Kellogg Company
Q3 2017 Earnings Call Transcript

Published: 31 Oct 2017

[Operator:]

Good morning. Welcome to the Kellogg Company Third Quarter 2017 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. Thank you. Please note this event is being recorded. At this time, I will turn the call over to John Renwick, Vice President of Investor Relations and Corporate Planning for Kellogg Company. Mr. Renwick, you may begin your conference call.

[John Renwick, CFA:]

Thank you, Gary. Good morning, and thank you for joining us today for a review of our third quarter 2017 results. I'm joined this morning by

[John A. Bryant:]

Thanks, John, and good morning, everyone. As announced last month, I am retiring, after seven years as Kellogg's CEO and 20 years with the company, in order to spend more time with my family. There's never a perfect time to make a move like this, but the Q3 results and outlook and where we are on key initiatives make this an appropriate time to make this transition. I also strongly believe that Steve Cahillane is the right person for the role. He has significant leadership experience, including as a CEO. His extensive background in CPG companies means he knows how to grow big brands. His experience in international markets means he knows how to expand abroad. And his latest stint at Nature's Bounty gives him keen insights on today's health and wellness definition. He brings fresh perspectives from the outside that can help drive new ideas. Steve's spent the past month reviewing the plans of each of our regions. He takes the reins at a time when the company is undergoing an enormous transformation, amidst an industry that is undergoing significant change. And I'm even more convinced today that he's the right person for the job. Steve, welcome aboard.

[Steven A. Cahillane:]

Thanks, John, and hello, everyone. I'm excited to be here. Let me first thank John for his service and a very effective transition. I'm glad to have him staying on as Chairman into March of next year. I'm only four weeks into the job, but I've had the opportunity to review the commercial and supply chain plans of most of our businesses. And what I've learned has only confirmed that I made the right decision to come to Kellogg. First, we've got incredible brands, outstanding food and a strong culture. These factors have made Kellogg special for over a century. Second, the company's on sound financial footing. Project K included some very aggressive actions, and Zero-Based Budgeting required the entire organization to change the way it works. The cost structure has been reduced, underlying profitability has been improved and returns on investment are improving. And third, based on what I've seen over the past few weeks, the company can and will return to top-line growth. Key elements are already in growth, from Pringles to our Frozen Foods brands, to our Specialty Channels businesses, to our expanding emerging market presence. The entire organization is hungry to get back to growth, and it's open to new ideas. For instance, our 1894 venture capital fund invests in early stage technology and food businesses. We've been experimenting with direct-to-consumer for our Bear Naked brand, and we're learning from the pop-up cafes we've opened up around the world. And as evidenced by the acquisition of RXBAR, we're even willing to acquire growth. This is not a company that's sitting on its hands. So Kellogg is already doing many of the right things to get back on track amidst a very challenging industry environment, particularly around cost structure and emerging market scale. Businesses are starting to turn, and there's more we can do, so I'm very excited. I'll have more thoughts to share after my first 100 days or roughly the time of CAGNY. I look forward to working with all of you in the investor community. So for now, I'll turn it back to John and the rest of the business update.

[John A. Bryant:]

Thanks, Steve. Let's turn to the quarter and slide 5. We generated strong double-digit growth in operating profit, and we generated sequential improvement in our top line. These results keep us on track to achieve our guidance for the year. A few highlights

[Fareed A. Khan:]

Thanks, John. Slide 10 shows a summary of our financial results in Q3 and year-to-date. Our third quarter results came in largely as expected. Net sales declined in the quarter on a currency-neutral comparable basis, but again showed sequential improvement, even despite the negative impact of the DSD transitions planned price adjustments and disruptions as we moved our U.S. Snacks business to a warehouse model. Operating profit continued to increase in the quarter, with growth accelerating, largely because our DSD overhead savings began to be realized. Earnings per share grew, despite comparing against an unusually low tax rate a year ago, keeping us solidly on track for our full year guidance. There's a little bit of timing favorability, which I'll discuss in a moment, but, overall, a good quarter. So let's get into a little bit more detail. Slide 11 breaks our currency-neutral comparable net sales performance into its key components. As you can see from the slide, our volume declines moderated again, as we saw marked improvement in the trends for specific brands and businesses that we had called out previously. For example, Pringles returned to growth in Europe after an unusual decline in the first half. We saw a moderation of declines in Special K and Kashi, as renovated product lines took hold on shelf and new media campaigns went on air. And our U.S. Frozen brands, Eggo and Morningstar Farms, picked up momentum that started in Q2. And, as planned, the DSD transition had a bigger negative impact on sales in Q3 than it did in the first half. This impact is comprised of two factors

[Paul T. Norman:]

Thanks, Fareed. We'll start with our transformation of U.S. Snacks and an update on our DSD transition on slide number 16. I'm very pleased with the execution of this extremely complex undertaking. Customer feedback has been very good, and our operational metrics are all on track. By the end of July, we were shipping completely via warehouse distribution to all customers and exiting our DCs, trucks and equipment and reducing the workforce. We are working diligently with our customer to ensure all details and issues are taken care of. And I'm extremely proud of how our organization has risen to this challenge. From the standpoint of in-market performance, you saw the impact of the transition in our scanner data and we expected this. We pulled right back on promotional activity in order to facilitate the production and shipping of initial inventories to the warehouses of our customers. This resulted in sharp declines in incremental sales, promotional volume and number of displays. Our average number of items are down, too, reflecting our SKU rationalization. Now, as we look forward, we will see momentum build behind a more focused assortment on-shelf and fewer, but bigger, displays with an emphasis on quality positions. All of this will be supported by significant increases in brand-building against our largest brands, as we move from push to pull. The net results of all of this will be an improvement in our in-market performance over the coming weeks and months. From a financial perspective, the transformation of Snacks remains on track. We have already begun to boost our brand-building investment. And, as you can see in our Q3 P&L, the expected overhead reductions are coming through to the bottom line. An undertaking of this magnitude isn't easy. We've come a long way and we still have work to do. But you're starting to see U.S. Snack's future taking shape. There is no question that this will become a stronger, more profitable business. Snack's Q3 results, summarized on slide number 17, came in as expected. Net sales were impacted by the factors we've already discussed

[John A. Bryant:]

Thanks, Paul. Let's now discuss Europe, shown on slide 21. We had a much improved top-line performance in Europe in Q3. And as we had anticipated, it was driven by two key factors. The first was Pringles. You'll recall that our European Pringles business, which had been growing reliably at a mid to high single-digit rate in recent years, suddenly declined at a sharp rate in the first half. This negative swing reflected prolonged negotiations with customers regarding our price increase on reformulated product. While these negotiations were largely behind us by early Q2, our share of merchandising events was reduced significantly through the entire first half. As anticipated, we resumed promotional activity during Q3 and returned the brand to year-on-year sales growth. The second major factor was UK cereal. This is a key business that has been declining for us in recent years, and that stabilization is something we called out as a major priority for us this year. And we're doing just that. In Q3, our consumption and share sustained the year-on-year growth trend from earlier in the year. This is an impressive turnaround. It's being driven by several of our brands, achieved by executing the three things we know works in cereal

[Steven A. Cahillane:]

Thanks, John. I would just reiterate that I feel extremely confident about the potential of this company. Results are coming in as expected and there is a lot of energy around getting back to sustainable profitable growth. I'm not in a position right now to give any guidance on 2018, as we are still evaluating our business units' plans. But I can tell you that there is a high degree of confidence in our expected cost savings and I'm very encouraged by the commitment of the organization to getting back to top-line growth. We are stabilizing soft elements of the business. We are gaining traction in growing elements of our business. And we have a lot of great ideas that can take us further. With that, let's open it up for questions.

[Operator:]

We will now begin the question-and-answer session. Our first question comes from Robert Moskow with Credit Suisse. Please go ahead. Mr. Moskow, your line is open on our end.

[Unknown Speaker:]

Hi. Yes. This is Neil Kugurney (36

[Steven A. Cahillane:]

Yeah, Neil, (36

[Unknown Speaker:]

Got it. Thanks very much, Steve.

[Operator:]

The next question comes from Ken Goldman with JPMorgan. Please go ahead.

[Kenneth B. Goldman:]

Hey. Thanks. I'm going to follow-up on that by asking about 2018 as well. The company already has given operating margin guidance for 2018. Two summers ago, Kellogg said the operating margin will be up about 350 basis points from 2015. Is this guidance still on the table? I realize there's some headwinds in terms of sales not being quite as strong as what you would have thought, but there's an incremental, and a pretty big incremental, tailwind as well in terms of going to warehouse. So I'm just trying to get your sense of how strong that guidance line item still is.

[Steven A. Cahillane:]

Again, just to reiterate, we're not going to give any 2018 guidance, but we are well on track to achieve those goals based on all the terrific work that's been happening around the transformation, around DSD, around Zero-Based Budgeting, Project K. So it gives us great momentum going into 2018. We just want to take the time, and for me to do exactly what you'd expect me to do, which is review all the businesses, look for the best opportunities to strike the right balance between top-line growth and what's continued to be excellent margin expansion.

[Fareed A. Khan:]

And, Ken, it's Fareed. Just as a reminder, that 350 basis points, the key drivers behind that were Project K and ZBB, and both of those initiatives are well in flight. The DSD exit was the largest remaining element of Project K. And as you've heard, we've got a very good line of sight. So from a cost perspective, which was really underpinning it all, we have very high confidence in delivering the two big initiatives in that.

[Kenneth B. Goldman:]

Okay. Thank you for that. And then, one thing I wanted to make sure of, your biggest competitor in U.S. cookies and crackers, they talked about getting a little bit more aggressive in the fourth quarter, especially after some shelf resets, perhaps getting some incremental displays. I know you've talked in the past about losing some displays, perhaps in some parts of the store that maybe weren't critical to you in this category. I just wanted to get a sense, how much does your guidance for the fourth quarter, I guess, contemplate your competitors getting a little bit more aggressive than they were in the third quarter in that part of your business?

[Paul T. Norman:]

Hey, Ken. It's Paul. Obviously, I'm not going to talk about competitors. We're pretty much focused on doing our job and that's rebuilding momentum. And I feel good about our plan and the strength of our plan in Q4. We're reinvesting in, obviously, significant amounts of brand-building here behind a pull model. We're reinvesting in in-store promotions behind a more focused assortment and we are driving more impactful, larger displays in key positions in stores. When you exit DSD, you're always going to lose some tertiary and secondary displays, but the benefits of shipping through warehouse is that we can drive some big impact displays across our biggest brands as we build momentum into what will be a strong Q1 as well from an innovation point of view and our ability to leverage the Power of K in-store going forward across one delivered platform. So we're focused on getting the momentum back in our brands. And our plans look very strong year-to-go.

[Kenneth B. Goldman:]

Thanks. And, John, best of luck to you.

[John A. Bryant:]

Thank you.

[Steven A. Cahillane:]

Thank you.

[Operator:]

The next question comes from Steve Strycula with UBS. Please go ahead.

[Steven Strycula:]

Hi, guys. A question for John and Paul, can you break down the revenue shortfall this year for U.S. Morning Foods relative to your initial plan as we started the year? Just want to get a feel for, in that specific business, our revenue velocity decelerated within U.S. cereal or are we seeing decreased category distribution? Just clarity into that and how we kind of exit and look to 2018 would be a helpful color. Thank you.

[Paul T. Norman:]

Okay. Steve. As it regards Morning Foods and cereal, specifically, we're not seeing points of distribution or things happen at a category level, per se. We are, obviously, disappointed with our performance this year. And we're not hitting our plan. We're hitting our plan on many elements around kids and productivity where we're not hitting our plan has been around our biggest adult brands. And that shortfall on brands like Mini-Wheats and Special K and, to a certain degree, Raisin Bran, is what's driving a softer category performance this year. The category's going be down between 2% and 3%. And some of that, quite frankly, is on us. We need to now pivot and reassert our health and wellness credentials on those adult brands, increasing claims, news and innovation around those brands as we go into next year. So I've mentioned probiotics on Special K. We have news coming on Raisin Bran. And one thing we'll talk to you about in coming months is some more transformational innovation coming to the category around the area of digestive health and convenience as we look to really stimulate adult growth within the cereal category. As you go back over time, this category has always responded, over the past 50 years, to health and wellness, whether it was fortification, fiber, oat bran, low calorie, low fat in the 1990s and 2000s. We need to drive the health credentials of the category. And that's what our plan is as we go into next year, whilst continue to drive fun and taste and versatility, and, as John said, big consumer excitement engagement through big properties and fun in-store. So that's really where we're headed. And I'm very much focused forward right now on those things.

[Steven Strycula:]

Great. Thank you.

[Operator:]

The next question comes from Andrew Lazar with Barclays. Please go ahead.

[Andrew Lazar:]

Good morning, everybody, and welcome, Steve.

[Steven A. Cahillane:]

Thanks, Andrew.

[Andrew Lazar:]

I guess my question, Steve, is really more to try and dig in a little deeper as to why you decided to join Kellogg, kind of what brought you there. And I ask this a little bit tongue in cheek, of course, just because of all the negative sentiment on the food space, overall, questions about the viability of big brands and the sustainability of margin structures and all of that, not to mention a consumer that seems more benefit-driven maybe than brand-driven than ever before. So I'd love to just get a sense of what brought you here, as you sort of assessed your next potential opportunities, to get a sense of your thoughts on some of those things that I brought up. Thank you.

[Steven A. Cahillane:]

Yes. No, thanks, Andrew. I think the pessimism around this category and U.S. food, I think, is overdone, in my estimation. There's going to be winners, and there's going be those who don't win. And I think Kellogg is uniquely positioned to be one of the winners. You've got great brands, great food, great people here, a great culture. You're not going find a more iconic company than Kellogg. And so the opportunity to come here was very humbling, but I also see tremendous opportunities for growth. And, as I've traveled around, I've seen those growth opportunities. They exist already. Look at Pringles globally and how well that's doing, what opportunities exist there. You hear Paul talk about the Frozen business, Eggo and Morningstar Farms; terrific brands growing very well with lots of momentum. The emerging markets and the opportunities in emerging markets and the JVs that we formed already, tremendous opportunities for growth. And you saw what we recently did with RXBAR, filling in a space that we weren't participating in with a terrific brand that's right on-trend. And so, as I looked at the opportunity, I saw tremendous opportunity for growth, a wonderful opportunity to join the most iconic of American companies, a great culture, love the people that I met. And so I couldn't be happier with the choice, and I see really tremendous opportunity for us moving forward.

[Andrew Lazar:]

Great. Thank you for that and all the best, John.

[John A. Bryant:]

Thank you.

[Operator:]

The next question comes from David Driscoll with Citi. Please go ahead.

[David Cristopher Driscoll:]

Great. Thank you. Good morning. John, thank you for all the assistance over the year and good luck with your next chapter and a welcome to Steve. My question is on U.S. Snacks. Can you guys give us some sense as to the size of the volume declines that occurred after the transition? And then, when do you expect to see the benefits from higher advertising and brand-building that you're going to execute on the snack operations?

[Paul T. Norman:]

Hey, David. It's Paul. It's hard for me to give you a sense of the exact volume declines, but remember what we said coming into this. There is a 50% to 20% SKU rationalization that will obviously not have that amount of impact on our business, but will have a limited impact. We hope to gain space on some of our core items to get a more powerful assortment there. At the same time, we said and we knew we would get fewer displays as we came out of DSD but more impactful displays. And we pulled right back on promotions and display support through a period of three to four months here to be able to operate effectively in what is a new model for the Snacks team. We have now pivoted. Brand-building was up in Q3 and will be up much more in Q4. Our investment in promotions and in-store support with our customers is now beginning to come to life as we reinvest behind these biggest brands, and that will continue as we go into next year. I'm optimistic we will see consumption improvement in the coming weeks and months on this business. We have a strong innovation pipeline coming at the beginning of the year, so that will accelerate into next year from a consumption point of view. So we're now, if you like, the transition is behind us in many ways. We're now very much focused on operating effectively in a warehouse-delivered model, which we think we can do because we do it across our other businesses.

[David Cristopher Driscoll:]

Paul, in one follow-up for me, do you have any concerns on your shelf space within the Snack business now that you're about three months since the DSD elimination? Do you have any concerns that you would lose shelf space larger than any expectation you previously had before you executed the transition?

[Paul T. Norman:]

It's a good question, David. Our business is responding in the way we expected it to. So all of our key metrics are right where the team expected them to be. It takes a lot of work in-store to make sure tags and placement and compliance is there across 20,000-plus stores, which we used to call on twice a week. But so far so good, and we'll continue to improve as we go forward. So there's nothing outside of our assumptions in our business case at the moment that would worry us. Like I say, we're just focused on getting back to growth with our customers and then obviously working with our customers in a new delivered environment, where we can also help them from a cost to serve point of view as we're on one platform now and build those joint value-creating plans in ways that we couldn't before, which I think will be really important looking forward.

[David Cristopher Driscoll:]

Thank you.

[Operator:]

The next question comes from Bryan Spillane with Bank of America. Please go ahead.

[Bryan D. Spillane:]

Hey. Good morning, everyone. Just a follow-up on the questions around the Snacks business in the U.S., and I guess maybe I didn't understand this correctly, but part of what I thought or what I'm expecting is that as you pulled back DSD, so all of that distribution resource into large format retailers, it frees up some resources to maybe expand into some other channels where you're under-resourced. So I guess my question is just is that still true? And if it is, as we're thinking about the timing, I guess, over the next year or two, is there a level of reinvestment that we should be thinking about that goes into sort of building more channel diversity?

[Paul T. Norman:]

Absolutely, Brian. When we laid out the business plan when we started this at the beginning of the year, this was really based on a set of consumer-based and shopper-based assumptions, which is exactly what you said. Investing money in a go-to market mechanism or operating model, the consumers don't see the benefit from, quite frankly, was not where we wanted to be. So those resources are now going into focusing on how and where the shopper shops. Whether that's brand-building in old-fashioned ways or new-fashioned ways from a shopper point of view, reaching those shoppers in whichever retail environment they choose to shop, that's exactly what we're doing. We're also investing more resources, people resources, against where the growth channels are in our business. So we're seeing, for example, eCommerce in North America in Q3 grew over 60%. So like every company, winning where the shopper shops in new environments, be that pure play or click-and-collect is right up there on our agenda. And investing in capabilities, whether it be supply chain, marketing, sales in that environment, is where some of these dollars are going. Also remember some of the highest growth potential brands in our portfolio, Pringles, Cheez-It, Rice Krispies Treats, these brands are going get significantly more brand-building, way up there in the double digits for the next year, as we look to accelerate those brands. Whether that's TV, media type investments, whether it's customer focused investments, whether it's capital into pack/price format investments to make sure that we have exactly the right offering in the right channel to fit the consumers and the shoppers' needs. What we said we're doing, we're going to do, and you'll see it come through in the months to come into next year.

[Bryan D. Spillane:]

Okay. Thank you.

[Operator:]

The next question comes from Rob Dickerson with Deutsche Bank. Please go ahead.

[Rob Dickerson:]

Thank you very much. John, thanks for all. Steve, welcome. So, Steve, I was just wondering if you could give us maybe one or two examples of what you may be focused on as you step into the role at Kellogg for each of the brands and really as you think about brand investment allocation. And I'm simply asking you to see if there's anything you believe as you step into the new role, are there best practices that you can bring from your prior position to leverage Kellogg's win potential going forward? Thanks.

[Steven A. Cahillane:]

Yeah, thanks, Rob. I certainly hope I can bring some new thinking in best practices, but I'm also humble enough to know that I'm joining the original health and wellness company, as I said before, very iconic with fantastic brands. And again, I see tremendous opportunities in many of the brands in all the categories. Some of the questions people ask is can cereal grow. And even within that, you see the kids' brands in the U.S. becoming stable. You see a great story in the UK with Corn Flakes return turn to double-digit growth on the back of really strong marketing programs. And I'm confident if we get the adult portfolio marketed properly around contemporary health and wellness, there's even opportunity there to continue to grow that. And then you look back at some of the areas that are already growing that I mentioned, Pringles globally, the Eggo business, Morningstar Farms, emerging markets, there's a lot of opportunities to grow this business. And it's not that there's a dearth of opportunities where we really have to search far and wide for that little gem. There's a lot. And so we have the opportunity to really evaluate where those opportunities are, make the right resource allocation decisions, and really put the pedal down on some of these areas of high growth. This company is not without strong brands. In fact, there's many, many brands across many categories and geographies. So I'll be spending the next 90 days really evaluating all those opportunities, evaluating the business plans. John's been a tremendous partner. We've been traveling all around the world, along with Fareed, to really evaluate these plans. And right about the fourth quarter call, we'll be talking about 2018, where we want to take 2018. And I'm looking forward to seeing all of you at CAGNY, where we'll be more fulsome about exactly where these opportunities are and where we believe we can really create long-term value for our shareholders.

[Rob Dickerson:]

Okay, great. Thanks a lot. I'll pass it on.

[Operator:]

The next question comes from John Baumgartner with Wells Fargo. Please go ahead.

[John Joseph Baumgartner:]

Good morning. Thanks for the question. Paul, just going back to U.S. cereal, you made comments around brand-building, but it feels as though that lever has been pulled a number of times on and off over the years with protein cereals, antioxidant cereals, and with, I guess, a fairly limited impact. So do you have a sense as to where maybe cereal share of voice is in the breakfast space relative to where it's been historically? And just given how the daypart's been bifurcating, are the brand-building levers also bifurcating, where any approach is maybe less incremental, in terms of its impact, overall? How do you think about the returns there on those efforts and where you invest going forward?

[Paul T. Norman:]

Thanks, John. As I look forward on our portfolio, as I emphasized, it's less about absolute money or share of voice as it used to be. It's more about getting the right ideas behind the right brands. We have a great set of existing core brands, the Core 6, as we call them. They cover 70% of the needs when it comes to the category, number one. We have to up our game on brands like Mini-Wheats, Special K, and Raisin Bran to bring, as Steve said, contemporary health and wellness credentials to those brands. We're down the track on Special K. And we're seeing the brand begin to respond, not only in the U.S. but around the world. And we're bringing more, in the way of probiotics to Special K next year. Raisin Bran and Mini-Wheats, we can do a lot more to pull out the wellness credentials of those brands and talk to consumers about them. This isn't category work, per se. This is brand work relevant to consumer needs, brand-on-brand. I've spoken before about how the category's always been driven over time, actually through nutrition. Whether it was fortification back in the 1950s, fiber, oat bran in the 1970s and 1980s, and then for a long while here, low calorie, low fat drove the Special K brand in particular and the category for years. Now, I believe gut health and science is coming back to nutrition and nutrition in the cereal category. We're well placed as a category to actually find tailwinds in nutrition in the months and years to come. It's good for cereal and it's good for our emphasis on health and wellness. You add the Kashi brands and the Kashi business to that as well and we have a on-trend set of brands, I think, for the 10 years to come. The critical thing, though, is finding great commercial ideas, renovation and innovation that can bring to life those trends in unique ways for our brands. Our portfolio and our category is uniquely placed to do that. It's incumbent on us to do it. So that's really where our focus is. 35%,36% of the cereal consumption in the U.S. today happens outside of the breakfast occasion. That trend's only increasing and will only continue to increase as you think of demographics and age cohorts going forward here. And so we are agnostic to what time of day we communicate the benefits of our foods. And we'll communicate to everybody, wherever they are throughout the day, these benefits. We've had great success with some of our kid brands against millennials in certain dayparts, like the evening, and we will continue to drive our portfolio where it makes sense to fit people's days. The final thing I'll mention is we do need to still bring transformational innovation to cereal, okay, and to the breakfast occasion, which means investing more, maybe, in new alternatives in the area of digestive health and/or convenience. And we're working hard on that. And hopefully, you'll see some transformational innovation ideas come out of our company over the next few months here that show that we are investing to grow our business across these key categories.

[John Renwick, CFA:]

Operator, because we're at the end of the call, we want to bring it back to John Bryant for some final comments.

[John A. Bryant:]

Thank you for your questions, everybody. On a personal note, I'd like to thank all of you in the investment community for your support and engaging discussions over the years. You're in very good hands with Steve, who I firmly believe will transform and successfully lead this great company into the future. Have a great day, and feel free to call John Renwick with any follow-up questions. Thank you.

[Operator:]

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.