Results of operations

Overview

Kellogg Company is the world's leading producer of cereal and a leading producer of convenience foods, including cookies, crackers, toaster pastries, cereal bars, fruit snacks, frozen waffles and veggie foods. Kellogg products are manufactured and marketed globally. We currently manage our operations in four geographic operating segments, comprised of North America and the three International operating segments of Europe, Latin America and Asia Pacific.

We manage our Company for sustainable performance defined by our long-term annual growth targets. These targets are low single-digit (1 to 3%) for internal net sales, mid single-digit (4 to 6%) for internal operating profit, and high single-digit (7 to 9%) for net earnings per share on a currency neutral basis. Internal net sales and internal operating profit exclude the impact of foreign currency translation, acquisitions, dispositions and shipping day differences. See the "Foreign currency translation" section for an explanation of management's definition of currency neutral.

For the quarter ended October 3, 2009, our reported net sales were flat compared to the same period last year; internal net sales increased by 3%. Consolidated operating profit grew 6%, while internal operating profit increased by 11%. Diluted earnings per share (EPS) grew 6% to $.94, compared to $.89 in the comparable prior period. EPS on a currency neutral basis grew 12%.

For the year-to-date period ended October 3, 2009, reported net sales declined by 2% with internal net sales increasing by 3%. Consolidated operating profit increased 3%, while internal operating profit increased by 10%. Diluted earnings per share grew 8% to $2.70, compared to $2.51 in the comparable prior period. EPS on a currency neutral basis grew 17%.

For the full year, we expect our business model and strategy will deliver results above our long-term targets with internal net sales growth of 3 to 4%, internal operating profit growth of 8 to 10% and earnings per share growth of 10 to 12% on a currency neutral basis. We are able to achieve these results by higher than expected cost savings, slightly lower inflation and solid price/mix performance.

We expect our momentum from 2009 to carry into 2010 allowing us to meet or exceed our long-term annual growth targets. For 2010 we expect internal net sales growth of 2 to 3%, in line with our targeted annual growth of 1 to 3%, but less than 2009 due to less pricing year-on-year. Internal operating profit is expected to grow in the high single-digit (7 to 9%) range, above our target of mid single-digit (4 to 6%) growth due to less spending on up-front costs and savings resulting from our $1 billion cost challenge. Diluted earnings per share on a currency neutral basis is expected to grow 10 to 12%, which is above our long-term targeted growth of high single-digits (7 to 9%).

Net sales and operating profit

The following table provides an analysis of net sales and operating profit performance for the third quarter of 2009 versus 2008:

                                              North                      Latin            Asia                             Consoli-
(dollars in millions)                        America       Europe       America        Pacific (a)        Corporate         dated
2009 net sales                               $  2,187      $   631      $    262      $         197      $         -      $    3,277

2008 net sales                               $  2,156      $   666      $    277      $         189      $         -      $    3,288

% change - 2009 vs. 2008:
Volume (tonnage) (b)                              -.8 %        4.2 %         6.4 %             -1.5 %              -              .7 %
Pricing/mix                                       2.5 %         .5 %         2.9 %              5.5 %              -             2.4 %
Subtotal - internal business                      1.7 %        4.7 %         9.3 %              4.0 %              -             3.1 %
Acquisitions (c)                                   .1 %          -             -                1.8 %              -              .1 %
Foreign currency impact                           -.3 %      -10.0 %       -14.7 %             -1.6 %              -            -3.5 %
Total change                                      1.5 %       -5.3 %        -5.4 %              4.2 %              -             -.3 %


                                              North                      Latin            Asia                             Consoli-
(dollars in millions)                        America       Europe       America        Pacific (a)        Corporate         dated
2009 operating profit                        $    415      $   105      $     51      $          28      $       (32 )    $      567

2008 operating profit                        $    380      $   113      $     61      $          26      $       (47 )    $      533

% change - 2009 vs. 2008:
Internal business                                 9.5 %        7.0 %        -3.3 %              8.6 %           34.4 %          11.3 %
Acquisitions (c)                                    -            -             -               -3.5 %              -             -.1 %
Foreign currency impact                           -.3 %      -14.5 %       -13.9 %              -.1 %              -            -4.9 %
Total change                                      9.2 %       -7.5 %       -17.2 %              5.0 %           34.4 %           6.3 %

(a) Includes Australia, Asia and South Africa.

(b) We measure the volume impact (tonnage) on revenues based on the stated weight of our product shipments.

(c) Impact of results for the quarter ended October 3, 2009 from the acquisitions of Specialty Cereal and certain assets and liabilities of IndyBake.

Our consolidated net sales were flat compared to last year, driven by a negative impact from foreign currency translation. Excluding this negative impact, internal net sales grew by 3%, lapping last year's strong 7% growth. This growth has been driven by global volume growth, particularly in cereal as well as our pricing/mix initiatives.

Our North America operating segment had internal net sales growth of 2% against a very difficult 9% comparative in the year ago period. The growth was driven by pricing, partially offset by lower volumes. The retail cereal product group grew by 2%, on top of last year's 7% growth. We are focusing our strategy to invest against our core cereal brands. As a result, Special K, Raisin Bran and Kashi performed well, responding to increased advertising and successful promotions. We are discontinuing our on-the-go cereal offerings which have become less attractive to consumers in this tough economic environment. Our innovation efforts continue to support our commitment to improve the quality of our food. During the third quarter we launched Froot Loops and Apple Jacks with increased fiber.

The retail snack product group (cookies, crackers, toaster pastries, cereal bars, and fruit snacks) grew by 3% over last year's strong 10% comparable. The growth was driven by our bar innovations such as FiberPlus and Cinnabon. Nutri-Grain bars continue to be a solid performer.

Internal net sales in the frozen and specialty channels (frozen foods, food service and vending) decreased by 3%. The decline was attributable to Frozen being up against a tough prior year comparable where customers bought ahead of a pre-announced price increase and a supply disruption which will continue into the first quarter of 2010. Additionally, we continued to see softness in the foodservice industry during the third quarter.

Our International operating segments collectively achieved net sales growth of almost 6% on an internal basis. Europe's internal net sales increased by 5% as we have resolved retailer disputes. While Europe has been a tough operating environment, we are experiencing the growth we expected in the second half of the year, with a strong increase from volume. In the UK we delivered strong mid single-digit internal net sales growth, driven by growth in retail cereal. Latin America's internal net sales growth continues to be strong at 9% attributable to both volume and price increases driven by retail cereal in Mexico and Venezuela. Internal net sales in Asia Pacific grew 4%, building upon last year's 10% growth.

Consolidated operating profit increased by 6% on an as reported basis and by 11% on an internal basis, when excluding the impact of foreign currency translation and acquisitions. While we continue to experience commodity cost pressures and have increased our spending on up-front costs, we have been able to more than offset those by savings from our cost reduction and productivity initiatives, media deflation and pricing. During the third quarter of 2009, our up-front costs were $34 million, which were $29 million higher than the previous year. Up-front costs represent both exit or disposal activities and other cost reduction initiatives. For the full year, we expect total up-front costs to be approximately $145 million.

Reported operating profit in each of our operating segments was negatively impacted by foreign exchange. North America's internal operating profit growth was driven by price and savings from our cost reduction initiatives, which was partially offset by higher up-front costs. Internal operating profit decreased in Latin America due to spending on up-front costs which reduced operating profit by 10%. Europe's internal operating profit increased, benefiting from top-line growth. Internal operating profit growth in Asia Pacific increased due to sales growth, while reported operating profit was negatively impacted by the acquisition of Navigable Foods. For further information on our acquisitions, see pages 34 to 35 in our 2008 Annual Report on Form 10-K.

The following tables provide analysis of our net sales and operating performance for the year-to-date period of 2009 compared to 2008. The year-to-date net sales performance was generally similar to the quarter's results, as growth in net sales was driven by price. On a year-to-date basis, volume in Europe was down due to the tough economic environment. As we predicted, results are improving in the back half of the year as we experienced a volume increase of over 4%. Acquisitions continue to increase reported growth, while foreign exchange continues to negatively impact it. The drivers of the increased operating profit are savings from our cost reduction initiatives, media efficiencies and pricing, partially offset by higher up-front costs in all of the operating segments on a year-to-date basis.

                                              North                      Latin            Asia                             Consoli-
(dollars in millions)                        America       Europe       America        Pacific (a)        Corporate         dated
2009 net sales                               $  6,574      $ 1,805      $    750      $         546      $         -      $    9,675

2008 net sales                               $  6,431      $ 2,089      $    813      $         556      $         -      $    9,889

% change - 2009 vs. 2008:
Volume (tonnage) (b)                              -.8 %       -1.9 %         3.4 %              2.0 %              -             -.5 %
Pricing/mix                                       3.8 %        3.3 %         5.2 %              3.8 %              -             3.8 %
Subtotal - internal business                      3.0 %        1.4 %         8.6 %              5.8 %              -             3.3 %
Acquisitions (c)                                   .1 %         .4 %           -                4.8 %              -              .4 %
Foreign currency impact                           -.9 %      -15.4 %       -16.3 %            -12.4 %              -            -5.9 %
Total change                                      2.2 %      -13.6 %        -7.7 %             -1.8 %              -            -2.2 %


                                              North                      Latin            Asia                             Consoli-
(dollars in millions)                        America       Europe       America        Pacific (a)        Corporate         dated
2009 operating profit                        $  1,244      $   304      $    157      $          74      $      (130 )    $    1,649

2008 operating profit                        $  1,163      $   347      $    166      $          79      $      (147 )    $    1,608

% change - 2009 vs. 2008:
Internal business                                 8.2 %        6.4 %        10.7 %             19.1 %           12.1 %          10.4 %
Acquisitions (c)                                    -            -             -               -9.8 %              -             -.5 %
Foreign currency impact                          -1.2 %      -18.9 %       -16.5 %            -16.0 %              -            -7.4 %
Total change                                      7.0 %      -12.5 %        -5.8 %             -6.7 %           12.1 %           2.5 %

(a) Includes Australia, Asia and South Africa.

(b) We measure the volume impact (tonnage) on revenues based on the stated weight of our product shipments.

(c) Impact of results for the year-to-date period ended October 3, 2009 from the acquisitions of United Bakers, Navigable Foods, Specialty Cereal and certain assets and liabilities of IndyBake.

Margin performance

Margin performance for the third quarter and year-to-date periods of 2009 versus 2008 is as follows:

                                                   Change vs. prior year
              Quarter             2009     2008           (pts.)
              Gross margin (a)    43.9%    42.7%            1.2
              SGA% (b)           -26.6%   -26.5%           -0.1
              Operating margin    17.3%    16.2%            1.1


              Year-to-date        2009     2008           Change
              Gross margin (a)    42.9%    42.6%            0.3
              SGA% (b)           -25.9%   -26.3%            0.4
              Operating margin   17.0%     16.3%            0.7

(a) Gross profit as a percentage of net sales. Gross profit is equal to net sales less cost of goods sold.

(b) Selling, general and administrative expense as a percentage of net sales.

We strive for gross profit dollar growth to reinvest in brand-building and innovation expenditures. We maximize our gross profit dollars by managing external cost pressures through product pricing and mix improvements, implementing productivity savings and technological initiatives as well as entering into commodity hedges and fixed price contracts to reduce the cost of product ingredients and packaging. For the quarter, our gross profit was up $37 million, despite the negative impact of foreign exchange of $54 million and $23 million of higher up-front costs in cost of goods sold. On a year-to-date basis, gross profit was down $65 million which included a $259 million negative impact from, foreign exchange.

As illustrated in the preceding table, our consolidated gross margin increased by 120 basis points in the quarter. Our recent acquisitions lowered gross margin by approximately 10 basis points for the quarter. Although moderating, we also continue to experience inflationary cost pressures for fuel, energy, commodities and employee benefits. During the quarter, higher costs, including increased investment in up-front costs, were more than offset by savings from cost reduction initiatives and price increases. On a year-to-date basis, gross margin is up 30 basis points compared to last year. Excluding a 20 basis point impact for acquisitions our gross margin would have been up 50 basis points. We expect our full year margin to be approximately 100 basis points higher than the prior year due to continued price realization and cost savings which will offset cost pressures.

Operating margin improved from the prior year both for the quarter and year-to-date periods due to lower up-front costs in SGA and savings from cost savings initiatives.

Foreign currency translation

The reporting currency for our financial statements is the U.S. dollar. Certain of our assets, liabilities, expenses and revenues are denominated in currencies other than the U.S. dollar, primarily in the euro, British pound, Mexican peso, Australian dollar and Canadian dollar. To prepare our consolidated financial statements, we must translate those assets, liabilities, expenses and revenues into U.S. dollars at the applicable exchange rates. As a result, increases and decreases in the value of the U.S. dollar against these other currencies will affect the amount of these items in our consolidated financial statements, even if their value has not changed in their original currency. This could have significant impact on our results if such increase or decrease in the value of the U.S. dollar is substantial.

The recent volatility in the foreign exchange markets has limited our ability to forecast future U.S. dollar reported earnings. As such, we are measuring diluted earnings per share growth and providing guidance on future earnings on a currency neutral basis, assuming earnings are translated at the prior year's exchange rates. This non-GAAP financial measure is being used to focus management and investors on local currency business results, thereby providing visibility to the underlying trends of the Company. Management believes that excluding the impact of foreign currency from EPS provides a better measurement of comparability given the volatility in foreign exchange markets.

Below is a reconciliation of reported EPS to currency neutral EPS for the quarter and year-to-date periods ended October 3, 2009: