EXHIBIT 13.01
MANAGEMENT'S DISCUSSION AND ANALYSIS
Kellogg Company and Subsidiaries
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, frozen waffles, and meat alternatives. Kellogg products are
manufactured and marketed globally. We currently manage our operations based
on the geographic regions of North America, Europe, Latin America, and Asia
Pacific. This organizational structure is the basis of the operating segment
data presented in this report.
In late 2004, our chief executive officer, Carlos Gutierrez, accepted the
invitation of the President of the United States to serve as U.S. Secretary
of Commerce, subject to Senate confirmation. In early 2005, Carlos assumed
his cabinet post and James Jenness was appointed the new CEO of Kellogg
Company. David Mackay continues to serve as president of our Company and has
been appointed to the Board of Directors.
Despite these leadership changes, we will continue to manage our Company for
steady, consistent growth and an attractive dividend yield, which together
should provide strong total return for shareholders. We plan to continue to
achieve this sustainability through a strategy focused on growing our cereal
business, expanding our snacks business, and pursuing selective growth
opportunities. We support our business strategy with operating principles
that emphasize sales dollars over shipment volume (Volume to Value), as well
as cash flow and return on invested capital (Manage for Cash). We believe the
success of our strategy and operating principles are reflected in our steady
growth in earnings and cash flow over the past several years. This growth has
been achieved despite significant challenges such as rising commodity and
benefit costs and increased investment in brand building, innovation, and
cost-reduction initiatives.
For the fiscal year ended January 1, 2005, the Company reported diluted net
earnings per share of $2.14, an 11% increase over fiscal 2003 results.
Consolidated net sales and operating profit each grew approximately 9%, with
net earnings up 13%. For the year ended December 27, 2003, net earnings per
share were $1.92, a 10% increase over fiscal 2002 net earnings per share of
$1.75. For 2004, net cash provided from operating activities was $1,229.0
million, a 5% increase over the 2003 amount of $1,171.0 million.
NET SALES AND OPERATING PROFIT
2004 COMPARED TO 2003
The following tables provide an analysis of net sales and operating profit
performance for 2004 versus 2003:
North Latin Asia
(dollars in millions) America Europe America Pacific(a) Corporate Consolidated
- ------------------------- -------- -------- ------- ---------- --------- ------------
2004 NET SALES $6,369.3 $2,007.3 $ 718.0 $ 519.3 $ -- $ 9,613.9
2003 NET SALES $5,954.3 $1,734.2 $ 666.7 $ 456.3 $ -- $ 8,811.5
-------- -------- ------- ---------- --------- ------------
% change - 2004 vs. 2003:
Volume (tonnage) (b) 2.4% -.1% 6.1% -.4% -- 2.1%
Pricing/mix 2.6% 3.7% 5.0% 2.7% -- 2.9%
-------- -------- ------- ---------- --------- ------------
SUBTOTAL - INTERNAL
BUSINESS 5.0% 3.6% 11.1% 2.3% -- 5.0%
Shipping day differences(c) 1.5% 1.0% -- 1.2% -- 1.3%
Foreign currency impact .5% 11.1% -3.4% 10.3% -- 2.8%
-------- -------- ------- ---------- --------- ------------
TOTAL CHANGE 7.0% 15.7% 7.7% 13.8% -- 9.1%
======== ======== ======= ========== ========= ============
North Latin Asia
(dollars in millions) America Europe America Pacific(a) Corporate Consolidated
- ------------------------- -------- -------- ------- ---------- --------- ------------
2004 OPERATING PROFIT $1,240.4 $ 292.3 $ 185.4 $ 79.5 ($ 116.5) $ 1,681.1
2003 OPERATING PROFIT $1,134.2 $ 279.8 $ 168.9 $ 61.1 ($ 99.9) $ 1,544.1
-------- -------- ------- ---------- --------- ------------
% change - 2004 vs. 2003:
INTERNAL BUSINESS 6.5% -7.4% 14.1% 13.8% -16.1% 4.5%
Shipping day differences(c) 2.4% 1.1% -- 2.8% -.5% 2.0%
Foreign currency impact .5% 10.8% -4.3% 13.4% -- 2.4%
-------- -------- ------- ---------- --------- ------------
TOTAL CHANGE 9.4% 4.5% 9.8% 30.0% -16.6% 8.9%
======== ======== ======= ========== ========= ============
(a) Includes Australia and Asia.
(b) We measure the volume impact (tonnage) on revenues based on the stated
weight of our product shipments.
(c) Impact of 53rd week in 2004. Refer to Note 1 within Notes to Consolidated
Financial Statements for further information.
During 2004, consolidated net sales increased approximately 9%. Internal net
sales (which excludes the impact of currency and, if applicable, acquisitions,
dispositions, and shipping day differences) grew 5%, which was on top of
approximately 4% growth in the prior year. During 2004, successful innovation
and brand-building investment continued to drive growth in most of our
businesses.
North America reported net sales growth of approximately 7%, with internal
growth across all major product groups. Internal net sales of our North America
retail cereal business increased approximately 2%, with successful innovation
and consumer promotion activities supporting sales growth and category share
gains in both the United States and Canada. Internal net sales of our North
America retail snacks business increased 8%, with the wholesome snacks,
crackers, and toaster pastries components of our snacks portfolio all
contributing to that growth. While our cookie sales were essentially unchanged
from the prior year, we were pleased with this performance, in light of a
category decline in measured channels of approximately 4%. We believe the
recovery of our snacks business this year was due primarily to successful
product and packaging innovation, combined with effective execution in our
direct store-door (DSD) delivery system. Internal net sales of our North America
frozen and specialty channel (which includes food service, vending, convenience,
drug stores, and custom manufacturing) businesses collectively increased
approximately 4%.
23
Net sales in our European operating segment increased approximately 16%, with
internal sales growth of nearly 4%. Both our U.K. business unit and
pan-European cereal business achieved internal net sales growth for the year
of approximately 2%. Sales of our snack products within the region grew at a
strong double-digit rate.
Strong performance in Latin America resulted in net sales growth of
approximately 8%, with internal net sales growth of 11% more than offsetting
unfavorable foreign currency movements. Most of this growth was due to very
strong price/mix and tonnage improvements in both cereal and snack sales by
our Mexican business unit.
Net sales in our Asia Pacific operating segment increased approximately 14%
due primarily to favorable foreign currency movements, with internal net
sales growth at 2%. Strong internal net sales performance in Australia was
partially offset by a sales decline in Asia, due primarily to the effect of
negative publicity regarding sugar-containing products in Korea throughout
most of the year.
Consolidated operating profit increased approximately 9% during 2004, with
internal growth of more than 4%. This internal growth was achieved despite
increased brand-building expenditures and significantly higher commodity
costs. Furthermore, corporate operating profit for 2004 includes a charge of
$9.5 million related to CEO transition expenses. Lastly, as discussed in the
"Cost-reduction initiatives" section beginning on page 25, we absorbed in
operating profit significant up-front costs in both 2003 and 2004, with 2004
charges exceeding 2003 charges by approximately $38 million.
The CEO transition expenses arise from the aforementioned departure of Carlos
Gutierrez related to his appointment as U.S. Secretary of Commerce. The total
charge (net of forfeitures) of $9.5 million is comprised principally of $3.7
million for special pension termination benefits and $5.5 million for
accelerated vesting of 606,250 stock options.
Operating profit for each of fiscal 2003 and 2004 includes intangibles
impairment losses of approximately $10 million. The 2003 loss was to reduce
the carrying value of a contract-based intangible asset and was included in
North American operating profit. The 2004 loss was comprised of $7.9 million
to write off the remaining value of this same contract-based intangible asset
in North America and $2.5 million to write off goodwill in Latin America.
2003 COMPARED TO 2002
The following tables provide an analysis of net sales and operating profit
performance for 2003 versus 2002. These results have been restated to conform
to the 2004 operating segment presentation as follows: 1) 2003 and 2002
Canadian results were combined into North America, 2) certain 2003 and 2002
U.S. export operations were moved from U.S. to Latin America, and 3) certain
2003 SGA expenditures were reallocated between Corporate and North America.
North Latin Asia
(dollars in millions) America Europe America Pacific(a) Corporate Consolidated
- ------------------------- -------- -------- --------- ---------- --------- ------------
2003 NET SALES $5,954.3 $1,734.2 $ 666.7 $ 456.3 -- $ 8,811.5
2002 NET SALES $5,800.1 $1,469.8 $ 648.9 $ 385.3 -- $ 8,304.1
-------- -------- --------- ---------- --------- ------------
% change - 2003 vs. 2002:
Volume (tonnage) (b) -.2% -.6% 7.1% -7.2% -- --
Pricing/mix 3.3% 3.4% 6.3% 9.8% -- 3.8%
-------- -------- --------- ---------- --------- ------------
SUBTOTAL - INTERNAL
BUSINESS 3.1% 2.8% 13.4% 2.6% -- 3.8%
Dispositions (c) -1.1% -- -- -- -- -.8%
Foreign currency impact .7% 15.2% -10.7% 15.8% -- 3.1%
-------- -------- --------- ---------- --------- ------------
TOTAL CHANGE 2.7% 18.0% 2.7% 18.4% -- 6.1%
======== ======== ========= ========== ========= ============
North Latin Asia
(dollars in millions) America Europe America Pacific(a) Corporate Consolidated
- ------------------------- -------- -------- --------- ---------- --------- ------------
2003 OPERATING PROFIT $1,134.2 $ 279.8 $ 168.9 $ 61.1 ($ 99.9) $ 1,544.1
2002 OPERATING PROFIT $1,138.0 $ 252.5 $ 170.6 $ 38.5 ($ 91.5) $ 1,508.1
-------- -------- --------- ---------- --------- ------------
% change - 2003 vs. 2002:
INTERNAL BUSINESS -.3% -2.1% 11.2% 38.1% -9.2% 1.1%
Dispositions (c) -.8% -- -- -- -- -.6%
Foreign currency impact .8% 12.9% -12.2% 20.7% -- 1.9%
-------- -------- --------- ---------- --------- ------------
TOTAL CHANGE -.3% 10.8% -1.0% 58.8% -9.2% 2.4%
======== ======== ========= ========== ========= ============
(a) Includes Australia and Asia.
(b) We measure the volume impact (tonnage) on revenues based on the stated
weight of our product shipments.
(c) Impact of results for the comparable 2002 period prior to divestiture of
various U.S. private label operations.
During 2003, we achieved consolidated internal net sales growth of nearly 4%,
against a similar year-ago growth rate. North American net sales in the
retail cereal channel increased approximately 6%, as the combination of
brand-building activities and innovation drove higher tonnage and improved
mix. A modest U.S. cereal price increase taken early in 2003 also contributed
to the sales increase. Internal net sales of our North American snacks
business were approximately even with the prior year. The 2003 sales
performance of our North American snacks business was negatively impacted by
our strategic decisions to discontinue a low-margin contract manufacturing
relationship in May 2003 and to accelerate stock-keeping unit (SKU)
rationalization, beginning in the second quarter of 2003. In addition to
these strategic factors, our North American snacks business experienced a
decline in cookie sales, which we believe was a result of aggressive price
promotion by competitors, a relative lack of innovation and brand-building
activities, and current trends in consumer preferences. Internal net sales of
our North American frozen and specialty channel businesses collectively
increased approximately 3%.
Total international net sales increased over 5% in local currencies, with
growth in all geographic segments. Our European operating segment exhibited
strong sales and category share performance throughout 2003, benefiting from
increased brand-building investment and innovation activities across the
region. Internal net sales growth in Latin America was driven by a strong
performance by our Mexican business unit in both cereal and snacks. Our Asia
Pacific operating segment delivered solid internal net sales growth, as
significant pricing and mix improvements offset the tonnage impact of
discontinuing product lines in Australia and Asia in late 2002.
24
Consolidated internal operating profit increased only 1% during 2003, as
significant charges related to cost-reduction initiatives (refer to
discussion below) partially offset solid underlying business growth. North
America internal operating profit declined slightly, absorbing the majority
of the charges, as well as higher commodity, energy, and employee benefit
costs, and a $10 million intangibles impairment charge. International
operating profit increased over 6% on a local currency basis. Brand-building
expenditures increased significantly in all core markets, reaching a
double-digit growth rate on a consolidated basis.
For 2002, the Company recorded in cost of goods sold an impairment loss of $5
million related to the Company's manufacturing facility in China,
representing a decline in real estate market value subsequent to an original
impairment loss recognized for this property in 1997. The Company completed a
sale of this facility in late 2003, and the carrying value of the property
approximated the net sales proceeds.
MARGIN PERFORMANCE
Margin performance is presented in the following table.
Change vs. prior year (pts.)
----------------------------
2004 2003 2002 2004 2003
------ ------ ------ ---- ----
Gross margin 44.9% 44.4% 45.0% .5 -.6
SGA% (a) -27.4% -26.9% -26.8% -.5 -.1
----- ----- ----- ---- ----
Operating margin 17.5% 17.5% 18.2% -- -.7
===== ===== ===== ==== ====
(a) Selling, general, and administrative expense as a percentage of net sales.
For 2004, our consolidated gross margin increased 50 basis points over the
prior-year results. Our strong sales growth continued to produce significant
operating leverage. This factor, combined with mix improvements and
productivity savings, offset the unfavorable impact of higher commodity
costs, as well as charges associated with our cost-reduction initiatives
(refer to discussion below). The 2003 gross margin reflects similar dynamics,
except that unfavorable cost pressures (commodities, energy, employee
benefits) more than offset the favorable factors such as operating leverage
and mix, resulting in a 60 basis point decline versus 2002. Our investment in
package-related promotions and cost-reduction initiatives also dampened gross
margin performance.
The SGA% remained fairly steady from 2002 to 2004, as significant increases
in brand-building and innovation expenditures over this time period were
offset by overhead savings.
For 2005, we expect continuing modest improvement in our gross margin, with
reinvestment in brand building and innovation, so as to maintain a relatively
steady operating margin.
COST-REDUCTION INITIATIVES
We view our continued spending on cost-reduction initiatives as part of our
ongoing financial strategy to reinvest earnings so as to provide greater
reliability in meeting long-term growth targets. Initiatives undertaken must
meet certain pay-back and internal rate of return (IRR) targets. We currently
require each project to recover total cash implementation costs within a
five-year period or to achieve an IRR of at least 20%. Each cost-reduction
initiative is of relatively short duration (normally one year or less), and
begins to deliver cash savings and/or reduced depreciation during the first
year of implementation, which is then used to fund new initiatives. To
implement these programs, the Company has incurred various up-front costs,
including asset write-offs, exit charges, and other project expenditures,
which we include in our measure and discussion of operating segment
profitability within the "Net sales and operating profit" section beginning
on page 23.
Major initiatives commenced in 2004 were the global rollout of the SAP
information technology system, reorganization of pan-European operations,
consolidation of U.S. meat alternatives manufacturing operations, and
relocation of our U.S. snacks business unit to Battle Creek, Michigan. Major
actions implemented in 2003 included a wholesome snack plant consolidation in
Australia, manufacturing capacity rationalization in the Mercosur region of
Latin America, and a plant workforce reduction in Great Britain.
Additionally, during all periods presented, we have undertaken various
manufacturing capacity rationalization and efficiency initiatives primarily
in our North American and European operating segments, as well as the 2003
disposal of a manufacturing facility in China. Future initiatives are still
in the planning stages and individual actions are being announced as plans
are finalized. The cost-saving initiatives that we are planning could
potentially result in a yet-undetermined amount of asset write-offs and other
costs during 2005.
For 2004, total program-related charges were approximately $109 million,
comprised of $41 million in asset write-offs, $1 million for special pension
termination benefits, $15 million in severance and other exit costs, and $52
million in other cash expenditures such as relocation and consulting.
Approximately 40% of the 2004 charges were recorded in cost of goods sold,
with the balance recorded in selling, general, and administrative (SGA)
expense. The 2004 charges impacted our operating segments as follows (in
millions): North America-$44, Europe-$65.
For 2003, total program-related charges were approximately $71 million,
comprised of $40 million in asset write-offs, $8 million for special pension
termination benefits, and $23 million in severance and other cash exit costs.
These charges were recorded principally in cost of goods sold and impacted
our operating segments as follows (in millions): North America.-$36,
Europe-$21, Latin America-$8, Asia Pacific-$6.
At year-end 2003, the exit cost reserve balance totaled approximately $19
million. These reserves were principally comprised of severance obligations
recorded in 2003, which were paid out during the first half of 2004. At
year-end 2004, the exit cost reserve balance totaled approximately $11
million, representing severance costs to be paid out in 2005.
25
2004 INITIATIVES
During 2004, our global rollout of the SAP information technology system
resulted in accelerated depreciation of legacy software assets to be
abandoned in 2005, as well as related consulting and other implementation
expenses. Total incremental costs for 2004 were approximately $30 million. In
close association with this SAP rollout, we undertook a major initiative to
improve the organizational design and effectiveness of pan-European
operations. Specific benefits of this initiative are expected to include
improved marketing and promotional coordination across Europe, supply chain
network savings, overhead cost reductions, and tax savings. To achieve these
benefits, we implemented, at the beginning of 2005, a new European legal and
operating structure headquartered in Ireland, with strengthened pan-European
management authority and coordination. During 2004, we incurred various
up-front costs, including relocation, severance, and consulting, of
approximately $30 million. Additional relocation and other costs to complete
this business transformation during the next several years are expected to be
insignificant.
To improve operations and provide for future growth, during 2004, we
substantially completed our plan to close a meat alternatives manufacturing
facility in Worthington, Ohio. The plan included the out-sourcing of certain
operations and consolidation of remaining production at the Zanesville, Ohio
facility by early 2005. The Worthington facility originally employed
approximately 300 employees, of which approximately 250 have separated from
the Company as a result of the plant closure. Total asset write-offs,
severance, and other up-front costs of the project are expected to be
approximately $30 million, of which approximately $20 million was recognized
during 2004. Management expects to complete a sale of the Worthington
facility in 2005.
In order to integrate it with the rest of our U.S. operations, during 2004,
we completed the relocation of our U.S. snacks business unit from Elmhurst,
Illinois (the former headquarters of Keebler Foods Company) to Battle Creek,
Michigan. About one-third of the approximately 300 employees affected by this
initiative accepted relocation/reassignment offers. The recruiting effort to
fill the remaining open positions was substantially completed by year-end
2004. Attributable to this initiative, we incurred approximately $15 million
in relocation, recruiting, and severance costs during 2004. Subject to
achieving certain employment levels and other regulatory requirements, we
expect to defray a significant portion of these up-front costs through
various multi-year tax incentives, beginning in 2005. The Elmhurst office
building was sold in late 2004, and the net sales proceeds approximated
carrying value.
2003 INITIATIVES
During 2003, we implemented a wholesome snack plant consolidation in
Australia, which involved the exit of a leased facility and separation of
approximately 140 employees. We incurred approximately $6 million in exit
costs and asset write-offs during 2003 related to this initiative.
We also undertook a manufacturing capacity rationalization in the Mercosur
region of Latin America, which involved the closure of an owned facility in
Argentina and separation of approximately 85 plant and administrative
employees during 2003. We recorded an impairment loss of approximately $6
million to reduce the carrying value of the manufacturing facility to
estimated fair value, and incurred approximately $2 million of severance and
closure costs during 2003 to complete this initiative. In 2004, we began
importing our products for sale in Argentina from other Latin America
facilities.
In Great Britain, we initiated changes in plant crewing to better match the
work pattern to the demand cycle, which resulted in voluntary workforce
reductions of approximately 130 hourly and salaried employee positions.
During 2003, we incurred approximately $18 million in separation benefit
costs related to this initiative.
INTEREST EXPENSE
Since the acquisition of Keebler Foods Company in early 2001, our Company has
paid down nearly $2.0 billion of debt, even early-retiring debt in each of
December 2003 and 2004. Early-retirement premiums, which primarily represent
accelerated interest, are recorded in interest expense and were $4.3 million
in 2004 and $16.5 million in 2003. After peaking in 2002, annual interest
expense has declined steadily for the past two years, due primarily to
continuing pay-down of our debt balances and lower interest rates on
refinancings.
Change vs. prior year
----------------------
(dollars in millions) 2004 2003 2002 2004 2003
- --------------------- ------ ------ ------ ------ ----
Reported interest
expense $308.6 $371.4 $391.2
Amounts capitalized .9 -- 1.0
------ ------ ------
Gross interest expense $309.5 $371.4 $392.2 -16.7% -5.3%
====== ====== ====== ===== ====
We currently expect total-year 2005 interest expense to be slightly less than
$300 million, representing a decline of 3-4% from the 2004 level. While we
expect net debt reduction in 2005 to be consistent with the 2004 reduction of
nearly $300 million, our interest expense projection takes into account a
forecasted increase in short-term interest rates and minimal benefit from
refinancing of higher-coupon long-term debt.
OTHER INCOME (EXPENSE), NET
Other income (expense), net includes non-operating items such as interest
income, foreign exchange gains and losses, charitable donations, and gains on
asset sales. Other income (expense), net for 2004 includes charges of
approximately $9 million for contributions to the Kellogg's Corporate
Citizenship Fund, a private trust established for charitable giving. Other
income (expense), net for 2003 includes credits of approximately $17 million
related to favorable legal settlements, a charge of $8 million for a
contribution to the Kellogg's Corporate Citizenship Fund, and a charge of
$6.5 million to recognize the impairment of a cost-basis investment in an
e-commerce business venture. Other income (expense), net for 2002 consists
primarily of $24.7 million in credits related to legal settlements.
26
INCOME TAXES
Our consolidated effective income tax rate has benefited from tax planning
initiatives over the past several years, declining from 37% in 2002 to
slightly less than 35% in 2004. The 2003 rate was even lower at less than
33%, as it included over 200 basis points of discrete benefits, such as
favorable audit closures and revaluation of deferred state tax liabilities.
The resulting tax savings have been reinvested, in part, in cost-reduction
initiatives, brand-building expenditures, and other growth initiatives.
On October 22, 2004, the American Jobs Creation Act ("AJCA") became law. The
AJCA creates a temporary incentive for U.S. multinationals to repatriate
foreign earnings by providing an 85 percent dividend received deduction for
qualified dividends. Our Company may elect to claim this deduction for
qualified dividends received in either our fiscal 2004 or 2005 years, and we
currently plan to elect this deduction for 2005. We cannot fully evaluate the
effects of this repatriation provision until the Treasury Department issues
clarifying regulations. Furthermore, pending technical corrections
legislation is needed to clarify that the dividend received deduction applies
to both the cash and "section 78 gross-up" portions of qualifying dividend
repatriations. While we believe the technical corrections legislation will
pass in 2005, we have currently developed our repatriation plan based on the
less favorable AJCA provisions in force as of year-end 2004. Under these
assumptions, we currently intend to repatriate during 2005 approximately $70
million of foreign earnings under the AJCA and an additional $550 million of
foreign earnings under regular rules. Prior to 2004, it was our intention to
indefinitely reinvest substantially all of our undistributed foreign
earnings. Accordingly, no deferred tax liability had been recorded in
connection with the future repatriation of these earnings. Now that
repatriation is foreseeable for up to $620 million of these earnings, we
provided in 2004 a deferred tax liability, net of related foreign tax
credits, of approximately $29 million. Should the technical corrections
legislation pass during 2005, we currently believe that we would most likely
repatriate a higher amount of earnings up to $1.1 billion under AJCA for a
similar amount of net tax cost.
The AJCA also provides an ongoing deduction from taxable income equal to a
stipulated percentage of qualified production income ("QPI"). The percentage
deduction is phased in over five years, beginning in our 2005 fiscal year.
While the Treasury Department has not issued detailed regulations on what
constitutes QPI, we believe that this provision will result in a moderate
reduction in our consolidated effective income tax rate, beginning in 2005.
In combination with tax benefits expected from the reorganization of our
European operations (refer to page 26 within the "Cost-reduction initiatives"
section for additional information on this initiative), we expect our 2005
consolidated effective income tax rate to decline to approximately 33%.
LIQUIDITY AND CAPITAL RESOURCES
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. 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 is relatively
short; although receivable collection patterns vary around the world, in the
United States, our days sales outstanding (DSO) averages 18-19 days. As a
result, the growth in our operating cash flow should generally reflect the
growth in our net earnings over time. As presented in the schedule below,
operating cash flow performance over the 2002 to 2004 time frame generally
reflects this principle, except for the level of benefit plan contributions
and working capital movements (operating assets and liabilities.)
(dollars in millions) 2004 2003 2002
- ----------------------------------- -------- -------- -------
OPERATING ACTIVITIES
Net earnings $ 890.6 $ 787.1 $ 720.9
year-over-year change 13.1% 9.2%
Items in net earnings not requiring
(providing) cash:
Depreciation and amortization 410.0 372.8 349.9
Deferred income taxes 57.7 74.8 111.2
Other 104.5 76.1 67.0
-------- -------- -------
Net earnings after non-cash items 1,462.8 1,310.8 1,249.0
-------- -------- -------
year-over-year change 11.6% 4.9%
Pension and other postretirement (204.0) (184.2) (446.6)
benefit plan contributions
Changes in operating assets and
liabilities:
Core working capital (a) 46.0 (.1) 29.5
Other working capital (75.8) 44.5 168.0
-------- -------- -------
Total (29.8) 44.4 197.5
-------- -------- -------
NET CASH PROVIDED BY OPERATING
ACTIVITIES $1,229.0 $1,171.0 $ 999.9
======== ======== =======
year-over-year change 5.0% 17.1%
(a) inventory and trade receivables less trade payables
The varying level of benefit plans contributions from year to year primarily
reflects our decision to voluntarily fund several of our major pension and
retiree health care plans, as influenced by tax strategies and market
factors. Total minimum benefit plan contributions for 2005 are expected to be
approximately $89 million. Actual contributions could exceed this amount, as
influenced by our decision to voluntarily pre-fund our obligations during
2005 versus other competing investment priorities.
With respect to movements in operating assets and liabilities, since 2001,
our Company has been successful in steadily reducing the level of core
working capital (inventory and trade receivables less trade payables) as a
percentage of net sales. This effort has involved logistics improvements to
reduce inventory on hand while continuing to meet customer requirements,
faster collection of accounts receivable, and extension of terms on trade
payables. For the year ended January 1, 2005, average core working capital as
a percentage of sales was 7.3%, compared to 8.2% for 2003 and 8.8% for 2002.
This continual reduction contributed positively to cash flow in 2002
27
and 2004, and had a neutral effect in 2003. For 2005, we expect additional
modest improvements in our core working capital position. The unfavorable
movements in other working capital for 2004, as presented in the table on page
27, relate largely to higher income tax payments and faster payment of customer
promotional incentives, as compared to prior years. This unfavorable trend
resulted in operating cash flow growth for 2004 trailing the growth in net
earnings.
Our management measure of cash flow is defined as net cash provided by operating
activities reduced by expenditures for property additions. We use this 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 GAAP-basis operating cash flow
as follows:
Change vs. prior year
---------------------
(dollars in millions) 2004 2003 2002 2004 2003
- --------------------- -------- -------- -------- ----- -----
Net cash provided by
operating activities $1,229.0 $1,171.0 $ 999.9 5.0% 17.1%
Additions to properties (278.6) (247.2) (253.5)
-------- -------- -------
Cash flow $ 950.4 $ 923.8 $ 746.4 2.9% 23.8%
======== ======== ======= === ====
Our 2004 cash flow increased approximately 3% versus the prior year.
Expenditures for property additions represented 2.9% of 2004 net sales compared
with 2.8% in 2003 and 3.1% in 2002. For 2005, expenditures for property
additions are currently expected to remain at approximately 3% of net sales and
cash flow (as defined) is expected to exceed the amount of net earnings.
Our Board of Directors authorized management to repurchase up to $300 million of
Kellogg common stock during 2004, up to $250 million in 2003, and up to $150
million in 2002. Under these authorizations, we paid $298 million during 2004
for approximately 7.3 million shares, approximately $90 million during 2003 for
approximately 2.9 million shares, and $101 million during 2002 for approximately
3.1 million shares. We funded this repurchase program principally by proceeds
from employee stock option exercises. For 2005, our Board of Directors has
authorized stock repurchases for general corporate purposes and to offset
issuances for employee benefit programs of up to $400 million.
Since the acquisition of Keebler Foods Company in early 2001, our Company has
paid down nearly $2.0 billion of debt, reducing our total debt balance from
approximately $6.8 billion at March 2001 to $4.9 billion at year-end 2004. Some
of the long-term debt has been redeemed prior to its maturity date. In September
2002, we redeemed $300.7 million of Notes due 2003, and in December 2003, we
redeemed $172.9 million of Notes due 2006. In December 2004, we redeemed $103.7
million of Notes due 2006. In January 2004, we repaid $500 million of maturing
seven-year Notes, replacing these Notes with short-term debt. During 2005, we
intend to reduce our debt balances by approximately $300 million.
Citing lower debt levels and strong operating performance, both Standard &
Poor's (S&P) and Moody's Investor Services have raised their credit ratings on
our Company's senior unsecured long-term debt. In August 2004, S&P upgraded its
rating from BBB to BBB+, and in October 2004, Moody's upgraded from Baa2 to
Baa1. Within these organizations' systems, these credit ratings generally
indicate medium-grade obligations, currently exhibiting adequate protection
parameters. Our investors should be aware that a security rating is not a
recommendation to buy, sell, or hold securities; that it may be subject to
revision or withdrawal at any time by the assigning rating organization; and
that each rating should be evaluated independently of any other rating.
In November 2004, we entered into an unsecured Five-Year Credit Agreement with
23 lenders to borrow, on a revolving credit basis, up to $2.0 billion, to obtain
letters of credit in an aggregate amount up to $75 million, and to provide a
procedure for the lenders to bid on short-term debt of our Company. This Credit
Agreement replaces a $1.15 billion five-year agreement expiring in January 2006
and a $650 million 364-day agreement expiring in January 2005. The new Credit
Agreement contains customary covenants and warranties, including specified
restrictions on indebtedness, liens, sale and leaseback transactions, and a
specified interest expense coverage ratio. If an event of default occurs, then,
to the extent permitted, the administrative agent may terminate the commitments
under the new credit facility, accelerate any outstanding loans, and demand the
deposit of cash collateral equal to the lender's letter of credit exposure plus
interest. As of year-end 2004, there were no borrowings outstanding under this
facility and we currently believe it is remote that our Company would violate
any of the stated covenants and warranties.
We 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 selective growth
opportunities, 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 its 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 credit facilities, which
are in amounts sufficient to cover the outstanding short-term debt balance and
debt principal repayments through 2006.
MARKET RISKS
Our Company is exposed to certain market risks, which exist as a part of our
ongoing business operations and we use derivative financial and commodity
instruments, where appropriate, to manage these risks. Our Company, as a matter
of policy, does not engage in trading or speculative transactions. Refer to Note
12 within Notes to Consolidated Financial Statements for further information on
accounting policies related to derivative financial and commodity instruments.
28
FOREIGN EXCHANGE RISK
Our Company is exposed to fluctuations in foreign currency cash flows related to
third-party purchases, intercompany loans and product shipments, and
nonfunctional currency denominated third-party debt. Our Company is also exposed
to fluctuations in the value of foreign currency investments in subsidiaries and
cash flows related to repatriation of these investments. Additionally, our
Company is exposed to volatility in the translation of foreign currency earnings
to U.S. Dollars. Primary exposures include the U.S. Dollar versus the British
Pound, Euro, Australian Dollar, Canadian Dollar, and Mexican Peso, and in the
case of inter-subsidiary transactions, the British Pound versus the Euro. We
assess foreign currency risk based on transactional cash flows and translational
positions and enter into forward contracts, options, and currency swaps to
reduce fluctuations in net long or short currency positions. Forward contracts
and options are generally less than 18 months duration. Currency swap agreements
are established in conjunction with the term of underlying debt issuances.
The total notional amount of foreign currency derivative instruments at year-end
2004 was $375.5 million, representing a settlement obligation of $60.3 million.
The total notional amount of foreign currency derivative instruments at year-end
2003 was $749.2 million, representing a settlement obligation of $67.8 million.
All of these derivatives were hedges of anticipated transactions, translational
exposure, or existing assets or liabilities, and mature within 18 months, except
for one currency swap transaction outstanding at year-end 2004 that matures in
2006. Assuming an unfavorable 10% change in year-end exchange rates, the
settlement obligation would have increased by approximately $37.5 million at
year-end 2004 and $74.9 million at year-end 2003. These unfavorable changes
would generally have been offset by favorable changes in the values of the
underlying exposures.
INTEREST RATE RISK
Our Company is exposed to interest rate volatility with regard to future
issuances of fixed rate debt and existing and future issuances of variable rate
debt. Primary exposures include movements in U.S. Treasury rates, London
Interbank Offered Rates (LIBOR), and commercial paper rates. We currently use
interest rate swaps and forward interest rate contracts to reduce interest rate
volatility and funding costs associated with certain debt issues, and to achieve
a desired proportion of variable versus fixed rate debt, based on current and
projected market conditions.
Note 7 within Notes to Consolidated Financial Statements provides information on
our Company's significant debt issues. There were no interest rate derivatives
outstanding at year-end 2004. The total notional amount of interest rate
derivative instruments at year-end 2003 was $1.91 billion, representing a
settlement obligation of $2.1 million. Assuming average variable rate debt
levels and issuances of fixed rate debt during the year, a one percentage point
increase in interest rates would have increased interest expense by
approximately $2.3 million in 2004 and $3.8 million in 2003.
PRICE RISK
Our Company is exposed to price fluctuations primarily as a result of
anticipated purchases of raw and packaging materials and energy. Primary
exposures include corn, wheat, soybean oil, sugar, cocoa, paperboard, natural
gas, and diesel fuel. We use the combination of long cash positions with
suppliers, and exchangetraded futures and option contracts to reduce price
fluctuations in a desired percentage of forecasted purchases over a duration of
generally less than one year. The total notional amount of commodity derivative
instruments at year-end 2004 was $61.3 million, representing a settlement
obligation of $4.8 million. Assuming a 10% decrease in year-end commodity
prices, this settlement obligation would have increased by approximately $5.6
million, generally offset by a reduction in the cost of the underlying material
purchases. The total notional amount of commodity derivative instruments at
year-end 2003 was $26.5 million, representing a settlement receivable of $.2
million. Assuming a 10% decrease in year-end commodity prices, this settlement
receivable would have converted to a settlement obligation of approximately $2.7
million, generally offset by a reduction in the cost of the underlying material
purchases.
In addition to the derivative commodity instruments discussed above, we use long
cash positions with suppliers to manage a portion of our 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.
OFF-BALANCE SHEET ARRANGEMENTS AND OTHER OBLIGATIONS
OFF-BALANCE SHEET ARRANGEMENTS
Our off-balance sheet arrangements are generally limited to residual value
guarantees and secondary liabilities on operating leases of approximately $14
million and guarantees on loans to independent contractors for their purchase of
DSD route franchises up to $17 million.We record the estimated fair value of
these loan guarantees on our balance sheet, which we currently estimate to be
insignificant. Refer to Note 6 within 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 of Notes to Consolidated Financial Statements. Further
information on lease obligations is contained in Note 6.
29
Contractual obligations Payments due by period
2010 and
(millions) Total 2005 2006 2007 2008 2009 beyond
- ------------------- --------- ------- ------- ------- -------- ------- ---------
Long-term debt $ 4,191.4 $ 278.6 $ 807.8 $ 2.0 $ 501.3 $ 1.4 $ 2,600.3
Capital leases 3.2 1.3 1.2 .7 -- -- --
Operating leases 404.2 87.2 72.5 57.0 44.9 76.7 65.9
Purchase
obligations (a) 410.4 275.7 71.8 36.7 12.6 11.9 1.7
Other long-term (b) 161.1 17.8 10.4 10.9 8.5 7.4 106.1
--------- ------- ------- ------- -------- ------- ---------
Total $ 5,170.3 $ 660.6 $ 963.7 $ 107.3 $ 567.3 $ 97.4 $ 2,774.0
========= ======= ======= ======= ======== ======= =========
(a) Purchase obligations consist primarily of fixed commitments under various
co-marketing agreements and to a lesser extent, of service agreements, and
contracts for future delivery of commodities, packaging materials, and
equipment. The amounts presented in the table do not include items already
recorded in accounts payable or other current liabilities at year-end 2004, nor
does the table reflect cash flows we are likely to incur based on our plans, but
are not obligated to incur. Therefore, it should be noted that the exclusion of
these items from the table could be a limitation in assessing our total future
cash flows under contracts.
(b) Other long-term contractual obligations are those associated with noncurrent
liabilities recorded within the Consolidated Balance Sheet at year-end 2004 and
consist principally of projected commitments under deferred compensation
arrangements and other retiree benefits in excess of those provided within our
broad-based plans. We do not have significant statutory or contractual funding
requirements for our broad-based retiree benefit plans during the periods
presented and have not included these amounts in the table. Refer to Notes 9 and
10 within Notes to Consolidated Financial Statements for further information on
these plans, including expected contributions for fiscal year 2005.
SIGNIFICANT ACCOUNTING ESTIMATES
Our significant accounting policies, as well as recently adopted and issued
pronouncements, are discussed in Note 1 of Notes to Consolidated Financial
Statements. None of the pronouncements adopted in fiscal 2003 or 2004 have had
or are expected to have a significant impact on our Company's financial
statements.
In 2005, we expect to adopt SFAS No. 123(Revised) "Share-Based Payment," which
generally requires public companies to recognize the fair value of equity-based
awards to employees as compensation expense within reported results. Because we
have historically used the intrinsic value method to account for employee stock
options, we have generally not recognized expense for these types of awards.
Once this standard is adopted, we currently expect full-year 2005 net earnings
per share to be reduced by approximately $.08. Application of this pronouncement
requires significant judgment regarding the inputs to an option pricing model,
including stock price volatility and employee exercise behavior. Most of these
inputs are either highly dependent on the current economic environment at the
date of grant or forward-looking over the expected term of the award. As a
result, the actual impact of adoption on 2005 and future years' earnings could
differ significantly from our current estimate. We are presently considering one
of the modified retrospective methods of transition, which would be first
effective for our 2005 fiscal third quarter, with retrospective restatement to
the beginning of 2005.
Our critical accounting estimates, which require significant judgments and
assumptions likely to have a material impact on our financial statements, are
currently limited to those governing the amount and timing of recognition of
consumer promotional expenditures, the assessment of the carrying value of
goodwill and other intangible assets, valuation of our pension and other
postretirement benefit obligations, and determination of our income tax expense
and liabilities.
PROMOTIONAL EXPENDITURES
Our promotional activities are conducted either through the retail trade or
directly with consumers and involve in-store displays; 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 in excess of .3% (.003) of our Company's net sales.
However, as our Company's total promotional expenditure represented over 35% of
2004 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. Under this standard, 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 periodically engage third party valuation
consultants to assist in this process. At January 1, 2005, intangible assets,
net, were $5.1 billion, consisting primarily of goodwill, trademarks, and DSD
delivery system associated with the Keebler acquisition. While we currently
believe that the fair value of all of our intangibles exceeds carrying value,
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.
30
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 bonds, real
estate, and other investments. We follow SFAS No. 87 "Employers' Accounting for
Pensions" and SFAS No. 106 "Employers' Accounting for Postretirement Benefits
Other Than Pensions" 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, therefore, 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. In addition, administrative
ambiguities concerning the Medicare Prescription Drug Improvement and
Modernization Act of 2003, presently result in uncertainty regarding the
eventual financial impact of this legislative change on our Company.
To conduct our annual review of the long-term rate of return on plan assets, we
work with third party financial consultants to model expected returns over a
20-year investment horizon with respect to the specific investment mix 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 2004 of 9.3% equated to approximately the 50th
percentile expectation of our 2004 model. In updating our model for 2005, we
have recently decided to reduce our assumed rate of return for U.S. plans in
2005 to 8.9% in order to remain well within the "more likely than not" corridor
of the model. Similar methods are used for various foreign plans with invested
assets, reflecting local economic conditions. Foreign plan investments represent
approximately 30% of our global benefit plan investments.
Any future variance between the assumed and actual rates of return on our plan
assets is recognized in the calculated value of plan assets over a five-year
period and once recognized, experience gains and losses are amortized using a
declining-balance method over the average remaining service period of active
plan participants. Under this recognition method, a 100 basis point shortfall in
actual versus assumed performance of all of our plan assets in year one would
result in an arising experience loss of approximately $30 million. The
unfavorable impact on earnings in year two would be approximately $1 million,
increasing to approximately $4 million in year five. Approximately 80% of this
experience loss would be amortized through earnings at the end of year 20.
Experience gains are recognized similarly.
To conduct our annual review of health care cost trend rates, we work with third
party financial consultants to model our actual claims cost data over a
five-year historical period, including an analysis of pre-65 versus post-65 age
group and other demographic trends. 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 our
historical model as well as any expectations regarding short-term future trends.
Our 2005 initial trend rate of 8.5% compares to our recent five-year compound
annual growth rate of approximately 8%. Our initial rate is trended downward by
1% per year, until the ultimate trend rate of 4.5% 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.
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. We also use third party financial consultants to model
specific AA-rated (or the equivalent in foreign jurisdictions) bond issues
against the expected settlement cash flows of our plans. The measurement dates
for our benefit plans are generally 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.
Despite the above-described rigorous policies for selecting major actuarial
assumptions, we periodically experience differences between assumed and actual
experience. For 2005, we currently expect incremental amortization of experience
losses of approximately $24 million, arising largely from a decline in discount
rates at year-end 2004, and to a lesser extent, the continuation of our health
care trend rate at 8.5%. Assuming actual future experience is consistent with
our current assumptions, annual amortization of accumulated experience losses
during each of the next several years would remain approximately level with the
2005 amount.
31
In December 2003, the Medicare Prescription Drug Improvement and Modernization
Act of 2003 (the Act) became law. The Act introduces a prescription drug benefit
under Medicare Part D as well as a federal subsidy (beginning in 2006) to
sponsors of retiree health care benefit plans that provide a benefit that is at
least actuarially equivalent to Medicare Part D. While detailed regulations
necessary to implement the Act have only recently been issued, we believe that
certain health care benefit plans covering a significant portion of our
workforce will qualify for the Medicare Part D subsidy, resulting in a reduction
in our Company's expense related to providing prescription drug benefits under
these plans. We have estimated the reduction in our benefit obligation
attributable to past service cost at approximately $73 million and we recognized
a reduction in benefit cost for 2004 of approximately $10 million. Significant
management judgment was required to assess the eligibility of our plans as well
as to estimate the underlying prescription drug costs to which the Act applies.
Future differences between assumed and actual experience, including the
eligibility of certain covered employee groups for which we have not yet claimed
a benefit, would be amortized as an experience gain or loss, as described above.
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.
Significant judgement is required in determining our effective tax rate and in
evaluating our tax positions. We establish reserves when, despite our belief
that our tax return positions are supportable, we believe that certain positions
are likely to be challenged and that we may not succeed. We adjust these
reserves in light of changing facts and circumstances, such as the progress of a
tax audit. Our effective income tax rate includes the impact of reserve
provisions and changes to reserves that we consider appropriate. While it is
often difficult to predict the final outcome or the timing of resolution of any
particular tax matter, we believe that our reserves reflect the probable outcome
of known tax contingencies. Favorable resolution would be recognized as a
reduction to our effective tax rate in the year of resolution. Our tax reserves
are presented in the balance sheet principally within accrued income taxes.
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. Historically, tax reserve adjustments for
individual issues have rarely exceeded 1% of earnings before income taxes
annually.
FUTURE OUTLOOK AND FORWARD-LOOKING STATEMENTS
Our long-term annual growth targets are low single-digit for internal net sales
and high single-digit for net earnings per share. In addition, we remain
committed to growing our brand-building investment faster than the rate of sales
growth. In general, we expect 2005 results to be consistent with these targets
and we will continue to reinvest in cost-reduction initiatives and other growth
opportunities.
Our Management's Discussion and Analysis and other parts of this Annual Report
contain "forward-looking statements" with projections concerning, among other
things, our strategy, financial principles, and plans; initiatives,
improvements, and growth; sales, gross margins, advertising, promotion,
merchandising, brand-building expenditures, operating profit, and earnings per
share; innovation opportunities; asset write-offs and expenditures related to
cost-reduction initiatives; the impact of accounting changes and significant
accounting estimates; our ability to meet interest and debt principal repayment
obligations; minimum contractual obligations; future common stock repurchases or
debt reduction; effective income tax rate; cash flow and core working capital
improvements; capital expenditures; interest expense; commodity and energy
prices; and employee benefit plan costs and funding. Forward-looking statements
include predictions of future results or activities and may contain the words
"expect," "believe," "will," "will deliver," "anticipate," "project," "should,"
or words or phrases of similar meaning. Our actual results or activities may
differ materially from these predictions. In addition, our future results could
be affected by a variety of other factors, including:
- - the impact of competitive conditions;
- - the effectiveness of pricing, advertising, and promotional programs;
- - the success of innovation and new product introductions;
- - the recoverability of the carrying value of goodwill and other
intangibles;
- - the success of productivity improvements and business transitions;
- - commodity and energy prices, and labor costs;
- - the availability of and interest rates on short-term financing;
- - actual market performance of benefit plan trust investments;
- - the levels of spending on systems initiatives, properties, business
opportunities, integration of acquired businesses, and other general and
administrative costs;
- - changes in consumer behavior and preferences;
- - the effect of U.S. and foreign economic conditions on items such as
interest rates, statutory tax rates, currency conversion and availability;
- - legal and regulatory factors; and,
- - business disruption or other losses from war, terrorist acts, or political
unrest.
Forward-looking statements speak only as of the date they were made, and we
undertake no obligation to publicly update them.
32
KELLOGG COMPANY AND SUBSIDIARIES
SELECTED FINANCIAL DATA
(millions, except per share data
and number of employees) 2004 2003 2002 2001 2000
- -------------------------------- ----------- ----------- ----------- ----------- -----------
OPERATING TRENDS
Net sales $ 9,613.9 $ 8,811.5 $ 8,304.1 $ 7,548.4 $ 6,086.7
Gross profit as a % of net sales 44.9% 44.4% 45.0% 44.2% 44.1%
Depreciation 399.0 359.8 346.9 331.0 275.6
Amortization 11.0 13.0 3.0 107.6 15.0
Advertising expense 806.2 698.9 588.7 519.2 604.2
Research and development expense 148.9 126.7 106.4 110.2 118.4
Operating profit (a) 1,681.1 1,544.1 1,508.1 1,167.9 989.8
Operating profit as a % of net sales 17.5% 17.5% 18.2% 15.5% 16.3%
Interest expense 308.6 371.4 391.2 351.5 137.5
Earnings before cumulative
effect of accounting change (a) (b) 890.6 787.1 720.9 474.6 587.7
Average shares outstanding:
Basic 412.0 407.9 408.4 406.1 405.6
Diluted 416.4 410.5 411.5 407.2 405.8
Earnings per share before cumulative
effect of accounting change (a) (b):
Basic 2.16 1.93 1.77 1.17 1.45
Diluted 2.14 1.92 1.75 1.16 1.45
----------- ----------- ----------- ----------- -----------
CASH FLOW TRENDS
Net cash provided from operating activities $ 1,229.0 $ 1,171.0 $ 999.9 $ 1,132.0 $ 880.9
Capital expenditures 278.6 247.2 253.5 276.5 230.9
Net cash provided from operating activities
reduced by capital expenditures (d) 950.4 923.8 746.4 855.5 650.0
Net cash used in investing activities (270.4) (219.0) (188.8) (4,143.8) (379.3)
Net cash provided from (used in) financing
activities (716.3) (939.4) (944.4) 3,040.2 (441.8)
Interest coverage ratio (c) 6.8 5.1 4.8 4.5 9.4
----------- ----------- ----------- ----------- -----------
CAPITAL STRUCTURE TRENDS
Total assets $ 10,790.4 $ 10,142.7 $ 10,219.3 $ 10,368.6 $ 4,886.0
Property, net 2,715.1 2,780.2 2,840.2 2,952.8 2,526.9
Short-term debt 988.3 898.9 1,197.3 595.6 1,386.3
Long-term debt 3,892.6 4,265.4 4,519.4 5,619.0 709.2
Shareholders' equity 2,257.2 1,443.2 895.1 871.5 897.5
----------- ----------- ----------- ----------- -----------
SHARE PRICE TRENDS
Stock price range $ 37-45 $ 28-38 $ 29-37 $ 25-34 $ 21-32
Cash dividends per common share 1.010 1.010 1.010 1.010 .995
----------- ----------- ----------- ----------- -----------
Number of employees 25,171 25,250 25,676 26,424 15,196
=========== =========== =========== =========== ===========
(a) Operating profit for 2001 includes restructuring charges, net of credits,
of $33.3 ($20.5 after tax or $.05 per share). Operating profit for 2000
includes restructuring charges of $86.5 ($64.2 after tax or $.16 per
share).
(b) Earnings before cumulative effect of accounting change for 2001 exclude
the effect of a charge of $1.0 after tax to adopt SFAS No. 133 Accounting
for Derivative Instruments and Hedging Activities.
(c) Interest coverage ratio is calculated based on earnings before interest
expense, income taxes, depreciation, and amortization, divided by interest
expense.
(d) The Company uses this non-GAAP financial measure to focus management and
investors on the amount of cash available for debt repayment, dividend
distribution, acquisition opportunities, and share repurchase.
33
KELLOGG COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF EARNINGS
(millions, except per share data) 2004 2003 2002
- -------------------------------------------- ----------- ----------- -----------
NET SALES $ 9,613.9 $ 8,811.5 $ 8,304.1
----------- ----------- -----------
Cost of goods sold 5,298.7 4,898.9 4,569.0
Selling, general, and administrative expense 2,634.1 2,368.5 2,227.0
----------- ----------- -----------
OPERATING PROFIT $ 1,681.1 $ 1,544.1 $ 1,508.1
----------- ----------- -----------
Interest expense 308.6 371.4 391.2
Other income (expense), net (6.6) (3.2) 27.4
----------- ----------- -----------
EARNINGS BEFORE INCOME TAXES $ 1,365.9 $ 1,169.5 $ 1,144.3
Income taxes 475.3 382.4 423.4
----------- ----------- -----------
NET EARNINGS $ 890.6 $ 787.1 $ 720.9
----------- ----------- -----------
NET EARNINGS PER SHARE:
Basic $ 2.16 $ 1.93 $ 1.77
Diluted 2.14 1.92 1.75
=========== =========== ===========
Refer to Notes to Consolidated Financial Statements
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
Accumulated Total Total
Common stock Capital in Treasury stock other share- compreh-
-------------- excess of Retained ------------------ comprehensive holders' ensive
(millions) shares amount par value earnings shares amount income equity income
- ---------------------------------- ------ ------ ---------- -------- -------- -------- ------------- --------- ---------
Balance, January 1, 2002 415.5 $103.8 $ 91.5 $1,564.7 8.8 ($ 337.1) ($ 551.4) $ 871.5 $ 357.5
--------
Common stock repurchases 3.1 (101.0) (101.0)
Net earnings 720.9 720.9 720.9
Dividends (412.6) (412.6)
Other comprehensive income (302.0) (302.0) (302.0)
Stock options exercised and other (41.6) (4.3) 159.9 118.3
------ ------ -------- -------- ------ -------- ---------- -------- ---------
Balance, December 28, 2002 415.5 $103.8 $ 49.9 $1,873.0 7.6 ($ 278.2) ($ 853.4) $ 895.1 $ 418.9
---------
Common stock repurchases 2.9 (90.0) (90.0)
Net earnings 787.1 787.1 787.1
Dividends (412.4) (412.4)
Other comprehensive income 124.2 124.2 124.2
Stock options exercised and other (25.4) (4.7) 164.6 139.2
------ ------ -------- -------- ------ -------- ---------- -------- ---------
Balance, December 27, 2003 415.5 $103.8 $ 24.5 $2,247.7 5.8 ($ 203.6) ($ 729.2) $1,443.2 $ 911.3
---------
Common stock repurchases 7.3 (297.5) (297.5)
Net earnings 890.6 890.6 890.6
Dividends (417.6) (417.6)
Other comprehensive income 289.3 289.3 289.3
Stock options exercised and other (24.5) (19.4) (10.7) 393.1 349.2
------ ------ -------- -------- ------ --------- ---------- -------- ---------
BALANCE, JANUARY 1, 2005 415.5 $103.8 -- $2,701.3 2.4 ($ 108.0) ($ 439.9) $2,257.2 $ 1,179.9
====== ====== ======== ======== ====== ========= ========== ======== =========
Refer to Notes to Consolidated Financial Statements.
34
KELLOGG COMPANY AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(millions, except share data) 2004 2003
- --------------------------------------------------------------------- ----------- -----------
CURRENT ASSETS
Cash and cash equivalents $ 417.4 $ 141.2
Accounts receivable, net 776.4 754.8
Inventories 681.0 649.8
Other current assets 247.0 242.1
----------- -----------
TOTAL CURRENT ASSETS $ 2,121.8 $ 1,787.9
----------- -----------
PROPERTY, NET 2,715.1 2,780.2
OTHER ASSETS 5,953.5 5,574.6
----------- -----------
TOTAL ASSETS $ 10,790.4 $ 10,142.7
=========== ===========
CURRENT LIABILITIES
Current maturities of long-term debt $ 278.6 $ 578.1
Notes payable 709.7 320.8
Accounts payable 767.2 703.8
Other current liabilities 1,090.5 1,163.3
----------- -----------
TOTAL CURRENT LIABILITIES $ 2,846.0 $ 2,766.0
----------- -----------
LONG-TERM DEBT 3,892.6 4,265.4
OTHER LIABILITIES 1,794.6 1,668.1
SHAREHOLDERS' EQUITY
Common stock, $.25 par value, 1,000,000,000 shares authorized
Issued: 415,451,198 shares in 2004 and 2003 103.8 103.8
Capital in excess of par value -- 24.5
Retained earnings 2,701.3 2,247.7
Treasury stock at cost:
2,428,824 shares in 2004 and 5,751,578 shares in 2003 (108.0) (203.6)
Accumulated other comprehensive income (loss) (439.9) (729.2)
----------- -----------
TOTAL SHAREHOLDERS' EQUITY $ 2,257.2 $ 1,443.2
----------- -----------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 10,790.4 $ 10,142.7
=========== ===========
Refer to Notes to Consolidated Financial Statements. In partiular, refer to Note
15 for supplemental information on various balance sheet captions
35
KELLOGG COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(millions) 2004 2003 2002
- ----------------------------------------------------------------------- ---------- ---------- --------
OPERATING ACTIVITIES
Net earnings $ 890.6 $ 787.1 $ 720.9
Adjustments to reconcile net earnings to operating cash flows:
Depreciation and amortization 410.0 372.8 349.9
Deferred income taxes 57.7 74.8 111.2
Other 104.5 76.1 67.0
Pension and other postretirement benefit plan contributions (204.0) (184.2) (446.6)
Changes in operating assets and liabilities (29.8) 44.4 197.5
--------- --------- -------
NET CASH PROVIDED FROM OPERATING ACTIVITIES $ 1,229.0 $ 1,171.0 $ 999.9
--------- --------- -------
INVESTING ACTIVITIES
Additions to properties ($ 278.6) ($ 247.2) ($ 253.5)
Acquisitions of businesses -- -- (2.2)
Dispositions of businesses -- 14.0 60.9
Property disposals 7.9 13.8 6.0
Other .3 .4 --
--------- --------- -------
NET CASH USED IN INVESTING ACTIVITIES ($ 270.4) ($ 219.0) ($ 188.8)
--------- --------- -------
FINANCING ACTIVITIES
Net increase (reduction) of notes payable, with maturities less than or
equal to 90 days $ 388.3 $ 208.5 ($ 226.2)
Issuances of notes payable, with maturities greater than 90 days 142.3 67.0 354.9
Reductions of notes payable, with maturities greater than 90 days (141.7) (375.6) (221.1)
Issuances of long-term debt 7.0 498.1 --
Reductions of long-term debt (682.2) (956.0) (439.3)
Net issuances of common stock 291.8 121.6 100.9
Common stock repurchases (297.5) (90.0) (101.0)
Cash dividends (417.6) (412.4) (412.6)
Other (6.7) (.6) --
--------- --------- -------
NET CASH USED IN FINANCING ACTIVITIES ($ 716.3) ($ 939.4) ($ 944.4)
--------- --------- -------
Effect of exchange rate changes on cash 33.9 28.0 2.1
--------- --------- -------
Increase (decrease) in cash and cash equivalents $ 276.2 $ 40.6 ($ 131.2)
Cash and cash equivalents at beginning of year 141.2 100.6 231.8
--------- --------- -------
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 417.4 $ 141.2 $ 100.6
========= ========= =======
Refer to Notes to Consolidated Financial Statements.
36
NOTE 1 ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of Kellogg Company
and its majority-owned subsidiaries. Intercompany balances and transactions
are eliminated. Certain amounts in the prior-year financial statements have
been reclassified to conform to the current-year presentation.
The Company's fiscal year normally ends on the last Saturday of December and
as a result, a 53rd week is added every fifth or sixth year. The Company's
2002 and 2003 fiscal years ended on December 28 and 27, respectively. The
Company's 2004 fiscal year ended on January 1, 2005, and included a 53rd
week.
CASH AND CASH EQUIVALENTS
Highly liquid temporary investments with original maturities of less than
three months are considered to be cash equivalents. The carrying amount
approximates fair value.
INVENTORIES
Inventories are valued at the lower of cost (principally average) or market.
In November 2004, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standard (SFAS) No. 151 "Inventory Costs,"
to converge U.S. GAAP principles with International Accounting Standards on
inventory valuation. SFAS No. 151 clarifies that abnormal amounts of idle
facility expense, freight, handling costs, and spoilage should be recognized
as period charges, rather than as inventory value. This standard also
provides that fixed production overheads should be allocated to units of
production based on the normal capacity of production facilities, with excess
overheads being recognized as period charges. The provisions of this standard
are effective for inventory costs incurred during fiscal years beginning
after June 15, 2005, with earlier application permitted. The Company plans to
adopt this standard for its 2006 fiscal year. Management currently believes
its accounting policy for inventory valuation is generally consistent with
this guidance and does not, therefore, expect the adoption of SFAS No. 151 to
have a significant impact on financial results.
PROPERTY
The Company's property consists mainly of plant and equipment used for
manufacturing activities. These assets are recorded at cost and depreciated
over estimated useful lives using straight-line methods for financial
reporting and accelerated methods, where permitted, for tax reporting. Cost
includes an amount of interest associated with significant capital projects.
Plant and equipment are reviewed for impairment when conditions indicate that
the carrying value may not be recoverable. Such conditions include an
extended period of idleness or a plan of disposal. Assets to be abandoned at
a future date are depreciated over the remaining period of use. Assets to be
sold are written down to realizable value at the time the assets are being
actively marketed for sale and the disposal is expected to occur within one
year. As of year-end 2003 and 2004, the carrying value of assets held for
sale was insignificant.
GOODWILL AND OTHER INTANGIBLE ASSETS
The Company's intangible assets consist primarily of goodwill, trademarks,
and direct store-door (DSD) delivery system arising from the 2001 acquisition
of Keebler Foods Company ("Keebler"). Management expects the Keebler
trademarks and DSD system to contribute indefinitely to the cash flows of the
Company. Accordingly, these assets have been classified as "indefinite-lived"
intangibles pursuant to SFAS No. 142 "Goodwill and Other Intangible Assets."
Under this standard, goodwill and indefinitelived intangibles are not
amortized, but are tested at least annually for impairment. Goodwill
impairment testing first requires a comparison between the carrying value and
fair value of a "reporting unit," which for the Company is generally
equivalent to a North American product group or International country market.
If carrying value exceeds fair value, goodwill is considered impaired and is
reduced to the implied fair value. Impairment testing for non-amortized
intangibles requires a comparison between the fair value and carrying value
of the intangible asset. If carrying value exceeds fair value, the intangible
is considered impaired and is reduced to fair value. The Company uses various
market valuation techniques to determine the fair value of goodwill and other
intangible assets and periodically engages third party valuation consultants
for this purpose. Refer to Note 2 for further information on goodwill and
other intangible assets.
REVENUE RECOGNITION AND MEASUREMENT
The Company recognizes sales upon delivery of its products to customers net
of applicable provisions for discounts, returns, and allowances. The Company
classifies promotional payments to its customers, the cost of consumer
coupons, and other cash redemption offers in net sales. The cost of
promotional package inserts are recorded in cost of goods sold. Other types
of consumer promotional expenditures are normally recorded in selling,
general, and administrative (SGA) expense.
ADVERTISING
The costs of advertising are generally expensed as incurred and are
classified within SGA.
STOCK COMPENSATION
The Company currently uses the intrinsic value method prescribed by
Accounting Principles Board Opinion (APB) No. 25 "Accounting for Stock Issued
to Employees," to account for its employee stock options and other
stock-based compensation. Under this method, because the exercise price of
the Company's employee stock options equals the market price of the
underlying stock on the date of the grant, no compensation expense is
recognized. The table on page 38 presents the pro forma results for the
current and prior years, as if the Company had used the alternate fair value
method of accounting for stock-based compensation, prescribed by SFAS
37
No. 123 "Accounting for Stock-Based Compensation" (as amended by SFAS No.
148). Under this pro forma method, the fair value of each option grant (net
of estimated unvested forfeitures) was estimated at the date of grant using
an option-pricing model and was recognized over the vesting period, generally
two years. Prior to 2004, the Company used the Black-Scholes option pricing
model. For 2004, the Company converted to a lattice-based or binomial model,
which management believes to be a superior method for valuing the impact of
different employee option exercise patterns under various economic and market
conditions. This change in methodology did not have a significant impact on
pro forma results for 2004. Pricing model assumptions are presented below.
Refer to Note 8 for further information on the Company's stock compensation
programs.
(millions, except per share data) 2004 2003 2002
- --------------------------------- -------- -------- --------
Stock-based compensation expense,
net of tax:
As reported (a) $ 11.4 $ 12.5 $ 10.7
Pro forma $ 41.8 $ 42.1 $ 52.8
Net earnings:
As reported $ 890.6 $ 787.1 $ 720.9
Pro forma $ 860.2 $ 757.5 $ 678.8
Basic net earnings per share:
As reported $ 2.16 $ 1.93 $ 1.77
Pro forma $ 2.09 $ 1.86 $ 1.66
Diluted net earnings per share:
As reported $ 2.14 $ 1.92 $ 1.75
Pro forma $ 2.07 $ 1.85 $ 1.65
Weighted average pricing model
assumptions 2004(a) 2003 2002
- ------------------------------- -------- -------- --------
Risk-free interest rate 2.73% 1.89% 3.58%
Dividend yield 2.60% 2.70% 2.92%
Volatility 23.00% 25.75% 29.71%
Average expected term (years) 3.69 3.00 3.00
Fair value of options granted $ 6.39 $ 4.75 $ 6.67
(a) As reported stock-based compensation expense for 2004 includes a pre-tax
charge of $5.5 ($3.6 after tax) related to the accelerated vesting of .6
stock options pursuant to a separation agreement between the Company and its
former CEO. This modification to the terms of the original awards was treated
as a renewal under FASB Interpretation No. 44 "Accounting for Certain
Transactions involving Stock Compensation." Accordingly, the Company
recognized in SGA the intrinsic value of the awards at the modification date.
The pricing assumptions for this renewal are excluded from the table above
and were: risk-free interest rate-2.32%; dividend yield-2.6%; volatility-23%;
expected term-.33 years, resulting in a per-option fair value of $9.16.
In December 2004, the FASB issued SFAS No. 123(Revised) "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. The standard also provides that any corporate tax
benefit realized upon exercise of an award in excess of that previously
recognized in earnings will be presented in the Statement of Cash Flows as a
financing (rather than an operating) cash flow.
This standard is effective for public companies for interim or annual periods
beginning after June 15, 2005, and may be adopted using either the "modified
prospective" or "modified retrospective" method. If adopted retrospectively,
companies may restate results using the fair value of awards as determined
under original SFAS No. 123 either 1) for all years beginning after December
15, 1994, or 2) from the beginning of the fiscal year that includes the
interim period of adoption. Early adoption is encouraged. The Company plans
to adopt SFAS No. 123(Revised) as of the beginning of its 2005 fiscal third
quarter and is currently considering retrospective restatement to the
beginning of its 2005 fiscal year. Once this standard is adopted, management
believes full-year fiscal 2005 net earnings per share will be reduced by
approximately $.08.
RECENTLY ADOPTED PRONOUNCEMENTS
Exit activities
The Company adopted SFAS No. 146 "Accounting for Costs Associated with Exit
or Disposal Activities," with respect to exit or disposal activities
initiated after December 31, 2002. This statement is intended to achieve
consistency in timing of recognition between exit costs, such as one-time
employee separation benefits and contract termination payments, and all other
costs. Under pre-existing literature, certain costs associated with exit
activities were recognized when management committed to a plan. Under SFAS
No. 146, costs are recognized when a liability has been incurred under
general concepts. Adoption of this standard did not have a significant impact
on the Company's 2003 and 2004 financial results. Refer to Note 3 for further
information on the Company's exit activities during the periods presented.
Leasing
In May 2003, the Emerging Issues Task Force of the FASB reached consensus on
Issue No. 01-8 "Determining Whether an Arrangement Contains a Lease." This
consensus provides criteria for identifying "in-substance" leases of plant,
property, and equipment within supply agreements, service contracts, and
other arrangements not historically accounted for as leases. This guidance is
generally applicable to arrangements entered into or modified in interim
periods beginning after May 28, 2003. The Company has applied this consensus
prospectively beginning in its fiscal third quarter of 2003. Management
believes this guidance could apply to certain future agreements with contract
manufacturers that produce or pack the Company's products, potentially
resulting in capital lease recognition within the balance sheet. However, the
impact of this consensus during 2003 and 2004 was insignificant.
Medicare prescription benefits
In December 2003, the Medicare Prescription Drug Improvement and
Modernization Act of 2003 (the Act) became law. The Act introduces a
prescription drug benefit under Medicare Part D as well as a federal subsidy
(beginning in 2006) to sponsors of retiree health care benefit plans that
provide a benefit that is at least actuarially equivalent to Medicare Part D.
In January 2004, the Company elected, pursuant to FASB Staff Position (FSP)
FAS 106-1, to defer accounting recognition of the effects of the Act until
authoritative FASB guidance was issued.
38
In May 2004, the FASB issued FSP FAS 106-2, which applies to sponsors of
single-employer defined benefit postretirement health care plans that are
impacted by the Act. In general, the FSP concludes that plan sponsors should
follow SFAS No. 106 "Employers' Accounting for Postretirement Benefits Other
Than Pensions," in accounting for the effects of the Act, with benefits
attributable to past service cost accounted for as an actuarial experience
gain. The FSP is generally effective for the first interim period beginning
after June 15, 2004, with earlier application encouraged. For employers such
as Kellogg that elected deferral under FSP FAS 106-1, this guidance may be
adopted retroactively to the date of Act enactment or prospectively from the
date of adoption.
While detailed regulations necessary to implement the Act have only recently
been issued, management believes that certain health care benefit plans
covering a significant portion of the Company's U.S. workforce will qualify
for the Medicare Part D subsidy, resulting in a reduction in the Company's
expense related to providing prescription drug benefits under these plans.
Accordingly, the Company adopted FSP FAS 106-2 as of its 2004 fiscal second
quarter reporting period and has performed a remeasurement of its plan assets
and obligations as of the end of its 2003 fiscal year. The reduction in the
benefit obligation attributable to past service cost was approximately $73
million and the total reduction in benefit cost for full-year 2004 was
approximately $10 million.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
NOTE 2 GOODWILL AND OTHER INTANGIBLE ASSETS
For 2004, the Company recorded in selling, general, and administrative (SGA)
expense impairment losses of $10.4 million to write off the remaining
carrying value of certain intangible assets. As presented in the following
tables, the total amount consisted of $7.9 million attributable to a
long-term licensing agreement in North America and $2.5 million of goodwill
in Latin America.
For 2003, the Company recorded in SGA expense an impairment loss of $10.0
million to reduce the carrying value of a contract-based intangible asset.
The asset is associated with a long-term licensing agreement principally in
North America and the decline in value was based on the proportionate decline
in estimated future cash flows to be derived from the contract versus
original projections.
INTANGIBLE ASSETS SUBJECT TO AMORTIZATION
- -------------------------------------------------------------------------------
(millions) Gross carrying amount Accumulated amortization
- ------------------------ --------------------- ------------------------
2004 2003 2004 2003
- ------------------------ ----- ----- ----- -----
Trademarks $29.5 $29.5 $19.4 $18.3
Other 29.1 29.1 26.7 16.8
----- ----- ----- -----
Total $58.6 $58.6 $46.1 $35.1
===== ===== ===== =====
2004(b) 2003(c)
------- -------
AMORTIZATION EXPENSE (a) $ 11.0 $ 13.0
(a) The currently estimated aggregate amortization expense for each of
the 5 succeeding fiscal years is approximately $1.5 per year.
(b) Amortization for 2004 includes an impairment loss of $7.9.
(c) Amortization for 2003 includes an impairment loss of $10.0.
INTANGIBLE ASSETS NOT SUBJECT TO AMORTIZATION
- ------------------------------------------------------------------
(millions) Total carrying amount
- ---------------------------------------- ------------------------
2004 2003
- ---------------------------------------- --------- ---------
Trademarks $ 1,404.0 $ 1,404.0
Direct store-door (DSD) delivery system 578.9 578.9
Other 25.7 28.0
--------- ---------
Total $ 2,008.6 $ 2,010.9
========= =========
CHANGES IN THE CARRYING AMOUNT OF GOODWILL
- --------------------------------------------------------------------------------
Latin Asia Consoli-
(millions) United States Europe America Pacific(a) dated
- ------------------- ------------- ------ ------- ---------- --------
December 28, 2002 $ 3,103.2 -- $ 2.0 $ 1.4 $3,106.6
Purchase accounting
adjustments (4.2) -- -- -- (4.2)
Dispositions (5.0) -- -- -- (5.0)
Other (.2) -- .5 .7 1.0
------------- ------ ------- ---------- --------
December 27, 2003 $ 3,093.8 -- $ 2.5 $ 2.1 $3,098.4
Purchase accounting (.9) -- -- -- (.9)
adjustments
Impairments -- -- (2.5) -- (2.5)
Other -- -- .1 .1
------------- ------ ------- ---------- --------
JANUARY 1, 2005 $ 3,092.9 -- -- $ 2.2 $3,095.1
============= ====== ======= ========== ========
(a) Includes Australia and Asia.
NOTE 3 COST-REDUCTION INITIATIVES
To position the Company for sustained reliable growth in earnings and cash
flow for the long term, management is undertaking a series of cost-reduction
initiatives. Major initiatives commenced in 2004 were the global rollout of
the SAP information technology system, reorganization of pan-European
operations, consolidation of U.S. meat alternatives manufacturing operations,
and relocation of the Company's U.S. snacks business unit to Battle Creek,
Michigan. Major actions implemented in 2003 included a wholesome snack plant
consolidation in Australia, manufacturing capacity rationalization in the
Mercosur region of Latin America, and a plant workforce reduction in Great
Britain. Additionally, during all periods presented, the Company has
undertaken various manufacturing capacity rationalization and efficiency
initiatives primarily in its North American and European operating segments,
as well as the 2003 disposal of a manufacturing facility in China. Future
initiatives are still in the planning stages and individual actions are being
announced as plans are finalized.
39
COST SUMMARY
To implement all of these programs, the Company has incurred various up-front
costs, including asset write-offs, exit charges, and other project
expenditures.
For 2004, the Company recorded total program-related charges of approximately
$109 million, comprised of $41 million in asset write-offs, $1 million for
special pension termination benefits, $15 million in severance and other exit
costs, and $52 million in other cash expenditures such as relocation and
consulting. Approximately 40% of the 2004 charges were recorded in cost of
goods sold, with the balance recorded in selling, general, and administrative
(SGA) expense. The 2004 charges impacted the Company's operating segments as
follows (in millions): North America-$44, Europe-$65.
For 2003, the Company recorded total program-related charges of approximately
$71 million, comprised of $40 million in asset write-offs, $8 million for
special pension termination benefits, and $23 million in severance and other
cash costs. These charges were recorded principally in cost of goods sold and
impacted the Company's operating segments as follows (in millions): North
America.-$36, Europe-$21, Latin America-$8, Asia Pacific-$6.
For 2002, the Company recorded in cost of goods sold an impairment loss of $5
million related to the Company's manufacturing facility in China,
representing a decline in real estate market value subsequent to an original
impairment loss recognized for this property in 1997. The Company completed a
sale of this facility in late 2003, and the carrying value of the property
approximated the net sales proceeds.
At year-end 2003, the exit cost reserve balance totaled approximately $19
million. These reserves were principally comprised of severance obligations
recorded in 2003, which were paid out during the first half of 2004. At
year-end 2004, the exit cost reserve balance totaled approximately $11
million, representing severance costs to be paid out in 2005.
2004 INITIATIVES
During 2004, the Company's global rollout of its SAP information technology
system resulted in accelerated depreciation of legacy software assets to be
abandoned in 2005, as well as related consulting and other implementation
expenses. Total incremental costs for 2004 were approximately $30 million. In
close association with this SAP rollout, management undertook a major
initiative to improve the organizational design and effectiveness of
pan-European operations. Specific benefits of this initiative are expected to
include improved marketing and promotional coordination across Europe, supply
chain network savings, overhead cost reductions, and tax savings. To achieve
these benefits, management implemented, at the beginning of 2005, a new
European legal and operating structure headquartered in Ireland, with
strengthened pan-European management authority and coordination. During 2004,
the Company incurred various up-front costs, including relocation, severance,
and consulting, of approximately $30 million. Additional relocation and other
costs to complete this business transformation during the next several years
are expected to be insignificant.
To improve operations and provide for future growth, during 2004, the Company
substantially completed its plan to close its meat alternatives manufacturing
facility in Worthington, Ohio. The plan included the out-sourcing of certain
operations and consolidation of remaining production at the Zanesville, Ohio
facility by early 2005. The Worthington facility originally employed
approximately 300 employees, of which approximately 250 have separated from
the Company as a result of the plant closure. Total asset write-offs,
severance, and other up-front costs of the project are expected to be
approximately $30 million, of which approximately $20 million was recognized
during 2004. Management expects to complete a sale of the Worthington
facility in 2005.
In order to integrate it with the rest of our U.S. operations, during 2004,
the Company completed the relocation of its U.S. snacks business unit from
Elmhurst, Illinois (the former headquarters of Keebler Foods Company) to
Battle Creek, Michigan. About one-third of the approximately 300 employees
affected by this initiative accepted relocation/reassignment offers. The
recruiting effort to fill the remaining open positions was substantially
completed by year-end 2004. Attributable to this initiative, the Company
incurred approximately $15 million in relocation, recruiting, and severance
costs during 2004. Subject to achieving certain employment levels and other
regulatory requirements, management expects to defray a significant portion
of these up-front costs through various multi-year tax incentives, beginning
in 2005. The Elmhurst office building was sold in late 2004, and the net
sales proceeds approximated carrying value.
2003 INITIATIVES
During 2003, the Company implemented a wholesome snack plant consolidation in
Australia, which involved the exit of a leased facility and separation of
approximately 140 employees. The Company incurred approximately $6 million in
exit costs and asset write-offs during 2003 related to this initiative.
The Company also undertook a manufacturing capacity rationalization in the
Mercosur region of Latin America, which involved the closure of an owned
facility in Argentina and separation of approximately 85 plant and
administrative employees during 2003. The Company recorded an impairment loss
of approximately $6 million to reduce the carrying value of the manufacturing
facility to estimated fair value, and incurred approximately $2 million of
severance and closure costs during 2003 to complete this initiative. In 2004,
the Company began importing its products for sale in Argentina from other
Latin America facilities.
In Great Britain, management initiated changes in plant crewing to better
match the work pattern to the demand cycle, which resulted in voluntary
workforce reductions of approximately 130 hourly and
40
salaried employee positions. During 2003, the Company incurred approximately
$18 million in separation benefit costs related to this initiative.
NOTE 4 OTHER INCOME (EXPENSE), NET
Other income (expense), net includes non-operating items such as interest
income, foreign exchange gains and losses, charitable donations, and gains on
asset sales. Other income (expense), net for 2004 includes charges of
approximately $9 million for contributions to the Kellogg's Corporate
Citizenship Fund, a private trust established for charitable giving. Other
income (expense), net for 2003 includes credits of approximately $17 million
related to favorable legal settlements, a charge of $8 million for a
contribution to the Kellogg's Corporate Citizenship Fund, and a charge of
$6.5 million to recognize the impairment of a cost-basis investment in an
e-commerce business venture. Other income (expense), net for 2002 consists
primarily of $24.7 million in credits related to legal settlements.
NOTE 5 EQUITY
EARNINGS PER SHARE
Basic net earnings per share is determined by dividing net earnings by the
weighted average number of common shares outstanding during the period.
Diluted net earnings per share is similarly determined, except that the
denominator is increased to include the number of additional common shares
that would have been outstanding if all dilutive potential common shares had
been issued. Dilutive potential common shares are comprised principally of
employee stock options issued by the Company. Basic net earnings per share is
reconciled to diluted net earnings per share as follows:
Average
shares
Net out
(millions, except per share data) earnings standing Per share
- ---------------------------------- -------- -------- ---------
2004
Basic $ 890.6 412.0 $ 2.16
Dilutive potential common shares -- 4.4 (.02)
-------- -------- --------
Diluted $ 890.6 416.4 $ 2.14
======== ======== ========
2003
Basic $ 787.1 407.9 $ 1.93
Dilutive potential common shares -- 2.6 (.01)
-------- -------- --------
Diluted $ 787.1 410.5 $ 1.92
======== ======== ========
2002
Basic $ 720.9 408.4 $ 1.77
Dilutive potential common shares -- 3.1 (.02)
-------- -------- --------
Diluted $ 720.9 411.5 $ 1.75
======== ======== ========
COMPREHENSIVE INCOME
Comprehensive income includes all changes in equity during a period except
those resulting from investments by or distributions to shareholders.
Comprehensive income for the periods presented consists of net earnings,
minimum pension liability adjustments (refer to Note 9), unrealized gains and
losses on cash flow hedges pursuant to SFAS No. 133 "Accounting for
Derivative Instruments and Hedging Activities," and foreign currency
translation adjustments pursuant to SFAS No. 52 "Foreign Currency
Translation" as follows:
Tax
Pretax (expense) After-tax
(millions) amount benefit amount
- ------------------------------- -------- --------- ---------
2004
Net earnings $ 890.6
Other comprehensive income:
Foreign currency translation
adjustments $ 71.7 $ -- 71.7
Cash flow hedges:
Unrealized gain (loss) on
cash flow hedges (10.2) 3.1 (7.1)
Reclassification to net
earnings 19.3 (6.9) 12.4
Minimum pension liability
adjustments 308.9 (96.6) 212.3
-------- --------- ---------
$ 389.7 ($ 100.4) 289.3
-------- --------- ---------
Total comprehensive income $ 1,179.9
=========
2003
Net earnings $ 787.1
Other comprehensive income:
Foreign currency translation
adjustments $ 81.6 $ -- 81.6
Cash flow hedges:
Unrealized gain (loss) on
cash flow hedges (18.7) 6.6 (12.1)
Reclassification to net
earnings 10.3 (3.8) 6.5
Minimum pension liability
adjustments 75.7 (27.5) 48.2
-------- --------- ---------
$ 148.9 ($ 24.7) 124.2
-------- --------- ---------
Total comprehensive income $ 911.3
=========
2002
Net earnings $ 720.9
Other comprehensive income:
Foreign currency translation
adjustments $ 1.6 $ -- 1.6
Cash flow hedges:
Unrealized gain (loss) on
cash flow hedges (2.9) 1.3 (1.6)
Reclassification to net
earnings 6.9 (2.7) 4.2
Minimum pension liability
adjustments (453.5) 147.3 (306.2)
-------- --------- ---------
($ 447.9) $ 145.9 (302.0)
-------- --------- ---------
Total comprehensive income $ 418.9
=========
Accumulated other comprehensive income (loss) at year end consisted of the
following:
(millions) 2004 2003
- --------------------------------------------------- ------- -------
Foreign currency translation adjustments ($334.3) ($406.0)
Cash flow hedges - unrealized net loss (46.6) (51.9)
Minimum pension liability adjustments (59.0) (271.3)
------- -------
Total accumulated other comprehensive income (loss) ($439.9) ($729.2)
======= =======
NOTE 6 LEASES AND OTHER COMMITMENTS
The Company's leases are generally for equipment and warehouse space. Rent
expense on all operating leases was $87.3 million in 2004, $80.5 million in
2003, and $89.5 million in 2002. Additionally, the Company is subject to
residual value guarantees and secondary liabilities on operating leases
totaling approximately $14 million, for which liabilities of $1.1 million had
been recorded at January 1, 2005.
41
At January 1, 2005, future minimum annual lease commitments under
noncancelable capital and operating leases were as follows:
Operating Capital
(millions) leases leases
- -------------------------------- --------- -------
2005 $ 87.2 $ 1.3
2006 72.5 1.2
2007 57.0 .7
2008 44.9 -
2009 76.7 -
2010 and beyond 65.9 -
--------- -------
Total minimum payments $ 404.2 $ 3.2
Amount representing interest (.3)
--------- -------
Obligations under capital leases 2.9
Obligations due within one year (1.3)
-------
Long-term obligations under
capital leases $ 1.6
-------
One of the Company's subsidiaries is guarantor on loans to independent
contractors for the purchase of DSD route franchises. At year-end 2004, there
were total loans outstanding of $16.1 million to 559 franchisees. All loans
are variable rate with a term of 10 years. Related to this arrangement, the
Company has established with a financial institution a one-year renewable
loan facility up to $17.0 million with a five-year term-out and servicing
arrangement. The Company has the right to revoke and resell the route
franchises in the event of default or any other breach of contract by
franchisees. Revocations are infrequent. The Company's maximum potential
future payments under these guarantees are limited to the outstanding loan
principal balance plus unpaid interest. The fair value of these guarantees is
recorded in the Consolidated Balance Sheet and is currently estimated to be
insignificant.
The Company has provided various standard indemnifications in agreements to
sell business assets and lease facilities over the past several years,
related primarily to pre-existing tax, environmental, and employee benefit
obligations. Certain of these indemnifications are limited by agreement in
either amount and/or term and others are unlimited. The Company has also
provided various "hold harmless" provisions within certain service type
agreements. Because the Company is not currently aware of any actual
exposures associated with these indemnifications, management is unable to
estimate the maximum potential future payments to be made. At January 1,
2005, the Company had not recorded any liability related to these
indemnifications.
NOTE 7 DEBT
Notes payable at year end consisted of commercial paper borrowings in the
United States and to a lesser extent, bank loans and commercial paper of
foreign subsidiaries at competitive market rates, as follows:
(dollars in millions) 2004 2003
- ----------------------------- ---------------------- ---------------------
EFFECTIVE Effective
PRINCIPAL INTEREST Principal interest
AMOUNT RATE amount rate
--------- --------- --------- ---------
U.S. commercial paper $ 690.2 2.5% $ 296.0 1.2%
Canadian commercial paper 12.1 2.7% 15.3 3.0%
Other 7.4 9.5
--------- ---------
$ 709.7 $ 320.8
========= =========
Long-term debt at year end consisted primarily of fixed rate issuances of
U.S. Dollar Notes, as follows:
(millions) 2004 2003
- -------------------------------- -------- --------
(a) 4.875% U.S. Dollar Notes due
2005 $ 199.8 $ 200.0
(b) 6.625% Euro Dollar Notes due
2004 - 500.0
(c) 6.0% U.S. Dollar Notes due
2006 722.2 824.2
(c) 6.6% U.S. Dollar Notes due
2011 1,494.5 1,493.6
(c) 7.45% U.S. Dollar Debentures
due 2031 1,086.8 1,086.3
(d) 4.49% U.S. Dollar Notes due
2006 150.0 225.0
(e) 2.875% U.S. Dollar Notes due
2008 499.9 499.9
Other 18.0 14.5
-------- --------
4,171.2 4,843.5
Less current maturities (278.6) (578.1)
-------- --------
Balance at year end $3,892.6 $4,265.4
======== ========
(a) In October 1998, the Company issued $200 of seven-year 4.875% fixed rate
U.S. Dollar Notes to replace maturing long-term debt. In conjunction with
this issuance, the Company settled $200 notional amount of interest rate
forward swap agreements, which, when combined with original issue discount,
effectively fixed the interest rate on the debt at 6.07%.
(b) In January 1997, the Company issued $500 of seven-year 6.625% fixed rate
Euro Dollar Notes. In conjunction with this issuance, the Company settled
$500 notional amount of interest rate forward swap agreements, which
effectively fixed the interest rate on the debt at 6.354%. These Notes were
repaid in January 2004.
(c) In March 2001, the Company issued $4,600 of long-term debt instruments,
primarily to finance the acquisition of Keebler Foods Company. The table
above reflects the remaining principal amounts outstanding as of year-end
2004 and 2003. The effective interest rates on these Notes, reflecting
issuance discount and swap settlement, are as follows: due 2006-6.39%; due
2011-7.08%; due 2031-7.62%. Initially, these instruments were privately
placed, or sold outside the United States, in reliance on exemptions from
registration under the Securities Act of 1933, as amended (the "1933 Act").
The Company then exchanged new debt securities for these initial debt
instruments, with the new debt securities being substantially identical in
all respects to the initial debt instruments, except for being registered
under the 1933 Act. These debt securities contain standard events of default
and covenants. The Notes due 2006 and 2011, and the Debentures due 2031 may
be redeemed in whole or part by the Company at any time at prices determined
under a formula (but not less than 100% of the principal amount plus unpaid
interest to the redemption date). In December 2004, the Company redeemed
$103.7 of the Notes due 2006. In December 2003, the Company redeemed $172.9
of the Notes due 2006.
(d) In November 2001, a subsidiary of the Company issued $375 of five-year
4.49% fixed rate U.S. Dollar Notes to replace other maturing debt. These
Notes are guaranteed by the Company and mature $75 per year over the
five-year term. These Notes, which were privately placed, contain standard
warranties, events of default, and covenants. They also require the
maintenance of a specified consolidated interest expense coverage ratio, and
limit capital lease obligations and subsidiary debt. In conjunction with this
issuance, the subsidiary of the Company entered into a $375 notional US$/
Pound Sterling currency swap, which effectively converted this debt into a
5.302% fixed rate Pound Sterling obligation for the duration of the five-year
term.
(e) In June 2003, the Company issued $500 of five-year 2.875% fixed rate U.S.
Dollar Notes, using the proceeds from these Notes to replace maturing
long-term debt. These Notes were issued under an existing shelf registration
statement. In conjunction with this issuance, the Company settled $250
notional amount of forward interest rate contracts for a loss of $11.8, which
is being amortized to interest expense over the term of the debt. Taking into
account this amortization and issuance discount, the effective interest rate
on these five-year Notes is 3.35%.
At January 1, 2005, the Company had $2.1 billion of short-term lines of
credit, virtually all of which were unused and available for borrowing on an
unsecured basis. These lines were comprised principally of an unsecured
Five-Year Credit Agreement, expiring November 2009. The agreement allows the
Company to borrow, on a revolving credit basis, up to $2.0 billion, to obtain
letters of credit in an aggregate amount up to $75 million, and to provide a
procedure for the lenders to bid on short-term debt of the Company. This
Credit Agreement replaced a $1.15 billion five-year agreement expiring in
January 2006 and a $650 million 364-day agreement expiring in January 2005.
The new Credit Agreement
42
contains customary covenants and warranties, including specified restrictions
on indebtedness, liens, sale and leaseback transactions, and a specified
interest expense coverage ratio. If an event of default occurs, then, to the
extent permitted, the administrative agent may terminate the commitments
under the new credit facility, accelerate any outstanding loans, and demand
the deposit of cash collateral equal to the lender's letter of credit
exposure plus interest.
Scheduled principal repayments on long-term debt are (in millions):
2005-$278.6; 2006-$807.8; 2007-$2.0; 2008-$501.3; 2009-$1.4; 2010 and
beyond-$2,600.3.
Interest paid was (in millions): 2004-$333; 2003-$372; 2002-$386. Interest
expense capitalized as part of the construction cost of fixed assets was (in
millions): 2004-$.9; 2003-$0; 2002-$1.0.
NOTE 8 STOCK COMPENSATION
The Company uses various equity-based compensation programs to provide
long-term performance incentives for its global workforce. Currently, these
incentives are administered through several plans, as described below.
The 2003 Long-Term Incentive Plan ("2003 Plan"), approved by shareholders in
2003, permits benefits to be awarded to employees and officers in the form of
incentive and non-qualified stock options, performance shares or performance
share units, restricted stock or restricted stock units, and stock
appreciation rights. The 2003 Plan authorizes the issuance of a total of (a)
25 million shares plus (b) shares not issued under the 2001 Long-Term
Incentive Plan (the "2001 Plan"), with no more than 5 million shares to be
issued in satisfaction of performance units, performance-based restricted
shares and other awards (excluding stock options and stock appreciation
rights), and with additional annual limitations on awards or payments to
individual participants. Options granted under the 2003 Plan and 2001 Plan
generally vest over two years, subject to earlier vesting if a change of
control occurs. Restricted stock and performance share grants under the 2003
Plan and the 2001 Plan generally vest in three years, subject to earlier
vesting and payment if a change in control occurs.
The Non-Employee Director Stock Plan ("Director Plan") was approved by
shareholders in 2000 and allows each eligible non-employee director to
receive 1,700 shares of the Company's common stock annually and annual grants
of options to purchase 5,000 shares of the Company's common stock. Shares
other than options are placed in the Kellogg Company Grantor Trust for
Non-Employee Directors (the "Grantor Trust"). Under the terms of the Grantor
Trust, shares are available to a director only upon termination of service on
the Board. Under this plan, awards were as follows: 2004-55,000 options and
18,700 shares; 2003-55,000 options and 18,700 shares; 2002-50,850 options and
18,700 shares.
Options under all plans described above are granted with exercise prices
equal to the fair market value of the Company's common stock at the time of
the grant and have a term of no more than ten years, if they are incentive
stock options, or no more than ten years and one day, if they are
non-qualified stock options. These plans permit stock option grants to
contain an accelerated ownership feature ("AOF"). An AOF option is generally
granted when Company stock is used to pay the exercise price of a stock
option or any taxes owed. The holder of the option is generally granted an
AOF option for the number of shares so used with the exercise price equal to
the then fair market value of the Company's stock. For all AOF options, the
original expiration date is not changed but the options vest immediately.
Subsequent to 2003, the terms of options granted to employees and directors
have not contained an AOF feature.
In addition to employee stock option grants presented in the tables on page
44, under its long-term incentive plans, the Company made restricted stock
grants to eligible employees as follows (approximate number of shares):
2004-140,000; 2003- 209,000; 2002-132,000. Additionally, performance units
were awarded to a limited number of senior executive-level employees for the
achievement of cumulative three-year performance targets as follows: awarded
in 2001 for cash flow targets ending in 2003; awarded in 2002 for sales
growth targets ending in 2004; awarded in 2003 for gross margin targets
ending in 2005. If the performance targets are met, the award of units
represents the right to receive shares of common stock (or a combination of
shares and cash) equal to the dollar award valued on the vesting date. No
awards are earned unless a minimum threshold is attained. The 2001 award was
earned at 200% of target and vested in February 2004 for a total dollar
equivalent of $15.5 million. The 2002 award was earned at 200% of target and
vested in February 2005 for a total dollar equivalent of $6.8 million. The
maximum future dollar award that could be attained under the 2003 award is
approximately $8 million.
The 2002 Employee Stock Purchase Plan was approved by shareholders in 2002
and permits eligible employees to purchase Company stock at a discounted
price. This plan allows for a maximum of 2.5 million shares of Company stock
to be issued at a purchase price equal to the lesser of 85% of the fair
market value of the stock on the first or last day of the quarterly purchase
period. Total purchases through this plan for any employee are limited to a
fair market value of $25,000 during any calendar year. Shares were purchased
by employees under this plan as follows (approximate number of shares): 2004
- 214,000; 2003-248,000; 2002-119,000. Additionally, during 2002, a foreign
subsidiary of the Company established a stock purchase plan for its
employees. Subject to limitations, employee contributions to this plan are
matched 1:1 by the Company. Under this plan, shares were granted by the
Company to match an approximately equal number of shares purchased by
employees as follows (approximate number of shares): 2004-82,000;
2003-94,000; 2002-82,000.
43
The Executive Stock Purchase Plan was established in 2002 to encourage and
enable certain eligible employees of the Company to acquire Company stock,
and to align more closely the interests of those individuals and the
Company's shareholders. This plan allows for a maximum of 500,000 shares of
Company stock to be issued. Under this plan, shares were granted by the
Company to executives in lieu of cash bonuses as follows (approximate number
of shares): 2004-8,000; 2003-11,000; 2002-14,000.
Transactions under these plans are presented in the tables below. Refer to
Note 1 for information on the Company's method of accounting for these plans.
(millions) 2004 2003 2002
- ------------------------------------- ------ ------ ------
NUMBER OF OPTIONS:
Under option, beginning of year 37.0 38.2 37.0
Granted 9.7 7.5 9.2
Exercised (12.9) (6.0) (5.2)
Cancelled (1.3) (2.7) (2.8)
------ ------ ------
Under option, end of year 32.5 37.0 38.2
------ ------ ------
Exercisable, end of year 22.8 24.4 20.1
====== ====== ======
AVERAGE PRICES PER SHARE:
Under option, beginning of year $ 33 $ 33 $ 31
Granted 40 31 33
Exercised 32 28 27
Cancelled 41 35 32
------ ------ ------
Under option, end of year $ 35 $ 33 $ 33
------ ------ ------
Exercisable, end of year $ 35 $ 34 $ 34
====== ====== ======
SHARES AVAILABLE, END OF YEAR,
FOR STOCK-BASED AWARDS THAT
MAY BE GRANTED UNDER THE FOLLOWING
PLANS:
Kellogg Employee Stock Ownership Plan 1.4 1.3 .6
2000 Non-Employee Director Stock Plan .5 .6 .6
2001 Long-Term Incentive Plan - - 10.1
2002 Employee Stock Purchase Plan 1.9 2.1 2.4
Executive Stock Purchase Plan .5 .5 .5
2003 Long-Term Incentive Plan (a) 24.7 30.5 -
------ ------ ------
Total 29.0 35.0 14.2
====== ====== ======
(a) Refer to description of 2003 Plan within this note for restrictions on
availability.
Employee stock options outstanding and exercisable under these plans as of
January 1,2005,were:
(millions, except per share data)
Outstanding Exercisable
--------------------------------- ------------------
Weighted
average
Weighted remaining Weighted
Range of Number average contractual Number average
exercise of exercise life of exercise
prices options price (yrs.) options price
- -------- ------- -------- ----------- ------- --------
$24 - 30 9.7 $ 28 6.4 6.6 $ 27
31 - 35 8.5 34 6.0 8.5 34
36 - 39 8.6 39 7.7 2.1 38
39 - 51 5.7 44 3.8 5.6 44
------- -------- ----------- --- --------
32.5 22.8
======= =======
NOTE 9 PENSION BENEFITS
The Company sponsors a number of U.S. and foreign pension plans to provide
retirement benefits for its employees. The majority of these plans are funded
or unfunded defined benefit plans, although the Company does participate in a
few multiemployer or other defined contribution plans for certain employee
groups. Defined benefits for salaried employees are generally based on salary
and years of service, while union employee benefits are generally a
negotiated amount for each year of service. The Company uses its fiscal year
end as the measurement date for the majority of its plans.
OBLIGATIONS AND FUNDED STATUS
The aggregate change in projected benefit obligation, change in plan assets,
and funded status were:
(millions) 2004 2003
- -------------------------------------- ----------- ----------
CHANGE IN PROJECTED BENEFIT OBLIGATION
Projected benefit obligation at
beginning of year $ 2,640.9 $ 2,261.4
Service cost 76.0 67.5
Interest cost 157.3 151.1
Plan participants' contributions 2.8 1.7
Amendments 23.0 8.1
Actuarial loss 144.2 195.8
Benefits paid (155.0) (134.9)
Foreign currency adjustments 68.8 82.7
Curtailment and special termination
benefits 8.7 7.2
Other 6.2 .3
----------- ----------
Projected benefit obligation at end
of year $ 2,972.9 $ 2,640.9
=========== ==========
CHANGE IN PLAN ASSETS
Fair value of plan assets at
beginning of year $ 2,319.2 $ 1,849.5
Actual return on plan assets 319.1 456.9
Employer contributions 139.6 82.4
Plan participants' contributions 2.8 1.7
Benefits paid (149.3) (132.3)
Foreign currency adjustments 53.0 61.0
Other 1.5 -
----------- ----------
Fair value of plan assets at end of
year $ 2,685.9 $ 2,319.2
=========== ==========
FUNDED STATUS ($ 287.0) ($ 321.7)
Unrecognized net loss 868.4 822.3
Unrecognized transition amount 2.4 2.4
Unrecognized prior service cost 70.0 54.4
----------- ----------
Prepaid pension $ 653.8 $ 557.4
=========== ==========
AMOUNTS RECOGNIZED IN THE CONSOLIDATED
BALANCE SHEET CONSIST OF
Prepaid benefit cost $ 730.9 $ 388.1
Accrued benefit liability (190.5) (256.3)
Intangible asset 24.7 28.0
Minimum pension liability 88.7 397.6
----------- ----------
Net amount recognized $ 653.8 $ 557.4
=========== ==========
The accumulated benefit obligation for all defined benefit pension plans was
$2.70 billion and $2.41 billion at January 1, 2005 and December 27, 2003,
respectively. Information for pension plans with accumulated benefit
obligations in excess of plan assets were:
(millions) 2004 2003
- ------------------------------ --------- ---------
Projected benefit obligation $ 411.2 $ 1,590.4
Accumulated benefit obligation 350.2 1,394.6
Fair value of plan assets 160.5 1,220.0
44
The significant reduction in under-funded plans for 2004 relates to increased
funding and favorable performance of trust assets during 2004, leading to a
reduction in the minimum pension liability at January 1, 2005. At January 1,
2005, a cumulative after-tax charge of $59.0 million ($88.7 million pretax)
has been recorded in other comprehensive income to recognize the additional
minimum pension liability in excess of unrecognized prior service cost. Refer
to Note 5 for further information on the changes in minimum liability
included in other comprehensive income for each of the periods presented.
EXPENSE
The components of pension expense were:
(millions) 2004 2003 2002
- ------------------------------ ---------- ---------- ----------
Service cost $ 76.0 $ 67.5 $ 57.0
Interest cost 157.3 151.1 140.7
Expected return on plan assets (238.1) (224.3) (217.5)
Amortization of unrecognized
transition obligation .2 .1 .3
Amortization of unrecognized
prior service cost 8.2 7.3 6.9
Recognized net loss 54.1 28.6 11.5
Curtailment and special
termination benefits -
net loss 12.2 8.1 --
---------- ---------- ----------
Pension expense (income) -
Company plans 69.9 38.4 (1.1)
Pension expense - defined
contribution plans 3.8 3.2 2.9
---------- ---------- ----------
Total pension expense $ 73.7 $ 41.6 $ 1.8
========== ========== ==========
Certain of the Company's subsidiaries sponsor 401(k) or similar savings plans
for active employees. Expense related to these plans was (in millions):
2004-$26; 2003-$26; 2002-$26. Company contributions to these savings plans
approximate annual expense. Company contributions to multiemployer and other
defined contribution pension plans approximate the amount of annual expense
presented in the table above.
All gains and losses, other than those related to curtailment or special
termination benefits, are recognized over the average remaining service
period of active plan participants. Net losses from special termination
benefits and curtailment recognized in 2004 are related primarily to special
termination benefits granted to the Company's former CEO and other former
executive officers pursuant to separation agreements, and to a lesser extent,
liquidation of the Company's pension fund in South Africa and continuing
plant workforce reductions in Great Britain. Net losses from special
termination benefits recognized in 2003 are related primarily to a plant
workforce reduction in Great Britain. Refer to Note 3 for further information
on this initiative.
ASSUMPTIONS
The worldwide weighted average actuarial assumptions used to determine
benefit obligations were:
2004 2003 2002
---- ---- ----
Discount rate 5.7% 5.9% 6.6%
Long-term rate of compensation
increase 4.3% 4.3% 4.7%
==== ==== ====
The worldwide weighted average actuarial assumptions used to determine annual
net periodic benefit cost were:
2004 2003 2002
---- ---- ----
Discount rate 5.9% 6.6% 7.0%
Long-term rate of compensation
increase 4.3% 4.7% 4.7%
Long-term rate of return on
plan assets 9.3% 9.3% 10.5%
==== ==== ====
To determine the overall expected long-term rate of return on plan assets,
the Company works with third party financial consultants to model expected
returns over a 20-year investment horizon with respect to the specific
investment mix of its 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. The U.S. model, which corresponds to approximately 70%
of consolidated trust assets, incorporates a long-term inflation assumption
of 2.7% and an active management premium of 1% (net of fees) validated by
historical analysis. Similar methods are used for various foreign plans with
invested assets, reflecting local economic conditions. Although management
reviews the Company's expected long-term rates of return annually, the
benefit trust investment performance for one particular year does not, by
itself, significantly influence this evaluation. The 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 the Company's modeling process.
The expected rate of return for 2004 of 9.3% equated to approximately the
50th percentile expectation. Any future variance between the expected and
actual rates of return on plan assets is recognized in the calculated value
of plan assets over a five-year period and once recognized, experience gains
and losses are amortized using a declining-balance method over the average
remaining service period of active plan participants.
PLAN ASSETS
The Company's year-end pension plan weighted-average asset allocations by
asset category were:
2004 2003
---- ----
Equity securities 76% 75%
Debt securities 23% 24%
Other 1% 1%
---- ----
Total 100% 100%
==== ====
The Company's investment strategy for its major defined benefit plans is to
maintain a diversified portfolio of asset classes with the primary goal of
meeting long-term cash requirements as they become due. Assets are invested
in a prudent manner to maintain the security of funds while maximizing
returns within the Company's guidelines. The current weighted-average target
asset allocation reflected by this strategy is: equity securities-74%; debt
securities- 24%; other-2%. Investment in Company common stock represented
less than 2% of consolidated plan assets at January 1, 2005 and December 27,
2003. Plan funding strategies are influenced by tax regulations. The Company
currently expects to contribute approximately $26 million to its defined
benefit pension plans during 2005
45
BENEFIT PAYMENTS
The following benefit payments, which reflect expected future service, as
appropriate, are expected to be paid:
(millions)
- ---------
EXPECTED BENEFIT PAYMENTS BY YEAR:
2005 $ 138.3
2006 148.3
2007 151.7
2008 155.4
2009 158.9
2010-2014 879.9
=======
NOTE 10 NONPENSION POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS
POSTRETIREMENT
The Company sponsors a number of plans to provide health care and other
welfare benefits to retired employees in the United States and Canada, who
have met certain age and service requirements. The majority of these plans
are funded or unfunded defined benefit plans, although the Company does
participate in a few multiemployer or other defined contribution plans for
certain employee groups. The Company contributes to voluntary employee
benefit association (VEBA) trusts to fund certain U.S. retiree health and
welfare benefit obligations. The Company uses its fiscal year end as the
measurement date for these plans.
OBLIGATIONS AND FUNDED STATUS
The aggregate change in accumulated postretirement benefit obligation, change
in plan assets, and funded status were:
(millions) 2004 2003
- --------- ---------- ----------
CHANGE IN ACCUMULATED BENEFIT OBLIGATION
Accumulated benefit obligation at
beginning of year $ 1,006.6 $ 908.6
Service cost 12.1 12.5
Interest cost 55.6 60.4
Actuarial loss 24.3 78.4
Amendments -- (5.9)
Benefits paid (53.9) (51.4)
Foreign currency adjustments 2.0 3.4
Other -- .6
---------- ----------
Accumulated benefit obligation at end
of year $ 1,046.7 $ 1,006.6
---------- ----------
CHANGE IN PLAN ASSETS
Fair value of plan assets at beginning
of year $ 402.2 $ 280.4
Actual return on plan assets 54.4 69.6
Employer contributions 64.4 101.8
Benefits paid (52.6) (50.1)
Other -- .5
---------- ----------
Fair value of plan assets at end of year $ 468.4 $ 402.2
---------- ----------
FUNDED STATUS ($ 578.3) ($ 604.4)
Unrecognized net loss 291.2 295.6
Unrecognized prior service cost (29.2) (32.0)
---------- ----------
Accrued postretirement benefit cost
recognized as a liability ($ 316.3) ($ 340.8)
========== ==========
EXPENSE
Components of postretirement benefit expense were:
(millions) 2004 2003 2002
- ---------- ------ ------ ------
Service cost $ 12.1 $ 12.5 $ 11.9
Interest cost 55.6 60.4 60.3
Expected return on plan assets (39.8) (32.8) (26.8)
Amortization of unrecognized
prior service cost (2.9) (2.5) (2.3)
Recognized net losses 14.8 12.3 9.2
Curtailment and special
termination
benefits - net gain -- -- (16.9)
------ ------ ------
Postretirement benefit expense $ 39.8 $ 49.9 $ 35.4
====== ====== ======
All gains and losses, other than those related to curtailment or special
termination benefits, are recognized over the average remaining service
period of active plan participants. During 2002, the Company recognized a
$16.9 million curtailment gain related to a change in certain retiree health
care benefits from employer-provided defined benefit plans to multiemployer
defined contribution plans.
ASSUMPTIONS
The weighted average actuarial assumptions used to determine benefit
obligations were:
2004 2003 2002
---- ---- ----
Discount rate 5.8% 6.0% 6.9%
The weighted average actuarial assumptions used to determine annual net
periodic benefit cost were:
2004 2003 2002
---- ---- ----
Discount rate 6.0% 6.9% 7.3%
Long-term rate of return on
plan assets 9.3% 9.3% 10.5%
The Company determines the overall expected long-term rate of return on VEBA
trust assets in the same manner as that described for pension trusts in Note
9.
The assumed health care cost trend rate is 8.5% for 2005, decreasing
gradually to 4.5% by the year 2009 and remaining at that level thereafter.
These trend rates reflect the Company's recent historical experience and
management's expectation that future rates will decline. A one percentage
point change in assumed health care cost trend rates would have the following
effects:
One Percentage One Percentage
(millions) Point Increase Point Decrease
- ---------- -------------- --------------
Effect on total of service and
interest cost components $ 8.3 ($7.1)
Effect on postretirement benefit
obligation $122.8 ($103.9)
In December 2003, the Medicare Prescription Drug Improvement and
Modernization Act of 2003 (the Act) became law. The Act introduces a
prescription drug benefit under Medicare Part D as well as a federal subsidy
to sponsors of retiree health care benefit plans that provide a benefit that
is at least actuarially equivalent to Medicare Part D. While detailed
regulations necessary to implement the Act have only recently been issued,
management believes that certain health care benefit plans covering a
significant portion of the Company's U.S. workforce will qualify for the
46
Medicare Part D subsidy, resulting in a reduction in the Company's expense
related to providing prescription drug benefits under these plans. Upon
remeasurement at year-end 2003, the reduction in the benefit obligation
attributable to past service cost was approximately $73 million and the total
reduction in benefit cost for full-year 2004 was approximately $10 million.
Refer to Note 1 for further information.
PLAN ASSETS
The Company's year-end VEBA trust weighted-average asset allocations by asset
category were:
2004 2003
---- ----
Equity securities 77% 66%
Debt securities 23% 21%
Other -- 13%
--- ---
Total 100% 100%
=== ===
The Company's asset investment strategy for its VEBA trusts is consistent
with that described for its pension trusts in Note 9. The current target
asset allocation is 74% equity securities, 25% debt securities and 1% other.
Actual asset allocations at year-end 2003 differ significantly from the
target due to late-year cash contributions not yet invested. The Company
currently expects to contribute approximately $63 million to its VEBA trusts
during 2005.
POSTEMPLOYMENT
Under certain conditions, the Company provides benefits to former or inactive
employees in the United States and several foreign locations, including
salary continuance, severance, and long-term disability. The Company
recognizes an obligation for any of these benefits that vest or accumulate
with service. Postemployment benefits that do not vest or accumulate with
service (such as severance based solely on annual pay rather than years of
service) or costs arising from actions that offer benefits to employees in
excess of those specified in the respective plans are charged to expense when
incurred. The Company's postemployment benefit plans are unfunded. Actuarial
assumptions used are consistent with those presented for postretirement
benefits on page 46. The aggregate change in accumulated postemployment
benefit obligation and the net amount recognized were:
(millions) 2004 2003
- ---------- ---- ----
CHANGE IN ACCUMULATED BENEFIT OBLIGATION
Accumulated benefit obligation at beginning of year $35.0 $27.1
Service cost 3.5 3.0
Interest cost 1.9 2.0
Actuarial loss 7.8 11.3
Benefits paid (10.8) (9.2)
Foreign currency adjustmensts .5 .8
----- -----
Accumulated benefit obligation at end of year $37.9 $35.0
----- -----
FUNDED STATUS ($37.9) ($35.0)
Unrecognized net loss 15.1 11.8
----- -----
Accrued postemployment benefit cost
recognized as a liability ($22.8) ($23.2)
====== ======
Components of postemployment benefit expense were:
(millions) 2004 2003 2002
- ---------- ---- ---- ----
Service cost $3.5 $3.0 $2.0
Interest cost 1.9 2.0 1.7
Recognized net losses 4.5 3.0 1.4
---- ---- ----
Postemployment benefit
expense $9.9 $8.0 $5.1
==== ==== ====
BENEFIT PAYMENTS
The following benefit payments, which reflect expected future service, as
appropriate, are expected to be paid:
(millions) Postretirement Postemployment
- ---------- -------------- --------------
EXPECTED BENEFIT PAYMENTS BY YEAR:
2005 $58.8 $7.5
2006 59.1 7.0
2007 61.5 5.8
2008 63.7 4.3
2009 65.5 3.5
2010-2014 348.3 13.0
NOTE 11 INCOME TAXES
Earnings before income taxes and and the provision for U. S.
federal,state,and foreign taxes on these earnings were:
(millions) 2004 2003 2002
- ---------- ---------- ---------- ----------
EARNINGS BEFORE INCOME TAXES
United States $ 952.0 $ 799.9 $ 791.3
Foreign 413.9 369.6 353.0
---------- ---------- ----------
$ 1,365.9 $ 1,169.5 $ 1,144.3
---------- ---------- ----------
INCOME TAXES
Currently payable:
Federal $ 249.8 $ 141.9 $ 157.1
State 30.0 40.5 46.2
Foreign 137.8 125.2 108.9
---------- ---------- ----------
417.6 307.6 312.2
---------- ---------- ----------
DEFERRED:
Federal 51.5 91.7 82.8
State 5.3 (8.6) 8.4
Foreign .9 (8.3) 20.0
---------- ---------- ----------
57.7 74.8 111.2
---------- ---------- ----------
Total income taxes $ 475.3 $ 382.4 $ 423.4
========== ========== ==========
The difference between the U.S. federal statutory tax rate and the Company's
effective income tax rate was:
2004 2003 2002
---- ---- ----
U. S. statutory tax rate 35.0% 35.0% 35.0%
Foreign rates varying from 35% -.5 -.9 -.8
State income taxes, net of
federal benefit 1.7 1.8 3.1
Foreign earnings repatriation 2.1 -- 2.8
Donation of appreciated assets -- -- -1.5
Net change in valuation
allowances -1.5 -.1 -.2
Statutory rate changes, deferred
tax impact .1 -.1 --
Other -2.1 -3.0 -1.4
---- ---- ----
Effective income tax rate 34.8% 32.7% 37.0%
==== ==== ====
47
The Company's consolidated effective income tax rate has benefited from tax
planning initiatives over the past several years, declining from 37% in 2002
to slightly less than 35% in 2004. The 2003 rate was even lower at less than
33%, as it included over 200 basis points of discrete benefits, such as
favorable audit closures and revaluation of deferred state tax liabilities.
On October 22, 2004, the American Jobs Creation Act ("AJCA") became law. The
AJCA creates a temporary incentive for U.S. multinationals to repatriate
foreign earnings by providing an 85 percent dividend received deduction for
qualified dividends. The Company may elect to claim this deduction for
qualified dividends received in either its fiscal 2004 or 2005 years, and
management currently plans to elect this deduction for 2005. Management
cannot fully evaluate the effects of this repatriation provision until the
Treasury Department issues clarifying regulations. Furthermore, pending
technical corrections legislation is needed to clarify that the dividend
received deduction applies to both the cash and "section 78 gross-up"
portions of qualifying dividend repatriations. While management believes that
technical corrections legislation will pass in 2005, the Company has
currently developed its repatriation plan based on the less favorable AJCA
provisions in force as of year-end 2004. Under these assumptions, management
currently intends to repatriate during 2005 approximately $70 million of
foreign earnings under the AJCA and an additional $550 million of foreign
earnings under regular rules. Prior to 2004, it was management's intention to
indefinitely reinvest substantially all of the Company's undistributed
foreign earnings. Accordingly, no deferred tax liability had been recorded in
connection with the future repatriation of these earnings. Now that
repatriation is foreseeable for up to $620 million of these earnings, the
Company provided in 2004 a deferred tax liability of approximately $41
million. Within the preceding table, this amount is shown net of related
foreign tax credits of approximately $12 million, for a net rate increase due
to repatriation of 2.1 percent.
Should the technical corrections legislation pass during 2005, management
currently believes that the Company would most likely repatriate a higher
amount of foreign subsidiary earnings up to $1.1 billion under AJCA for a
similar amount of tax cost. However, under the law as enacted at January 1,
2005, management has determined that reinvestment of these earnings in the
local businesses should provide a superior rate of return to the Company, as
compared to repatriation. Accordingly, U.S. income taxes have not yet been
provided on approximately $730 million of foreign subsidiary earnings.
Generally, the changes in valuation allowances on deferred tax assets and
corresponding impacts on the effective income tax rate result from
management's assessment of the Company's ability to utilize certain operating
loss and tax credit carryforwards. For 2004, the 1.5 percent rate reduction
presented in the preceding table primarily reflects reversal of a valuation
allowance against U.S. foreign tax credits, which management currently
believes will be utilized in conjunction with the aforementioned 2005 foreign
earnings repatriation. Total tax benefits of carryforwards at year-end 2004
and 2003 were approximately $48 million and $40 million, respectively. Of the
total carryforwards at year-end 2004, approximately $3 million expire in 2005
and another $4 million will expire within five years. Based on management's
assessment of the Company's ability to utilize these benefits prior to
expiration, the carrying value of deferred tax assets associated with
carryforwards was reduced by valuation allowances to approximately $37
million at January 1, 2005.
The deferred tax assets and liabilities included in the balance sheet at
year-end were:
Deferred tax assets Deferred tax liabilities
----------------------------------------------
(millions) 2004 2003 2004 2003
- ---------- -------- -------- -------- --------
CURRENT:
Promotion and advertising $ 17.0 $ 19.0 $ 8.9 $ 8.0
Wages and payroll taxes 29.5 39.9 -- --
Inventory valuation 20.2 18.0 13.4 16.0
Health and postretirement
benefits 34.7 41.2 .1 --
State taxes 6.8 12.4 -- --
Operating loss and credit
carryforwards 31.8 1.0 -- --
Unrealized hedging losses, net 26.5 31.2 -- .1
Foreign earnings repatriation -- -- 40.5 --
Other 27.8 34.5 20.6 11.0
-------- -------- -------- --------
194.3 197.2 83.5 35.1
Less valuation allowance (3.9) (3.2) -- --
-------- -------- -------- --------
190.4 194.0 83.5 35.1
======== ======== ======== ========
NONCURRENT:
Depreciation and asset
disposals 8.0 10.2 376.9 365.4
Health and postretirement
benefits 134.8 238.9 229.8 223.1
Capitalized interest -- -- 9.7 12.6
State taxes -- -- 74.5 74.8
Operating loss and credit
carryforwards 16.3 39.1 -- --
Trademarks and other
intangibles -- -- 664.2 665.7
Deferred compensation 37.6 39.8 -- --
Other 12.6 11.3 7.3 6.5
-------- -------- -------- --------
209.3 339.3 1,362.4 1,348.1
Less valuation allowance (12.9) (33.6) -- --
-------- -------- -------- --------
196.4 305.7 1,362.4 1,348.1
-------- -------- -------- --------
Total deferred taxes $ 386.8 $ 499.7 $1,445.9 $1,383.2
======== ======== ======== ========
Cash paid for income taxes was (in millions): 2004-$421; 2003-$289;
2002-$250.
NOTE 12 FINANCIAL INSTRUMENTS AND CREDIT RISK CONCENTRATION
The fair values of the Company's financial instruments are based on carrying
value in the case of short-term items, quoted market prices for derivatives
and investments, and, in the case of long term debt, incremental borrowing
rates currently available on loans with similar terms and maturities. The
carrying amounts of the Company's cash, cash equivalents, receivables, and
notes payable approximate fair value. The fair value of the Company's
long-term debt at January 1, 2005, exceeded its carrying value by
approximately $487 million.
48
The Company is exposed to certain market risks which exist as a part of its
ongoing business operations and uses derivative financial and commodity
instruments, where appropriate, to manage these risks. In general,
instruments used as hedges must be effective at reducing the risk associated
with the exposure being hedged and must be designated as a hedge at the
inception of the contract. In accordance with SFAS No. 133, the Company
designates derivatives as either cash flow hedges, fair value hedges, net
investment hedges, or other contracts used to reduce volatility in the
translation of foreign currency earnings to U.S. Dollars. The fair values of
all hedges are recorded in accounts receivable or other current liabilities.
Gains and losses representing either hedge ineffectiveness, hedge components
excluded from the assessment of effectiveness, or hedges of translational
exposure are recorded in other income (expense), net. Within the Consolidated
Statement of Cash Flows, settlements of cash flow and fair value hedges are
classified as an operating activity; settlements of all other derivatives are
classified as a financing activity.
CASH FLOW HEDGES
Qualifying derivatives are accounted for as cash flow hedges when the hedged
item is a forecasted transaction. Gains and losses on these instruments are
recorded in other comprehensive income until the underlying transaction is
recorded in earnings. When the hedged item is realized, gains or losses are
reclassified from accumulated other comprehensive income to the Statement of
Earnings on the same line item as the underlying transaction. For all cash
flow hedges, gains and losses representing either hedge ineffectiveness or
hedge components excluded from the assessment of effectiveness were
insignificant during the periods presented.
The total net loss attributable to cash flow hedges recorded in accumulated
other comprehensive income at January 1, 2005, was $46.6 million, related
primarily to forward-starting interest rate swaps settled during 2001 and
treasury rate locks settled during 2003 (refer to Note 7). This loss is being
reclassified into interest expense over periods of 5 to 30 years. Other
insignificant amounts related to foreign currency and commodity price cash
flow hedges will be reclassified into earnings during the next 18 months.
FAIR VALUE HEDGES
Qualifying derivatives are accounted for as fair value hedges when the hedged
item is a recognized asset, liability, or firm commitment. Gains and losses
on these instruments are recorded in earnings, offsetting gains and losses on
the hedged item. For all fair value hedges, gains and losses representing
either hedge ineffectiveness or hedge components excluded from the assessment
of effectiveness were insignificant during the periods presented.
NET INVESTMENT HEDGES
Qualifying derivative and nonderivative financial instruments are accounted
for as net investment hedges when the hedged item is a foreign currency
investment in a subsidiary. Gains and losses on these instruments are
recorded as a foreign currency translation adjustment in other comprehensive
income.
OTHER CONTRACTS
The Company also enters into foreign currency forward contracts and options
to reduce volatility in the translation of foreign currency earnings to U.S.
Dollars. Gains and losses on these instruments are recorded in other income
(expense), net, generally reducing the exposure to translation volatility
during a full-year period.
FOREIGN EXCHANGE RISK
The Company is exposed to fluctuations in foreign currency cash flows related
primarily to third-party purchases, intercompany loans and product shipments,
and nonfunctional currency denominated third party debt. The Company is also
exposed to fluctuations in the value of foreign currency investments in
subsidiaries and cash flows related to repatriation of these investments.
Additionally, the Company is exposed to volatility in the translation of
foreign currency earnings to U.S. Dollars. The Company assesses foreign
currency risk based on transactional cash flows and translational positions
and enters into forward contracts, options, and currency swaps to reduce
fluctuations in net long or short currency positions. Forward contracts and
options are generally less than 18 months duration. Currency swap agreements
are established in conjunction with the term of underlying debt issues.
For foreign currency cash flow and fair value hedges, the assessment of
effectiveness is generally based on changes in spot rates. Changes in time
value are reported in other income (expense), net.
INTEREST RATE RISK
The Company is exposed to interest rate volatility with regard to future
issuances of fixed rate debt and existing issuances of variable rate debt.
The Company currently uses interest rate swaps, including forward-starting
swaps, to reduce interest rate volatility and funding costs associated with
certain debt issues, and to achieve a desired proportion of variable versus
fixed rate debt, based on current and projected market conditions.
Variable-to-fixed interest rate swaps are accounted for as cash flow hedges
and the assessment of effectiveness is based on changes in the present value
of interest payments on the underlying debt. Fixed-to-variable interest rate
swaps are accounted for as fair value hedges and the assessment of
effectiveness is based on changes in the fair value of the underlying debt,
using incremental borrowing rates currently available on loans with similar
terms and maturities.
PRICE RISK
The Company is exposed to price fluctuations primarily as a result of
anticipated purchases of raw and packaging materials and energy. The Company
uses the combination of long cash positions with suppliers, and
exchange-traded futures and option contracts to reduce price fluctuations in
a desired percentage of forecasted purchases over a duration of generally
less than 18 months.
Commodity contracts are accounted for as cash flow hedges. The assessment of
effectiveness is based on changes in futures prices.
49
CREDIT RISK CONCENTRATION
The Company is exposed to credit loss in the event of nonperformance by
counterparties on derivative financial and commodity contracts. This credit
loss is limited to the cost of replacing these contracts at current market
rates. Management believes the probability of such loss is remote.
Financial instruments, which potentially subject the Company to
concentrations of credit risk, are primarily cash, cash equivalents, and
accounts receivable. The Company places its investments in highly rated
financial institutions and investment-grade short-term debt instruments, and
limits the amount of credit exposure to any one entity. Historically,
concentrations of credit risk with respect to accounts receivable have been
limited due to the large number of customers, generally short payment terms,
and their dispersion across geographic areas. However, there has been
significant worldwide consolidation in the grocery industry in recent years.
At January 1, 2005, the Company's five largest customers globally comprised
approximately 20% of consolidated accounts receivable.
NOTE 13 QUARTERLY FINANCIAL DATA
(UNAUDITED)
(millions,
except share data) Net sales Gross profit
- ------------------ ---------------------- ---------------------
2004 2003 2004 2003
---------- ---------- --------- ---------
First $ 2,390.5 $ 2,147.5 $ 1,035.0 $ 916.4
Second 2,387.3 2,247.4 1,080.2 1,015.3
Third 2,445.3 2,281.6 1,126.2 1,034.0
Fourth 2,390.8 2,135.0 1,073.8 946.9
---------- ---------- --------- ---------
$ 9,613.9 $ 8,811.5 $ 4,315.2 $ 3,912.6
========== ========== ========= =========
Net earnings Net earnings per share
------------ ----------------------
2004 2003
---- ----
2004 2003 Basic Diluted Basic Diluted
------- ------- ------ -------- ----- -------
First $ 219.8 $ 163.9 $ .54 $ .53 $ .40 $ .40
Second 237.4 203.9 .58 .57 .50 .50
Third 247.0 231.3 .60 .59 .57 .56
Fourth 186.4 188.0 .45 .45 .46 .46
------- ----- ------ ------ ----- -------
$ 890.6 $ 787.1
======= =======
The principal market for trading Kellogg shares is the New York Stock
Exchange (NYSE). The shares are also traded on the Boston, Chicago,
Cincinnati, Pacific, and Philadelphia Stock Exchanges. At year-end 2004, the
closing price (on the NYSE) was $44.66 and there were 43,584 shareholders of
record.
Dividends paid per share and the quarterly price ranges on the NYSE during
the last two years were:
Stock price
Dividend -----------
2004 - QUARTER per share High Low
- -------------- --------- ------- -------
First $ .2525 $ 39.88 $ 37.00
Second .2525 43.41 38.41
Third .2525 43.08 39.88
Fourth .2525 45.32 41.10
--------- ------- -------
$ 1.0100
=========
Stock price
Dividend -----------
2003 - Quarter per share High Low
- -------------- --------- ------- -------
First $ .2525 $ 34.96 $ 28.02
Second .2525 35.36 30.46
Third .2525 35.04 33.06
Fourth .2525 37.80 32.92
------- ------- -------
$1.0100
=======
NOTE 14 OPERATING SEGMENTS
Kellogg Company is the world's leading producer of cereal and a leading
producer of convenience foods, including cookies, crackers, toaster pastries,
cereal bars, frozen waffles, and meat alternatives. Kellogg products are
manufactured and marketed globally. Principal markets for these products
include the United States and United Kingdom.
In recent years, the Company was managed in two major divisions - United
States and International. During late 2003, the Company reorganized its
geographic management structure to North America, Europe, Latin America, and
Asia Pacific. This new organizational structure is the basis of the following
operating segment data. The prior periods have been restated to conform to
the current-period presentation. This restatement includes: 1) the
combination of U.S. and Canadian results into North America, 2) the
reclassification of certain U.S. export operations from U.S. to Latin
America, and 3) the reallocation of certain selling, general, and
administrative (SGA) expenses between Corporate and North America.
The measurement of operating segment results is generally consistent with the
presentation of the Consolidated Statement of Earnings and Balance Sheet.
Intercompany transactions between reportable operating segments were
insignificant in all periods presented.
(millions) 2004 2003 2002
- ---------- --------- --------- ---------
NET SALES
North America $ 6,369.3 $ 5,954.3 $ 5,800.1
Europe 2,007.3 1,734.2 1,469.8
Latin America 718.0 666.7 648.9
Asia Pacific (a) 519.3 456.3 385.3
--------- --------- ---------
Consolidated $ 9,613.9 $ 8,811.5 $ 8,304.1
========= ========= =========
SEGMENT OPERATING PROFIT
North America $ 1,240.4 $ 1,134.2 $ 1,138.0
Europe 292.3 279.8 252.5
Latin America 185.4 168.9 170.6
Asia Pacific 79.5 61.1 38.5
Corporate (116.5) (99.9) (91.5)
--------- --------- ---------
Consolidated $ 1,681.1 $ 1,544.1 $ 1,508.1
========= ========= =========
DEPRECIATION AND AMORTIZATION
North America $ 261.4 $ 246.4 $ 229.3
Europe 95.7 71.1 65.7
Latin America 15.4 21.6 17.1
Asia Pacific 20.9 20.0 21.9
Corporate 16.6 13.7 15.9
--------- --------- ---------
Consolidated $ 410.0 $ 372.8 $ 349.9
========= ========= =========
(a) Includes Australia and Asia
50
(millions) 2004 2003 2002
- ---------- ----------- ----------- -----------
INTEREST EXPENSE
North America $ 1.7 $ 4.0 $ 6.3
Europe 15.6 18.2 22.3
Latin America .2 .2 .6
Asia Pacific (a) .2 .3 .4
Corporate 290.9 348.7 361.6
----------- ----------- -----------
Consolidated $ 308.6 $ 371.4 $ 391.2
=========== =========== ===========
INCOME TAXES
North America $ 371.5 $ 345.0 $ 364.2
Europe 64.5 54.6 46.3
Latin America 39.8 40.0 42.5
Asia Pacific (.8) 3.3 7.8
Corporate .3 (60.5) (37.4)
----------- ----------- -----------
Consolidated $ 475.3 $ 382.4 $ 423.4
=========== =========== ===========
TOTAL ASSETS
North America $ 10,287.5 $ 10,381.8 $ 10,079.6
Europe 2,363.6 1,801.7 1,687.3
Latin America 411.1 341.2 337.4
Asia Pacific 347.4 300.4 259.1
Corporate 6,679.4 6,274.2 6,112.1
Elimination entries (9,298.6) (8,956.6) (8,256.2)
----------- ----------- -----------
Consolidated $ 10,790.4 $ 10,142.7 $ 10,219.3
=========== =========== ===========
ADDITIONS TO LONG-LIVED
ASSETS
North America $ 167.4 $ 185.6 $ 202.8
Europe 59.7 35.5 33.4
Latin America 37.2 15.4 13.6
Asia Pacific 9.9 10.1 4.7
Corporate 4.4 .6 1.2
----------- ----------- -----------
Consolidated $ 278.6 $ 247.2 $ 255.7
=========== =========== ===========
(a) Includes Australia and Asia.
The Company's largest customer,Wal-Mart Stores, Inc. and its affiliates,
accounted for approximately 14% of consolidated net sales during 2004, 13% in
2003, and 12% in 2002, comprised principally of sales within the United States.
Supplemental geographic information is provided below for net sales to external
customers and long-lived assets:
(millions) 2004 2003 2002
- ---------- ------------ ---------- ----------
NET SALES
United States $ 5,968.0 $ 5,608.3 $ 5,507.7
United Kingdom 859.6 740.2 667.4
Other foreign countries 2,786.3 2,463.0 2,129.0
------------ ---------- ----------
Consolidated $ 9,613.9 $ 8,811.5 $ 8,304.1
============ ========== ==========
LONG-LIVED ASSETS
United States $ 7,264.7 $ 7,350.5 $ 7,434.2
United Kingdom 734.1 435.1 423.5
Other foreign countries 648.2 627.6 584.6
------------ ---------- ----------
Consolidated $ 8,647.0 $ 8,413.2 $ 8,442.3
============ ========== ==========
Supplemental product information is provided below for net sales to external
customers:
(millions) 2004 2003 2002
- ---------- ------------- ---------- ----------
North America
Retail channel cereal $ 2,404.5 $ 2,304.7 $ 2,140.4
Retail channel snacks 2,801.4 2,547.6 2,587.6
Other 1,163.4 1,102.0 1,072.1
International
Cereal 2,829.2 2,583.5 2,288.1
Snacks 415.4 273.7 215.9
------------ ---------- ----------
Consolidated $ 9,613.9 $ 8,811.5 $ 8,304.1
============ ========== ==========
NOTE 15 SUPPLEMENTAL FINANCIAL STATEMENT DATA
(millions)
CONSOLIDATED STATEMENT OF EARNINGS 2004 2003 2002
- ---------------------------------- ------------ ---------- ----------
Research and development expense $ 148.9 $ 126.7 $ 106.4
Advertising expense $ 806.2 $ 698.9 $ 588.7
============ ========== ==========
CONSOLIDATED STATEMENT OF CASH FLOWS 2004 2003 2002
- ------------------------------------ ------------ ---------- ----------
Trade receivables $ 13.8 ($ 36.7) $ 14.6
Other receivables (39.5) 18.8 13.5
Inventories (31.2) (48.2) (26.4)
Other current assets (17.8) .4 70.7
Accounts payable 63.4 84.8 41.3
Other current liabilities (18.5) 25.3 83.8
------------ ---------- ----------
CHANGES IN OPERATING ASSETS AND LIABILITIES ($ 29.8) $ 44.4 $ 197.5
============ ========== ==========
CONSOLIDATED BALANCE SHEET 2004 2003
- -------------------------- ---------- ----------
Trade receivables $ 700.9 $ 716.8
Allowance for doubtful accounts (13.0) (15.1)
Other receivables 88.5 53.1
---------- ----------
ACCOUNTS RECEIVABLE, NET $ 776.4 $ 754.8
---------- ----------
Raw materials and supplies $ 188.0 $ 185.3
Finished goods and materials in process 493.0 464.5
---------- ----------
INVENTORIES $ 681.0 $ 649.8
---------- ----------
Deferred income taxes $ 101.9 $ 150.0
Other prepaid assets 145.1 92.1
---------- ----------
OTHER CURRENT ASSETS $ 247.0 $ 242.1
---------- ----------
Land $ 78.3 $ 75.1
Buildings 1,504.7 1,417.5
Machinery and equipment 4,751.3 4,555.3
Construction in progress 159.6 171.6
Accumulated depreciation (3,778.8) (3,439.3)
---------- ----------
PROPERTY, NET $ 2,715.1 $ 2,780.2
---------- ----------
Goodwill $ 3,095.1 $ 3,098.4
Other intangibles 2,067.2 2,069.5
- -Accumulated amortization (46.1) (35.1)
Other 837.3 441.8
---------- ----------
OTHER ASSETS $ 5,953.5 $ 5,574.6
---------- ----------
Accrued income taxes $ 96.2 $ 143.0
Accrued salaries and wages 270.2 261.1
Accrued advertising and promotion 322.0 323.1
Accrued interest 69.9 108.3
Other 332.2 327.8
---------- ----------
OTHER CURRENT LIABILITIES $ 1,090.5 $ 1,163.3
---------- ----------
Nonpension postretirement benefits $ 269.7 $ 291.0
Deferred income taxes 1,187.6 1,062.8
Other 337.3 314.3
---------- ----------
OTHER LIABILITIES $ 1,794.6 $ 1,668.1
========== ==========
51
MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS
Management is responsible for the preparation of the Company's consolidated
financial statements and related notes. Management believes that the
consolidated financial statements present the Company's financial position and
results of operations in conformity with accounting principles that are
generally accepted in the United States, using our best estimates and judgments
as required.
The independent registered public accounting firm audits the Company's
consolidated financial statements in accordance with the standards of the Public
Company Accounting Oversight Board and provides an objective, independent review
of the fairness of reported operating results and financial position.
The Board of Directors of the Company has an Audit Committee composed of four
non-management Directors. The Committee meets regularly with management,
internal auditors, and the independent registered public accounting firm to
review accounting, internal control, auditing and financial reporting matters.
Formal policies and procedures, including an active Ethics and Business Conduct
program, support the internal controls, and are designed to ensure employees
adhere to the highest standards of personal and professional integrity. We have
a vigorous internal audit program that independently evaluates the adequacy and
effectiveness of these internal controls.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Our management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Exchange Act Rules
13a-15(f). Under the supervision and with the participation of management,
including our chief executive officer and chief financial officer, we conducted
an evaluation of the effectiveness of our internal control over financial
reporting based on the framework in Internal Control - Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
Based on our evaluation under the framework in Internal Control - Integrated
Framework, management concluded that our internal control over financial
reporting was effective as of January 1, 2005. Our management's assessment of
the effectiveness of our internal control over financial reporting as of January
1, 2005 has been audited by PricewaterhouseCoopers LLP, an independent
registered public accounting firm, as stated in their report which follows on
page 53.
/s/ James M. Jenness
- --------------------------
James M. Jenness
Chairman and Chief Executive Officer
/s/ Jeffrey M. Boromisa
- -------------------------
Jeffrey M. Boromisa
Senior Vice President, Chief Financial Officer
52
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
PRICEWATERHOUSECOOPERS LLP
TO THE SHAREHOLDERS AND BOARD OF DIRECTORS OF KELLOGG COMPANY
INTRODUCTION
We have completed an integrated audit of Kellogg Company's 2004 consolidated
financial statements and of its internal control over financial reporting as
of January 1, 2005 and audits of its 2003 and 2002 consolidated financial
statements in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Our opinions, based on our audits, are
presented below.
CONSOLIDATED FINANCIAL STATEMENTS
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of earnings, of shareholders' equity and of cash
flows present fairly, in all material respects, the financial position of
Kellogg Company and its subsidiaries at January 1, 2005 and December 27,
2003, and the results of their operations and their cash flows for each of
the three years in the period ended January 1, 2005 in conformity with
accounting principles generally accepted in the United States of America.
These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits of these statements
in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit of financial statements includes
examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
INTERNAL CONTROL OVER FINANCIAL REPORTING
Also, in our opinion, management's assessment, included in the accompanying
Management's Report on Internal Control over Financial Reporting, that the
Company maintained effective internal control over financial reporting as of
January 1, 2005 based on criteria established in Internal Control -
Integrated Framework issued by the Committee of Sponsoring Organizations of
the Treadway Commission ("COSO"), is fairly stated, in all material respects,
based on those criteria. Furthermore, in our opinion, the Company maintained,
in all material respects, effective internal control over financial reporting
as of January 1, 2005, based on criteria established in Internal Control -
Integrated Framework issued by COSO. The Company's management is responsible
for maintaining effective internal control over financial reporting and for
its assessment of the effectiveness of internal control over financial
reporting. Our responsibility is to express opinions on management's
assessment and on the effectiveness of the Company's internal control over
financial reporting based on our audit. We conducted our audit of internal
control over financial reporting in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those standards
require that we plan and perform the audit to obtain reasonable assurance
about whether effective internal control over financial reporting was
maintained in all material respects. An audit of internal control over
financial reporting includes obtaining an understanding of internal control
over financial reporting, evaluating management's assessment, testing and
evaluating the design and operating effectiveness of internal control, and
performing such other procedures as we consider necessary in the
circumstances. We believe that our audit provides a reasonable basis for our
opinions.
A company's internal control over financial reporting is a process designed
to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes
in accordance with generally accepted accounting principles. A company's
internal control over financial reporting includes those policies and
procedures that (i) pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and dispositions of
the assets of the company; (ii) provide reasonable assurance that
transactions are recorded as necessary to permit preparation of financial
statements in accordance with generally accepted accounting principles, and
that receipts and expenditures of the company are being made only in
accordance with authorizations of management and directors of the company;
and (iii) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate.
Pricewaterhousecoopers, LLP
Battle Creek, Michigan
March 1, 2005
53