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Hillshire Brands Co 10-Q 2010
Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

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

For the quarterly period ended DECEMBER 26, 2009

OR

 

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

Commission file number 1-3344

 

 

Sara Lee Corporation

(Exact name of registrant as specified in its charter)

 

 

 

Maryland   36-2089049

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

3500 Lacey Road, Downers Grove, Illinois 60515

(Address of principal executive offices)

(Zip Code)

(630) 598-6000

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “accelerated filer, large accelerated filer, smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer   x    Accelerated filer   ¨
Non-accelerated filer   ¨    Smaller reporting company   ¨

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

On December 26, 2009, the Registrant had 697,326,315 outstanding shares of common stock $.01 par value, which is the Registrant’s only class of common stock.

 

 

 


Table of Contents

SARA LEE CORPORATION AND SUBSIDIARIES

INDEX

 

PART I       
ITEM 1     FINANCIAL STATEMENTS (Unaudited)   
    Condensed Consolidated Balance Sheets - At December 26, 2009 and June 27, 2009    3
    Consolidated Statements of Income - For the Quarter and Six Months ended December 26, 2009 and December 27, 2008    4
    Condensed Consolidated Statements of Equity - For the period June 28, 2008 to December 26, 2009    5
    Consolidated Statements of Cash Flows - For the Six Months ended December 26, 2009 and December 27, 2008    6
    Notes to Consolidated Financial Statements    7
ITEM 2     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS    28
ITEM 4     CONTROLS AND PROCEDURES    54
PART II       
ITEM 1     LEGAL PROCEEDINGS    55
ITEM 1A     RISK FACTORS    57
ITEM 2(c)     REPURCHASES OF EQUITY SECURITES BY THE ISSUER    57
ITEM 6     EXHIBITS    58
SIGNATURE      59

 

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SARA LEE CORPORATION AND SUBSIDIARIES

Condensed Consolidated Balance Sheets at December 26, 2009 and June 27, 2009

(Unaudited)

 

In millions

   Dec. 26,
2009
   June 27,
2009

Assets

     

Cash and equivalents

   $ 1,331    $ 951

Trade accounts receivable, less allowances

     1,398      1,272

Inventories

     

Finished goods

     436      443

Work in process

     25      32

Materials and supplies

     335      291
             
     796      766

Current deferred income taxes

     181      207

Other current assets

     314      250

Assets held for sale

     403      384
             

Total current assets

     4,423      3,830

Property, net of accumulated depreciation of $2,881 and $2,776, respectively

     2,156      2,200

Trademarks and other identifiable intangibles, net

     570      585

Goodwill

     1,312      1,295

Deferred income taxes

     314      309

Other noncurrent assets

     175      245

Noncurrent assets held for sale

     980      953
             
   $ 9,930    $ 9,417
             

Liabilities and Equity

     

Notes payable

   $ 42    $ 20

Accounts payable

     900      1,004

Income taxes payable and current deferred taxes

     7      23

Other accrued liabilities

     1,372      1,467

Current maturities of long-term debt

     22      46

Liabilities held for sale

     336      286
             

Total current liabilities

     2,679      2,846
             

Long-term debt

     2,749      2,738

Pension obligation

     582      595

Deferred income taxes

     48      55

Other liabilities

     1,079      1,061

Noncurrent liabilities held for sale

     11      64

Equity

     

Sara Lee common stockholders’ equity

     2,753      2,036

Noncontrolling interest

     29      22
             

Total Equity

     2,782      2,058
             
   $ 9,930    $ 9,417
             

See accompanying Notes to Consolidated Financial Statements.

 

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SARA LEE CORPORATION AND SUBSIDIARIES

Consolidated Statements of Income

For the Quarter and Six Months ended December 26, 2009 and December 27, 2008

(Unaudited)

 

     Quarter ended     Six Months ended  

In millions, except per share data

   Dec. 26,
2009
    Dec. 27,
2008
    Dec. 26,
2009
    Dec. 27,
2008
 

Continuing Operations

        

Net sales

   $ 2,858      $ 2,856      $ 5,446      $ 5,650   
                                

Cost of sales

     1,753        1,887        3,372        3,704   

Selling, general and administrative expenses

     791        832        1,555        1,670   

Net charges for exit activities, asset and business dispositions

     15        34        28        30   

Impairment charges

     17        107        17        107   

Contingent sale proceeds

     —          —          (133     (150

Interest expense

     38        41        73        86   

Interest income

     (6     (5     (12     (25
                                
     2,608        2,896        4,900        5,422   
                                

Income (loss) from continuing operations before income taxes

     250        (40     546        228   

Income tax expense (benefit)

     (55     —          51        77   
                                

Income (loss) from continuing operations

     305        (40     495        151   

Discontinued Operations

        

Net income from discontinued operations, net of tax expense (benefit) of $(7), $14, $(38) and $36

     66        23        160        62   
                                

Net income (loss)

   $ 371      $ (17   $ 655      $ 213   
                                

Income (loss) from continuing operations per share of common stock

        

Basic

   $ 0.44      $ (0.06   $ 0.71      $ 0.21   
                                

Diluted

   $ 0.43      $ (0.06   $ 0.71      $ 0.21   
                                

Net income (loss) per share of common stock

        

Basic

   $ 0.53      $ (0.02   $ 0.94      $ 0.30   
                                

Diluted

   $ 0.53      $ (0.02   $ 0.94      $ 0.30   
                                

Average shares outstanding

        

Basic

     699        703        698        705   
                                

Diluted

     701        703        700        706   
                                

Cash dividends declared per share of common stock

   $ 0.11      $ 0.11      $ 0.11      $ 0.11   
                                

See accompanying Notes to Consolidated Financial Statements.

 

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SARA LEE CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Equity

For the period June 28, 2008 to December 26, 2009

(Unaudited)

 

           Sara Lee Common Stockholders’ Equity        

In millions

   Total     Common
Stock
   Capital
Surplus
    Retained
Earnings
    Unearned
Stock
    Accumulated
Other
Comprehensive
Income (Loss)
    Noncontrolling
Interest
 

Balances at June 28, 2008

   $ 2,830      $ 7    $ 7      $ 2,760      $ (112   $ 149      $ 19   

Net income

     364        —        —          364        —          —          —     

Earnings of noncontrolling interest

     11        —        —          —          —          —          11   

Translation adjustments, net of tax

     (563     —        —          —          —          (561     (2

Net unrealized gain (loss) on qualifying cash flow hedges, net of tax

     (30     —        —          —          —          (30     —     

Pension/Postretirement activity, net of tax

     (164     —        —          —          —          (164     —     

Other comprehensive income activity, net of tax

     (4     —        —          —          —          (2     (2
                           

Comprehensive income (loss)

   $ (386                7   
                           

Dividends on common stock

     (310     —        —          (310     —          —          —     

Dividends paid on noncontrolling interest/Other

     (4                (4

Stock issuances—

               

Stock option and benefit plans

     4        —        4        —          —          —          —     

Restricted stock

     29        —        29        —          —          —          —     

Share repurchases and retirement

     (103     —        (25     (78     —          —          —     

Pension/Postretirement – adjustment to change in measurement date, net of tax

     (13     —        —          (16     —          3        —     

ESOP tax benefit, redemptions and other

     11        —        2        1        8        —          —     
                                                       

Balances at June 27, 2009

     2,058        7      17        2,721        (104     (605     22   

Net income

     655        —        —          655        —          —          —     

Earnings of noncontrolling interest

     7        —        —          —          —          —          7   

Translation adjustments, net of tax

     140        —        —          —          —          139        1   

Net unrealized gain (loss) on qualifying cash flow hedges, net of tax

     9        —        —          —          —          9        —     

Pension/Postretirement activity, net of tax

     (32     —        —          —          —          (32     —     

Other comprehensive income activity, net of tax

     2        —        —          —          —          1        1   
                           

Comprehensive income

   $ 781                   9   
                           

Dividends on common stock

     (78     —        —          (78     —          —          —     

Dividends paid on noncontrolling interest

     (2     —        —          —          —          —          (2

Stock issuances—

               

Stock option and benefit plans

     2        —        2        —          —          —          —     

Restricted stock

     18        —        18        —          —          —          —     

ESOP tax benefit, redemptions and other

     3        —        —          —          3        —          —     
                                                       

Balances at December 26, 2009

   $ 2,782      $ 7    $ 37      $ 3,298      $ (101   $ (488   $ 29   
                                                       

Comprehensive loss was $358 million in the first six months of 2009. There was no comprehensive loss attributable to noncontrolling interests in the first six months of 2009.

See accompanying Notes to Consolidated Financial Statements.

 

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SARA LEE CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows

For the Six Months ended December 26, 2009 and December 27, 2008

(Unaudited)

 

     Six Months ended  

In millions

   Dec. 26,
2009
    Dec. 27,
2008
 

OPERATING ACTIVITIES—

    

Net income

   $ 655      $ 213   

Less: Cash received from contingent sale proceeds

     (133     (150

Adjustments to reconcile net income to net cash from operating activities:

    

Depreciation

     181        184   

Amortization

     48        58   

Impairment charges

     17        107   

Net (gain) loss on business dispositions

     9        (3

Pension contributions, net of expense

     25        (21

Other

     (12     142   

Changes in current assets and liabilities, net of businesses acquired and sold

     (318     (316
                

Net cash from operating activities

     472        214   
                

INVESTMENT ACTIVITIES—

    

Purchases of property and equipment

     (142     (134

Purchases of software and other intangibles

     (11     (14

Acquisitions of businesses and investments

     —          (10

Dispositions of businesses and investments

     (1     15   

Cash received from contingent sale proceeds

     133        150   

Cash received from (used in) derivative transactions

     75        (153

Sales of assets

     9        5   
                

Net cash received from (used in) investment activities

     63        (141
                

FINANCING ACTIVITIES—

    

Purchases of common stock

     —          (103

Borrowings of other debt

     32        —     

Repayments of other debt

     (48     (327

Net change in financing with less than 90-day maturities

     1        (18

Payments of dividends

     (154     (149
                

Net cash used in financing activities

     (169     (597
                

Effect of changes in foreign exchange rates on cash

     25        (198
                

Increase (decrease) in cash and equivalents

     391        (722

Add: Cash balances of discontinued operations at beginning of year

     8        1   

Less: Cash balances of discontinued operations at end of period

     (19     (4

Cash and equivalents at beginning of year

     951        1,282   
                

Cash and equivalents at end of quarter

   $ 1,331      $ 557   
                

COMPONENTS OF CHANGES IN CURRENT ASSETS AND LIABILITIES—

    

Trade accounts receivable

   $ (108   $ (89

Inventories

     (3     (77

Other current assets

     50        (7

Accounts payable

     (43     (151

Accrued liabilities

     (36     28   

Accrued taxes

     (178     (20
                

Changes in current assets and liabilities, net of businesses acquired and sold

   $ (318   $ (316
                

See accompanying Notes to Consolidated Financial Statements.

 

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SARA LEE CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

  1. Basis of Presentation

The consolidated financial statements for the quarter and six months ended December 26, 2009 and December 27, 2008 have not been audited by an independent registered public accounting firm, but in the opinion of Sara Lee Corporation (corporation or company), these financial statements include all normal and recurring adjustments necessary for a fair presentation of our financial position, operating results, and cash flows. The results of operations for the six months ended December 26, 2009 are not necessarily indicative of the operating results to be expected for the full fiscal year. The Condensed Consolidated Balance Sheet as of June 27, 2009 has been derived from the corporation’s audited financial statements included in our Annual Report on Form 10-K for the year ended June 27, 2009. The businesses comprising the former International Household and Body Care segment are presented as discontinued operations in the corporation’s consolidated financial statements. See Note 4 – “Discontinued Operations” for additional information regarding these discontinued operations. Unless stated otherwise, any reference to income statement items in these financial statements refers to results from continuing operations.

The interim consolidated financial statements included herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Although the corporation believes the disclosures are adequate to make the information presented not misleading, certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the corporation’s Form 10-K for the year ended June 27, 2009 and other financial information filed with the Securities and Exchange Commission. These financial statements consider subsequent events through the date of filing with the Securities and Exchange Commission.

The corporation’s fiscal year ends on the Saturday closest to June 30. Fiscal 2010 ends on July 3, 2010. The second quarter and first six months of fiscal 2010 ended on December 26, 2009 and the second quarter and first six months of fiscal 2009 ended on December 27, 2008. Each of the quarters was a thirteen-week period and each of the six month periods was a twenty-six week period. Fiscal 2010 is a 53-week year, whereas fiscal 2009 was a 52-week year. Unless otherwise stated, references to years relate to fiscal years.

In 2010, the corporation adopted new accounting guidance related to noncontrolling interests in consolidated financial statements. This guidance requires the classification of noncontrolling interests in subsidiaries, formerly referred to as minority interest, as a separate component of equity and the changes in ownership interest must be accounted for as equity transactions. It also requires that the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of income. The adoption of this accounting guidance did not have an impact on the Consolidated Statements of Income as the corporation does not have any noncontrolling interests associated with its continuing operations. However, the Condensed Consolidated Balance Sheets and Condensed Consolidated Statements of Equity have been revised, for all periods presented, to isolate the impact of noncontrolling interests on equity and comprehensive income.

In 2010, the corporation adopted new accounting guidance related to business combinations, which requires changes in the accounting and reporting of business acquisitions. This guidance requires an acquirer to recognize and measure the identifiable assets acquired, liabilities assumed, contractual contingencies, contingent consideration and any noncontrolling interest in an acquired business at fair value on the acquisition date. In addition, it also requires that acquisition costs generally be expensed when incurred, restructuring costs generally be expensed in periods subsequent to the acquisition date and any adjustments to deferred tax asset valuation allowances and acquired uncertain tax positions after the measurement period to be reflected in income tax expense. The adoption of this guidance has not impacted the consolidated financial statements.

 

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Table of Contents
  2. Net Income Per Share

Net income per share – basic is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding for the period. Net income per share – diluted reflects the potential dilution that could occur if options or fixed awards to be issued under stock-based compensation awards were converted into common stock. For the quarter and six month period ended December 26, 2009, options to purchase 23.9 million shares of the corporation’s common stock had exercise prices that were greater than the average market price of those shares during the respective reporting periods. For the quarter and six months ended December 27, 2008, options to purchase 28.6 million shares of the corporation’s common stock had exercise prices that were greater than the average market price of those shares during the respective reporting periods. These shares are excluded from the earnings per share calculation as they are anti-dilutive. In addition, the dilutive effect of stock options and award plans were excluded from the determination of the dilutive average shares outstanding calculation for the quarter ended December 27, 2008, as the impact would have been anti-dilutive due to the net loss in the quarter.

The average shares outstanding declined in the second quarter and first six months of 2010 as compared to the second quarter and first six months of 2009 as a result of shares repurchased under the corporation’s ongoing share repurchase program. The corporation repurchases common stock at times management deems appropriate, given current market valuations. During the first six months of 2010, the corporation did not repurchase any shares of its common stock. During 2009, the corporation repurchased 11.4 million shares of common stock, all of which were repurchased during the second quarter. At December 26, 2009, the corporation was authorized to repurchase $1 billion of common stock under its share repurchase program. In addition, 13.5 million shares of common stock remain authorized for repurchase under the corporation’s prior share repurchase program. The timing and amount of future share repurchases will be based upon the completion of the corporation’s sale of its household and body care businesses, market conditions and other factors.

The following is a reconciliation of net income (loss) to net income (loss) per share – basic and diluted – for the second quarter and first six months of 2010 and 2009 (per share amounts are rounded and may not add to total):

Computation of Net Income per Common Share

(In millions, except per share data)

 

     Quarter ended     Six months ended
     Dec. 26,
2009
   Dec. 27,
2008
    Dec. 26,
2009
   Dec. 27,
2008

Income (loss) from continuing operations

   $ 305    $ (40   $ 495    $ 151

Income from discontinued operations, net of tax

     66      23        160      62
                            

Net income (loss)

   $ 371    $ (17   $ 655    $ 213
                            

Average shares outstanding – basic

     699      703        698      705

Dilutive effect of stock option and award plans

     2      —          2      1
                            

Diluted shares outstanding

     701      703        700      706
                            

Income (loss) from continuing operations per share

          

Basic

   $ 0.44    $ (0.06   $ 0.71    $ 0.21
                            

Diluted

   $ 0.43    $ (0.06   $ 0.71    $ 0.21
                            

Income from discontinued operations per share

          

Basic

   $ 0.09    $ 0.03      $ 0.23    $ 0.09
                            

Diluted

   $ 0.09    $ 0.03      $ 0.23    $ 0.09
                            

Net income (loss) per share

          

Basic

   $ 0.53    $ (0.02   $ 0.94    $ 0.30
                            

Diluted

   $ 0.53    $ (0.02   $ 0.94    $ 0.30
                            

 

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Table of Contents
  3. Segment Information

The following is a general description of the corporation’s five business segments:

 

 

North American Retail – sells a variety of packaged meat and frozen bakery products to retail customers in North America and includes the corporation’s U.S. Senseo retail coffee business.

 

 

North American Fresh Bakery – sells a variety of fresh bakery products to retail customers in North America.

 

 

North American Foodservice – sells a variety of meat, bakery, and beverage products to foodservice customers in North America.

 

 

International Beverage – sells coffee and tea products in major markets around the world, including Europe, Australia and Brazil.

 

 

International Bakery – sells a variety of bakery and dough products to retail and foodservice customers in Europe and Australia.

The results of the businesses comprising the corporation’s former International Household and Body Care segment are now being reported as discontinued operations for all periods presented. See Note 4 – “Discontinued Operations” for additional information regarding these discontinued operations.

The corporation incurs various information technology (IT) and human resource (HR) costs related to its business segments. The IT costs include amortization of software used directly by the business segments, intranet website management costs, systems support, maintenance and project costs. The HR costs include benefits administration, organizational development, labor relations and recruiting costs incurred by the corporate human resource function on behalf of the business segments. Prior to 2010, these costs were included in Other general corporate expenses. Beginning in 2010, the corporation now includes these IT and HR costs in the operating results of the business segments. The reason for this change is that the integration of our operations over the past several years has resulted in more centralized services, which in many cases are conducted directly for the benefit of the business segments. Management believes these costs should be reflected in operating segment income in order to provide better information regarding the actual results of the business segment. Business segment information for 2009 has been revised to be consistent with the new basis of presentation.

The following is a summary of net sales and operating segment income by business segment for the second quarter and first six months of 2010 and 2009.

 

     Net Sales  

(In millions)

   Second
Quarter
2010
    Second
Quarter
2009
    Six
Months
2010
    Six
Months
2009
 

North American Retail

   $ 745      $ 746      $ 1,404      $ 1,426   

North American Fresh Bakery

     499        539        1,040        1,110   

North American Foodservice

     529        614        986        1,151   

International Beverage

     884        770        1,618        1,554   

International Bakery

     211        197        415        428   
                                

Total business segments

     2,868        2,866        5,463        5,669   

Intersegment sales

     (10     (10     (17     (19
                                

Net sales

   $ 2,858      $ 2,856      $ 5,446      $ 5,650   
                                

 

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Table of Contents
     Income (Loss) Before Income Taxes  

(In millions)

   Second
Quarter
2010
    Second
Quarter
2009
    Six
Months
2010
    Six
Months
2009
 

North American Retail

   $ 122      $ 73      $ 202      $ 128   

North American Fresh Bakery

     16        (16     30        1   

North American Foodservice

     45        (48     83        (23

International Beverage

     172        108        295        250   

International Bakery

     (1     (19     5        (4
                                

Total operating segment income

     354        98        615        352   

Amortization of intangibles

     (12     (11     (23     (23

General corporate expenses:

        

Other

     (64     (68     (119     (132

Mark-to-market derivative gains/(losses)

     4        (23     1        (58

Contingent sale proceeds

     —          —          133        150   
                                

Operating income (loss)

     282        (4     607        289   

Net interest expense

     (32     (36     (61     (61
                                

Income (loss) before income taxes

   $ 250      $ (40   $ 546      $ 228   
                                

In 2010, the corporation is now presenting certain segment assets, principally consisting of cash, in corporate assets for all periods since these assets are primarily controlled by the corporate group. A summary of segment assets as of December 26, 2009 and June 27, 2009 is as follows:

 

     Dec. 26,
2009
   June 27,
2009

Assets

     

North American Retail

   $ 1,238    $ 1,266

North American Fresh Bakery

     1,115      1,140

North American Foodservice

     1,120      1,134

International Beverage

     2,008      1,932

International Bakery

     750      719
             
     6,231      6,191

Net assets held for sale

     1,383      1,337

Other corporate assets (a)

     2,316      1,889
             

Total assets

   $ 9,930    $ 9,417
             

 

  (a) Principally cash and cash equivalents, certain corporate fixed assets, deferred tax assets and certain other noncurrent assets.

 

  4. Discontinued Operations

In September 2009, the corporation announced that it had received a binding offer for the sale of its global body care and European detergents businesses for 1.275 billion euros. In December 2009, the corporation also announced that it received a binding offer for the sale of its air care business for 320 million euros. These proposed transactions are subject to certain customary closing conditions and regulatory approvals and are anticipated to close during calendar 2010. Together these businesses represent approximately 70% of the net sales of the international household and body care businesses. The corporation had previously announced that it was reviewing strategic options for its international household and body care businesses after receiving expressions of interest. The corporation is also actively marketing for sale its remaining household and body care businesses and, as a result, the businesses that formerly comprised the International Household and Body Care segment – air care, body care, shoe care and insecticides – are classified as discontinued operations and are presented in a separate line in the Consolidated Statements of Income for all periods presented. The assets and liabilities of these businesses to be sold meet the accounting criteria to be classified as held for sale and have been aggregated and reported on separate lines of the Condensed Consolidated Balance Sheets for all periods presented.

 

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The following is a summary of the operating results of the corporation’s discontinued operations:

 

     Second Quarter 2010    Second Quarter 2009

(In millions)

   Net
Sales
   Pretax
Income
   Net
Income
   Net
Sales
   Pretax
Income
   Net
Income

International Household and Body Care businesses

   $ 565    $ 59    $ 66    $ 484    $ 37    $ 23
                                         
     First Six Months 2010    First Six Months 2009

(In millions)

   Net
Sales
   Pretax
Income
   Net
Income
   Net
Sales
   Pretax
Income
   Net
Income

International Household and Body Care businesses

   $ 1,086    $ 122    $ 160    $ 1,039    $ 98    $ 62
                                         

The $38 million tax benefit reported in the first six months of 2010 was primarily due to a $53 million tax benefit related to the reversal of a tax valuation allowance on United Kingdom net operating loss carryforwards as a result of the anticipated gain from the household and body care business disposition. In addition, there was a $27 million tax benefit related to the anticipated utilization of U.S. capital loss carryforwards available to offset the capital gain resulting from the household and body care business disposition.

The following is a summary of the net assets held for sale as of December 26, 2009 and June 27, 2009, which includes the net assets of the international household and body care businesses.

 

(In millions)

   Dec. 26,
2009
   June 27,
2009

Cash and cash equivalents

   $ 19    $ 8

Trade accounts receivable

     75      61

Inventories

     262      262

Other current assets

     47      53
             

Total current assets held for sale

     403      384
             

Property

     157      156

Trademarks and other intangibles

     221      221

Goodwill

     583      568

Other assets

     19      8
             

Assets held for sale

   $ 1,383    $ 1,337
             

Notes payable

   $ 1    $ —  

Accounts payable

     54      49

Accrued expenses and other current liabilities

     273      228

Current maturities of long-term debt

     8      9
             

Total current liabilities held for sale

     336      286

Long-term debt

     5      7

Other liabilities

     6      57
             

Liabilities held for sale

   $ 347    $ 350
             

Noncontrolling interest

   $ 29    $ 22
             

 

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The discontinued operations cash flows are summarized in the table below:

 

(In millions) – Increase / (Decrease)

   Six Months
Ended
Dec. 26, 2009
    Six Months
Ended
Dec. 27, 2008
 

Cash flow from operating activities

   $ 158      $ 86   

Cash flow used in investing activities

     (7     (9

Cash flow used in financing activities

     (140     (74
                

Increase in net cash of discontinued operations

     11        3   

Cash and cash equivalents at beginning of year

     8        1   
                

Cash and cash equivalents at end of period

   $ 19      $ 4   
                

The cash used in financing operations primarily represents the net transfers of cash with the corporate office. The net assets of the discontinued operations exclude virtually all of its cash as most of the cash of those businesses has been retained as a corporate asset.

 

  5. Impairment Review and Goodwill

The corporation tests goodwill for impairments in the second quarter of each fiscal year and whenever a significant event occurs or circumstances change that would more likely than not reduce the fair value of these intangible assets.

As a result of the review performed in the second quarter of 2010, the corporation determined that no goodwill impairment was required to be recognized as the carrying amounts of the reporting units did not exceed their fair values. The change in the goodwill balance from June 27, 2009 is due to the impact of changes in foreign currency exchange rates on foreign denominated goodwill. In the second quarter of 2009, a $107 million goodwill impairment charge was recognized in the foodservice beverage reporting unit after it was determined the carrying value of assets exceeded their fair value. The foodservice beverage reporting unit had experienced a significant decline in profitability due to a highly competitive marketplace and difficult economic conditions which led to the impairment charge. The impairment loss recognized equaled the entire remaining amount of goodwill in the foodservice beverage reporting unit and no tax benefit was recognized on the charge.

In the second quarter of 2010, the corporation recognized a $17 million impairment charge related to fixed assets. Thirteen million related to the writedown of manufacturing equipment associated with the North American foodservice bakery reporting unit due to the loss of a customer contract. The remaining $4 million related to the writedown of bakery equipment associated with the Spanish bakery reporting unit.

For the 2010 goodwill impairment test, the fair value of the reporting units was estimated based on a weighting of two models - a discounted cash flow model and a market multiple model. The discounted cash flow model uses management’s business plans and projections as the basis for expected future cash flows for the first ten years and a 2% residual growth rate thereafter. A separate discount rate derived from published sources was utilized for each reporting unit and, on a weighted average basis, the discount rate used was 9.3%. The market multiple approach employs market multiples of revenues or earnings for companies comparable to the corporation’s reporting units. Management believes the assumptions used for the impairment test are consistent with those utilized by a market participant performing similar valuations for our reporting units.

The majority of goodwill impairments recognized by the corporation in the past several years relate to goodwill attributable to the Earthgrains bakery acquisition in 2002. Three reporting units that continue to carry significant Earthgrains goodwill balances at December 26, 2009 include North American foodservice bakery with $476 million, North American fresh bakery with $270 million and international bakery France with $186 million. Although the corporation currently believes the operations support the value of goodwill reported, these entities are the most sensitive to changes in inherent assumptions and estimates used in determining fair value. These three reporting units represent approximately 71% of goodwill remaining in continuing operations. Holding all other assumptions constant at the test date for both models, a 100 basis point increase in the discount rate used for these three reporting units would reduce the enterprise value approximately 10% indicating no potential impairment. These three reporting units have estimated fair values in excess of net asset carrying values in the range of 21% to 33% as of the test date.

 

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  6. Exit, Disposal and Transformation/Accelerate Activities

As part of its ongoing efforts to improve its operational performance and reduce costs, the corporation initiated Project Accelerate (“Accelerate”) in 2009, which is a series of global initiatives designed to drive significant savings in the next three years. It is anticipated that the overall cost of the initiatives will include severance costs as well as transition costs associated with transferring services to an outside third party. An important component of Project Accelerate involves outsourcing pieces of the North American and European Finance (transaction processing) and Global Information Services (applications development and maintenance) groups as well as the company’s global indirect procurement activities. In addition to cost savings, this business process outsourcing will help the corporation drive standardization, increase efficiency and provide flexibility. The corporation began implementation of the initiative in North America and Europe in the second quarter of 2009 and plans to complete global implementation within three years.

The company announced a transformation plan in February 2005 designed to improve performance and better position the company for long-term growth. The plan involved significant changes in the company’s organizational structure, portfolio changes involving the disposition of a significant portion of the corporation’s business, and a number of actions to improve operational efficiency. The corporation continues to recognize certain trailing costs related to these transformation actions, including the impact of certain activities that were completed for amounts more favorable than previously estimated.

The nature of the costs incurred under these plans includes the following:

1) Exit Activities, Asset and Business Disposition Actions – These amounts primarily relate to:

 

   

Employee termination costs

 

   

Lease exit costs

 

   

Gains or losses on the disposition of assets or asset groupings that do not qualify as discontinued operations

2) Transformation/Accelerate Costs recognized in Cost of sales and Selling, general and administrative expenses primarily relate to:

 

   

Expenses associated with the installation of new information systems

 

   

Costs to retain and relocate employees

 

   

Consulting costs

 

   

Costs associated with the transition of services to an outside third party vendor as part of a business process outsourcing initiative

Transformation/Accelerate costs are recognized in Cost of sales or Selling, general and administrative expenses in the Consolidated Statements of Income as they do not qualify for treatment as an exit activity or asset and business disposition under the accounting rules for exit and disposal activities. However, management believes the disclosure of these transformation/Accelerate related charges provides the reader greater transparency to the total cost of the initiatives.

 

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The following is a summary of the (income) expense associated with new and ongoing actions, which also highlights where the costs are reflected in the Consolidated Statements of Income along with the impact on diluted EPS:

 

     Quarter ended     Six months ended  

(In millions)

   Dec. 26,
2009
    Dec. 27,
2008
    Dec. 26,
2009
    Dec. 27,
2008
 

Selling, general and administrative expenses:

        

Transformation charges – IT costs

   $ —        $ —        $ —        $ 3   

Project Accelerate charges – other

     5        2        10        2   

Net charges for (income from):

        

Exit activities

     6        34        19        33   

Asset and business dispositions

     9        —          9        (3
                                

Decrease in income from continuing operations before income taxes

     20        36        38        35   

Income tax benefit

     (7     (9     (13     (9
                                

Decrease in income from continuing operations

   $ 13      $ 27      $ 25      $ 26   
                                

Impact on diluted EPS

   $ .02      $ .04      $ .04      $ .04   
                                

The impact of these actions on the corporation’s business segments and general corporate expenses is summarized as follows:

 

     Quarter ended     Six months ended  

(In millions)

   Dec. 26,
2009
    Dec. 27,
2008
    Dec. 26,
2009
   Dec. 27,
2008
 

North American Retail

   $ —        $ —        $ 3    $ (1

North American Fresh Bakery

     —          —          1      —     

North American Foodservice

     2        (1     2      (4

International Beverage

     (2     1        —        3   

International Bakery

     9        29        16      29   
                               

Decrease in operating segment income

     9        29        22      27   

Increase in general corporate expenses

     11        7        16      8   
                               

Total

   $ 20      $ 36      $ 38    $ 35   
                               

The following discussion provides information concerning the exit, disposal and transformation/Accelerate activities for each year where actions were initiated and material reserves exist.

2010 Actions

During 2010, the corporation approved certain actions related to exit, disposal, and Accelerate activities and recognized charges of $43 million related to these actions. Each of these activities is to be completed within a 12-month period after being approved and include the following:

 

   

Recognized a charge to implement a plan to terminate 351 employees, related to both European and North American operations, and provide them with severance benefits in accordance with benefit plans previously communicated to the affected employee group or with local employment laws. Of the 351 targeted employees, 258 employees have not yet been terminated, but are expected to be terminated within the next 12 months.

 

   

Recognized costs associated with the transition of services to an outside third party vendor as part of a business process outsourcing initiative.

 

   

Recognized a $9 million net loss associated with the disposition of certain bakery manufacturing facilities in Spain.

The following table summarizes the net charges taken for the exit, disposal and Accelerate activities approved during 2010 and the related status as of December 26, 2009. The accrued amounts remaining represent those cash expenditures necessary to satisfy remaining obligations. The majority of the cash payments to satisfy the accrued costs are expected to be paid in the next 12 months. The composition of these charges and the remaining accruals are summarized below. Approximately $46 million of additional charges are expected to be recognized in the remainder of 2010. Included in this amount is an estimated loss of $10 million that will be recognized in the third quarter related to the disposition of an additional bakery facility in Spain.

 

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(In millions)

   Employee
termination and
other benefits
    Accelerate costs
– IT and other
    Non-cancellable
Leases
   Asset and
Business
Disposition
Actions
    Total  

Exit, disposal and other costs recognized during 2010

   $ 20      $ 11      $ 3    $ 9      $ 43   

Cash payments

     (3     (6     —        —          (9

Non-cash charges

     —          —          —        —          —     

Asset and business disposition losses

     —          —          —        (9     (9
                                       

Accrued costs as of December 26, 2009

   $ 17      $ 5      $ 3    $ —        $ 25   
                                       

2009 Actions

During 2009, the corporation approved certain actions related to exit, disposal, transformation and Accelerate activities and recognized cumulative charges of $125 million related to these actions. Each of these activities is to be completed within a 12-month period after being approved and include the following:

 

   

Recognized a charge to implement a plan to terminate 1,076 employees, related to both European and North American operations, and provide them with severance benefits in accordance with benefit plans previously communicated to the affected employee group or with local employment laws. Of the 1,076 targeted employees, 185 employees have not yet been terminated, but are expected to be terminated by the end of 2010.

 

   

Recognized a net gain associated with the disposal of the sauces and dressings business in the North American Foodservice segment.

 

   

Recognized costs related to the implementation of common information systems across the organization in order to improve operational efficiencies.

 

   

Recognized costs associated with the transition of services to an outside third party vendor as part of a business process outsourcing initiative.

Significant actions completed during the first six months of 2010 and the status of the remaining elements of the 2009 actions, along with the remaining accruals, is described below. The accrued amounts remaining represent those cash expenditures necessary to satisfy remaining obligations. The majority of the cash payments to satisfy the accrued costs are expected to be paid in the next 12 months. The corporation does not anticipate any additional material future charges related to the 2009 actions. The composition of these charges and the remaining accruals are summarized below.

 

(In millions)

   Employee
termination and
other benefits
    Transformation/
Accelerate costs
– IT and other
    Total  

Accrued costs as of June 27, 2009

   $ 95      $ 6      $ 101   

Non-cash charges

     (1     —          (1

Cash payments

     (40     (2     (42

Change in estimate

     (5     (1     (6

Foreign exchange impacts

     2        —          2   
                        

Accrued costs as of December 26, 2009

   $ 51      $ 3      $ 54   
                        

2008 Actions

During 2008, the corporation approved certain actions related to exit, disposal and transformation activities and recognized cumulative charges of $89 million related to these actions. Each of these activities was completed within a 12-month period after being approved and included the following:

 

   

Implemented a plan to terminate 525 employees and provide them with severance benefits in accordance with benefit plans previously communicated to the affected employee group or with local employment laws. Essentially all of these employees have been terminated at this time.

 

   

Incurred costs to exit certain leased space, including the exit of a North American R&D facility.

 

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Recognized net gains associated with the disposal of several asset groupings, the largest of which was a $3 million gain related to the disposition of a North American Foodservice manufacturing facility. Total proceeds from these disposals were $9 million.

 

   

Recognized costs related to the implementation of common information systems across the organization in order to improve operational efficiencies.

The status of the remaining elements of the 2008 actions, along with the remaining accruals, is described below. The accrued amounts remaining represent those cash expenditures necessary to satisfy remaining obligations. The majority of the cash payments to satisfy the accrued costs are expected to be paid in the next 12 months. The corporation does not anticipate any additional material future charges related to the 2008 actions. The composition of these charges and the remaining accruals are summarized below.

 

(In millions)

   Employee
termination and
other benefits
    Non-cancelable
lease and other
contractual
obligations
   Total  

Accrued costs as of June 27, 2009

   $ 11      $ 3    $ 14   

Cash payments

     (2     —        (2

Change in estimate

     —          2      2   
                       

Accrued costs as of December 26, 2009

   $ 9      $ 5    $ 14   
                       

In periods prior to 2008, the corporation had approved and completed various actions to exit certain defined business activities and lower its cost structure and these actions have had minimal impact on current year results. As of December 26, 2009, the accrued liabilities remaining in the Condensed Consolidated Balance Sheet related to these completed actions total $30 million and primarily represent certain severance obligations. These accrued amounts are expected to be satisfied in cash and will be funded from operations.

 

  7. Financial Instruments

Background Information

The corporation uses derivative financial instruments, including forward exchange, futures, options and swap contracts, to manage its exposures to foreign exchange, commodity prices and interest rate risks. The use of these derivative financial instruments modifies the exposure of these risks with the intent to reduce the risk or cost to the corporation. The corporation does not use derivatives for trading or speculative purposes and is not a party to leveraged derivatives.

The corporation recognizes all derivative instruments as either assets or liabilities at fair value in the Condensed Consolidated Balance Sheet. The corporation uses either hedge accounting or mark-to-market accounting for its derivative instruments. For derivatives that qualify for hedge accounting, the corporation designates these derivatives as fair value, cash flow or net investment hedges by formally documenting the hedge relationships, including identification of the hedging instruments and the hedged items, as well as its risk management objectives and strategies for undertaking the hedge transaction. The process includes linking derivatives that are designated as hedges of specific assets, liabilities, firm commitments or forecasted transactions.

As noted above, the corporation uses derivative financial instruments to manage some of its exposure to commodity prices. A commodity derivative not declared a hedge in accordance with the accounting rules related to derivative instruments and hedging activities is accounted for under mark-to-market accounting with changes in fair value recorded in the Consolidated Statements of Income. The corporation includes these unrealized mark-to-market gains and losses in general corporate expenses until the derivative instrument is settled. At that time, the cumulative gain or loss previously recorded in general corporate expenses for the derivative instrument will be reclassified into the business segment’s results.

 

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On the date the derivative is entered into, the corporation designates the derivative as one of the following types of hedging instruments and accounts for the derivative as follows:

Fair Value Hedge – A hedge of a recognized asset or liability or an unrecognized firm commitment is declared as a fair value hedge which qualifies for hedge accounting. For fair value hedges, both the effective and ineffective portions of the changes in the fair value of the derivative, along with the gain or loss on the hedged item that is attributable to the hedged risk, are recorded in earnings and are reported in the Consolidated Statements of Income on the same line as the hedged item.

Cash Flow Hedge – A hedge of a forecasted transaction, firm commitment or of the variability of cash flows to be received or paid related to a recognized asset or liability is declared a cash flow hedge. Cash flow hedges qualify for hedge accounting. The effective portion of the change in the fair value of the derivative that is declared as a cash flow hedge is recorded in accumulated other comprehensive income (within common stockholders’ equity) and later reclassified to the income statement at the same time the underlying hedged item impacts the income statement. In addition, both the fair value of changes excluded from the corporation’s effectiveness assessments and the ineffective portion of the changes in the fair value of derivatives used as cash flow hedges are reported in Selling, general and administrative expenses in the Consolidated Statements of Income.

Net Investment Hedge – A hedge of the exposure of changes in the underlying foreign currency denominated subsidiary net assets is declared as a net investment hedge. Net investment hedges qualify for hedge accounting. Net investment hedges can include either derivative or non-derivative instruments such as, non-U.S. dollar financing transactions or non-U.S. dollar assets or liabilities, including intercompany loans. The effective portion of the change in the fair value of net investment hedges is recorded in the cumulative translation adjustment account within common stockholders’ equity. At December 26, 2009, the U.S. dollar equivalent of intercompany loans designated as net investment hedges was $2.7 billion.

Mark-to-Market Hedge – A derivative that does not qualify for hedge accounting in one of the categories above is accounted for under mark-to-market accounting and referred to as a mark-to-market hedge. Changes in the fair value of a mark-to-market hedge are recognized in the Consolidated Statements of Income to act as an economic hedge against the changes in the values of another item or transaction. Changes in the fair value of derivatives classified as mark-to-market hedges are reported in earnings in either the “Cost of sales” or “Selling, general and administrative expenses” lines of the Consolidated Statements of Income where the change in value of the underlying transaction is recorded.

Types of Derivative Instruments

Interest Rate and Cross Currency Swaps – To manage interest rate risk, the corporation has entered into interest rate swaps that effectively convert certain fixed-rate debt instruments into floating-rate debt instruments. Interest rate swap agreements that are effective at hedging the fair value of fixed-rate debt agreements are designated and accounted for as fair value hedges. The corporation utilizes interest rate swap derivatives in order to maintain a targeted amount of both fixed-rate and floating-rate long-term debt and notes payable. Currently the corporation has a fixed interest rate on approximately 70% of long-term debt and notes payable issued.

The corporation has issued certain foreign-denominated debt instruments and utilizes cross currency swaps to reduce the variability of functional currency cash flows related to the foreign currency debt. Cross currency swap agreements that are effective at hedging the variability of foreign-denominated cash flows are designated and accounted for as cash flow hedges. As of December 26, 2009, the total notional amount of the corporation’s interest rate swaps and cross currency swaps were $385 million and $805 million, respectively. The notional value of the cross currency swaps is calculated by multiplying the euro value swapped by the exchange rate at the reporting date.

In connection with the funding of the anticipated retirement of the 6.25% notes in September 2011, the corporation maintains a $50 million forward starting swap to effectively fix the cash flows related to interest payments on the anticipated debt issuance.

Currency Forward Exchange, Futures and Option Contracts – The corporation uses forward exchange and option contracts to reduce the effect of fluctuating foreign currencies on short-term foreign-currency-denominated intercompany transactions, third-party product-sourcing transactions, foreign-denominated investments and other known foreign currency exposures. Gains and losses on the derivative

 

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instruments are intended to offset losses and gains on the hedged transaction in an effort to reduce the earnings volatility resulting from fluctuating foreign currency exchange rates. Forward currency exchange contracts mature at the anticipated cash requirement date of the hedged transaction, generally within one year to eighteen months. Forward currency exchange contracts which are effective at hedging the fair value of a recognized asset or liability are designated and accounted for as fair value hedges. All remaining currency forward and options contracts are accounted for as mark-to-market hedges.

The principal currencies hedged by the corporation include the European euro, British pound, Danish krone, Hungarian forint, U.S. dollar, Swiss franc and Brazilian real. As of December 26, 2009, the net U.S. dollar equivalent of commitments to purchase and sell foreign currencies is $1,905 million and $1,913 million, respectively, using the exchange rate at the reporting date. The corporation hedges virtually all foreign exchange risk derived from recorded transactions and firm commitments and only hedges foreign exchange risk related to anticipated transactions where the exposure is potentially significant.

The corporation has held foreign exchange option contracts to reduce the foreign exchange fluctuations on anticipated purchase transactions. As of December 26, 2009, the U.S. dollar equivalent notional amount of foreign exchange options is $4.1 million and is determined by the delta adjusted value as of period end.

Commodity Futures and Options Contracts – The corporation uses commodity futures and options to hedge a portion of its commodity price risk. The principal commodities hedged by the corporation include hogs, beef, natural gas, diesel fuel, coffee, corn, wheat and other ingredients. The corporation does not use significant levels of commodity financial instruments to hedge commodity prices and primarily relies upon fixed rate supplier contracts to determine commodity pricing. In circumstances where commodity-derivative instruments are used, there is a high correlation between the commodity costs and the derivative instruments. For those instruments where the commodity instrument and underlying hedged item correlate between 80-125%, the corporation accounts for those contracts as cash flow hedges. However, the majority of commodity derivative instruments are accounted for as mark-to-market hedges.

As of December 26, 2009, the total notional amount of commodity futures and option contracts was $160 million and $21 million, respectively. The notional amount of commodity futures contracts is determined by the initial cost of the contracts while the notional amount of options contracts is determined by the delta adjusted value as of period end.

The corporation only enters into futures and options contracts that are traded on established, well-recognized exchanges that offer high liquidity, transparent pricing, daily cash settlement and collateralization through margin requirements.

Cash Flow Presentation

The settlement of derivative contracts related to the purchase of inventory, commodities or other hedged items that utilize hedge accounting are reported in the Consolidated Statements of Cash Flows as an operating cash flow, while those derivatives that utilize the mark-to-market hedge accounting model are reported in investing activities when those contracts are settled in cash. Fixed to floating rate swaps are reported as a component of interest expense and therefore are reported in cash flow from operating activities similar to how cash interest payments are reported. The portion of the gain or loss on a cross currency swap that offsets the change in the value of interest expense is recognized in cash flow from operations, while the gain or loss on the swap that is offsetting the change in value of the debt is classified as a financing activity in the Consolidated Statement of Cash Flows.

Contingent Features/Concentration of Credit Risk

All of the corporation’s derivative instruments are governed by International Swaps and Derivatives Association (i.e. ISDA) master agreements, requiring the corporation to maintain an investment grade credit rating from both Moody’s and Standard & Poor’s credit rating agencies. If the corporation’s debt were to fall below investment grade, it would be in violation of these provisions, and the counterparties to the derivative instruments could request immediate payment or demand immediate collateralization on the derivative instruments in net liability positions. The aggregate fair value of all derivative instruments

 

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with credit-risk-related contingent features that are in a liability position on December 26, 2009, is $283 million for which the corporation has posted no collateral. If the credit-risk-related contingent features underlying these agreements were triggered on December 26, 2009, the corporation would be required to post collateral of, at most, $283 million with its counterparties.

A large number of major international financial institutions are counterparties to the corporation’s financial instruments including cross currency swaps, interest rate swaps, and currency exchange forwards and swaps. The corporation enters into financial instrument agreements only with counterparties meeting very stringent credit standards (a credit rating of A-/A3 or better), limiting the amount of agreements or contracts it enters into with any one party and, where legally available, executing master netting agreements. These positions are continually monitored. While the corporation may be exposed to credit losses in the event of nonperformance by individual counterparties of the entire group of counterparties, it has not recognized any losses with these counterparties in the past and does not anticipate material losses in the future.

Fair Value Measurements

Effective the beginning of 2009, the corporation implemented new accounting guidance related to the fair value of financial assets and liabilities while in 2010 new fair value accounting rules were adopted for non-financial assets and liabilities. The adoption of these rules did not have a significant impact on the measurement of the corporation’s assets and liabilities.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., exit price) in an orderly transaction between market participants at the measurement date. Assets and liabilities measured at fair value must be categorized into one of three different levels depending on the assumptions (i.e., inputs) used in the valuation. Level 1 provides the most reliable measure of fair value while level 3 generally requires significant management judgment. Assets and liabilities are classified in their entirety based on the lowest level of input significant to the fair value measurement. The fair value hierarchy is defined as follows:

Level 1 – Unadjusted Quoted Prices – Valuations are based on unadjusted quoted prices in active markets for identical assets or liabilities. An example would be a marketable equity security that is traded on a major stock exchange.

Level 2 – Pricing Models with Significant Observable Inputs – Valuations are based on information derived from either an active market quoted price, which may require further adjustment based on the attributes of the asset or liability being measured, or an inactive market transaction. Circumstances when adjustments to market quoted prices may be appropriate include (i) a quoted price for an actively traded equity investment that is adjusted for a contractual trading restriction, or (ii) the fair value derived from a trade of an identical or similar security in an inactive market. An interest rate swap derivative valued based on a LIBOR swap curve is an example of a level 2 asset or liability.

Level 3 – Pricing Models with Significant Unobservable Inputs – Valuations are based on internally derived assumptions surrounding the timing and amount of expected cash flows for the financial instrument, which are significant to the overall fair value measurement. These assumptions are unobservable in either an active or inactive market. The inputs reflect management’s best estimate of what market participants would use in valuing the asset or liability at the measurement date. A goodwill impairment test that utilizes an internally developed discounted cash flow model is an example of a level 3 asset or liability.

The carrying amounts of cash and equivalents, trade accounts receivables, accounts payable, derivative instruments and notes payable approximate fair values.

The fair values and carrying amounts of long-term debt, including the current portion, at December 26, 2009 were $2,851 million and $2,771 million, and at June 27, 2009 were $2,780 million and $2,784 million, respectively. The fair value of the corporation’s long-term debt, including the current portion, is estimated using discounted cash flows based on the corporation’s current incremental borrowing rates for similar types of borrowing arrangements.

 

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Information on the location and amounts of derivative fair values in the Condensed Consolidated Balance Sheet at December 26, 2009 and June 27, 2009 is as follows:

 

     Assets    Liabilities
     Other Current
Assets
   Other Non-
Current Assets
   Accrued
Liabilities – Other
   Other
     Dec. 26,
2009
   June 27,
2009
   Dec. 26,
2009
   June 27,
2009
   Dec. 26,
2009
   June 27,
2009
   Dec. 26,
2009
   June 27,
2009

Derivatives designated as hedging instruments:

                       

Interest rate contracts (b)

   $ 3    $ 3    $ 29    $ 30    $ —      $ —      $ —      $ —  

Foreign exchange contracts (b)

     —        1      —        —        3      8      261      249

Commodity contracts (a)

     3      1      —        —        —        —        —        —  
                                                       

Total derivatives designated as hedges

     6      5      29      30      3      8      261      249
                                                       

Derivatives not designated as hedging instruments:

                       

Foreign exchange contracts (b)

     13      61      —        —        19      34      —        —  

Commodity contracts (a)

     1      1      —        —        —        —        —        —  
                                                       

Total derivatives not designated as hedges

     14      62      —        —        19      34      —        —  
                                                       

Total derivatives

   $ 20    $ 67    $ 29    $ 30    $ 22    $ 42    $ 261    $ 249
                                                       

 

(a) Categorized as level 1: Fair value of level 1 assets and liabilities as of December 26, 2009 are $4 million and nil and at June 27, 2009 are $2 million and nil, respectively.
(b) Categorized as level 2: Fair value of level 2 assets and liabilities as of December 26, 2009 are $45 million and $283 million and at June 27, 2009 are $95 million and $291 million, respectively.

Information on the location and amounts of derivative gains and losses in the Consolidated Statements of Income for the quarter ended December 26, 2009 is as follows:

 

    

Gain (Loss)

Recognized in Income on Derivatives

  

Gain (Loss)

Recognized in Income on Hedged Item

Fair Value Derivatives

  

Location

   Amount   

Location

   Amount

Interest rate contracts

   Interest income    $ 2    Interest income    $ 2
                   

 

     Gain (Loss)
Deferred in OCI
on Derivative
(effective portion)
  

Gain (Loss)

Reclassified from Accumulated OCI into

Income (effective portion)

  

Gain (Loss)

Recognized in Income on Derivative

(ineffective portion and amount excluded

from effectiveness testing)

 

Cash Flow

Derivatives

   Amount   

Location

   Amount   

Location

   Amount  

Interest rate contracts

   $ 2    N/A    $ —      N/A    $ —     

Foreign exchange contracts

     15    Selling, general and administrative expenses      12    Interest expense      (3

Commodity contracts

     4    Cost of sales      —      Selling, general and administrative expenses      —     
                            

Total

   $ 21       $ 12       $ (3
                            

 

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Information on the location and amounts of derivative gains and losses in the Consolidated Statements of Income for the six months ended December 26, 2009 is as follows:

 

    

Gain (Loss)

Recognized in Income on Derivatives

  

Gain (Loss)

Recognized in Income on Hedged Item

Fair Value Derivatives

  

Location

   Amount   

Location

   Amount

Interest rate contracts

   Interest income    $ 7    Interest income    $ 1
                   

 

     Gain (Loss)
Deferred in OCI
on Derivative
(effective portion)
   

Gain (Loss)

Reclassified from Accumulated OCI into

Income (effective portion)

   

Gain (Loss)

Recognized in Income on Derivative

(ineffective portion and amount excluded

from effectiveness testing)

 

Cash Flow

Derivatives

   Amount    

Location

   Amount    

Location

   Amount  

Interest rate contracts

   $ 1      N/A    $ —        N/A    $ —     

Foreign exchange contracts

     (6   Selling, general and administrative expenses      (14   Interest expense      (6

Commodity contracts

     2      Cost of sales      (3   Selling, general and administrative expenses      —     
                              

Total

   $ (3      $ (17      $ (6
                              

At December 26, 2009 the maximum maturity date of any cash flow hedge was approximately four years principally related to two cross currency swaps that mature in 2012 and 2013. The corporation expects to reclassify into earnings during the next twelve months net losses from Accumulated Other Comprehensive Income of approximately $5 million at the time the underlying hedged transaction is recognized in the Consolidated Statement of Income.

 

     Gain (Loss) Recognized in OCI on
Derivative (effective portion)
 

Net Investment

Derivatives

   Quarter ended
Dec. 26, 2009
   Six months ended
Dec. 26, 2009
 

Foreign exchange contracts

   $ 65    $ (87
               

 

    

Gain (Loss) Recognized in Income on Derivative

Derivatives Not Designated as Hedging

Instruments

  

Location

   Quarter ended
Dec. 26, 2009
    Six months ended
Dec. 26, 2009

Foreign exchange contracts

   Cost of sales    $ 6      $ 1

Foreign exchange contracts

   Selling, general and administrative expenses      (8     41

Commodity contracts

   Cost of sales      1        3

Commodity contracts

   Selling, general and administrative expenses      6        1
                 

Total

      $ 5      $ 46
                 

 

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  8. Pension and Other Postretirement Benefit Plans

The components of the net periodic pension cost and the postretirement medical cost (income) for the second quarter and first six months of 2010 and 2009 are as follows:

 

     Pension     Postretirement Medical and
Life Insurance
 
(In millions)    Second
Quarter
2010
    Second
Quarter
2009
    Second
Quarter
2010
    Second
Quarter
2009
 

Service cost

   $ 15      $ 15      $ 1      $ 1   

Interest cost

     66        63        2        3   

Expected return on plan assets

     (63     (65     —          —     

Amortization of

        

Transition (asset) obligation

     —          —          (1     —     

Prior service cost

     2        2        (6     (5

Net actuarial loss

     13        2        1        —     
                                

Net periodic benefit cost

   $ 33      $ 17      $ (3   $ (1
                                
     Pension     Postretirement Medical and
Life Insurance
 
(In millions)    Six
Months
2010
    Six
Months
2009
    Six
Months
2010
    Six
Months
2009
 

Service cost

   $ 29      $ 30      $ 2      $ 3   

Interest cost

     134        133        5        7   

Expected return on plan assets

     (128     (138     —          —     

Amortization of

        

Transition (asset) obligation

     —          —          (1     (1

Prior service cost

     4        4        (14     (11

Net actuarial loss

     26        5        1        1   
                                

Net periodic benefit cost

   $ 65      $ 34      $ (7   $ (1
                                

Curtailment gain

   $ —        $ —        $ —        $ 12   
                                

The net periodic benefit cost of the corporation’s defined benefit pension plans in the first six months of 2010 was $31 million higher than in 2009 as a result of the following:

 

   

A decline in the expected return on plan assets as a result of a decline in asset values as of the beginning of the current fiscal year as compared to the prior year end.

 

   

The amortization of net actuarial losses increased in 2010 as a result of an increase in net unamortized actuarial losses which are required to be amortized in future years. The amount of unamortized actuarial losses increased from $570 million at the end of 2008 to $883 million as of the end of 2009 primarily as a result of actuarial losses on plan assets. This resulted in a higher level of loss amortization in 2010.

In 2010, the corporation classified the international household and body care businesses as discontinued operations and anticipates retaining the pension and postretirement medical obligations related to those businesses. The corporation no longer anticipates incurring service cost for the participants in those plans after these businesses are sold and this cost component is recognized in discontinued operations while the remainder of net periodic benefit cost is recognized in continuing operations.

During the first six months of 2010 and 2009, the corporation contributed $43 million and $61 million, respectively, to its defined benefit pension plans. At the present time, the corporation expects to contribute approximately $130 million of cash to its defined benefit pension plans in 2010. The exact amount of cash contributions made to pension plans in any year is dependent upon a number of factors including minimum funding requirements in the jurisdictions in which the corporation operates and arrangements made with trustees of certain foreign plans. As a result, the actual funding in 2010 may differ from the current estimate.

 

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During 2009, the corporation entered into a new collective labor agreement in the Netherlands which eliminated postretirement health care benefits for certain employee groups, while also reducing benefits provided to others. The elimination of benefits resulted in the recognition of a curtailment gain of $17 million, of which $12 million impacted continuing operations, related to a portion of the unamortized prior service cost credit which was reported in accumulated other comprehensive income. The plan changes also resulted in a $32 million reduction in the accumulated postretirement benefit obligation with an offset to accumulated other comprehensive income (AOCI).

As discussed in footnote 4, Discontinued Operations, the corporation received a binding offer for the sale of the corporation’s body care and European detergents businesses in the first quarter of 2010 and a binding offer for the air care business in the second quarter of 2010. Based on the proposed terms of the sales agreements, the corporation anticipates a significant reduction in the expected years of future service for the employees associated with a defined benefit pension plan in the Netherlands. Although the business dispositions have not yet been completed, a pretax curtailment loss of $11 million has been recognized because the loss is both probable and reasonably estimable. The curtailment loss, which relates to the previously unamortized prior service cost associated with this benefit plan, was recognized in the results of discontinued operations. In conjunction with the curtailment, the plan assets and liabilities of the Netherlands defined benefit plan were remeasured. Based on the results of the remeasurement, the net funded position of this plan declined by approximately $81 million, which was recognized as a decrease in noncurrent pension assets with an offsetting increase in the unamortized actuarial loss in accumulated other comprehensive income (AOCI). This reduction in net funded position primarily related to a reduction in the discount rate used to determine the projected benefit obligation.

The corporation recognized a $7 million charge to income during the first quarter of 2010 to establish the estimated partial withdrawal liability for certain multi-employer pension plans. The charges were all recognized in Selling, general and administrative expenses in the Consolidated Statements of Income and related to the North American Fresh Bakery segment.

 

  9. Receipt of Contingent Sale Proceeds

The corporation sold its European cut tobacco business in 1999. Under the terms of that agreement, the corporation was to receive an annual cash payment of 95 million euros if tobacco continued to be a legal product in the Netherlands, Germany and Belgium through July 15, 2009. The contingencies associated with the 2010 and 2009 payments passed in the first quarter of each fiscal year and the corporation received the annual payments and recorded income in the Contingent sales proceeds line in the Consolidated Statements of Income. The payment received in 2009 increased annual diluted earnings per share by $0.21 and the payment received in 2010 is expected to increase annual diluted earnings per share by $0.19. The payment received in 2010 represents the final payment to be received under the terms of the sale agreement.

 

  10. Income Taxes

Effective Annual Tax Rate for Interim Reporting – Generally accepted accounting principles require that the interim period tax provision be determined as follows:

 

   

At the end of each quarter, the corporation estimates the tax that will be provided for the fiscal year stated as a percent of estimated “ordinary” income for the fiscal year. The term ordinary income refers to income from continuing operations before income taxes, excluding significant unusual or infrequently occurring items as defined by the guidelines for the accounting for income taxes. Discontinued operations are excluded in determining ordinary income.

 

   

The estimated annual effective tax rate is applied to the year-to-date “ordinary” income at the end of each quarter to compute the year-to-date tax applicable to ordinary income. The tax expense or benefit related to ordinary income in each quarter is the difference between the most recent year-to-date and the prior quarter year-to-date computations.

 

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The tax effects of significant unusual or infrequently occurring items are recognized as discrete items in the interim period in which the events occur. The impact of changes in tax laws or rates on deferred tax amounts, the effects of changes in judgment about valuation allowances established in prior years and changes in tax reserves resulting from the finalization of tax audits or reviews are examples of significant unusual or infrequently occurring items which are recognized as discrete items in the interim period in which the event occurs.

The determination of the annual effective tax rate is based upon a number of significant estimates and judgments, including the estimated annual pretax income of the corporation in each tax jurisdiction in which it operates and the development of tax planning strategies during the year. In addition, as a global commercial enterprise, the corporation’s tax expense can be impacted by changes in tax rates or laws, the finalization of tax audits and reviews, as well as other factors that cannot be predicted with certainty. As such, there can be significant volatility in interim tax provisions.

The following table sets out the tax expense (benefit) and the effective tax rate for the corporation:

 

     Second Quarter     Six Months  
(In millions)    2010     2009     2010     2009  

Continuing operations

        

Income (loss) before income taxes

   $ 250      $ (40   $ 546      $ 228   

Income tax expense (benefit)

     (55     —          51        77   

Effective tax rate

     (21.5 )%      (0.8 )%      9.4     33.8

Second Quarter and First Six Months of 2010

In the second quarter of 2010, the corporation recognized a tax benefit of $55 million on pretax income from continuing operations of $250 million, or a negative effective tax rate of (21.5%). The tax benefit and related effective tax rate on continuing operations were impacted by recognizing $113 million of discrete tax benefits related to the following items:

 

   

$93 million primarily from the settlement during the quarter of tax audits in the United Kingdom, Hungary, Spain, the United States, and various state and local jurisdictions.

 

   

$20 million from the release of a valuation allowance on the deferred tax assets of the corporation’s Brazilian subsidiaries.

In the first six months of 2010, the corporation recognized tax expense of $51 million on pretax income from continuing operations of $546 million, or an effective tax rate of 9.4%. The tax expense and related effective tax rate on continuing operations was determined by applying a 25.7% estimated annual effective tax rate to pretax earnings and then recognizing $89 million of discrete tax benefits. The discrete tax items relate to the following:

 

   

$25 million of tax expense to establish a valuation allowance on net operating losses and other deferred tax assets in Belgium.

 

   

$94 million of tax benefit primarily from the settlement of tax audits in the United Kingdom, Hungary, Spain, the United States, South Africa, and various state and local jurisdictions.

 

   

$20 million of tax benefit from the release of a valuation allowance on the deferred tax assets of the corporation’s Brazilian subsidiaries.

The 2010 estimated annual effective rate includes a charge of $35 million related to the expected repatriation of a portion of 2010 earnings, which increases the rate by 4%. The estimated annual effective tax rate also includes $18 million of non-recurring tax benefits related to the utilization of United Kingdom net operating losses which lowered the estimated annual effective rate by approximately 2%. The portion of this tax benefit recognized in the first six months of 2010 is $12 million, of which $6 million was recognized in the second quarter.

 

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Second Quarter and First Six Months of 2009

In the second quarter of 2009, the corporation recognized tax expense of nil on a pretax loss of $40 million, or a negative effective tax rate of (0.8%). The corporation’s effective tax rate was impacted by the recognition of a $107 million non-deductible goodwill impairment charge. The tax rate in the second quarter was also impacted by various discrete items, none of which were material individually or in the aggregate.

In the first six months of 2009, the corporation recognized tax expense of $77 million on pretax income of $228 million, or an effective tax rate of 33.8%. This rate was determined by applying a 33.4% estimated annual effective tax rate to pretax earnings and then recognizing the impact of various discrete tax items, none of which were material individually or in the aggregate. The estimated annual effective tax rate includes a charge of $60 million for the repatriation of a portion of 2009 earnings, which increased the estimated effective annual tax rate by approximately 12%.

Unrecognized Tax Benefits

Each quarter, the corporation makes a determination of the tax liability needed for unrecognized tax benefits that should be recorded in the financial statements. For tax benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by the taxing authorities. The amount recognized is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement.

The year-to-date net decrease in unrecognized tax benefits was $93 million, resulting in an ending balance of $454 million as of December 26, 2009. There was a decrease in uncertain tax positions of $114 million, of which $98 million relates to audit settlements, and $16 million relates to the expiration of statutes of limitations. This decrease was offset by an increase in uncertain tax positions of $21 million, of which $17 million relates to 2010 increases and $4 million relates to unfavorable foreign currency exchange translation.

At this time, the corporation estimates that it is reasonably possible that unrecognized tax benefits will decrease between $70—$130 million in the next twelve months from a variety of uncertain tax positions as a result of the completion of various worldwide tax audits currently in process and the expiration of statutes of limitations in several jurisdictions.

The corporation’s tax returns are routinely audited by federal, state, and foreign tax authorities and these audits are at various stages of completion at any given time. The Internal Revenue Service (IRS) has completed examinations of the company’s U.S. income tax returns through July 1, 2006. Fiscal years remaining open to examination in the Netherlands include 2003 and forward. Other foreign jurisdictions remain open to audits after 1998. With few exceptions, the company is no longer subject to state and local income tax examinations by tax authorities for years before June 28, 2003.

As expected, in October 2009, the Spanish tax administration upheld the challenge made by its local field examination team against tax positions taken by the corporation’s Spanish subsidiaries. In November 2009, the corporation filed an appeal against this claim with the Spanish Tax Court. The corporation believes it is adequately reserved for the challenge raised by the Spanish tax authorities. However, in order to continue its appeal, the corporation will be required in the next 6 – 9 months to either provide a cash deposit or obtain a bank guarantee in the amount of $90—$150 million to fund all allegations. The corporation continues to dispute the challenge and will continue to have further proceedings with the Spanish tax authorities regarding this issue.

 

  11. Contingencies and Commitments

Aris – This is a consolidation of cases filed by individual complainants with the Republic of the Philippines, Department of Labor and Employment and the National Labor Relations Commission (NLRC) from 1998 through July 1999. The complaint alleges unfair labor practices due to the termination of manufacturing operations in the Philippines by Aris Philippines, Inc. (Aris), a former subsidiary of the corporation. The complaint names the corporation as a party defendant. In 2006, the arbitrator ruled

 

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against the corporation and awarded the plaintiffs $60 million in damages and fees, and the corporation appealed this ruling. In December 2006, the NLRC set aside the arbitrator’s ruling, and remanded the case to the arbitrator for further proceedings. The complainants and the corporation have filed motions for reconsideration – the corporation seeking a final judgment and outright dismissal of the case, and complainants seeking to reinstate the original arbitrator’s judgment against the defendants, including the corporation. The respective motions for reconsideration have been fully briefed and the parties await the NLRC’s rulings.

In response to the arbitrator’s original ruling, the Court of Appeals required the corporation to post a bond of approximately $25 million. The corporation has appealed the decision to the Supreme Court and no additional bond posting is required until all allowable appeals have been exhausted. The corporation continues to believe that the plaintiffs’ claims are without merit; however, it is reasonably possible that this case will be ruled against the corporation and have a material adverse impact on the corporation’s results of operations or cash flows.

American Bakers Association Retirement Plan (ABA Plan) – The corporation is a participating employer in the ABA Plan. In 1979, the Pension Benefit Guaranty Corporation (PBGC) determined that the ABA Plan was an aggregate of single-employer pension plans rather than a multiple employer plan. Under the express terms of the ABA Plan’s governing documents, the corporation’s contributions can only be used to pay for the benefits of its own employee-participants. In August 2006, the PBGC reversed its 1979 determination and concluded that the ABA Plan is and always has been a multiple employer plan in which the participating parties share responsibility for any plan liabilities (2006 Determination). If the 2006 Determination is upheld, it will require the corporation to be responsible for a substantial portion of the ABA Plan’s underfunded liabilities. The corporation initiated litigation in the United States District Court for the District of Columbia seeking to overturn the 2006 Determination.

On December 1, 2009, the United States District Court upheld the 2006 Determination, but then invited the parties to comment on whether the Court’s December 1, 2009 Order resolved all the claims in the action. The corporation believes that the Court, in its December 1 decision, determined that the 2006 Determination applies on a prospective basis only. The corporation has moved the Court to alter or amend its judgment, proposing that the amended judgment specifically state, among other things, that because the 2006 Determination is prospective only, the ABA Plan is deemed to have been, and shall for all purposes be treated as, an aggregate of single-employer pension plans from its establishment until the date of the 2006 Determination. If the corporation’s motion is granted and the Court adopts the proposed amended judgment, we believe the ABA Plan would be treated as an aggregate of single-employer pension plans prior to the 2006 Determination (i.e., the 2006 Determination would have no retroactive application) and as a multiple employer pension plan after the 2006 Determination. If there is no retroactive application, the corporation can move to terminate the plan and eliminate all future ABA Plan funding risks. As a result of the Court’s December 1, 2009 Order, the corporation began to recognize the obligations as if the ABA Plan was a multiple employer pension plan, with all future contributions to the plan immediately expensed in the consolidated statements of income.

The corporation continues to believe that the 2006 Determination is without merit and that the corporation is responsible only for the obligations related to its current and former employees; however, it is reasonably possible that a court may rule against the corporation and determine that the 2006 Determination has retroactive and prospective application. The 2008 actuary report used to determine minimum funding levels indicated the ABA Plan was approximately 86% funded. Based on this funding level, regardless of the outcome of the litigation, the corporation does not believe its portion of the aggregate plan funding will have a material adverse impact on the corporation’s financial position, results of operations or cash flows.

Hanesbrands Inc. In September 2006, the corporation spun off its branded apparel business into an independent publicly-traded company named Hanesbrands Inc. (HBI). In connection with the spin off, the corporation and HBI entered into a tax sharing agreement that governs the allocation of tax assets and liabilities between the parties. HBI has initiated binding arbitration claiming that it is owed $72 million from the corporation under the tax sharing agreement. The corporation believes HBI’s claims are without merit and is vigorously contesting the matter.

 

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Multi-Employer Pension Plans The corporation participates in various multi-employer pension plans that provide retirement benefits to certain employees covered by collective bargaining agreements (MEPP). Participating employers in a MEPP are jointly responsible for any plan underfunding. MEPP contributions are established by the applicable collective bargaining agreements; however, the MEPPs may impose increased contribution rates and surcharges based on the funded status of the plan and the provisions of the Pension Protection Act, which requires substantially underfunded MEPPs to implement rehabilitation plans to improve funded status. The corporation believes that its contributions to MEPPs may increase by approximately 12% to 15% through 2011 due to increased contribution rates and surcharges MEPPs are expected to impose under the Pension Protection Act. Factors that could impact funded status of a MEPP include investment performance, changes in the participant demographics, financial stability of contributing employers and changes in actuarial assumptions.

In addition to regular contributions, the corporation could be obligated to pay additional contributions (known as a complete or partial withdrawal liability) if a MEPP has unfunded vested benefits. These withdrawal liabilities, which would be triggered if the corporation ceases to make contributions to a MEPP with respect to one or more collective bargaining units, would equal the corporation’s proportionate share of the unfunded vested benefits based on the year in which liability is triggered. The corporation believes that certain of the MEPPs in which it participates have unfunded vested benefits, and some are significantly underfunded. Withdrawal liability triggers could include the corporation’s decision to close a plant or the dissolution of a collective bargaining unit. Due to uncertainty regarding future withdrawal liability triggers, we are unable to determine the amount and timing of the corporation’s future withdrawal liability, if any, or whether the corporation’s participation in these MEPPs could have any material adverse impact on its financial condition, results of operations or liquidity. Disagreements over potential withdrawal liability may lead to legal disputes. The corporation currently is involved in litigation with one MEPP and it is reasonably possible that the outcome of this litigation may result in an additional partial withdrawal liability of approximately $16 million.

The corporation’s regular scheduled contributions to MEPPs totaled $49 million in 2009, $48 million in 2008 and $47 million in 2007. The corporation recognized charges for partial withdrawal liabilities of approximately $7 million in 2010 to date, $31 million in 2009, and an immaterial amount in 2008.

Competition Law During the past few years, competition authorities in various European countries and the European Commission have initiated investigations into the conduct of consumer products companies. These investigations usually continue for several years and, if violations are found, may result in substantial fines. In connection with these investigations, Sara Lee’s household and body care business operating in Europe has received requests for information, made employees available for interviews, and been subjected to unannounced inspections by various competition authorities. In January 2010, the corporation was fined 3.7 million euros by the Spanish Competition Authorities related to claims that the corporation engaged in inappropriate activities to indirectly increase prices of its shower gel products. To date, except for the Spanish fine and the previously disclosed 5.5 million euros fine imposed by the German cartel authorities in February 2008, no formal charges have been brought against Sara Lee concerning the substantive conduct that is the subject of these investigations. Our practice is to comply with all laws and regulations applicable to our business, including the antitrust laws, and to cooperate with relevant regulatory authorities. Based on currently available information, it is reasonably possible the corporation may be subject to additional fines. As of the second quarter, the corporation has reflected the fines noted above in the consolidated statements of income in the year we were notified of the fine; however, we are unable to estimate the financial impact of additional fines, if any, on our consolidated financial statements.

Belgian tax matter In 1997, the corporation sold a Belgian subsidiary to an unrelated third party. At the time of the sale, the Belgian subsidiary owed a Belgian tax liability of approximately 30 million euros (resulting from an intercompany restructuring completed before the 1997 sale) and the third party buyer assumed all assets and liabilities of the subsidiary. In 1999, the former Belgian subsidiary, then owned by the third party buyer, declared bankruptcy and did not pay the outstanding Belgian tax liability. In 2001, the Belgian Ministry of Finance launched an investigation into the 1997 sale. In November 2009, the corporation received from the Belgian state prosecutor a notice of intent to indict the third party buyer as well as several of the corporation’s international subsidiaries and several current and former directors and officers of such subsidiaries, in connection with the 1997 sale. The notice alleges various tax-related

 

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legal violations, some of which carry criminal penalties. We have not yet completed our evaluation of the Belgian state prosecutor’s case; however, based on currently available information, the corporation believes the allegations are without merit. At this time, we do not know the size of any taxes, fines or penalties that ultimately may be imposed on the corporation.

Item 2

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

Introduction

The following is management’s discussion and analysis of the results of operations for the second quarter and first six months of 2010 compared with the second quarter and first six months of 2009 and a discussion of the changes in financial condition and liquidity during the first six months of 2010. Below is an outline of the analyses included herein:

 

   

Business Overview

 

   

Summary of Results

 

   

Consolidated Results – Second Quarter and First Six Months of 2010

 

   

Operating Results by Business Segment

 

   

Financial Condition

 

   

Liquidity

 

   

Significant Accounting Policies and Critical Estimates

 

   

Issued but not yet Effective Accounting Standards

 

   

Forward-Looking Information

Business Overview

Our Business

Sara Lee is a global manufacturer and marketer of high-quality, brand name products for consumers throughout the world focused primarily in the meat, bakery, and beverage products categories. Our brands include Ball Park, Douwe Egberts, Hillshire Farm, Jimmy Dean, Senseo and our namesake, Sara Lee.

In North America, the company sells a variety of packaged meat products that include hot dogs, corn dogs, breakfast sausages, dinner sausages and deli meats as well as a variety of fresh and frozen baked products and specialty items that include bread, buns, bagels, cakes and cheesecakes. These products are sold through the retail channel to supermarkets, warehouse clubs and national chains. The company also sells a variety of meat, bakery and beverage products to foodservice customers in North America. Internationally, the company sells coffee and tea products in Europe, Brazil, Australia and Asia through both the retail and foodservice channels as well as a variety of bakery and dough products to retail and foodservice customers in Europe and Australia.

In September 2009, the corporation announced that it had received a binding offer to acquire its global body care and European detergents businesses for 1.275 billion euros. In December 2009, the corporation also announced that it had received a binding offer for the sale of its air care business for 320 million euros. Together these businesses represent approximately 70% of the net sales of the international household and body care businesses. The results of these businesses and the remaining household and body care businesses, which were previously reported as a separate business segment, are now being reported as discontinued operations. Prior period results have been revised to reflect these businesses as discontinued operations. See Note 4 – “Discontinued Operations” for additional information regarding these discontinued operations. Unless stated otherwise, any reference to income statement items in these financial statements refers to results from continuing operations. The corporation intends to use the proceeds from the divestiture to invest for growth in its core businesses and to repurchase stock.

 

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Summary of Results

The business highlights include the following:

 

   

Reported operating income for the second quarter of 2010 was $282 million, an increase of $286 million over the same period of the prior year. The increase was primarily due to improved operating results at each of the business segments, especially North American Retail and International Beverage, as well as a $90 million reduction in impairment charges, a $27 million improvement in mark-to-market results related to unrealized commodity derivatives and a $49 million reduction in charges for exit activities, asset and business dispositions and pension partial withdrawal liabilities.

 

   

Net sales for the second quarter of $2.9 billion were virtually unchanged as the negative impact of volume declines, planned business exits, and pricing actions were offset by the favorable impact of changes in foreign currency exchange rates.

 

   

Diluted earnings per share from continuing operations improved from a loss of $0.06 to income of $0.43 due to the increase in operating income noted above, as well as approximately $119 million, or $0.17 per share, of tax benefits related primarily to tax audit settlements and a valuation allowance adjustment in the current year.

 

   

Cash flow from operating activities for the first six months of 2010 showed a very strong increase from $214 million to $472 million in the current year driven primarily by improved operating results.

Challenges and Risks

As an international consumer products company, we face certain risks and challenges that impact our business and financial performance. The risks and challenges described below have impacted our performance and are likely to impact our future results as well.

The food businesses are highly competitive. In many product categories, we compete not only with widely advertised branded products, but also with private label products that are generally sold at lower prices. As a result, from time to time, we may need to reduce the prices for some of our products to respond to competitive pressures. In addition, the turmoil in the financial markets has led to general economic weakness, which has negatively impacted our business. The continued economic uncertainty may also result in increased pressure to reduce the prices for some of our products, limit our ability to increase or maintain prices or lead to a continued shift toward private label products. Any reduction in prices or our inability to increase prices could negatively impact profit margins and the overall profitability of our reporting units, which could potentially trigger a goodwill impairment.

Commodity prices directly impact our business because of their effect on the cost of raw materials used to make our products and the cost of inputs to manufacture, package and ship our products. In addition, under some of our contracts, the prices at which we sell our products are tied to increases and decreases in commodity costs. Many of the commodities we use, including coffee, wheat, beef, pork, corn, corn syrup, soybean and corn oils, butter, sugar and fuel, have experienced price volatility due to factors beyond our control. The company’s objective is to offset commodity price increases with pricing actions and to offset any operating cost increases with continuous improvement savings.

The company’s business results are also heavily influenced by changes in foreign currency exchange rates. For the most recently completed fiscal year, approximately 35% of net sales and 50% of operating segment income were generated outside of the U.S. As a result, changes in foreign currency exchange rates, particularly the European euro, can have a significant impact on the reported results. Changes in foreign currency exchange rates increased net sales by $59 million and increased operating income by $11 million for the first six months of 2010.

 

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The company’s international operations also provide a significant portion of the company’s cash flow from operating activities, which is expected to require the company to continue to repatriate a significant portion of cash generated outside of the U.S. The repatriation of these funds has and is expected to continue to result in a higher effective income tax rate and cash tax payments.

Significant Items Affecting Comparability

The reported results for 2010 and 2009 reflect amounts recognized for actions associated with the corporation’s ongoing business transformation program, Project Accelerate and other significant amounts that impact comparability. More information on these costs can be found in Note 6 to the Consolidated Financial Statements, “Exit, Disposal and Transformation/Accelerate Activities.” The nature of these items includes the following:

Exit Activities, Asset and Business Dispositions These costs are reported on a separate line of the Consolidated Statements of Income. Exit activities primarily relate to charges taken to recognize severance actions approved by the corporation’s management and the exit of leased facilities or other contractual arrangements. Asset and business disposition activities include costs associated with separating businesses targeted for sale, as well as gains and losses associated with the disposition of asset groups that do not qualify for discontinued operations reporting.

Project Accelerate Costs – These include costs associated with the transition of services to an outside third party vendor as part of a business process outsourcing initiative. The initiative includes the outsourcing of a portion of the North American and European finance processing functions, information systems application development and maintenance as well as indirect procurement activities. These costs are recognized in the Consolidated Statements of Income in Selling, general and administrative expenses or Cost of sales. Employee termination costs, lease exit costs and gains or losses on the disposition of assets or asset groupings that do not qualify as discontinued operations associated with these initiatives are reported as part of exit activities, asset and business dispositions.

The savings resulting from the Project Accelerate and other restructuring actions were approximately $68 million in the first six months of 2010, of which $48 million is incremental to the prior year. The corporation anticipates annualized savings in 2010 of approximately $125-$150 million related to these actions, of which $75-$100 million is incremental to the Project Accelerate savings in 2009.

Business Transformation Costs – These include costs to retain and relocate existing employees, recruit new employees, and third-party consulting costs associated with transformation efforts. These costs are recognized in the Consolidated Statements of Income in Selling, general and administrative expenses or Cost of sales. Employee termination costs, lease exit costs and gains or losses on the disposition of assets or asset groupings that do not qualify as discontinued operations associated with these initiatives are reported as part of exit activities, asset and business dispositions.

Other Significant Items – The reported results are also impacted by other items that affect comparability. These items may include, but are not limited to, impairment charges, pension partial withdrawal liability charges, curtailment gains (losses) and certain discrete tax matters, which include contingent tax obligation and valuation allowance adjustments and various other tax matters.

 

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Impact of Significant Items on Net Income and Diluted Earnings per Share

 

     Quarter ended December 26, 2009     Quarter ended December 27, 2008  

In millions, except per share data

   Pretax
Impact
    Net
Income (2)
    Diluted EPS
Impact (1)
    Pretax
Impact
    Net
Income (2)
    Diluted
EPS Impact (1)
 

Income (loss) from continuing operations

   $ 250      $ 305      $ 0.43      $ (40   $ (40   $ (0.06
                                                

Net income (loss)

     $ 371      $ 0.53        $ (17   $ (0.02
                                    

Significant items affecting comparability of income from continuing operations:

            

Charges for exit activities, asset and business dispositions:

            

Income from (charges for) exit activities

   $ (6   $ (3   $ (0.01   $ (34   $ (23   $ (0.03

Income from (charges for) business disposition activities

     (9     (6     (0.01     —          (2     —     
                                                

Subtotal

     (15     (9     (0.01     (34     (25     (0.04

(Charges to) income in Cost of sales:

            

Pension partial withdrawal liability charge

     —          —          —          (12     (8     (0.01

(Charges to) income in SG&A expenses:

            

Accelerate charges - Other

     (5     (4     (0.01     (2     (2     —     

Pension partial withdrawal liability charge

     —          —          —          (18     (11     (0.02

Impairment charges

     (17     (11     (0.02     (107     (107     (0.15
                                                

Impact of significant items on income (loss) from continuing operations before significant tax matters

     (37     (24     (0.03     (173     (153     (0.22

Significant tax matters affecting comparability:

            

Tax audit settlements

     —          93        0.14        —          —          —     

Tax valuation allowance adjustment

     —          20        0.03        —          —          —     

U.K. net operating loss utilization

     —          6        0.01        —          —          —     

Other tax adjustments

     —          —          —          —          1        —     
                                                

Impact of significant items on income (loss) from continuing operations

     (37     95        0.13        (173     (152     (0.22
                                                

Significant items impacting discontinued operations:

            

Professional fees/other

     (11     (10     (0.01     (2     (1     —     

Curtailment gain (loss)

     (11     (9     (0.01     —          —          —     

Transformation/Accelerate charges

     —          —          —          (6     (5     (0.01

Valuation allowance adjustment

     —          6        0.01        —          —          —     

Tax audit settlement

     —          (6     (0.01     —          —          —     

Capital loss carryforward utilization

     —          27        0.04        —          —          —     

Other tax adjustments

     —          —          —          —          (1     —     
                                                

Impact of significant items on net income (loss)

   $ (59   $ 103      $ 0.15      $ (181   $ (159   $ (0.22
                                                

Notes:

(1) EPS amounts are rounded to the nearest $0.01 and may not add to the total.
(2) Taxes computed at applicable statutory rates.

 

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Impact of Significant Items on Net Income and Diluted Earnings per Share

 

     Six months ended December 26, 2009     Six months ended December 27, 2008  

In millions, except per share data

   Pretax
Impact
    Net
Income (2)
    Diluted EPS
Impact (1)
    Pretax
Impact
    Net
Income (2)
    Diluted EPS
Impact (1)
 

Income from continuing operations

   $ 546      $ 495      $ 0.71      $ 228      $ 151      $ 0.21   
                                                

Net income

     $ 655      $ 0.94        $ 213      $ 0.30   
                                    

Significant items affecting comparability of income from continuing operations:

            

Charges for exit activities, asset and business dispositions:

            

Income from (charges for) exit activities

   $ (19   $ (12   $ (0.02   $ (33   $ (23   $ (0.03

Income from (charges for) business disposition activities

     (9     (6     (0.01     3        —          —     
                                                

Subtotal

     (28     (18     (0.03     (30     (23     (0.03

(Charges to) income in Cost of sales:

            

Curtailment gain

     —          —          —          6        4        0.01   

Pension partial withdrawal liability charge

     (1     (1     —          (12     (8     (0.01

(Charges to) income in SG&A expenses:

            

Transformation charges - IT costs

     —          —          —          (3     (1     —     

Accelerate charges - Other

     (10     (7     (0.01     (2     (2     —     

Curtailment gain

     —          —          —          6        4        0.01   

Pension partial withdrawal liability charge

     (6     (4     (0.01     (18     (11     (0.02

Impairment charges

     (17     (11     (0.02     (107     (107     (0.15
                                                

Impact of significant items on income from continuing operations before significant tax matters

     (62     (41     (0.06     (160     (144     (0.21

Significant tax matters affecting comparability:

            

Tax valuation allowance adjustment

     —          (5     (0.01     —          —          —     

U.K. net operating loss utilization

     —          12        0.02        —          —          —     

Tax Audit settlement

     —          94        0.14        —          —          —     

Other tax adjustments

     —          —          —          —          1        —     
                                                

Impact of significant items on income from continuing operations

     (62     60        0.09        (160     (143     (0.21
                                                

Significant items impacting discontinued operations:

            

Professional fees/other

     (15     (13     (0.01     (2     (1     —     

Curtailment gain (loss)

     (11     (9     (0.01     5        4        —     

Transformation/Accelerate charges

     —          —          —          (2     (2     —     

Charges for exit activities

     —          —          —          (6     (5     (0.01

Valuation allowance adjustment

     —          53        0.08        —          —          —     

Tax audit settlement

     —          (6     (0.01     —          (1     —     

Capital loss carryforward utilization

     —          27        0.04        —          —          —     

Tax basis difference adjustment

     —          11        0.02        —          —          —     

Tax on unremitted earnings

     —          (5     (0.01     —          —          —     
                                                

Impact of significant items on net income

   $ (88   $ 118      $ 0.17      $ (165   $ (148   $ (0.21
                                                

Notes:

(1) EPS amounts are rounded to the nearest $0.01 and may not add to the total.
(2) Taxes computed at applicable statutory rates.

 

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Consolidated Results – Second Quarter of 2010 Compared with Second Quarter of 2009

The following table summarizes net sales and operating income for the second quarter of 2010 and 2009 and certain items that affected the comparability of these amounts:

 

     Quarter ended  

Total Corporation Performance (In millions)

   Dec. 26,
2009
    Dec. 27,
2008
    Change     Percent
Change
 

Net sales

   $ 2,858      $ 2,856      $ 2      0.1
                              

Increase / (Decrease) in net sales from:

        

Changes in foreign currency exchange rates

   $ —        $ (133   $ 133     

Acquisitions/dispositions

     —          52        (52  
                          

Total

   $ —        $ (81   $ 81     
                          

Operating income (loss)

   $ 282      $ (4   $ 286      NM
                              

Increase / (Decrease) in operating income from:

        

Changes in foreign currency exchange rates

   $ —        $ (17   $ 17     

Exit activities, asset and business dispositions

     (15     (34     19     

Transformation/Accelerate charges

     (5     (2     (3  

Impairment charges

     (17     (107     90     

Pension partial withdrawal liability charge

     —          (30     30     

Acquisitions/dispositions

     —          5        (5  
                          

Total

   $ (37   $ (185   $ 148     
                          

Net Sales

Net sales increased by $2 million or 0.1%. The strengthening of foreign currencies, particularly the European euro and Brazilian real increased reported net sales by $133 million, or 4.6%. Divestitures net of acquisitions occurring after the start of the second quarter of 2009 reduced net sales by $52 million, or 1.8%. Sales were negatively impacted by a 1% decline in unit volumes and pricing actions that decreased net sales by approximately 2%. Excluding the planned exits from the commodity meat and kosher meat businesses, unit volumes would have increased 0.7%. The following table summarizes the components of the percentage change in net sales as compared to the prior year:

Second Quarter 2010

 

Net Sales Changes    Unit
Volumes
  +    Price/
Mix/Other
  +    Acquisitions/
Divestitures
  +    Foreign
Exchange
  =    Net Sales
Change

Total Corporation

   (1.0)%      (1.7)%      (1.8)%      4.6%      0.1%
                                

Operating Income

Operating income increased by $286 million. The year-over-year net impact of the changes in foreign currency exchange rates, transformation/Accelerate charges and the other factors identified in the preceding table increased operating income by $148 million. Operating income was also favorably impacted by a $27 million improvement in unrealized commodity mark-to-market derivatives versus the prior year. The remaining increase in operating income of $111 million was primarily due to improved operating results in the business segments, especially the North American Retail and International Beverage segments, and a reduction in other general corporate expenses. The individual components that impacted operating income are discussed in more detail below.

Gross Margin

Gross margin dollars in the second quarter of 2010 increased $136 million over the prior year due to the impact of lower commodity costs, savings from continuous improvement programs and the favorable impact of changes in foreign currency exchange rates partially offset by the unfavorable impact of pricing actions, lower unit volumes, and the impact of business dispositions. The gross margin percent in the

 

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second quarter of 2010 increased to 38.7% from 33.9% in the second quarter of 2009 primarily due to the impact of lower commodity costs and savings from continuous improvement programs.

Selling, General and Administrative Expenses

 

     Quarter ended