• by Karlene Lukovitz  @KLmarketdaily, July 29, 2010

Citing weak cereal sales in North America and the U.K., fallout from a late-June voluntary recall of 28 million boxes of cereal, and a supply disruption that is still affecting Eggo sales, Kellogg Company reported a 15% drop in net income to $302 million for Q2 2010.

The company also lowered its full-year EPS growth (on a currency-neutral basis) to 8%-10%, from its previous guidance of 11%-13%.

Q2 diluted EPS declined 14% to $0.79, and currency-neutral EPS declined 11%. Net sales declined 5% to $3.1 billion (internal net sales, excluding foreign currency translation, declined 4%). Operating profit declined 13%, to $483 million.

During the quarter's performance call on July 29, CEO David Mackay, noting weaker-than-expected cereal category performance and the recall's effects, acknowledged disappointment in the Q2 results.

However, he said that Kellogg expects a stronger second half driven by increased innovation, increased advertising and other reinvestment in the business, and gradual improvement in key category trends. Internal net sales are now projected to be flat to up by 1% for the year. The company's three-year, $1 billion-plus cost savings initiative continues to be on track, Kellogg reported.

The Q2 financial effects of the product recall -- involving boxes of Apple Jacks, Corn Pops, Froot Loops and Honey Smacks whose liners produced an unusual taste and odor (causing nausea and diarrhea among some consumers, but no known serious health threats) -- included an 11% negative impact on internal operating profit, a 90-basis point decline in gross margin (to 42.6%), and a negative EPS impact of approximately $0.10, according to the company.

On a full-year basis, Kellogg estimates that the recall's impacts -- including lost sales -- will reduce EPS by approximately $0.12 or about 4% versus previous guidance, while sales performance will account for 1% to 2% of the lower EPS projection. Lower cereal input costs should lift EPS by 1%.

Responding to an analyst who noted that the cereal recall represents the second recent food safety issue for Kellogg (in January, the FDA order the company to improve sanitation controls at an Atlanta plant after Eggo buttermilk waffles were found to be contaminated with Listeria bacteria), Mackay emphasized that Kellogg has increased its diligence in working with suppliers to ensure that they meet the company's "high quality standards."

Q2 cereal sales were impacted by a deflationary environment for the category, particularly in the U.S. and U.K., according to Mackay. An abundance of cereal discount promotions, welcomed by retailers looking to drive store traffic, has resulted in somewhat weakened promotion results for all category manufacturers, he noted during the quarterly call.

A 5% Q2 decline in Kellogg's total North American net sales was driven primarily by a 13% decline in net cereal sales -- reflecting the category's continued weakness, the recall, and reductions in retailer inventories of its cereal brands, Kellogg reported. Consumption of Kellogg's North American cereal brands was down 5%, and the recall and lower trade inventories had negative impacts of 5% and 3%, respectively, resulting in a one-point share loss for the period (this was against a 6% to 7% consumption gain, 4% net sales gain and one-point share gain in N.A. during Q2 2009).

Frozen and specialty channels product sales were down 9%, as Eggo sales continued to suffer from a shortage/supply disruption resulting from flooding last fall in an Atlanta waffle factory and equipment changes/slowed production at a key Tennessee waffle factory in last year's second half. Kellogg now has sufficient supply to begin advertising/trade promotions for the brand, and expects its sales to show modest growth in the second half as a result of advertising, new additions to the line such as Eggo Cinnabon Pancakes, and increased retailer freezer space for the brand, COO/CFO John Bryant said during the quarterly call.

North American snack sales rose 1%. Crackers and cookies were down, but Pop Tart sales rose by mid-single digits and launches -- including new varieties of Town House Flatbread Crisps, 100 Calorie Right Bites Brownie Minis, Special K Fruit Crisps and FiberPlus extensions such as Antioxidant Bars -- are performing well, Bryant reported. Kellogg expects continued growth in "wholesome snacks" and Pop Tarts, but continued weakness in cookies, in the second half.

Internationally, Kellogg's Q2 net sales were down 3% in Europe -- reflecting performance in its important U.K. market -- but up 5% in Latin America and 3% in Asia-Pacific, for flat international performance overall.

Kellogg's companywide advertising spend (excluding foreign currency translation) decreased by 3% in Q1, but increased by 4% in Q2, reflecting mid-single-digit or greater spending increases in all regions, according to Bryant. The company expects to grow ad spend by a percentage in the mid-single digits for the overall year.

Questioned during the call about the level of advertising spending versus sales results, Mackay noted that cereal as a whole tends to be among the highest-spending categories, and said that Kellogg sees important opportunities in marketing outreach to the Hispanic market, support of product launches and other areas.

"We believe that mid-single-digits growth [in ad spending] is a good level for us," Mackay said, adding that Kellogg is "comfortable that we will realize good ROI in the medium to longer term."