Kellogg Company (NYSE:K) Q2 2023 Earnings Call Transcript

Kellogg Company (NYSE:K) Q2 2023 Earnings Call Transcript August 3, 2023

Kellogg Company beats earnings expectations. Reported EPS is $1.25, expectations were $1.11.

Operator: Good morning. Welcome to the Kellogg Company’s Second Quarter 2023 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session with publishing analysts. At this time, I will turn the call over to John Renwick, Vice President of Investor Relations and Corporate Planning for Kellogg Company. Mr. Renwick, you may begin your conference call.

John Renwick: Thank you, operator. Good morning and thank you for joining us today for a review of our second quarter results and an update on our outlook for 2023. I am joined this morning by: Steve Cahillane, our Chairman and Chief Executive Officer; and Amit Banati, our Vice Chairman and Chief Financial Officer. Slide number 3 shows our forward-looking statements disclaimer. As you are aware, certain statements made today, such as projections for Kellogg Company’s future performance, are forward-looking statements. Actual results could be materially different from those projected. For further information concerning factors that could cause these results to differ, please refer to the third slide of this presentation, as well as to our public SEC filings.

A recording of today’s webcast and supporting documents will be archived for at least 90 days on the Investor page of KelloggCompany.com. As always, when referring to our results and outlook, unless otherwise noted, we will be referring to them on an organic basis for net sales and on a currency-neutral adjusted basis for operating profit and earnings per share. And now, I’ll turn it over to Steve.

Steve Cahillane: Thanks, John, and good morning, everyone. We’re pleased to report another better than expected quarter featuring two key elements depicted on slide number 5. Not only did we sustain top line growth that remained better than our long-term targets, but we did so across our portfolio and geographies with growth in all major category groups in each of our four regions. And we did so even as we lapped the prior year’s retail inventory replenishment and particularly strong in-market performance. We also continued to experience a sooner-than sooner than expected recovery in our gross profit margin. Much of this is related to bottlenecks and shortages diminishing. This recovery is ahead of schedule and it was a principal driver behind our better than expected profit and earnings this quarter.

Also encouraging is the momentum, we’ve continued to see in our biggest, most differentiated brands shown on slide number 6. These advantage brands made up half of our net sales in 2022 and they continue to outpace our overall growth creating both top-line momentum and a favorable margin mix. So when we put it all together the earlier than expected margin recovery and the sustained top-line growth across our portfolio, you can see why we feel comfortable raising our full year sales profit and earnings guidance again. We also remain very active on our social and environmental program Kellogg’s Better Days Promise. Slide number 7 shows just a few examples of actions we took during the quarter, including donations and volunteering in the area of hunger and tie-ins to important commercial programs with customers.

The slide also shows another wave of recognitions that we have received, simply confirming what we already know, that doing what is right is in our DNA. In the center of the slide, you can see that we have published an update regarding our progress toward our Better Days targets. On social goals like addressing hunger or environmental goals like reducing our admissions or in diversity goals like gender representation and management, we remain ahead of pace on our Better Days goals. And of course, we remain very busy in getting ready for our pending separation. Indeed on slide number eight most of what you see under the Q1, Q2 and the Q2, Q3 phases are now complete. The team has done an exceptional job of digging into every detail, every brand, every process, every role to make sure we have left no stone unturned in our quest to create two successful value-creating companies.

And as you look to the Q3 phase, you can see a few milestones that are very much upon us. On July 24th WK Kellogg Co.’s Form-10 was filed publicly providing you with important information about management, strategy, capital structure, and carve out financials. On July 30th, just this past Sunday, we began to run WK Kellogg Co. and Kelanova in parallel. By running the water through the pipes, so to speak, we can identify and address any process gaps and other opportunities well before the separation takes place. Employees in new roles can transition properly. Services under the transition services agreement can be ironed out more completely. And while this requires incremental expenses, they are already incorporated into our guidance. And then less than a week from today on August 9th, we will host our Day at K investor event at which leaders of both WK Kellogg Co. and Kellenova will present to the strategies, the capital structures, and the financial outlooks for both companies.

And we still expect the separation transaction to take place during the fourth quarter. Because we can’t know the exact timing of the various customary approvals, we can’t be more specific than that quite yet. But we have every confidence that it is on track. In sum, the second quarter was another very good quarter in terms of financial results, sustainability actions, and progress toward our spinoff. And now let me turn it over to Amit to take you through our financial results and outlook in more detail.

Amit Banati: Thank you, Steve, and good morning, everyone. Slide number 10 provides a summary of our second quarter and first half results. Net sales growth in quarter two was 7% on an organic basis. Importantly, this growth remained broad-based across category groups and regions, and paces us a little ahead of our previous full-year outlook. Operating profit grew 14% on an adjusted basis. This growth came on top of last year’s 10% currency neutral growth, and it featured the sooner than expected recovery in gross profit margin that Steve discussed. This operating profit performance puts us a little ahead of our previous full year outlook. Earnings per share grew 5% on an adjusted basis, sustaining mid-single-digit growth in spite of macro-related headwinds versus last year on below-the-line items such as interest expense and pension income.

Cash flow through the first half is down year-on-year because of outlays related to the pending spin-off but on track for the full year. Let’s now discuss each of these in more detail. Slide number 11 splits our year-on-year net sales growth into its components. Price mix growth was sustained in the mid-teens with growth in both developed markets and emerging markets. As expected, price elasticities continued to move higher around the world, and this weighed down our volume. Also contributing to our volume decline was lapping last year’s replenishment of trade inventories, particularly as we recovered from the serial strike. Foreign currency translation continued to negatively impact net sales growth by nearly 3% year-on-year in the quarter.

If today’s exchange rates versus the US dollar were to hold, we would expect to see a similar impact in the second half, as the favorable impact of lapping last year’s dollar strengthening is offset by the recent devaluation of the Nigerian naira. So our top line growth in quarter two supports our long-standing planning assumptions for elasticities to rise and for revenue growth management actions to begin to anniversary. Next, let’s discuss gross profit shown on slide number 12. As we’ve discussed numerous times, our objective in this high inflation environment has been to protect gross profit dollars via productivity savings and revenue growth management. In quarter two, our adjusted gross profit increased by 9% year-on-year. On top of a year ago quarter that itself was up more than 6% on a currency-neutral basis.

From a margin perspective, recall that our expectation was for a gradual improvement as the year progresses. But as Steve mentioned, we are ahead of pace in this recovery with year-on-year expansion coming sooner than expected. Much of this is driven by bottlenecks and shortages receding, which eliminates many of the inefficiencies and incremental costs experienced over the past year or more. In addition, productivity and revenue growth management continue to catch up to a high market-driven input cost inflation. So while we have a ways to go before we get back to pre-pandemic levels, this performance gives us increased confidence in our ability to recover margins. For 2023, there is no change to our outlook for expansion in the second half, but Q2’s better-than-expected performance moves up our full year outlook for gross margin to be somewhere around 50 basis points of expansion year-on-year.

Operating profit, as shown on slide number 13, grew 14% year-on-year in quarter two, even as it laps a robust 10% gain in the year earlier quarter, and even with advertising and promotion investment increasing year-on-year. Through the first half, our operating profit was up 16% year-on-year. Our second half comparisons get a little tougher, and we have begun to run W.K. Kellogg Company in parallel requiring incremental expenses year-on-year that are already baked into our guidance. That, we are ahead of pace, and this gives us the confidence to raise our full year operating profit guidance. Moving down the income statement. Slide number 14 shows that our earnings per share growth has been attributable to operating profit, which has grown enough to more than offset what are severe macro-related headwinds in within our below-the-line items.

These below-the-line pressures were expected and will continue through the year. Interest expense increased significantly year-on-year due to higher interest rates. In the second half, we expect to see modestly lower interest expense than we recorded in the first half, owing to the timing of cash flow. Other income decreased sharply year-on-year in each of the first two quarters this year. reflecting the accounting of pension and postretirement plan asset values and interest rates stemming from last year’s declines in financial markets. Owing to favorability in some other items in the slide, Q2 came in higher than both Q1 and the run rate we would expect for the remaining quarters. Our effective tax rate in quarter two was back to the kind of 22% rate we would expect for the full year after being a bit above that in quarter one.

Average shares outstanding were up slightly year-on-year in both quarter one and quarter two. And we would expect that to be the case for the full year as well. Foreign currency translation turned slightly positive to EPS in quarter two, finishing the half with about a negative 1% impact. We leave foreign currency translation out of our guidance because it is out of our control and difficult to predict. But if we took today’s exchange rates, including a substantially devalued Nigerian Naira partially offset by the lapping of other currencies a year ago weakening, we would estimate a similar impact for the full year as that of the first half. A key message here is that these below the line items are collectively weighing down EPS as expected, but it is important to remember that the operational side of our P&L through operating profit remains very strong.

Turning to slide number 15, we see that cash flow is below last year’s high level. This is due to three factors. First, one-time cash outlays related to the spin-off amounting to roughly $130 million. Secondly, lapping unusually strong inflows in the year-ago period, including some related to derivatives. And thirdly, timing of capital expenditure, which last year was much more weighted to the second half due to supply disruptions earlier that year. So while it is down from a high level last year, we believe cash flow is right on track to achieve our full year guidance. Meanwhile, we continue to reduce our debt leverage year-on-year, further enhancing our financial flexibility. All in, our second quarter performance puts us slightly ahead of pace for the full year.

Accordingly, we are once again moving up our full year guidance as shown on slide number 16. We are raising our guidance for organic net sales growth to approximately 7%, which is the high end of our previous guidance range. Our quarter two performance was consistent with our assumption of decelerating growth as the year progresses, which reflects a likely return of elasticity towards historical levels as well as lapping of particularly substantial revenue growth management actions in the second half of last year. This 7% organic growth is well above our long-term target. We are raising our guidance for adjusted operating profit growth to 9%-10% on a currency-neutral basis, which is the upper half of our previous guidance range. This raise reflects a stronger-than-expected Q2 performance, particularly our earlier recovery in gross profit margin, and yet still accounts for some investment shifts into the second half as well as incremental costs in the second half for operating WK Kellogg Company in parallel as a company within a company.

We expect to improve margins this year which combined with our above target net sales growth will deliver operating profit growth that is also above our long-term target. Based on the improved operating profit outlook, we are raising our adjusted earnings per share guidance as well, now looking for a year-on-year decline of 1% to 2%, the upper portion of our previous guidance range. Remember that all and more of this decline is explained by the year-on-year reduction in pension and post-retirement income, a non-operating, non-cash item that is expected to have a negative impact of nearly 7% on EPS this year. The negative impact of higher interest expense due to higher interest rates in the economy is another negative impact of more than 4%.

If it weren’t for these two macro-related impacts, our guidance for EPS growth would also be well above a long-term growth rate. Our guidance for cash flow remains at $1 to $1.1 billion. Recall that, within this guidance, we are expecting a year-on-year increase in our underlying cash flow offset by one-time cash costs and capital related to the spin-off. A couple of elements to keep in mind regarding this guidance. First, while we expect the spin-off to be transacted during quarter four our guidance assumes it takes place at year-end purely for simplicity reasons. And secondly, the impact of our recently completed divestiture of our Russian business does not have a material impact on our guidance. So to summarize our financial position on slide number 17, quarter two was yet another quarter of over-delivery and we have plans in place to sustain our earnings momentum.

Accordingly, we are again raising our full year guidance for 2023. Our profit margins have expanded sooner than anticipated and this should continue, particularly as our service levels return to normal. Our net sales growth remains strong and while we are keeping our assumption of rising elasticity in the second half, along with lapping sizable revenue growth management actions, we are confident enough in our top-line growth to raise our full-year outlook. Our financial flexibility is strong, marked by a solid balance sheet and cash flow that remains in good shape, even with some adverse timing in the first half. We continue to make good progress on setting up both Kellanova and WK Kellogg for operational and financial success, and we are looking forward to sharing with you the two companies’ exciting strategies, capital structures, and financial outlooks next week.

And with that, I’ll turn it back to Steve to walk you through our individual businesses.

Steve Cahillane: Thanks, Amit. With the spin-off approaching, we’ll once again organize our discussion around the businesses that will comprise Kellenova and WK Kellogg. Slide number 19 reminds you of the composition of the two businesses, and on the slide you can see how both remain in good form with good top-line growth. Let’s start by discussing the Kelinova businesses leading off with our emerging markets regions. Slide number 20 shows the financial performance of our EMEA region. This region sustained its outstanding underlying momentum in the second quarter, posting mid-teens organic net sales growth on top of extremely strong comparisons. It again expanded its operating profit margin year-on-year in the second quarter, and it again posted exceptional 19% operating profit growth.

And this performance came in spite of exceedingly high cost inflation and reinvestment into the business. Drilling down into its key category groups, we see on slide number 21 that EMEA’s snacks sustained double-digit organic net sales growth in quarter two, with this growth coming on top of exceptional growth in the year-ago quarter. In market, snacks category growth rates remained elevated and have even accelerated slightly from the previous quarter. Pringles this year has outpaced the salty snacks category that is growing in the high-teens or better across key markets and during the second quarter we continued to gain share in markets like Australia, Japan, Korea and Thailand. EMEA cereal is also sustaining strong growth momentum as shown on slide number 22.

This business delivered growth on top of last year’s strong growth with particular strength in Australia, Africa, and the Middle East, North Africa, Turkey sub-region. And in market, we’ve outpaced a category this year that has grown in the mid single digits collectively across key markets which brings us to noodles and other and slide number 23. Led by Multipro in Nigeria, this business continued to deliver organic net sales growth in excess of 20% in the second quarter. Multipro continues to execute extremely well, widening its competitive moat and staying on an impressive growth trajectory in an always exciting market. Meanwhile, we continue to expand our Kellogg’s noodles business outside of Nigeria. In the second quarter, net sales of Kellogg’s noodles grew significantly year-on-year in both South Africa and Egypt.

As you know the Nigerian Naira has been officially devalued recently but our team has been proactively managing through de facto currency devaluation for some time in order to protect our margins. Much of this proactive pricing which has contributed to the 20% plus growth you see on the slide is behind us now. This reflects the experience and savvy of our local team and the strength of this business. And we expect continued, if moderated top line growth going forward. Clearly, EMEA is a growth engine for Kellogg Company and soon, Kellanova. And it is performing extremely well so far in 2023. For the full year, we continue to expect sustained momentum across all three category groups, delivering yet another year of organic net sales growth, and while improving our profit margins.

Let’s turn to our other emerging markets region, Latin America, starting on slide number 25. Kellogg Latin America, in the second quarter delivered another quarter of strong organic net sales growth on top of equally strong growth last year. This growth was led by our two largest markets, Mexico and Brazil. We again expanded our operating margin in the second quarter leading to another quarter of operating profit growth of 20% year-on-year. As shown on slide number 26, our snacks business in Latin America was up against an unusually high comparison in the second quarter, but its organic net sales growth was a solid 6% year-on-year through the first half. In market, we saw sustained double-digit growth for the salty snacks category in Mexico and Brazil, and Pringles has gained share in both of these key markets.

We also outpaced a very strong portable wholesome snacks category in Mexico and stabilized our share in cookies in Brazil. On slide number 27 you can see that Kellogg Latin America again recorded double-digit organic net sales growth in cereal. This growth was broad-based with good growth across each of our sub regions. In market cereal category growth rates remain robust in the region and in the second quarter we kept pace in Mexico and we gained share in Brazil and Puerto Rico. So Latin America continues to perform well and remains right on track. For the full year, we continue to expect this region to sustain strong top-line momentum with growth in both snacks and cereal and continued recovery in its profit margins, all while working on separating its Caribbean cereal business as part of the spinoff.

Once again, we can see that both of our emerging markets regions are showing current momentum to go with their outstanding long-term prospects. Now let’s turn to our developed markets, starting with Kellogg Europe and slide number 29. The region posted sustained top-line growth, accelerating to 11% organic growth in the second quarter. Operating profit declined once again due to Russia, which we divested just after the end of the quarter. Excluding Russia, Kellogg Europe’s operating profit increased in the mid-single digits in spite of extremely high cost pressures. So our underlying European business is performing very well. On slide number 30, you can see that snacks which represent just over half of our sales in Kellogg Europe continue to lead our growth in this region.

In fact quarter two marked the eighth quarter in the last ten in which we have posted double-digit growth in our European snacks business. This was growth on top of strong year-ago growth and it was driven by both volume and price mix. The growth was also broad-based with double-digit gains in all sub-regions except for suspended shipments into Russia. In market the salty snacks category remains in strong double-digit growth across key markets with Pringles gaining share in key markets like Italy and France and sustaining strong consumption growth in spite of lapping notably robust year ago performance in markets like the UK, Germany and Spain. And in portable wholesome snacks, we are experiencing double-digit consumption growth overall in the region paced by a two-point share gain in the UK led by Rice Krispies Squares.

Our cereal business in Europe, shown on Slide number 31, also sustained growth in the second quarter. Growth has slowed as we’ve discussed previously, owing to category elasticities rising, but we continue to execute well in a challenging market. So it was another good quarter for Kellogg Europe, keeping us right on track for another good year. For the full year, we continue to expect the region to post yet another year of solid top line growth, led by Snacks. We’ll continue to navigate through cost pressures, which were particularly heavy in the first half, and we have a plan to gradually improve margins during the second half. And as we mentioned, we have closed on our divestiture of our Russia business. We’ll now turn to Kellogg North America and Slide number 33.

As anticipated, net sales growth decelerated in the second quarter as elasticity continued to move higher and as we lapped last year’s sizable replenishment of trade inventories. However, mid-teens price mix growth was sustained and we delivered solid organic growth in net sales. Importantly, we continue to recover gross profit margin, reflecting productivity, revenue growth management and diminishing bottlenecks and shortages. This enabled us to increase investments in our brands and still deliver 14% operating profit growth year-on-year. This region again generated organic net sales growth in all three category groups in the second quarter. Slide number 34 shows snacks, which represents over half of our North American net sales. In the second quarter, it grew net sales by 5% on top of a notably strong year earlier quarter, which had included retailer inventory replenishment.

We also grew in frozen foods, shown on Slide number 35. In market, Eggo’s consumption growth improved in the second quarter, continuing to moderate its share losses as our supply has improved. And Morningstar Farms gained share in the quarter as its supply is improving as well. All of the regions and categories we have discussed up to now will be part of Kellanova, and all of them are showing continued net sales growth to go with progress towards recovering margins. Now let’s turn to our North America cereal business which forms the vast majority of what will soon be W.K. Kellogg Co. As shown on Slide number 36, this business continues to recover, growing its net sales in the second quarter despite lapping substantial retailer inventory replenishment last year.

In the US the category remained in high single-digit growth in spite of gradually rising elasticities. Led by brands like Corn Flakes, Frosted Flakes, Rice Krispies and Raisin brand, we continue to gain share year-on-year and we continue to activate more commercial support, increase our distribution and increase our velocities. A similar recovery is happening in Canada, where we also continued to gain share in the second quarter. So this business is back on solid footing with more to come. Turning to Slide number 37. Our North America region had a very strong first half, giving us confidence in our full year expectations. Snacks should remain solidly in growth while Frozen is expected to continue to show improved performance, and our North America cereal business continues its recovery.

We are off to an earlier-than-expected start to margin recovery in this region even as we reinvest more in our brands. So North America is in good shape as we set up for the spin-off of W.K. Kellogg Co. later this year. So let me summarize on Slide number 39. We continue to put up better-than-expected results. Our first half featured top line growth across our regions and across our categories with notable momentum in snacks around the world and our businesses in emerging markets. It also featured an earlier-than-expected recovery in profit margins, which enables us to reinvest in the business and sustain strong earnings and cash flow growth. Thanks to the passion and skill of our organization, we have not allowed the spin-off work to prevent us from delivering and even overdelivering on our plans.

In fact, we’re halfway through the year, and we’ve already raised our full year outlook twice. And the work we are doing for the spin-off will pay off. We are separating this great company into two, even better companies, one with enhanced focus and the fit-for-purpose strategy and resourcing it deserves and the other with a portfolio-oriented solidly towards growth. And we’ll share with you our plans for both companies at our Day 8-K investor event next week. And with that, we’ll open up the line for your questions.

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Q&A Session

Operator: Thank you. We will now begin the question-and-answer session with publishing analysts. [Operator Instructions] Our first question for today comes from Andrew Lazar of Barclays. Your line is now open. Please go ahead.

Andrew Lazar: Thanks so much. Good morning, everybody. Steve, some food companies, as you’ve noticed this quarter — some food companies this quarter have started to discuss maybe some recent shifts at least in what they’re seeing in consumer behavior, in promotional activity and sort of elasticity in the US, some of which is to be expected as supply constraints are eased, of course. I was hoping you could talk a bit about any more recent shifts that you are seeing in your business, if any? And if they are outside of sort of what your expectations might have been even a quarter ago? Thank you.

A – Steve Cahillane: Yes. Thanks for the question, Andrew. I’d say a couple of things. The consumer behavior is pretty much in line with our expectations. And I know probably underlying your question is also some volume questions around what’s happening in North America, which was also in line with our expectations. You have to remember, obviously, we’ve taken such significant pricing over the last several years and elasticities have been almost nonexistent. So we’ve been forecasting their return for quite some time. And so in line with our expectations, we’re also lapping inventory replenishment from last year. So it’s pretty much where we expected it to be. In terms of consumer behavior, I’d say the shift that we’re starting to see is consumers are really maximizing their pantries.

They’re closely managing their household inventories, their pantry inventories, zealously guarding against waste, as you would expect in this environment. And so we haven’t seen shifts out of our category really. We haven’t seen meaningful moves in private label or anything like that. I would just say a consumer that’s ever more conscious of the strains on their household budgets, and we would expect that to continue moving forward. And as we look at our promotional activities for the balance of the year, we’re also taking that into account. And we’re pleased our service levels are going back up and allowing us to be a little bit more front-footed as we think about display execution, quality, merchandising and things of that nature.

Q – Andrew Lazar: Got it. Thanks so much and see you next week.

A – Steve Cahillane: Thank you.

Operator: Thank you. Our next question comes from Cody Ross of UBS. Your line is now open. Please go ahead.

Cody Ross: Hey, good morning. Thank you for taking our questions.

A – Steve Cahillane: Good morning, Cody.

Cody Ross: I just want to talk a little bit about the volume growth. Hey, good morning. I just want to talk about your volume performance in the quarter as that’s what investors are really primarily focusing on these days. Your volume in developed markets, particularly the US came in below what we expected. How are you thinking about volume growth moving forward into the back half and into next year? And how much visibility do you have to return to volume growth? And what would those levers be to drive it? And then I have a follow-up.

Steven Cahillane: Yeah. Thanks, Cody. As I mentioned, volumes were in line with our expectations. It doesn’t mean we’re pleased about it, but take the level of pricing that we’ve taken, you have to see elasticity’s moving higher, which is exactly what we’ve seen. Our quarter two was amplified by lapping the year ago trade inventory replenishment in North America. There’s no question about that. In Latin America, more than a third of our volume decline in the second quarter came from price pack architecture and calling of lower-margin SKUs, which was very much planned. So we’ve been planning on these elasticities returning and they have returned. I would say, on a go-forward basis, we’re more optimistic and more constructive about our volumes.

So I don’t see – I don’t see this volume continuing this level. I see sequential improvement, and we do see, as we’ll talk about next week in great detail exactly what that looks like as we return to a more balanced equation of volume versus price, but there’s no question, this has been an unprecedented time in this industry with the type of pricing that’s been necessary to take because of the input cost inflation. But we’ve got lots of dry powder as we think about the second half of the year to drive real quality merchandising. I’m talking about display execution, brand building with significant advertising spend, really creating those connections with our consumers. So, in line with expectations, admittedly a high volume decline, but nothing that surprised us going forward.

And maybe Amit can build on that.