consisted of the following for the three and nine months ended September 30, 2007 and 2006:

 

         For the Three Months Ended
September 30,
     For the Nine Months Ended
September 30,
        
         2007      2006      2007      2006         
         (in millions)      (in millions)         
 

Service cost

   $ 11      $ 12      $ 35      $ 37       
 

Interest cost

     44        44        132        131       
 

Amortization:

                
 

Net loss from experience differences

     15        17        44        58       
 

Prior service credit

     (7 )      (6 )      (20 )      (19 )     
                                          
 

Net postretirement health care costs

   $             63      $             67      $           191      $           207       
                                          

 

Postemployment Benefit Plans:

 

Net postemployment costs consisted of the following for the three and nine months ended September 30, 2007 and 2006:

 

         For the Three Months Ended
September 30,
     For the Nine Months Ended
September 30,
        
         2007      2006      2007      2006         
         (in millions)      (in millions)         
 

Service cost

   $ 1      $ 1      $ 3      $ 4       
 

Interest cost

     1        1        4        3       
 

Amortization of unrecognized net gains

     (1 )      (2 )      (2 )      (6 )     
 

Other expense

     26        54        85        170       
                                          
 

Net postemployment costs

   $           27      $           54      $             90      $             171       
                                          

As previously discussed in Note 2, Asset Impairment, Exit and Implementation Costs, we announced several workforce reduction initiatives as part of the Restructuring Program. The postemployment benefit plan cost of these initiatives was $26 million during the three months and $85 million during the nine months ended September 30, 2007. These costs are included in other expense, above.

Note 15. Income Taxes:

Kraft accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. Prior to the Distribution, Altria included our U.S. accounts in its consolidated federal income tax return, and we generally computed income taxes on a separate company basis. However, some of our foreign tax credits, capital losses and other credits could not be used on a separate company basis. To the extent that Altria used our foreign tax credits and other tax benefits in its consolidated federal income tax return, we recognized the benefit in the calculation of our provision for income taxes. We made payments to, or were reimbursed by, Altria for the tax effects resulting from being included in Altria’s tax return, including current taxes payable and net changes in tax provisions. As of March 31, 2007, we are no longer a member of the Altria consolidated tax return group and will file our own federal consolidated income tax return. Altria also previously carried our federal tax contingencies on its balance sheet and reported them in its financial statements. As a result of the Distribution, Altria transferred our federal tax contingencies of $375 million to our balance sheet and related interest income of $77 million at the end of the first quarter of 2007. During the second quarter, Altria paid us $305 million for the federal tax contingencies held by them, less the impact of federal reserves reversed due to the adoption of FASB Interpretation No. 48. This amount is reflected as a component of other within the net cash provided by operating activities section of the condensed consolidated statement of cash flows.

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for the Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (“FIN 48”). The provisions of FIN 48 became effective for us as of January 1, 2007. FIN 48 clarifies when tax benefits should be recorded in the financial statements and provides measurement criteria for valuing such benefits. In order for us

 

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to recognize benefits, our tax position must be more-likely-than-not to be sustained upon audit. The amount we recognize is measured as the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. Before the implementation of FIN 48, we established additional provisions for certain positions that were likely to be challenged even though we believe that those existing tax positions were fully supportable. The adoption of FIN 48 resulted in an increase to shareholders’ equity as of January 1, 2007 of $213 million and resulted from:

 

   

a $265 million decrease in the liability for unrecognized tax benefits, comprised of $247 million in tax and $18 million in interest;

 

   

a reduction in goodwill of $85 million; and

 

   

an increase to federal and state deferred tax assets of $33 million.

As of January 1, 2007, after the implementation of FIN 48, our unrecognized tax benefits were $667 million. If we had recognized all of these benefits, the net impact on our income tax provision would have been $530 million. There were no material changes due to settlements with tax authorities or the expiration of the statute of limitations during the nine months ended September 30, 2007. As a result, the change in our unrecognized tax benefits during the nine months ended September 30, 2007 was insignificant. We expect that the amount of unrecognized tax benefits will increase by approximately $70-$85 million from a variety of federal, state and foreign tax positions during the next 12 months. We include accrued interest and penalties related to uncertain tax positions in our tax provision. As of January 1, 2007, we had $125 million of accrued interest and penalties. The change in accrued interest and penalties during the nine months ended September 30, 2007 was insignificant.

We are regularly examined by federal and various state and foreign tax authorities. The U.S. federal statute of limitations remains open for the year 2000 and onward, with years 2000 through 2003 currently under examination by the IRS. Taxing authorities in various U.S. state and foreign jurisdictions are also currently examining us. U.S. state and foreign jurisdictions have statutes of limitations generally ranging from 3 to 5 years. Years still open to examination by foreign tax authorities in major jurisdictions include Germany (1999 onward), Brazil (2001 onward), Canada (2001 onward) and Spain (2001 onward).

Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Description of the Company

Kraft manufactures and markets packaged food products, including beverages, cheese, snacks, convenient meals and various packaged grocery products. We manage and report operating results through two commercial units, Kraft North America and Kraft International. We manage Kraft North America’s operations by product category, and Kraft International’s operations by geographic location.

In the first quarter of 2007, Altria Group, Inc. (“Altria”) spun off its entire interest (89.0%) in Kraft on a pro rata basis to Altria stockholders in a tax-free transaction. Effective as of the close of business on March 30, 2007, all Kraft shares owned by Altria were distributed to Altria’s stockholders, and our separation from Altria was completed (the “Distribution”). Before the Distribution, Altria converted its Class B shares of Kraft common stock into Class A shares of our common stock. The Distribution ratio was calculated by dividing the number of shares of Kraft Common Stock held by Altria by the number of Altria shares outstanding on the date of record, March 16, 2007. Based on the calculation, the Distribution ratio was 0.692024 shares of Kraft Common Stock for every share of Altria common stock outstanding. Following the Distribution, we only have Class A common stock outstanding.

Executive Summary

The following executive summary provides significant highlights of the Discussion and Analysis that follows.

 

   

Net revenues in the third quarter of 2007 increased 9.8% to $9.1 billion and increased 7.4% to $26.8 billion in the first nine months of 2007.

 

   

Diluted EPS in the third quarter of 2007 decreased 15.6% to $0.38 and decreased 15.0% to $1.25 in the first nine months of 2007.

 

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We made solid progress executing our long-term growth strategy, which focuses on: rewiring the organization for growth; reframing our categories; exploiting our sales capabilities; and driving down costs without compromising quality.

 

   

On October 29, 2007, we announced that we have signed final agreements to acquire the global biscuit business of Groupe Danone S.A. for €5.3 billion (approximately $7.5 billion) in cash. The transaction is subject to customary closing conditions, including regulatory approval, and we expect it to close by the end of the year.

 

   

We recorded Restructuring Program charges of $81 million during the three months and $326 million during the nine months ended September 30, 2007.

 

   

In August 2007, we issued $3.5 billion of senior unsecured notes. We used the net proceeds ($3,462 million) from the sale of the offered securities for general corporate purposes, including the repayment of outstanding commercial paper.

 

   

A new $5.0 billion, two-year share repurchase program went into effect immediately following the Distribution. During the third quarter of 2007, we repurchased 30.2 million shares of our Common Stock for approximately $1.0 billion, bringing total repurchases since the beginning of the program to 90.9 million shares for $3.0 billion.

 

   

In the third quarter of 2007, our Board of Directors approved an 8.0% increase in the current quarterly dividend rate to $0.27 per share on our Common Stock. As a result, our present annualized dividend rate is $1.08 per common share.

Discussion and Analysis

Growth Strategy

At the Lehman Brothers Back-To-School Consumer Conference in September 2007, our Chairman and CEO, Irene Rosenfeld, highlighted the solid progress that we made executing our long-term growth strategy. Below is a summary of our four growth strategies and the developments within each.

Rewire the organization for growth – We are making significant changes to our leadership, reward systems and structure. Over the past year, we have built a new management team, with roughly half of our top executives new to Kraft or their positions. That includes Tim McLevish as our new CFO effective October 1, 2007 and the two leaders of our commercial units, Rick Searer, the president of Kraft North America, and Sanjay Khosla, the president of Kraft International. Additionally, we directly linked our annual incentive program with business unit performance and our long-term incentive program with key drivers such as operating income growth. Furthermore, we expect to complete the implementation of a new structure by early 2008 built on three core elements: accountable business units; shared services that leverage the scale of our global portfolio; and a streamlined corporate staff. We expect some job eliminations as we improve effectiveness and streamline our headquarter functions.

Reframe our categories – We compared each of our categories to those of our competitors, focusing on: growth potential; relative market share position; and profitability. Our assessment allowed us to prioritize exactly “where” to invest to best accelerate our growth. For those businesses that we determine no longer fit our long-term growth plan, we will explore options for divestitures in a tax efficient manner, as well as outright sales.

A framework was also established to define “how” we will invest. The reframing of our categories is predicated on four clear consumer growth trends in the food industry: Snacking; Quick Meals; Health and Wellness; and Premium Quality. Through this framework that we call the “Growth Diamond,” we are building a robust pipeline of new ideas across Kraft.

In 2007, we plan to spend on the high end of an incremental $300-$400 million primarily on product quality improvements, new products and increased marketing to jumpstart growth. We have incurred approximately $250 million of these incremental costs during the nine months ended September 30, 2007. In Kraft North America, we are focusing these incremental investments on large, highly profitable categories, including macaroni & cheese, pizza, biscuits, cheese and coffee. In Kraft International, we are building our core brands, particularly in our chocolate and coffee categories in the European Union.

 

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Exploit our sales capabilities – We are using our scale to combine the executional benefits of direct store delivery used in our Biscuit business unit with the economics of our warehouse delivery to drive faster growth in Kraft North America. We are creating a sustainable competitive advantage as one sales representative covers an entire store “Wall-to-Wall.” Wall-to-Wall will increase the frequency of our retail visits and build stronger, ongoing relationships with store management allowing us to: reduce out-of-stocks; get new items to the shelves more quickly; and increase the number and quality of displays. We plan to complete the full rollout in North America by mid-2008.

Kraft International is expanding our reach to the traditional trade in key developing markets. In select markets, we invested to expand our reach to the traditional trade, and have seen positive results. By expanding our distribution reach in countries with rapidly growing demand, we plan to build profitable scale.

Drive down costs without compromising product quality – We plan to contain administrative overhead costs while investing in quality, R&D, marketing, sales and other capabilities that support growth. We anticipate completing our Restructuring Program in 2008 with total annualized savings of at least $1.0 billion. We are seeking ways to expand margins while providing the funding to drive growth. We believe the new organizational structure will be a key enabler.

Summary of Financial Results

The following table shows the significant changes in our net earnings and diluted EPS between the three months ended September 30, 2007 and 2006, and between the nine months ended September 30, 2007 and 2006 (in millions, except per share data):

 

     For the Three Months Ended     For the Nine Months Ended  
    

Net

Earnings

    Diluted
EPS
   

Net

Earnings

    Diluted
EPS
 

September 30, 2006

   $ 748     $ 0.45     $ 2,436     $ 1.47  

2007 Losses on divestitures

                 (2 )      

2006 Losses on divestitures

     60       0.04       70       0.04  

2006 Gain on redemption of United Biscuits investment

     (148 )     (0.09 )     (148 )     (0.09 )

2007 Restructuring Program

     (51 )     (0.03 )     (208 )     (0.13 )

2006 Restructuring Program

     94       0.06       331       0.20  

2007 Asset impairment charges

     (52 )     (0.03 )     (52 )     (0.03 )

2006 Asset impairment charges

                 78       0.05  

Change in tax rate

     16       0.01       11       0.01  

Interest from tax reserve transfers from Altria Group, Inc.

                 50       0.03  

Favorable resolution of the Altria Group, Inc. 1996-1999 IRS Tax Audit

                 (405 )     (0.24 )

Shares outstanding

           0.02             0.04  

Consolidated Results of Operations

     (71 )     (0.05 )     (156 )     (0.10 )
                                

September 30, 2007

   $             596     $           0.38     $           2,005     $             1.25  
                                

See below for a discussion of those events affecting comparability and a discussion of operating results.

Acquisitions and Divestitures

On October 29, 2007, we announced that we have signed final agreements to acquire the global biscuit business of Groupe Danone S.A. (“Danone Biscuit”) for €5.3 billion (approximately $7.5 billion) in cash subject to purchase price adjustments. This follows the announcement of our binding offer in July which, according to French law, was subject to consultation with Groupe Danone S.A.’s works councils. The recent conclusion of these consultations has allowed the Group Danone S.A. Board of Directors to approve the transaction and both parties to sign the final sale agreement. Danone Biscuit generated global revenues of approximately $2.7 billion during 2006. Completion of this transaction is subject to customary closing conditions, including regulatory approval. We expect it to close by the end of the year.

 

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In October 2007, we announced and closed the sale of our flavored water and juice brand assets and related trademarks, including Veryfine and Fruit2O.

In September 2006, we acquired the Spanish and Portuguese operations of United Biscuits (“UB”) for approximately $1.1 billion. The non-cash acquisition was financed by our assumption of $541 million of debt issued by the acquired business immediately prior to the acquisition, as well as $530 million of value for the redemption of our outstanding investment in UB, primarily deep-discount securities. The redemption of our outstanding investment resulted in a gain on closing of approximately $251 million or $0.09 per diluted share in the third quarter of 2006. As part of the transaction, we also recovered the rights to all Nabisco trademarks in the European Union, Eastern Europe, the Middle East and Africa, which UB had held since 2000. The Spanish and Portuguese operations of UB include its biscuits, dry desserts, canned meats, tomato and fruit juice businesses. The operations also include seven manufacturing facilities and 1,300 employees. These businesses contributed net revenues of approximately $129 million during the three months and $344 million during the nine months ended September 30, 2007. Due to the timing of closing of the acquisition, our financial statements for the period ended September 30, 2006 do not reflect results from these operations, the amounts of which were not material.

During the second quarter of 2007, we sold sugar confectionery assets in Romania and related trademarks. During the first quarter of 2007, we sold our hot cereal assets and trademarks. In aggregate, we received $203 million in proceeds, and recorded pre-tax gains of $20 million on these sales. We recorded an after-tax loss of $2 million on these divestitures primarily due to the differing tax bases of our hot cereal assets and trademarks.

In the nine months ended September 30, 2006, we received $674 million in proceeds and recorded pre-tax losses of $14 million, or $0.04 per diluted share after-taxes, on the following sales. During the first quarter of 2006, we sold certain Canadian assets and a small U.S. biscuit brand. During the second quarter of 2006, we sold our industrial coconut assets. During the third quarter of 2006, we sold our pet snacks brand and assets.

The aggregate operating results of the businesses sold were not material to our financial statements in any of the periods presented.

Restructuring Program

In January 2004, we announced a three-year restructuring program (the “Restructuring Program”) and, in January 2006, extended it through 2008. The objectives of this program are to leverage our global scale, realign and lower our cost structure, and optimize capacity. As part of the Restructuring Program we anticipate:

 

   

incurring approximately $3.0 billion in pre-tax charges reflecting asset disposals, severance and implementation costs, including approximately $500 million of the charges during 2007;

   

closing up to 40 facilities and eliminating approximately 14,000 positions;

   

using cash to pay for approximately $1.9 billion of the $3.0 billion in charges; and

   

annual savings of at least $1.0 billion upon completion.

In September 2007, we announced that we are implementing a new operating structure built on three core elements: accountable business units; shared services that leverage the scale of our global portfolio; and a streamlined corporate staff. We expect to complete the roll-out of this new structure by early 2008. The primary objective of this initiative is improved effectiveness, and as a result, we expect some job eliminations as we streamline our headquarter functions.

We incurred charges under the Restructuring Program of $81 million, or $0.03 per diluted share, during the three months and $326 million, or $0.13 per diluted share, during the nine months ended September 30, 2007, and $148 million, or $0.06 per diluted share, during the three months and $496 million, or $0.20 per diluted share, during the nine months ended September 30, 2006. In total, we have incurred $1.9 billion in charges since the inception of the Restructuring Program. We expect to pay cash for approximately 60% of the charges. In connection with severance initiatives announced since 2004, we expect to eliminate approximately 10,800 positions. As of September 30, 2007, we had eliminated approximately 10,400 of these positions.

In addition, we expect to spend approximately $550 million in capital to implement the Restructuring Program. We have spent $334 million in capital since the inception of the Restructuring Program, including $89 million spent in the first nine months of 2007. Cumulative annualized cost savings resulting from the Restructuring Program were approximately $540 million through 2006. Incremental cost savings totaled approximately $180 million in the first nine months of 2007, resulting in cumulative annualized

 

25


savings under the Restructuring Program of approximately $720 million to date. We expect these savings to reach approximately $775 million by the end of 2007. Refer to Note 2, Asset Impairment, Exit and Implementation Costs, for further details of our Restructuring Program.

Asset Impairment Charges

In October 2007, we announced and closed the sale of our flavored water and juice brand assets and related trademarks. In recognition of the anticipated sale, we recorded a $120 million, or $0.03 per diluted share, asset impairment charge for these assets in the third quarter. The charge, which included the write-off of the associated goodwill, intangible assets and property, plant and equipment, was recorded as asset impairment and exit costs on the condensed consolidated statement of earnings.

During the first quarter of 2007, we completed our annual review of goodwill and intangible assets. No impairments resulted from this review. During the first quarter of 2006, we completed our annual review of goodwill and intangible assets and recorded a $24 million non-cash charge for impairment of biscuits assets in Egypt and hot cereal assets in the U.S. We recorded these charges as asset impairment and exit costs on the condensed consolidated statement of earnings.

In the first quarter of 2006, we incurred an asset impairment charge of $86 million in anticipation of the pet snacks brand and assets sale. The charge, which included the write-off of a portion of the associated goodwill, intangible assets and property, plant and equipment, was recorded as asset impairment and exit costs on the 2006 consolidated statement of earnings. We recorded aggregate asset impairment charges in the nine months ended September 30, 2006 amounting to $110 million, or $0.05 per diluted share.

Provision for Income Taxes

Our tax rate was 27.0% in the third quarter of 2007 and 31.2% in the first nine months of 2007. Our provision for income taxes includes a net benefit of $98 million in the third quarter of 2007 primarily resulting from the tax consequences of the impairment of our flavored water and juice brand assets and related trademarks as of the end of the quarter, and various foreign tax law changes enacted during the quarter. For the first nine months of 2007, the provision includes a net tax benefit of $106 million primarily resulting from the third quarter impairment and tax law changes plus the second quarter resolution of outstanding items in our international operations and various state jurisdictions, partially offset by tax costs associated with the sale of our hot cereal assets and trademarks in the first quarter.

As discussed in Note 15, Income Taxes, Altria transferred our federal tax contingencies of $375 million to our balance sheet and related interest income of $77 million, or $0.03 per diluted share, at the end of the first quarter of 2007 as a result of the Distribution. Following the Distribution, we are no longer a member of the Altria consolidated tax return group, and we will file our own federal consolidated income tax return. As a result of filing separately, we currently estimate the annual amount of lost tax benefits to be in the range of $50 million to $75 million.

In the first quarter of 2006, the IRS concluded its examination of Altria’s consolidated tax returns for the years 1996 through 1999. The IRS issued a final Revenue Agents Report on March 15, 2006. Consequently, Altria reimbursed us $337 million for federal tax reserves that were no longer necessary and $46 million for interest ($29 million net of tax). We also recognized net state tax reversals of $39 million, for a total tax provision benefit of $376 million ($337 million federal plus $39 million state). The total benefit to net earnings that we recognized in the first quarter of 2006 due to the IRS settlement was $405 million, or $0.24 per diluted share.

Consolidated Results of Operations

The following discussion compares our consolidated results of operations for the three months ended September 30, 2007 and 2006, and for the nine months ended September 30, 2007 and 2006.

Many factors impact the timing of sales to our customers. These factors include, among others, the timing of holidays and other annual or special events, seasonality, significant weather conditions, timing of our own or customer incentive programs and pricing actions, customer inventory programs, our initiatives to improve supply chain efficiency, the financial condition of our customers and general economic conditions. For instance, changes in the timing of the Easter holiday will often affect first and second quarter comparisons with the prior year.

 

26


        

For the Three Months Ended

September 30,

                           
         2007    2006        $ change              % change                    
         (in millions, except per share data)                            
 

Net revenues

   $       9,054    $       8,243    $       811      9.8%          
                             
 

Operating income

     981      1,355      (374 )    (27.6% )        
                             
 

Net earnings

   $ 596    $ 748      (152 )    (20.3% )        
                             
 

Weighted average shares for
diluted earnings per share

     1,576      1,648              
                             
 

Diluted earnings per share

   $ 0.38    $ 0.45              
                             
        

For the Nine Months Ended

September 30,

                           
         2007    2006    $ change      % change                
         (in millions, except per share data)                            
 

Net revenues

   $ 26,845    $ 24,985    $ 1,860      7.4%          
                             
 

Operating income

     3,291      3,548      (257 )    (7.2% )        
                             
 

Net earnings

   $ 2,005    $ 2,436      (431 )    (17.7% )        
                             
 

Weighted average shares for
diluted earnings per share

     1,608      1,658              
                             
 

Diluted earnings per share

   $ 1.25    $ 1.47              
                             

Three Months Ended September 30:

Net Revenues – Net revenues increased $811 million (9.8%), due to favorable currency (2.5 pp), higher pricing, net of increased promotional spending (2.3 pp), higher volume (2.0 pp), favorable mix (1.9 pp), and the impact of acquisitions (1.6 pp), partially offset by the impact of divestitures (0.5 pp). Currency movements increased net revenues by $212 million, due primarily to the continuing weakness of the U.S. dollar against the euro, Canadian dollar and Brazilian real. Total volume increased 3.7% (1.7pp due to acquisitions net of divestitures), resulting from higher shipments in European Union and Developing Markets, partially offset by declines in our North American segments, including the impact of divestitures.

Operating Income – Operating income declined $374 million (27.6%), due primarily to the prior year $251 million gain on the redemption of our UB investment, higher total manufacturing costs, including higher commodity costs, net of the impact of higher pricing ($117 million), an asset impairment charge related to our flavored water and juice brand assets and related trademarks ($120 million) and higher marketing, administration and research costs ($89 million, including higher marketing support). These items were partially offset by favorable volume/mix ($116 million), and lower Restructuring Program charges ($67 million). Currency movements increased operating income by $27 million due primarily to the continuing weakness of the U.S. dollar against the euro and Canadian dollar.

Net Earnings – Net earnings of $596 million decreased by $152 million (20.3%), due to operating income declines and higher interest expense, partially offset by a favorable tax rate.

Earnings per Share – Third quarter 2007 diluted earnings per share were $0.38, down 15.6% from $0.45 in 2006. During the third quarter of 2007, we incurred $0.03 per diluted share ($81 million before taxes) in Restructuring Program costs as compared to $0.06 per diluted share ($148 million before taxes) in the third quarter of 2006. Additionally in the third quarter of 2007, we recorded an asset impairment charge related to the divestiture of our flavored water and juice brand assets and related trademarks amounting to $120 million or $0.03 per diluted share. During the third quarter of 2006, we recorded a gain on the redemption of our UB investment amounting to $0.09 per diluted share. Additionally, in the third quarter of 2006, we incurred a $0.04 per diluted share loss on divestitures.

 

27


Nine Months Ended September 30:

Net Revenues – Net revenues increased $1,860 million (7.4%), due primarily to favorable mix (2.4 pp), favorable currency (2.3 pp), the impact of acquisitions (1.4 pp), higher pricing, net of increased promotional spending (1.4 pp) and higher volume (0.8 pp), partially offset by the impact of divestitures (0.9 pp). Currency movements increased net revenues by $574 million, due primarily to the continuing weakness of the U.S. dollar against the euro. Total volume increased 1.4% (0.6pp due to acquisitions net of divestitures), driven by higher shipments in the European Union and Developing Markets, partially offset by lower volume in all North American segments due primarily to the impact of divestitures, the discontinuation of select lower margin foodservice products and declines in ready-to-drink beverages.

Operating Income – Operating income declined $257 million (7.2%), due primarily to higher marketing, administration and research costs ($346 million, including higher marketing support), the prior year $251 million gain on the redemption of our UB investment, higher total manufacturing costs, including higher commodity costs, net of the impact of higher pricing ($194 million) and an asset impairment charge related to our flavored water and juice brand assets and related trademarks ($120 million). These items were partially offset by favorable volume/mix ($326 million), lower Restructuring Program charges ($170 million) and 2006 asset impairment charges related to the divested pet snacks and hot cereal assets and trademarks and biscuits assets in Egypt ($110 million). Currency movements increased operating income by $67 million due primarily to the continuing weakness of the U.S. dollar against the euro.

Net Earnings – Net earnings of $2,005 million decreased by $431 million (17.7%), due primarily to operating income declines and a favorable tax rate in 2006 from a significant tax resolution.

Earnings per Share – In the first nine months of 2007 diluted earnings per share were $1.25, down 15.0% from $1.47 in 2006. During the first nine months of 2007, we incurred $0.13 per diluted share ($326 million before taxes) in Restructuring Program costs as compared to $0.20 per diluted share ($496 million before taxes) in the first nine months of 2006. Additionally, during the first nine months of 2007, we incurred $0.03 per diluted share ($120 million before taxes) in asset impairment charges as compared to $0.05 per diluted share ($110 million before taxes) in the first nine months of 2006. Due to the Distribution, we recognized interest income of $0.03 per diluted share ($77 million before taxes) from tax reserve transfers from Altria. In the first quarter of 2006, we benefited from favorable federal and state tax resolutions amounting to $405 million, or $0.24 per diluted share. Additionally, in the first nine months of 2006, we incurred a $0.04 per diluted share loss on divestitures.

 

28


Results of Operations by Business Segment

The following discussion compares our operating results of each of our reportable segments for the three months ended September 30, 2007 and 2006, and for the nine months ended September 30, 2007 and 2006.

 

         For the Three Months Ended
September 30,
     For the Nine Months Ended
September 30,
        
         2007      2006      2007      2006         
         (in millions)      (in millions)         
 

Net revenues:

                
 

North America Beverages

   $                 773      $                 731      $             2,453      $           2,345       
 

North America Cheese & Foodservice

     1,537        1,446        4,545        4,410       
 

North America Convenient Meals

     1,311        1,232        3,831        3,676       
 

North America Grocery

     602        597        2,001        2,019       
 

North America Snacks & Cereals

     1,655        1,585        4,812        4,729       
 

European Union

     1,855        1,544        5,446        4,550       
 

Developing Markets (1)

     1,321        1,108        3,757        3,256       
                                          
 

Net revenues

   $ 9,054      $ 8,243      $ 26,845      $ 24,985       
                                          
         For the Three Months Ended
September 30,
     For the Nine Months Ended
September 30,
        
         2007      2006      2007      2006         
         (in millions)      (in millions)         
 

Operating income:

                
 

Segment operating income:

                
 

North America Beverages

   $ (4 )    $ 83      $ 269      $ 345       
 

North America Cheese & Foodservice

     159        233        501        615       
 

North America Convenient Meals

     185        183        526        568       
 

North America Grocery

     184        176        651        674       
 

North America Snacks & Cereals

     240        255        754        666       
 

European Union

     129        347        372        562       
 

Developing Markets (1)

     137        122        366        255       
 

General corporate expenses

     (46 )      (43 )      (139 )      (131 )     
 

Amortization of intangibles

     (3 )      (1 )      (9 )      (6 )     
                                          
 

Operating income

   $ 981      $ 1,355      $ 3,291      $ 3,548       
                                          

(1) This segment was formerly known as Developing Markets, Oceania & North Asia

As discussed in Note 12, Segment Reporting, our management uses segment operating income to evaluate segment performance and allocate resources. Segment operating income excludes unallocated general corporate expenses and amortization of intangibles. Management believes it is appropriate to disclose this measure to help investors analyze segment performance and trends. We incurred asset impairment, exit and implementation costs of $201 million during the three months and $446 million during the nine months ended September 30, 2007. Refer to Note 2, Asset Impairment, Exit and Implementation Costs, for a breakout of charges by segment.

In September 2007 we announced that we are implementing a new operating structure effective in early 2008. We expect to finalize the new reporting structure thereafter.

 

29


North America Beverages

          For the Three Months Ended
September 30,
                 
          2007      2006      $ change        % change      
          (in millions)                  
  

Net revenues

   $ 773      $ 731    $ 42      5.7%    
  

Segment operating income

     (4 )      83      (87 )    (100+% )  
          For the Nine Months Ended
September 30,
                 
          2007      2006    $ change      % change      
          (in millions)                  
  

Net revenues

   $       2,453      $       2,345    $           108                4.6%    
  

Segment operating income

     269        345      (76 )    (22.0% )  

 

Three Months Ended September 30:

Net revenues increased $42 million (5.7%), due primarily to favorable mix (2.2 pp), higher net pricing (1.8 pp) and higher volume (1.3 pp). Favorable mix was driven by Crystal Light On the Go base growth and new products, and growth in premium coffee. Higher commodity related pricing in coffee was partially offset by higher promotional spending in powdered beverages. Volume growth in the quarter was driven by ready-to-drink beverages, primarily Capri Sun.

 

Segment operating income decreased $87 million (100.0+%), due primarily to an asset impairment charge related to our flavored water and juice brand assets and related trademarks and higher commodity costs (primarily coffee), partially offset by favorable mix and higher pricing.

 

Nine Months Ended September 30:

Net revenues increased $108 million (4.6%), due primarily to favorable mix (5.2 pp) and higher net pricing (0.9 pp), which were partially offset by lower volume (1.6 pp). Favorable mix from Crystal Light On the Go sticks and premium coffee drove higher net revenues. Higher commodity-based pricing in coffee was partially offset by increased promotional spending in ready-to-drink beverages and powdered beverages. Net revenues growth was tempered by lower shipments of ready-to-drink beverages, powdered beverages and Maxwell House coffee.

 

Segment operating income decreased $76 million (22.0%), due primarily to asset impairment charges related to our flavored water and juice brand assets and related trademarks and higher commodity costs (primarily coffee and packaging), partially offset by favorable mix and higher pricing.

 

North America Cheese & Foodservice

          For the Three Months Ended
September 30,
                 
          2007      2006    $ change      % change      
          (in millions)                  
  

Net revenues

   $ 1,537      $ 1,446    $ 91      6.3%    
  

Segment operating income

     159        233      (74 )    (31.8% )  
          For the Nine Months Ended
September 30,
                 
          2007      2006    $ change      % change      
          (in millions)                  
  

Net revenues

   $       4,545      $       4,410    $           135                3.1%    
  

Segment operating income

     501        615      (114 )    (18.5% )  

Three Months Ended September 30:

Net revenues increased $91 million (6.3%), due primarily to higher commodity-based net pricing (7.3 pp), favorable currency (0.9 pp) and favorable mix (0.5 pp), partially offset by lower volume (2.2 pp). Cheese net revenues increased, driven by commodity-based pricing and favorable mix from new product introductions, partially offset by lower shipments. In foodservice, net revenues growth

 

30


from commodity-based pricing was partially offset by lower volume due to the discontinuation of lower margin product lines and unfavorable mix.

Segment operating income decreased $74 million (31.8%), as the favorable impact of pricing and lower fixed manufacturing costs were more than offset by higher commodity costs and higher marketing, administration and research costs (including higher marketing support).

Nine Months Ended September 30:

Net revenues increased $135 million (3.1%), due primarily to higher commodity-based net pricing (4.2 pp) and favorable mix (0.4 pp), partially offset by lower volume (1.5 pp). Cheese net revenues increased driven by higher commodity-based pricing and favorable mix from new product introductions, partially offset by lower shipments. In foodservice, net revenues growth from higher commodity-based net pricing was partially offset by lower volume due to the discontinuation of lower margin product lines and unfavorable mix.

Segment operating income decreased $114 million (18.5%), due primarily to higher commodity costs and higher marketing, administration and research costs (including higher marketing support). These unfavorable variances were partially offset by higher pricing, lower Restructuring Program charges and a 2006 loss on the sale of industrial coconut assets.

North America Convenient Meals

          For the Three Months Ended
September 30,
                 
          2007    2006      $ change          % change        
          (in millions)                  
  

Net revenues

   $       1,311    $       1,232    $             79                6.4%    
  

Segment operating income

     185      183      2      1.1%    
          For the Nine Months Ended
September 30,
                 
          2007    2006    $ change      % change      
          (in millions)                  
  

Net revenues

   $ 3,831    $ 3,676    $ 155      4.2%    
  

Segment operating income

     526      568      (42 )    (7.4% )  

Three Months Ended September 30:

Net revenues increased $79 million (6.4%), due primarily to favorable mix (3.5 pp), higher volume (2.7 pp) and higher net pricing (1.8 pp), partially offset by the impact of the divested rice brand and assets (1.9 pp). Favorable product mix and higher volume from new product introductions including Oscar Mayer Deli Creations, Oscar Mayer Lunchables Jr. and DiGiorno Ultimate pizza and the continued success of Oscar Mayer Deli Shaved sandwich meat, California Pizza Kitchen pizza and Kraft Easy Mac cups drove higher net revenues. Higher volume from new products was partially offset by lower shipments of chicken strips due to a first quarter recall. Meat net revenues also grew, driven by higher commodity-based net pricing, primarily in bacon.

Segment operating income increased $2 million (1.1%), as gains from higher pricing, favorable volume/mix and lower Restructuring Program charges were partially offset by higher commodity costs, higher marketing support costs and the impact of divestitures.

Nine Months Ended September 30:

Net revenues increased $155 million (4.2%), due primarily to favorable mix (3.1 pp), higher volume (1.7 pp) and higher net pricing (1.2 pp), partially offset by the impact of divestitures (2.0 pp). Net revenues increased in meat due to higher shipments of sandwich meat, new product introductions, favorable mix and higher commodity-based net pricing, partially offset by lower shipments of chicken strips due to a first quarter recall. In pizza, net revenues increased due to the introduction of DiGiorno Ultimate and higher shipments of California Pizza Kitchen products. Macaroni and cheese net revenues also increased due to higher pricing, net of increased promotional spending, favorable mix and higher volume.

Segment operating income decreased $42 million (7.4%), as lower Restructuring Program charges, higher pricing and favorable volume/mix were more than offset by higher commodity costs, higher marketing, administration and research costs (including higher marketing support) and the impact of divestitures.

 

31


North America Grocery

          For the Three Months Ended
September 30,
                 
          2007    2006    $ change      % change      
          (in millions)                  
  

Net revenues

   $          602    $          597    $               5              0.8%    
  

Segment operating income

     184      176      8      4.5%    
          For the Nine Months Ended
September 30,
                 
          2007    2006    $ change      % change      
          (in millions)                  
  

Net revenues

   $ 2,001    $ 2,019    $ (18 )    (0.9% )  
  

Segment operating income

     651      674      (23 )    (3.4% )  

 

Three Months Ended September 30:

Net revenues increased $5 million (0.8%), due to higher net pricing (2.5 pp) and favorable currency (1.0 pp), partially offset by lower volume (2.2 pp) and unfavorable mix (0.5 pp). Net revenues increased due to higher net pricing in dry packaged desserts, pourable salad dressings and ready-to-eat desserts. Net revenues growth was partially offset by lower shipments in pourable and spoonable salad dressings, dry packaged desserts and ready-to-eat desserts.

 

Segment operating income increased $8 million (4.5%), due primarily to lower marketing, administration and research costs (including lower marketing support) and lower Restructuring Program charges partially offset by unfavorable volume/mix.

 

Nine Months Ended September 30:

Net revenues decreased $18 million (0.9%), due primarily to lower volume (1.7 pp) and the impact of divestitures (0.4 pp), partially offset by higher net pricing (1.3 pp). The impact of lower shipments in barbeque sauce, spoonable and pourable salad dressings and dry packaged desserts was partially offset by higher net pricing in spoonable salad dressings and dry packaged desserts.

 

Segment operating income decreased $23 million (3.4%), due primarily to unfavorable volume/mix.

 

North America Snacks & Cereals

          For the Three Months Ended
September 30,
                 
          2007    2006        $ change          % change      
          (in millions)                  
  

Net revenues

   $       1,655    $       1,585    $             70                4.4%    
  

Segment operating income

     240      255      (15 )    (5.9% )  
          For the Nine Months Ended
September 30,
                 
          2007    2006    $ change      % change      
          (in millions)                  
  

Net revenues

   $ 4,812    $ 4,729    $ 83      1.8%    
  

Segment operating income

     754      666      88      13.2%    

Three Months Ended September 30:

Net revenues increased $70 million (4.4%), due to favorable mix (2.4 pp), higher volume (1.6 pp), higher net pricing (0.6 pp) and favorable currency (0.6 pp), partially offset by the impact of the pet snack and hot cereal divestitures (0.8 pp). Biscuit net revenues increased, driven by favorable mix in cookies and crackers and higher volume, due to new product introductions including Oreo Cakesters, Lorna Doone 100 Calorie Packs and Garden Harvest Toasted Chips, as well as base volume gains in Triscuits and Chips Ahoy!. Net revenues growth in bars was driven by higher volume due to the introduction of Nabisco 100 Calorie and Back to Nature bars. Net revenues growth in snack nuts was driven by favorable mix and higher volume due to new products, as well as base volume growth in Planters.

 

32


Segment operating income decreased $15 million (5.9%), due primarily to higher manufacturing costs and higher marketing, administration and research costs (including higher marketing support), partially offset by favorable volume/mix.

Nine Months Ended September 30:

Net revenues increased $83 million (1.8%), due primarily to favorable mix (2.4 pp) and higher volume (1.7 pp), partially offset by the impact of divestitures (2.5 pp). Favorable mix and higher shipments in cookies and crackers due to new product introductions drove higher net revenues. Bar net revenues increased due to new product introductions and continued success of South Beach Diet bars. Snack nuts net revenues increased due to favorable mix and new product introductions.

Segment operating income increased $88 million (13.2%), due primarily to 2006 asset impairment charges related to the divested pet snacks and hot cereal assets and trademarks, favorable volume/mix and lower Restructuring Program charges. These favorabilities were partially offset by higher marketing, administration and research costs (including higher marketing support) and the impact of divestitures.

European Union

          For the Three Months Ended
September 30,
                 
          2007    2006        $ change              % change          
          (in millions)                  
  

Net revenues

   $       1,855    $       1,544    $           311              20.1%    
  

Segment operating income

     129      347      (218 )    (62.8% )  
          For the Nine Months Ended
September 30,
                 
          2007    2006    $ change      % change      
          (in millions)                  
  

Net revenues

   $ 5,446    $ 4,550    $ 896      19.7%    
  

Segment operating income

     372      562      (190 )    (33.8% )  

Three Months Ended September 30:

Net revenues increased $311 million (20.1%), due to the impact of the UB acquisition (8.2 pp), favorable currency (7.0 pp), higher volume (4.7 pp) and favorable mix (2.8 pp), partially offset by lower net pricing (2.6 pp). Net revenues increased, driven by volume growth (partially the result of unseasonably cool weather across Europe) and favorable mix in chocolate, coffee and cheese due to new product introductions and higher marketing support. Lower net pricing reflects higher promotional spending in chocolate (premium products), coffee (primarily in Central Europe) and cheese.

Segment operating income decreased $218 million (62.8%), due primarily to the prior year gain on the redemption of our UB investment, lower net pricing, higher marketing, administration and research costs and higher commodity costs. Partially offsetting these unfavorabilities were favorable volume/mix, lower Restructuring Program charges, favorable currency and the impact of the UB acquisition.

Nine Months Ended September 30:

Net revenues increased $896 million (19.7%), due to favorable currency (9.0 pp), the impact of the UB acquisition (7.4 pp), higher volume (3.1 pp) and favorable mix (2.2 pp), partially offset by lower net pricing (2.0 pp). Volume related growth and favorable mix were driven by premium chocolate, due to new product introductions and promotional activities, and higher shipments in mainstream coffee and cheese. Lower net pricing reflects higher promotional spending in chocolate, cheese and coffee (primarily in Germany).

Segment operating income decreased $190 million (33.8%), due primarily to the prior year gain on the redemption of our UB investment, lower net pricing, higher marketing, administration and research costs and higher commodity costs. Partially offsetting these unfavorabilities were favorable volume/mix, favorable currency, the impact of the UB acquisition, lower fixed manufacturing costs and lower Restructuring Program charges.

 

33


Developing Markets

          For the Three Months Ended
September 30,
              
          2007    2006        $ change            % change         
          (in millions)               
  

Net revenues

   $       1,321    $       1,108    $           213            19.2%   
  

Segment operating income

     137      122      15    12.3%   
          For the Nine Months Ended
September 30,
              
          2007    2006    $ change    % change     
          (in millions)               
  

Net revenues

   $ 3,757    $ 3,256    $ 501    15.4%   
  

Segment operating income

     366      255      111    43.5%   

Three Months Ended September 30:

Net revenues increased $213 million (19.2%), due primarily to higher volume (7.3 pp), favorable currency (6.1 pp) and higher net pricing (5.7 pp). In Eastern Europe, Middle East & Africa, net revenues increased, driven by growth in coffee and chocolate, pricing in Russia, Romania and Ukraine and favorable currency. Latin American net revenues increased, driven by favorable volume/mix and pricing in Brazil, favorable volume/mix and higher pricing in Argentina and higher pricing and volume in Venezuela. In Asia Pacific, net revenues increased, due primarily to higher volume in China and Southeast Asia and currency.

Segment operating income increased $15 million (12.3%), due primarily to the contribution of higher pricing and favorable volume/mix, partially offset by higher marketing, administration and research costs (including higher marketing support), higher manufacturing costs and higher Restructuring Program costs.

Nine Months Ended September 30:

Net revenues increased $501 million (15.4%), due primarily to higher net pricing (5.1 pp), higher volume (4.3 pp), favorable currency (4.1pp) and favorable mix (1.7 pp). In Eastern Europe, Middle East & Africa, net revenues increased due to higher pricing and growth in coffee and chocolate in Russia, Romania and Ukraine. In Latin America, net revenues increased due to higher pricing and favorable volume/mix, particularly in Brazil, Venezuela and Argentina. In A