PART II

 

 

 

 

 

 

 

Kellogg Company and Subsidiaries

 

 

execution continued to drive broad-based sales growth across each of our enterprise-wide product groups. In fact, we achieved growth in retail cereal sales within each of our operating segments.

 

 

For 2007, our North America operating segment reported a net sales increase of 6%. Internal net sales grew over 5%, with each major product group contributing as follows: retail cereal +3%; retail snacks (cookies, crackers, toaster pastries, cereal bars, fruit snacks) +7%; frozen and specialty (food service, club stores, vending, convenience, drug and value stores) channels +6%. The significant growth achieved by our North America snacks business built on internal growth of +11% in 2006. The 2007 growth in North America retail cereal sales represented the 7th consecutive year in which we’ve increased our dollar share of category sales.

 

 

Our International operating segments collectively achieved net sales growth of approximately 12% or 5% on an internal basis, with leading dollar contributions from our businesses in the UK, France, Mexico, and Venezuela. Internal sales of our Asia Pacific operating segment (which represents approximately 5% of our consolidated results) were approximately even with the prior year, as solid growth in Asian markets was offset by weak performance in our Australian business.

 

 

Consolidated operating profit for 2007 grew 6%, with internal operating profit up 3% versus 2006. For 2007, Europe contributed a strong 14% internal growth rate, driven by increased sales and stronger gross margins, as well as lower up-front costs. Despite a strong sales performance, operating profit in our North American segment was dampened by continued commodity cost pressures and significantly higher up-front costs associated with cost reduction initiatives, as more fully discussed on page 16. As previously predicted, our Latin America and Asia Pacific operating segments suffered operating profit declines, primarily driven by lower gross margins due to increased commodity costs, as well as the previously mentioned weak performance in our Australian business.

 

 

Our current-year operating profit growth was also affected by significant cost pressures as discussed in the “ Margin performance ” section beginning on page 14. Expenditures for brand-building activities increased at a mid single-digit rate; this rate of growth incorporates savings reinvestment from our recent focus on media buying efficiencies and global leverage of promotional campaigns. Within our total brand-building, advertising expenditures grew at a double-digit rate for 2007.

 

 

2006 compared to 2005

 

The following tables provide an analysis of net sales and operating profit performance for 2006 versus 2005:

 

 

 

 

During 2006, our consolidated net sales increased 7% on both an as-reported and internal basis, building on a 6% rate of internal growth during 2005.

 

 

For 2006, our North America operating segment reported a net sales increase of 8%. Internal net sales growth was also 8%, with each major product group contributing as follows: retail cereal +3%; retail snacks (cookies, crackers, toaster pastries, cereal bars, fruit snacks) +11%; frozen and specialty (food service, vending, convenience and drug stores, custom manufacturing) channels +8%. The significant growth achieved by our North America snacks business represented nearly one-half of the total dollar increase in consolidated internal net sales for 2006. The 2006 growth in North America retail cereal sales was on top of 8% growth in 2005 and represented the 6th consecutive year in which we’ve increased our dollar share of category sales. Although North America consumer retail cereal consumption remained steady throughout 2006, our shipment revenues declined in the fourth quarter of 2006 by approximately 2% versus the prior-year period. We believe this decline was largely attributable to year-end retail trade inventory adjustments, which brought inventories in line with year-end 2005 levels after several successive quarters of slight inclines.

 

 

Our International operating segments collectively achieved net sales growth of approximately 6% or 5% on an internal basis, with leading dollar contributions

from our UK, France, Mexico, and Venezuela business units. Internal sales of our Asia Pacific operating segment (which represents approximately 5% of our consolidated results) were approximately even with the prior year, as solid growth in Australia cereal and Asian markets was offset by weak performance in our Australia snack business.

 

 

Consolidated operating profit for 2006 grew 1%, with internal operating profit up 4% versus 2005. As discussed on page 12, our measure of internal operating profit growth is consistent with our measure of internal sales growth, except that during 2006, internal operating profit growth also excluded the impact of incremental stock compensation expense associated with our adoption of SFAS No. 123(R). We used this non-GAAP financial measure during our first year of adopting this FASB standard in order to assist management and investors in assessing the Company’s financial operating performance against comparative periods, which did not include stock option-related compensation expense. Accordingly, corporate selling, general, and administrative (SGA) expense was higher and operating profit was lower by $65 million for 2006, reducing consolidated operating profit growth by approximately four percentage points. Refer to the section beginning on page 24 entitled “ Stock compensation ” for further information on the Company’s adoption of SFAS No. 123(R).

 

 

Although total 2006 up-front costs of $82 million were not significantly changed from the 2005 amount of $90 million, a year-over-year shift in operating segment allocation of such costs affected relative segment performance. The 2006 versus 2005 change in project cost allocation was a $44 million decline in North America (improving 2006 segment operating profit performance by approximately 4%) and a $28 million increase in Europe (reducing 2006 segment operating profit performance by approximately 8%).

 

 

For 2006, operating profit growth was affected by significant cost pressures as discussed in the “ Margin performance ” section. Expenditures for brand-building activities increased at a low single-digit rate; this rate of growth incorporates savings reinvestment from our recent focus on media buying efficiencies and global leverage of promotional campaigns. Within our total brand-building metric, advertising expenditures grew at a high single-digit rate for 2006.

 

Margin performance

Margin performance is presented in the following table.

 

 

 

 

We strive for gross profit dollar growth to reinvest in brand-building and innovation expenditures. Our strategy for increasing our gross profit is to manage external cost pressures through product pricing and mix improvements, productivity savings, and technological initiatives to reduce the cost of product ingredients and packaging. For 2007, our gross profit was up 7% over 2006, an increase of $350 million.

 

 

Our gross margin performance for 2006 and 2007 reflects the impact of significant fuel, energy, and commodity price inflation experienced throughout most of that time, as well as increased employee benefit costs in 2006. In the aggregate, these input cost pressures reduced our consolidated gross margin by approximately 155 basis points for 2007 and 150 basis points in 2006. For 2006, our gross margin performance was also unfavorably impacted by incremental logistics and innovation start-up costs related to the significant sales growth within our North America operating segment.

 

 

The majority of the inflationary pressure during 2006 and 2007 was commodity and energy-driven. Total active and retired employee benefits expense was approximately $285 million in 2007 versus $325 million in 2006 and $290 million in 2005. For 2008, the combined effect of favorable trust asset performance in prior years and rising discount rates is expected to have a moderating effect on underlying benefit cost inflation. As a result, we expect 2008 benefits expense to be approximately 10% lower than 2007.

 

 

For 2008, we expect inflationary trends to accelerate, with net input cost (fuel, energy, commodity, and benefits) pressures forecasted to exceed realized savings. As compared to 2007 results, we currently expect incremental cost inflation, primarily associated with the prices of our 2008 ingredient purchases to be greater than $.65 per share. Accordingly, we believe our 2008 consolidated gross margin could decline by approximately 100 basis points which includes an approximately 40 basis point reduction related to our acquisitions and an approximately 30 basis point

reduction due to higher up-front costs expected in cost of goods sold.

 

 

In addition to external cost pressures, our discretionary investment in cost-reduction initiatives (refer to following section) has created variability in our gross margin performance during the periods presented. Although total annual program-related charges were relatively steady over the past several years, the amount recorded in cost of goods sold varied by year (in millions): 2007–$23; 2006–$74; 2005–$90. Additionally, cost of goods sold for 2005 includes a charge of approximately $12 million, related to a lump-sum payment to members of the major union representing the hourly employees at our U.S. cereal plants for ratification of a wage and benefits agreement with the Company covering the four-year period ended October 2009.

 

 

For 2006 both our SGA% and operating margin were affected by our fiscal 2006 adoption of SFAS No. 123(R). During 2006, we reported incremental stock compensation expense of $65 million which increased our SGA% and reduced our operating margin by approximately 60 basis points in 2006. Refer to the section beginning on page 24 entitled “ Stock compensation ” for further information on this subject.

 

 

For 2007, our SGA% was negatively impacted by the reorganization of our direct store-door delivery (DSD) operations. Total program costs of $77 million were recorded in SGA expense, as discussed further in the “ Exit or disposal plans” section.

 

 

 

Exit or disposal plans

We view our continued spending on cost-reduction initiatives as part of our ongoing operating principles to provide greater visibility in meeting long-term growth targets. Initiatives undertaken are currently expected to recover cash implementation costs within a five-year period of completion. Each cost-reduction initiative is normally one to three years in duration. Upon completion (or as each major stage is completed in the case of multi-year programs), the project begins to deliver cash savings and/or reduced depreciation, which is then reinvested in the business. Certain of these initiatives represent exit or disposal plans for which material charges will be incurred. We include these charges in our measure and discussion of operating segment profitability within the “Net sales and operating profit” section beginning on page 12.

 

 

In 2006, we commenced a multi-year European manufacturing optimization plan to improve utilization of our facility in Manchester, England and to better align production in Europe. Based on forecasted foreign exchange rates, the Company currently expects to incur approximately $55 million in total up-front costs, including $28 million recorded in 2006, and $19 million recorded in 2007, with the remainder to be incurred in 2008. The cost is comprised of approximately 90% cash expenditures and 10% non-cash asset write-offs. The cash portion of the total up-front costs results principally from management’s plan to eliminate approximately 220 hourly and salaried positions from the Manchester facility by the end of 2008 through voluntary early retirement and severance programs. The pension trust funding requirements of these early retirements are expected to exceed the recognized benefit expense impact by approximately $5 million; most of this incremental funding occurred in 2006. During the program, certain manufacturing equipment will also be removed from service.

 

 

All of the costs for the European manufacturing optimization plan have been recorded in cost of goods sold within the Company’s European operating segment. The following tables present total project costs to date and a reconciliation of employee severance reserves for this initiative. All other cash costs were paid in the period incurred.

 

 

 

 

 

In October 2007, we committed to reorganize certain production processes between our plants in Valls, Spain and Bremen, Germany. Commencement of this plan follows consultation with union representatives at the Bremen facility regarding the elimination of approximately 120 employee positions. This reorganization plan is specifically intended to improve manufacturing and distribution efficiency across our continental European operations, and is expected to be completed by mid 2008. Based on forecasted foreign exchange rates, we expect to incur approximately $25 million of total project costs, comprised of approximately 50% asset write-offs and 50% employee separation benefits and other cash costs. The Company recorded $4 million of costs in 2007, with the remaining to be incurred in 2008.

All of the costs for the European production process realignment have been recorded in cost of goods sold within the Company’s European operating segment.

 

 

The following tables present total project costs to date and a reconciliation of employee severance reserves for this initiative. All other cash costs were paid in the period incurred.

 

 

 

 

 

In July 2007, management commenced a plan to reorganize the Company’s direct store-door delivery (DSD) operations in the southeastern United States. This DSD reorganization plan is intended to integrate the Company’s southeastern sales and distribution regions with the rest of its U.S. direct store-door operations, resulting in greater efficiency across the nationwide network. In preparation for this initiative, in June 2007, the Company began to extend offers to exit approximately 517 distribution route franchise agreements with independent contractors, which were substantially accepted as of July 2007. The plan resulted in the involuntary termination or relocation of approximately 300 employee positions. Total project costs incurred were $77 million, principally consisting of cash expenditures for route franchise settlements and to a lesser extent, for employee separation, relocation, and reorganization. This initiative was substantially complete by the end of 2007.

 

 

All of the costs for the U.S. DSD reorganization plan have been recorded in selling, general, and administrative expense within the Company’s North America operating segment. The following tables present total project costs to date. Exit cost reserves were approximately $3 million as of December 29, 2007, primarily related to lease termination costs. All other cash costs were paid in the period incurred.

 

 

 

 

During 2006, we implemented several short-term initiatives to enhance the productivity and efficiency of our U.S. cereal manufacturing network and streamlined our sales distribution system in a Latin American market. In 2005, we undertook an initiative to consolidate U.S. snacks bakery capacity, resulting in the closure and sale of two facilities by mid 2006. These initiatives were substantially complete at December 30, 2006. Details of each initiative are described in Note 3 within Notes to Consolidated Financial Statements.

 

 

For 2007, the Company recorded total program-related charges of approximately $100 million, comprised of $7 million of asset write-offs, $72 million for severance and other exit costs including route franchise settlements, $15 million for other cash expenditures, and $6 million for a multiemployer pension plan withdrawal liability. Approximately $23 million of the total 2007 charges were recorded in cost of goods sold within the Europe operating segment results, with approximately $77 million recorded in SGA expense within the North America operating results.

 

 

For 2006, the Company recorded total program-related charges of approximately $82 million, comprised of $20 million of asset write-offs, $30 million for severance and other exit costs, $9 million for other cash expenditures, $4 million for a multiemployer pension plan withdrawal liability, and $19 million for pension and other postretirement plan curtailment losses and special termination benefits. Approximately $74 million of the total 2006 charges were recorded in cost of goods sold within operating segment results, with approximately $8 million recorded in SGA expense within corporate results. The Company’s operating segments were impacted as follows (in millions): North America-$46; Europe-$28.

 

 

For 2005, total program-related charges were approximately $90 million, comprised of $16 million for a multiemployer pension plan withdrawal liability, $44 million of asset write-offs, $21 million in severance and other exit costs, and $9 million for other cash expenditures. All of the charges were recorded in cost of goods sold within our North America operating segment.

For the periods presented, cash requirements to implement these programs approximated the exit costs and other cash charges incurred in each year, except for approximately $8 million of incremental pension trust funding that occurred in 2006 in connection with the European manufacturing optimization plan. At December 29, 2007, the Company’s remaining cash commitments to complete the executed programs were comprised of: exit cost reserves of $5 million expected to be paid out in 2008; and estimated multiemployer pension plan withdrawal liabilities of $26 million, which will not be finally determined until 2008 and once determined, are payable to the pension fund over a 20-year maximum period. We expect these cash requirements to be funded by operating cash flow.

 

 

Our 2008 earnings target includes total projected charges related to in-progress and potential cost-reduction initiatives of approximately $80 million or $.14 per share. Approximately one-third of this total is allocated to the aforementioned European projects. However, the specific cash versus non-cash mix or cost of goods sold versus SGA expense impact of the remainder has not yet been determined. Other potential initiatives to be commenced in 2008 are still in the planning stages and individual actions will be announced as we commit to these discretionary investments.

 

 

 

Interest expense

As illustrated in the following table, annual interest expense for the 2005-2007 period has been relatively steady, which reflects a stable effective interest rate on total debt and a relatively constant debt balance throughout most of that time. Interest income (recorded in other income) has trended upward from approximately $9 million in 2005 to $23 million in 2007, resulting in net interest expense of approximately $296 million for 2007. We currently expect that our 2008 net interest expense will be comparable to the 2007 amount.

 

 

 

Other income (expense), net

Other income (expense), net includes non-operating items such as interest income, charitable donations, and gains and losses related to foreign exchange and commodity derivatives. Other income (expense), net for the periods presented was (in millions): 2007-($2); 2006-$13; 2005-($25). The variability in other income (expense), net, among years reflects the timing of certain significant charges explained in the following paragraph.

 

 

Other expense includes charges for contributions to the Kellogg’s Corporate Citizenship Fund, a private trust established for charitable giving, as follows (in millions): 2007–$12; 2006–$3; 2005–$16. Other expense for 2005 also includes a charge of approximately $7 million to reduce the carrying value of a corporate commercial facility to estimated selling value. This facility was sold in August 2006.

 

 

 

Income taxes

Our long-term objective is to achieve a consolidated effective income tax rate of approximately 31%. In comparison to a U.S. federal statutory income tax rate of 35%, we pursue planning initiatives globally in order to move toward our target. Excluding the impact of discrete adjustments and the cost of repatriating foreign earnings, our sustainable consolidated effective income tax rate for 2005 was approximately 33%, with the rate for 2006 and 2007 at approximately 32%. We currently expect our 2008 sustainable rate to be approximately 31%, in line with our objective. Our reported rates of approximately 29% for 2007 and 31% for 2005 were lower than the sustainable rate due to the favorable effect of various discrete adjustments such as audit settlements, international restructuring initiatives and statutory rate changes. (Refer to Note 11 within Notes to Consolidated Financial Statements for further information.) For 2008, we expect our consolidated effective income tax rate to be approximately 31%. This could be impacted however, if pending uncertain tax matters, including tax positions that could be affected by planning initiatives, are resolved more or less favorably than we currently expect.

 

 

LIQUIDITY AND CAPITAL RESOURCES

 

 

 

Overview

Our principal source of liquidity is operating cash flows, supplemented by borrowings for major acquisitions and other significant transactions. This cash-generating capability is one of our fundamental strengths and provides us with substantial financial flexibility in meeting operating and investing needs. During 2007, we believe our Company’s financial strength has been especially evident in the face of the recent U.S. sub-prime mortgage market crisis and its pervasive effect on general credit market liquidity. For the year, we continued to have access to the U.S. commercial paper market without significant increase in our effective short-term borrowing rate, and our commercial paper and term debt credit ratings have not been affected. Our annual interest expense for the 2005-2007 period has been relatively steady, which reflects a stable effective interest rate on total debt and a relatively constant debt balance throughout most of that time. We have not had any significant new borrowings under our Euro or Canadian commercial paper programs since June 2007, which has limited our exposure to non-U.S. credit market illiquidity during this turbulent period.

 

 

 

Operating activities

The principal source of our operating cash flow is net earnings, meaning cash receipts from the sale of our products, net of costs to manufacture and market our products. Our cash conversion cycle (defined as days of inventory and trade receivables outstanding less days of trade payables outstanding) is relatively short; equating to approximately 27 days for the trailing 365-day period ended December 29, 2007, an improvement to the comparable prior year period which was 29 days. As a result, our operating cash flow should generally reflect our net earnings performance over time, although, as illustrated in the following schedule, specific results for any particular year may be significantly affected by the level of benefit plan contributions, working capital movements (operating assets and liabilities) and other factors.

 

 

 

 

Our net cash provided by operating activities for 2007 was $93 million higher than the comparable period of 2006, due primarily to growth in cash-basis earnings and favorable total working capital performance. Operating cash flow for 2006 was approximately $267 million higher than 2005, due primarily to lower benefit plan contributions, partially offset by unfavorable working capital movements. The decline in benefit plan contributions for 2006 and 2007, as compared to 2005, reflects the improved funded position of our major benefit plans that was achieved through a significant amount of funding in the 2003-2005 period.

 

 

On August 17, 2006, the Pension Protection Act (PPA) became law in the United States. The PPA revised the basis and methodology for determining defined benefit plan minimum funding requirements as well as maximum contributions to and benefits paid from tax-qualified plans. Most of these provisions are first applicable to our U.S. defined benefit pension plans in 2008 on a phased-in basis. The PPA will ultimately require us to make additional contributions to our U.S. plans. However, due to our historical funding practices, we currently believe that we will not be required to make any contributions under the new PPA requirements until after 2013. Accordingly, we do not expect to have significant statutory or contractual funding requirements for our major retiree benefit plans during the next several years, with total 2008 U.S. and foreign plan contributions currently estimated at approximately $63 million. Actual 2008 contributions could exceed our current projections, as influenced by our decision to undertake discretionary funding of our benefit trusts versus other competing investment priorities, future changes in government requirements, renewals of union contracts, or

higher-than-expected health care claims cost experience. Additionally, our projections concerning timing of PPA funding requirements are subject to change primarily based on general market conditions affecting trust asset performance and our future decisions regarding certain elective provisions of the PPA.

 

 

As compared to 2006, the favorable movement in core working capital during 2007 was related principally to higher trade payables, which are due in part, to increased payment terms in international locations. During 2007, our trade payables balance increased by almost 19% from year end 2006. In contrast, our December 30, 2006 trade payables balance was within 3% of the balance at year-end 2005.

 

 

For the trailing fifty-two weeks ended December 29, 2007, core working capital was 6.8% of net sales, consistent with year-end 2006, as compared to 7.0% as of year-end 2005. We have been able to maintain this level through the timely collection of accounts receivable and extension of terms on trade payables, offset by slightly higher inventory levels.

 

 

In comparison to 2005, the unfavorable movement in core working capital during 2006 was related to trade payables performance and higher inventory balances. The higher inventory balance was principally related to higher commodity prices for our raw material and packaging inventories and to a lesser extent, the overall increase in the average number of weeks of inventory on hand. Our consolidated inventory balances were unfavorably affected by U.S. capacity limitations during 2006.

 

 

As presented in the table on page 18, other working capital was a use of cash in 2007 versus a source of cash in 2006. The difference relates to year-over-year increase in the amount of income tax payments. The favorable movement in other working capital in 2006 as compared to 2005 was attributable to several factors including lower debt-related currency swap payments in 2006 as well as business-related growth in accrued compensation and promotional liabilities.

 

 

Investing activities

Our management measure of cash flow is defined as net cash provided by operating activities reduced by expenditures for property additions. We use this non-GAAP financial measure of cash flow to focus management and investors on the amount of cash available for debt repayment, dividend distributions, acquisition opportunities, and share repurchase. Our cash flow metric is reconciled to the most comparable GAAP measure, as follows:

 

 

 

Our cash flow (as defined) performance during the periods presented reflects increased spending for selected capacity expansions to accommodate our Company’s strong sales growth over the past several years. This increased capital spending represented 4.0% of net sales in 2007 and 4.2% of net sales in 2006, as compared to 3.7% of net sales in 2005. For 2008, we currently expect property expenditures to remain at approximately 4.0% of net sales, which is consistent with our long-term target for capital spending. This forecast includes expenditures associated with the construction of a new manufacturing facility in Kutno, Poland and expansion of our global research center in Battle Creek, Michigan which together represents approximately 15% of our 2008 capital plan. The facility in Poland will help us meet consumer demand for our ready-to-eat cereals in the emerging Central and Eastern European markets. The expansion of the W. K. Kellogg Institute for Food and Nutrition Research reflects our commitment to research and innovation which is a key driver to the growth of our business.

 

 

For 2008, we are expecting cash flow to be broadly in line with our 2007 results. We expect to achieve our target principally through operating profit growth, and prudent management of our working capital.

 

 

As discussed in Note 6 within Notes to Consolidated Financial Statements, our property additions for 2007 include approximately $16 million for the purchase of a previously leased snacks manufacturing facility in Chicago, Illinois.

 

 

As discussed in Note 2 within Notes to Consolidated Financial Statements, in order to support the continued growth of our North America operating segment, the Company completed two separate business acquisitions in late 2007 for a total of approximately $123 million in cash, including related transaction costs. On November 1, 2007, a subsidiary of the Company acquired 100% of the equity interests in Bear Naked, Inc., a leading seller of premium-branded natural granola products. On November 5, 2007, the Company acquired certain assets and liabilities of the Wholesome & Hearty Foods Company, a U.S. manufacturer of veggie foods marketed under the Gardenburger ^® brand.

To expand the Company’s presence in Eastern Europe, on January 16, 2008, subsidiaries of the Company acquired substantially all of the equity interests in OJSC Kreker (doing business as “United Bakers”) and consolidated subsidiaries for approximately $117 million in cash, including transaction fees incurred to date, and $3 million in assumed debt. The Company expects to acquire the remaining minority interests through tender offers initiated during 2008. United Bakers is a leading producer of cereal, cookie, and cracker products in Russia, with 4,000 employees, six manufacturing facilities, and a broad distribution network. The business realized approximately $100 million of revenues in 2007. (Due to various factors including accounting principle conformity, these revenues are not necessarily indicative of the pro forma incremental effect on the Company’s 2007 consolidated net sales, assuming this business combination had been completed at the beginning of 2007.) The purchase agreement between the Company and the seller provides for the payment of a currently undeterminable amount of contingent consideration at the end of three years, provided certain financial performance metrics are achieved. Such payment would be recognized as additional purchase price when the contingency is resolved. As part of the aforementioned initial purchase price for this acquisition, the Company incurred approximately $5 million in transaction fees and cash advances during 2007, which we classified as business acquisition-related investing cash outflows in the Consolidated Statement of Cash Flows for the year ended December 29, 2007.

 

 

In order to support the continued growth of our North American fruit snacks business, we completed two separate business acquisitions during 2005 for a total of approximately $50 million in cash, including related transaction costs. In June 2005, we acquired a fruit snacks manufacturing facility and related assets from Kraft Foods Inc. The facility is located in Chicago, Illinois and employs approximately 400 active hourly and salaried employees. In November 2005, we acquired substantially all of the assets and certain liabilities of a Washington State-based manufacturer of natural and organic fruit snacks.

 

 

 

Financing activities

For 2007, our Board of Directors authorized stock repurchases for general corporate purposes and to offset issuances for employee benefit programs of up to $650 million, which we spent to repurchase approximately 12 million shares. Pursuant to similar Board authorizations applicable to those years, we paid $650 million in 2006 to repurchase approximately 15 million shares, and $664 million in 2005 to repurchase approximately 16 million shares. The 2006 activity consisted principally of a February 2006 private transaction with the W. K. Kellogg Foundation Trust (“the Trust”) to repurchase approximately 13 million shares for $550 million. The 2005 activity consisted principally of a November 2005 private transaction with the Trust to repurchase approximately 9 million shares for $400 million. For 2008, our Board of Directors has authorized a stock repurchase program of up to $650 million.

 

 

Our Company paid dividends to shareholders in 2007 in the amount of $1.202 per common share. This represented a 5.7% increase from the previous level of $1.137 per common share paid in 2006. The increase was due to the Board’s authorization to pay quarterly dividends in the amount of $.31 per common share beginning in September, 2007. This increase is consistent with our current plan to maintain our dividend pay-out ratio between 40% and 50% of reported net earnings.

 

 

In December 2007, the Company issued $750 million of five-year 5.125% fixed rate U.S. Dollar Notes, using the proceeds from these Notes to replace a portion of our U.S. commercial paper. These Notes were issued under an existing shelf registration statement. The effective interest rate on these Notes, reflecting issuance discount and swap settlement, is 5.12%. The Notes contain customary covenants that limit the ability of the Company and our restricted subsidiaries (as defined) to incur certain liens or enter into certain sale and lease-back transactions as well as a change in control provision. Also in December, we redeemed approximately $72 million of notes issued in March, 2001, otherwise due in 2011.

 

 

During November 2005, subsidiaries of the Company issued approximately $930 million of foreign currency-denominated debt in offerings outside of the United States, consisting of Euro 550 million of floating rate notes due 2007 (the “Euro Notes”) and approximately C$330 million of Canadian commercial paper. These debt issuances were guaranteed by the Company and net proceeds were used primarily for the payment of dividends pursuant to the American Jobs Creation Act and the purchase of stock and assets of other direct or indirect subsidiaries of the Company, as well as for general corporate purposes.

 

 

To utilize excess cash and reduce financing costs, on February 28, 2007, we redeemed the Euro Notes otherwise due May 2007, for $728 million. To partially refinance this redemption, we established a program to issue euro-commercial paper notes up to a maximum aggregate amount outstanding at any time of $750 million or its equivalent in alternative currencies. The notes may have maturities ranging up to 364 days and are senior unsecured obligations of the applicable issuer, with subsidiary issuances guaranteed by the Company.

 

 

In connection with these financing activities, we increased our short-term lines of credit from $2.2 billion at December 30, 2006 to approximately $2.6 billion at December 29, 2007. This increase was

achieved via a $400 million unsecured 364-Day Credit Agreement effective January 31, 2007. The 364-Day Agreement contains customary covenants, warranties, and restrictions similar to those applicable to our existing $2.0 billion Five-Year Credit Agreement, which expires in 2011. Our credit facilities are available for general corporate purposes, including commercial paper back-up, although we do not currently anticipate any draw-down of the facilities. (Refer to Note 7 within Notes to Consolidated Financial Statements for further information on our debt issuances and credit facilities.) The $400 million Credit Agreement expired at the end of January, 2008 and the Company did not renew it.

 

 

At December 29, 2007, our total debt was approximately $5.2 billion, approximately even with the balance at year-end 2006. During 2006, we reduced the Company’s common stock outstanding through repurchase programs by approximately 4%, and implemented a mid-year increase in the shareholder dividend level of approximately 5%. Similarly, during 2007, we further reduced our common stock outstanding through repurchase programs by approximately 3% and implemented a mid-year increase in the shareholder dividend level of approximately 6.5%. Primarily due to the prioritization of these uses of cash flow, the aforementioned need to selectively invest in production capacity, as well as pursue selective acquisition opportunities, we did not reduce our total debt balance during the past two years, but remain committed to net debt reduction (total debt less cash) over the long term. We currently expect the total debt balance at year-end 2008 to be slightly higher than the 2007 year-end level.

 

 

Although we presently observe a general recovery of liquidity within the commercial paper market and improved pricing in the corporate bond market, we cannot reasonably predict the extent and duration of the continuing sub-prime mortgage market crisis, the economic environment, nor their potential indirect effect on our sector. However, we continue to believe that we will be able to meet our interest and principal repayment obligations and maintain our debt covenants for the foreseeable future, while still meeting our operational needs, including the pursuit of selected bolt-on acquisitions, through our strong cash flow, our program of issuing short-term debt, and maintaining credit facilities on a global basis. Our significant long-term debt issues do not contain acceleration of maturity clauses that are dependent on credit ratings. A change in the Company’s credit ratings could limit our access to the U.S. short-term debt market and/or increase the cost of refinancing long-term debt in the future. However, even under these circumstances, we would continue to have access to our aforementioned credit facilities. In addition, assuming continuation of the present market conditions, we believe it would be possible to term out certain short-term maturities or obtain additional credit facilities such that the Company could further extend its ability to meet its long-term borrowing obligations through 2008.

 

 

OFF-BALANCE SHEET ARRANGEMENTS AND OTHER OBLIGATIONS

 

 

Off-balance sheet arrangements

As of December 29, 2007 the Company did not have any off-balance sheet arrangements. As of December 30, 2006, our off balance sheet arrangements were limited to a residual value guarantee on one operating lease of approximately $13 million and guarantees on loans to independent contractors for their purchase of DSD route franchises up to $17 million. During 2007, we terminated the operating lease and purchased the facility. See Note 6 within the Notes to Consolidated Financial Statements for further information. Additionally, during 2007, we completed a program to reorganize the DSD operations resulting in the exiting of the route franchise agreements. See Note 3 within the Notes to Consolidated Financial Statements for further information.

 

 

Contractual obligations

The following table summarizes future estimated cash payments to be made under existing contractual obligations. Further information on debt obligations is contained in Note 7 within Notes to Consolidated Financial Statements. Further information on lease obligations is contained in Note 6. Further information on uncertain tax positions is contained in Note 11.

 

 

 

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

 

Our significant accounting policies are discussed in Note 1 within Notes to Consolidated Financial Statements.

 

 

At the beginning of our 2007 fiscal year, we adopted the Financial Accounting Standards Board (FASB) Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (FIN No. 48), which affects our process for estimating tax benefits and liabilities, as further discussed in the “ Income taxes ” section beginning on page 27. The initial application of FIN No. 48 resulted in a net decrease to accrued income tax and related interest liabilities of approximately $2 million, with an offsetting increase to retained earnings. Refer to Note 1 within Notes to Consolidated Financial Statements for further information on FIN No. 48.

 

 

In September 2006, the FASB issued SFAS No. 157 “Fair Value Measurements” in order to establish a single definition of fair value and a framework for measuring fair value in generally accepted accounting principles (GAAP) that is intended to result in increased consistency and comparability in fair value measurements. SFAS No. 157 also expands disclosures about fair value measurements, with the intention of improving the quality of information provided to users of financial statements. The standard applies whenever other authoritative literature requires (or permits) certain assets or liabilities to be measured at fair value, but does not expand the use of fair value. SFAS No. 157 was originally effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those years with early adoption permitted. In early 2008, the FASB issued Staff Position (FSP) FAS-157-2, which delays by one year, the effective date of SFAS No. 157 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). The delay pertains to items including, but not limited to, non-financial assets and non-financial liabilities initially measured at fair value in a business combination, reporting units measured at fair value in the first step of evaluating goodwill for impairment under SFAS No. 142 “Goodwill and Other Intangible Assets”, indefinite-lived intangible assets measured at fair value for impairment assessment under SFAS No. 142, and long-lived assets measured at fair value for impairment assessment under SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets”. We plan to adopt the portion of SFAS No. 157 that has not been delayed by FSP FAS-157-2 as of the beginning of our 2008 fiscal year, and plan to adopt the balance of its provisions as of the beginning of our 2009 fiscal year. For the Company, balance sheet items carried at fair value on a recurring basis (to which SFAS No. 157 applies in 2008) consist primarily of derivative financial instruments. Balance sheet items carried at fair value on a non-recurring basis (to which SFAS No. 157 will apply in 2009) consist of assets held for sale and exit liabilities. Relevant to the “ Intangibles ” section beginning on page 23, we also use fair value concepts to test various long-lived assets for impairment and to initially measure assets and liabilities acquired in a business combination. We do not currently expect the adoption of SFAS No. 157 in 2008 to have a material effect on the measurement of the Company’s financial

assets and liabilities. We are continuing to evaluate the impact the standard will have on the determination of fair value related to non-financial assets and non-financial liabilities in post-2008 years.

 

 

In December 2007, the FASB issued SFAS No. 141 (Revised 2007) “Business Combinations” and SFAS No. 160 “Noncontrolling Interests in Consolidated Financial Statements,” which are effective for fiscal years beginning after December 15, 2008. These new standards represent the completion of the FASB’s first major joint project with the International Accounting Standards Board (IASB) and are intended to improve, simplify, and converge internationally the accounting for business combinations and the reporting of noncontrolling interests (formerly minority interests) in consolidated financial statements. We will adopt these standards at the beginning of our 2009 fiscal year. The effect of adoption will generally be prospectively applied to transactions completed after the end of our 2008 fiscal year, although the new presentation and disclosure requirements for pre-existing noncontrolling interests will be retrospectively applied to all prior-period financial information presented.

 

 

SFAS No. 141(R) retains the underlying fair value concepts of its predecessor (SFAS No. 141), but changes the method for applying the acquisition method in a number of significant respects including the requirement to expense transaction fees and expected restructuring costs as incurred, rather than including these amounts in the allocated purchase price; the requirement to recognize the fair value of contingent consideration at the acquisition date, rather than the expected amount when the contingency is resolved; the requirement to recognize the fair value of acquired in-process research and development assets at the acquisition date, rather than immediately expensing; and the requirement to recognize a gain in relation to a bargain purchase price, rather than reducing the allocated basis of long-lived assets. Because this standard is generally applied prospectively, the effect of adoption on our financial statements will depend primarily on specific transactions, if any, completed after 2008. We are currently evaluating the effects that SFAS No. 141(R) is likely to have on potential post-2008 transactions.

 

 

Under SFAS No. 160, consolidated financial statements will be presented as if the parent company investors (controlling interests) and other minority investors (noncontrolling interests) in partially-owned subsidiaries have similar economic interests in a single entity. As a result, the investment in the noncontrolling interest, previously recorded on the balance sheet between liabilities and equity (the “mezzanine”), will be reported as equity in the parent company’s consolidated financial statements, subsequent to the adoption of SFAS No. 160. Furthermore, consolidated financial statements will include 100% of a controlled subsidiary’s earnings, rather than only the parent company’s share. Lastly, transactions between the parent company and noncontrolling interests will be reported in equity as transactions between shareholders, provided these transactions do not create a change in control. Previously, acquisitions of additional interests in a controlled subsidiary generally resulted in remeasurement of assets and liabilities acquired; dispositions of interests generally resulted in a gain or loss.

 

 

Management is currently evaluating the impact of adopting SFAS No. 160 on the Company’s financial statements. Presently, there are no significant noncontrolling interests in any of the Company’s consolidated subsidiaries. Therefore, we currently believe that the impact of SFAS No. 160, if any, will primarily depend on the materiality of noncontrolling interests arising in future transactions, including those entered into during 2008, to which the financial statement presentation and disclosure provisions of SFAS No. 160 will apply.

 

 

Our critical accounting estimates, which require significant judgments and assumptions likely to have a material impact on our financial statements, are discussed in the following sections on pages 23-27.

 

 

Promotional expenditures

Our promotional activities are conducted either through the retail trade or directly with consumers and involve in-store displays and events; feature price discounts on our products; consumer coupons, contests, and loyalty programs; and similar activities. The costs of these activities are generally recognized at the time the related revenue is recorded, which normally precedes the actual cash expenditure. The recognition of these costs therefore requires management judgment regarding the volume of promotional offers that will be redeemed by either the retail trade or consumer. These estimates are made using various techniques including historical data on performance of similar promotional programs. Differences between estimated expense and actual redemptions are normally insignificant and recognized as a change in management estimate in a subsequent period. On a full-year basis, these subsequent period adjustments have rarely represented more than .4% (.004) of our Company’s net sales. However, as our Company’s total promotional expenditures (including amounts classified as a revenue reduction) represented nearly 30% of 2007 net sales, the likelihood exists of materially different reported results if different assumptions or conditions were to prevail.

 

 

Intangibles

We follow SFAS No. 142 “Goodwill and Other Intangible Assets” in evaluating impairment of intangibles. We perform this evaluation at least annually during the fourth quarter of each year in conjunction with our annual budgeting process. Under SFAS No. 142, goodwill impairment testing first

requires a comparison between the carrying value and fair value of a reporting unit with associated goodwill. Carrying value is based on the assets and liabilities associated with the operations of that reporting unit, which often requires allocation of shared or corporate items among reporting units. The fair value of a reporting unit is based primarily on our assessment of profitability multiples likely to be achieved in a theoretical sale transaction. Similarly, impairment testing of other intangible assets requires a comparison of carrying value to fair value of that particular asset. Fair values of non-goodwill intangible assets are based primarily on projections of future cash flows to be generated from that asset. For instance, cash flows related to a particular trademark would be based on a projected royalty stream attributable to branded product sales. These estimates are made using various inputs including historical data, current and anticipated market conditions, management plans, and market comparables.

 

 

We also follow SFAS No. 142 in evaluating the useful life over which a non-goodwill intangible asset is expected to contribute directly or indirectly to the cash flows of the Company. An intangible asset with a finite useful life is amortized; an intangible asset with an indefinite useful life is not amortized, but is evaluated annually for impairment. Reaching a determination on useful life requires significant judgments and assumptions regarding the future effects of obsolescence, demand, competition, other economic factors (such as the stability of the industry, known technological advances, legislative action that results in an uncertain or changing regulatory environment, and expected changes in distribution channels), the level of required maintenance expenditures, and the expected lives of other related groups of assets.

 

 

At December 29, 2007, intangible assets, net, were $5.0 billion, consisting primarily of goodwill and trademarks associated with the 2001 acquisition of Keebler Foods Company. Within this total, approximately $1.4 billion of non-goodwill intangible assets were classified as indefinite-lived, comprised principally of Keebler trademarks. While we currently believe that the fair value of all of our intangibles exceeds carrying value and that those intangibles so classified will contribute indefinitely to the cash flows of the Company, materially different assumptions regarding future performance of our North American snacks business or the weighted-average cost of capital used in the valuations could result in significant impairment losses and/or amortization expense.

 

 

Stock compensation

In December 2004, the FASB issued SFAS No. 123(R) “Share-Based Payment,” which generally requires public companies to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value and to recognize this cost over the requisite service period. We adopted SFAS No. 123(R) as of the beginning of our 2006 fiscal year, using the modified prospective method. Accordingly, prior years were not restated. With the adoption of this pronouncement, stock-based compensation represents a critical accounting policy of the Company, which is further described in Note 1 within Notes to the Consolidated Financial Statements.

 

 

In 2006, our adoption of SFAS No. 123(R) resulted in an increase in the Company’s corporate SGA expense and a corresponding reduction to earnings and net earnings per share, due primarily to the recognition of compensation expense associated with employee and director stock option grants. No such expense was recognized under our previous accounting method in pre-2006 periods; however we were required to disclose pro forma results under the alternative fair value method prescribed by SFAS No. 123 “Accounting for Stock-Based Compensation”. Using reported results for 2006 and pro forma results for 2005, the comparable impact of stock compensation expense is presented in the following table:

 

 

 

Accounting for stock compensation under SFAS No. 123(R) represents a critical accounting estimate, which requires significant judgments and assumptions likely to have a material impact on our financial statements. Due to the need to determine the grant-date fair value of equity instruments that have not yet been awarded, the actual impact on future results will depend, in part, on actual awards during any reporting period and various market factors that affect the fair value of those awards. Additionally, while the timing and volume of grants associated with a particular year’s long-term incentive compensation are within our control, the timing and volume of “reload” option grants are not. Reload options are awarded to eligible employees and directors to replace previously-owned Company stock used by those individuals to pay the exercise price, including related employment taxes, of vested pre-2004 option awards containing this accelerated ownership feature. Under SFAS No. 123(R), these reload options result in additional compensation expense in the year of grant and for 2007 and 2006, represented approximately one-third of the Company’s total stock option expense.

The Company has not granted options containing an accelerated ownership feature since 2003; however, the potential requirement to award reload options over the contractual 10-year term of the original grants could continue to significantly impact the amount of our stock-based compensation expense for a number of years.

 

 

We estimate the fair value of each stock option award on the date of grant using a lattice-based option valuation model for annual grants and a Black-Scholes model for reload grants. These models require us to make predictive assumptions regarding future stock price volatility, employee exercise behavior, and dividend yield. Our methods for selecting these valuation assumptions are explained in Note 8 within Notes to Consolidated Financial Statements. In particular, our estimate of stock price volatility is based principally on historical volatility of the options granted, and to a lesser extent, on implied volatilities from traded options on the Company’s stock. For the lattice-based model, historical volatility corresponds to the 10-year contractual term of the options granted; whereas, for the Black-Scholes model, historical volatility corresponds to the expected term, which is currently 2.25 years. We decided to rely more heavily on historical volatility due to the greater availability of data and reliability of trends over longer periods of time, as compared to the terms of more thinly-traded options, which rarely extend beyond two years. At year-end 2007, historical volatilities using weekly price observations ranged from approximately 22% for 10 years to 11% for 2.25 years, while implied volatilities averaged approximately 20% for traded options with terms in excess of six months. Based on this data, our weighted-average composite volatility assumption for purposes of valuing our option grants during 2007 was 17.5%, as compared to 17.9% for 2006. All other assumptions held constant, a one percentage point increase or decrease in our 2007 volatility assumption would increase or decrease the grant-date fair value of our 2007 option awards by approximately 4%.

 

 

To the extent that actual outcomes differ from our assumptions, we are not required to true up grant-date fair value-based expense to final intrinsic values. However, these differences can impact the classification of cash tax benefits realized upon exercise of stock options, as explained in the following two paragraphs. Furthermore, as historical data has a significant bearing on our forward-looking assumptions, significant variances between actual and predicted experience could lead to prospective revisions in our assumptions, which could then significantly impact the year-over-year comparability of stock-based compensation expense.

 

 

SFAS No. 123(R) also provides that any corporate income tax benefit realized upon exercise or ve sting of an award in excess of that previously recognized in earnings (referred to as a “windfall tax benefit”) will be presented in the Consolidated Statement of Cash Flows as a financing (rather than an operating) cash flow. If this standard had been adopted in 2005, operating cash flow would have been lower (and financing cash flow would have been higher) by approximately $20 million as a result of this provision. For 2007 and 2006, the corresponding reduction in operating cash flow attributable to windfall tax benefits classified as financing cash flow was $15 million and $22 million respectively. The actual impact on future years’ operating cash flow will depend, in part, on the volume of employee stock option exercises during a particular year and the relationship between the exercise-date market value of the underlying stock and the original grant-date fair value previously determined for financial reporting purposes.

 

 

For balance sheet classification purposes, realized windfall tax benefits are credited to capital in excess of par value within the Consolidated Balance Sheet. Realized shortfall tax benefits (amounts which are less than that previously recognized in earnings) are first offset against the cumulative balance of windfall tax benefits, if any, and then charged directly to income tax expense, potentially resulting in volatility in our consolidated effective income tax rate. Under the transition rules for adopting SFAS No. 123(R) using the modified prospective method, we were permitted to calculate a cumulative memo balance of windfall tax benefits from post-1995 years for the purpose of accounting for future shortfall tax benefits. We completed such study prior to the first period of adoption and currently have sufficient cumulative memo windfall tax benefits to absorb projected arising shortfalls, such that 2008 earnings are not currently expected to be affected by this provision. However, as employee stock option exercise behavior is not within our control, the likelihood exists of materially different reported results if different assumptions or conditions were to prevail.

 

 

Retirement benefits

Our Company sponsors a number of U.S. and foreign defined benefit employee pension plans and also provides retiree health care and other welfare benefits in the United States and Canada. Plan funding strategies are influenced by tax regulations. A substantial majority of plan assets are invested in a globally diversified portfolio of equity securities with smaller holdings of debt securities and other investments. We follow SFAS No. 87 “Employers’ Accounting for Pensions” and SFAS No. 106 “Employers’ Accounting for Postretirement Benefits Other Than Pensions” (as amended by SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans”) for the measurement and recognition of obligations and expense related to our retiree benefit plans. Embodied in both of these standards is the concept that the cost of benefits

provided during retirement should be recognized over the employees’ active working life. Inherent in this concept is the requirement to use various actuarial assumptions to predict and measure costs and obligations many years prior to the settlement date. Major actuarial assumptions that require significant management judgment and have a material impact on the measurement of our consolidated benefits expense and accumulated obligation include the long-term rates of return on plan assets, the health care cost trend rates, and the interest rates used to discount the obligations for our major plans, which cover employees in the United States, United Kingdom, and Canada.

 

 

To conduct our annual review of the long-term rate of return on plan assets, we model expected returns over a 20-year investment horizon with respect to the specific investment mix of each of our major plans. The return assumptions used reflect a combination of rigorous historical performance analysis and forward-looking views of the financial markets including consideration of current yields on long-term bonds, price-earnings ratios of the major stock market indices, and long-term inflation. Our U.S. plan model, corresponding to approximately 70% of our trust assets globally, currently incorporates a long-term inflation assumption of 2.7% and an active management premium of 1% (net of fees) validated by historical analysis. Although we review our expected long-term rates of return annually, our benefit trust investment performance for one particular year does not, by itself, significantly influence our evaluation. Our expected rates of return are generally not revised, provided these rates continue to fall within a “more likely than not” corridor of between the 25th and 75th percentile of expected long-term returns, as determined by our modeling process. Our assumed rate of return for U.S. plans in 2007 of 8.9% equated to approximately the 50th percentile expectation of our 2007 model. Similar methods are used for various foreign plans with invested assets, reflecting local economic conditions. Foreign trust investments represent approximately 30% of our global benefit plan assets.

 

 

Based on consolidated benefit plan assets at December 29, 2007, a 100 basis point reduction in the assumed rate of return would increase 2008 benefits expense by approximately $44 million. Correspondingly, a 100 basis point shortfall between the assumed and actual rate of return on plan assets for 2008 would result in a similar amount of arising experience loss. Any arising asset-related experience gain or loss is recognized in the calculated value of plan assets over a five-year period. Once recognized, experience gains and losses are amortized using a declining-balance method over the average remaining service period of active plan participants, which for U.S. plans is presently about 13 years. Under this recognition method, a 100 basis point shortfall in actual versus assumed performance of all of our plan assets in 2008 would reduce pre-tax earnings by approximately $1 million in 2009, increasing to approximately $7 million in 2013. For each of the three fiscal years, our actual return on plan assets exceeded/(was less than) the recognized assumed return by the following amounts (in millions): 2007–($99); 2006–$257; 2005–$39.

 

 

To conduct our annual review of health care cost trend rates, we model our actual claims cost data over a five-year historical period, including an analysis of pre-65 versus post-65 age groups and other important demographic components of our covered retiree population. This data is adjusted to eliminate the impact of plan changes and other factors that would tend to distort the underlying cost inflation trends. Our initial health care cost trend rate is reviewed annually and adjusted as necessary to remain consistent with recent historical experience and our expectations regarding short-term future trends. In comparison to our actual five-year compound annual claims cost growth rate of approximately 6%, our initial trend rate for 2008 of 8.5% reflects the expected future impact of faster-growing claims experience for certain demographic groups within our total employee population. Our initial rate is trended downward by 1% per year, until the ultimate trend rate of 4.75% is reached. The ultimate trend rate is adjusted annually, as necessary, to approximate the current economic view on the rate of long-term inflation plus an appropriate health care cost premium. Based on consolidated obligations at December 29, 2007, a 100 basis point increase in the assumed health care cost trend rates would increase 2008 benefits expense by approximately $16 million. A 100 basis point excess of 2008 actual health care claims cost over that calculated from the assumed trend rate would result in an arising experience loss of approximately $9 million. Any arising health care claims cost-related experience gain or loss is recognized in the calculated amount of claims experience over a four-year period. Once recognized, experience gains and losses are amortized using a straight-line method over 15 years, resulting in at least the minimum amortization prescribed by SFAS No. 106. The net experience gain arising from recognition of 2007 claims experience was approximately $6 million.

 

 

To conduct our annual review of discount rates, we use several published market indices with appropriate duration weighting to assess prevailing rates on high quality debt securities, with a primary focus on the Citigroup Pension Liability Index ^® for our U.S. plans. To test the appropriateness of these indices, we periodically conduct a matching exercise between the expected settlement cash flows of our plans and bond maturities, consisting principally of AA-rated (or the equivalent in foreign jurisdictions) non-callable issues with at least $25 million principal outstanding. The model does not assume any reinvestment rates and assumes that bond investments mature just in time to

pay benefits as they become due. For those years where no suitable bonds are available, the portfolio utilizes a linear interpolation approach to impute a hypothetical bond whose maturity matches the cash flows required in those years. As of three different interim dates during 2007 and four different dates during 2006, this matching exercise for our U.S. plans produced a discount rate within +/- 20 basis points of the equivalent-dated Citigroup Pension Liability Index ^® . The measurement dates for our defined benefit plans are consistent with our Company’s fiscal year end. Thus, we select discount rates to measure our benefit obligations that are consistent with market indices during December of each year. Based on consolidated obligations at December 29, 2007, a 25 basis point decline in the weighted-average discount rate used for benefit plan measurement purposes would increase 2008 benefits expense by approximately $15 million. All obligation-related experience gains and losses are amortized using a straight-line method over the average remaining service period of active plan participants.

 

 

Despite the previously-described rigorous policies for selecting major actuarial assumptions, we periodically experience material differences between assumed and actual experience. As of December 29, 2007, we had consolidated unamortized prior service cost and net experience losses of approximately $.6 billion, as compared to approximately $.9 billion at December 30, 2006. The year-over-year decline in net unamortized amounts was attributable primarily to the favorable impact of rising discount rates on our benefit obligations. Of the total unamortized amounts at December 29, 2007, approximately 50% was related to discount rate reductions prior to 2007, with the remainder primarily related to net unfavorable health care claims cost experience (including upward revisions in the assumed trend rate.) For 2008, we currently expect total amortization of prior service cost and net experience losses to be approximately $41 million lower than the actual 2007 amount of approximately $99 million. As discussed on page 14, total employee benefits expense for 2008 is expected to be slightly lower than the 2007 amount, due to increases in the discount rate environment and the on-going phase in of favorable asset returns.

 

 

Assuming actual future experience is consistent with our current assumptions, annual amortization of accumulated prior service cost and net experience losses during each of the next several years would decrease versus the 2008 amount.

 

 

Income taxes

Our consolidated effective income tax rate is influenced by tax planning opportunities available to us in the various jurisdictions in which we operate. Judgment is required in evaluating our tax positions to determine how much benefit should be recognized in our income tax expense. We establish tax reserves in accordance with FIN No. 48 (which we adopted at the beginning of 2007). FIN No. 48 is based on a benefit recognition model, which we believe could result in a greater amount of benefit (and a lower amount of reserve) being initially recognized in certain circumstances. Prior to the adoption of FIN No. 48, our policy was to establish reserves that reflected the probable outcome of known tax contingencies. Favorable resolution was recognized as a reduction to our effective tax rate in the period of resolution. The initial application of FIN No. 48 resulted in a net decrease to the Company’s consolidated accrued income tax and related interest liabilities of approximately $2 million, with an offsetting increase to retained earnings.

 

 

The Company evaluates a tax position in two-steps in accordance with FIN No. 48. The first step is to determine whether it is more-likely-than not that a tax position will be sustained upon examination based upon the technical merit of the position. In weighing the technical merits of the position, we consider the facts and circumstances of the position; we assume the reviewing tax authority has full knowledge of the position; and we consider the weight of authoritative guidance. The second step is measurement; a tax position that meets the more-likely-than not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. While reviewing the ranges of probable outcomes, the Company records the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. The tax position will be derecognized when it is no longer more-likely-than not of being sustained.

 

 

For the periods presented, our income tax and related interest reserves have averaged approximately $170 million. Reserve adjustments for individual issues have rarely exceeded 1% of earnings before income taxes annually. Significant tax reserve adjustments impacting our effective tax rate would be separately presented in the rate reconciliation table of Note 11 within Notes to Consolidated Financial Statements.

 

 

The current portion of our tax reserves is presented in the balance sheet within accrued income taxes and the amount expected to be settled after one year is recorded in other noncurrent liabilities. Likewise, the current portion of related interest reserves are presented in the balance sheet within accrued other liabilities, with the amount expected to be settled after one year recorded in other noncurrent liabilities.

 

 

 

FUTURE OUTLOOK

 

 

Our 2008 forecasted consolidated results are generally based on our long-term annual growth targets as discussed on page 12, although we currently expect our internal net sales could increase at a mid-single digit rate, slightly exceeding our low single-digit growth target. We expect this higher-than-targeted growth to come principally from previously announced pricing initiatives, improved product mix and continued innovation. Despite a projected decline in gross margin of approximately 100 basis points, which is being negatively impacted by 40 basis points due to acquisitions and 30 basis points due to up-front costs recorded in cost of goods sold, we believe the higher-than-targeted sales growth will support mid single-digit consolidated operating profit growth. As discussed on page 17, net interest expense for 2008 is expected to be comparable to 2007 expense, and our consolidated effective income tax rate is expected to be approximately 31%. Finally, as discussed in more detail on page 34, our fiscal year 2008 will benefit from a 53rd week. The benefit associated with this extra week will be largely invested in emerging markets and various acquisitions in the United States. These factors are expected to provide the growth necessary to achieve our target of high single-digit growth in 2008 net earnings per share. In addition, we remain committed to reinvesting in brand building, cost-reduction initiatives, and other growth opportunities. Lastly, we expect our cash flow performance to remain strong and are currently expecting 2008 cash flow to be approximately even with our 2007 results.

 

 

18 months. During 2006, we entered into two separate 10-year over-the-counter commodity swap transactions to reduce fluctuations in the price of natural gas used principally in our manufacturing processes. The notional amount of the swaps totaled $188 million as of December 29, 2007 and equates to approximately 50% of our North America manufacturing needs. At year-end 2006, the notional amount was $209 million.

 

 

The total notional amount of commodity derivative instruments at year-end 2007, including the natural gas swaps, was $229 million, representing a settlement receivable of approximately $22 million. Assuming a 10% decrease in year-end commodity prices, the settlement receivable would decrease by approximately $22 million, generally offset by a reduction in the cost of the underlying commodity purchases. The total notional amount of commodity derivative instruments at year-end 2006, including the natural gas swaps, was $239 million, representing a settlement obligation of approximately $11 million. Assuming a 10% decrease in year-end commodity prices, this settlement obligation would increase by approximately $17 million, generally offset by a reduction in the cost of the underlying commodity purchases.

 

 

In addition to the derivative commodity instruments discussed above, we use long-term contracts with suppliers to manage a portion of the price exposure. It should be noted that the exclusion of these positions from the analysis above could be a limitation in assessing the net market risk of our Company.

 

 

 

 

Refer to Notes to Consolidated Financial Statements.