Attached files
| file | filename |
|---|---|
| EX-32.2 - EXHIBIT 32.2 - KELLOGG CO | k-2017q1ex322.htm |
| EX-32.1 - EXHIBIT 32.1 - KELLOGG CO | k-2017q1ex321.htm |
| EX-31.2 - EXHIBIT 31.2 - KELLOGG CO | k-2017q1ex312.htm |
| EX-31.1 - EXHIBIT 31.1 - KELLOGG CO | k-2017q1ex311.htm |
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
(Mark One)
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended April 1, 2017
OR
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission file number 1-4171
KELLOGG COMPANY
State of Incorporation—Delaware | IRS Employer Identification No.38-0710690 | |
One Kellogg Square, P.O. Box 3599, Battle Creek, MI 49016-3599
Registrant’s telephone number: 269-961-2000
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or shorter period that the registrant was required to submit and post such files).
Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer”, “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer x | Accelerated filer ¨ | Non-accelerated filer ¨ | Smaller reporting company ¨ | Emerging growth company o |
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨ No x
Common Stock outstanding as of April 29, 2017 — 350,277,682 shares
KELLOGG COMPANY
INDEX
Page | |
Financial Statements | |
Management’s Discussion and Analysis of Financial Condition and Results of Operations | |
Quantitative and Qualitative Disclosures about Market Risk | |
Controls and Procedures | |
Risk Factors | |
Unregistered Sales of Equity Securities and Use of Proceeds | |
Exhibits | |
Part I – FINANCIAL INFORMATION
Item 1. Financial Statements.
Kellogg Company and Subsidiaries
CONSOLIDATED BALANCE SHEET
(millions, except per share data)
April 1, 2017 (unaudited) | December 31, 2016 * | |||||
Current assets | ||||||
Cash and cash equivalents | $ | 298 | $ | 280 | ||
Accounts receivable, net | 1,464 | 1,231 | ||||
Inventories: | ||||||
Raw materials and supplies | 318 | 315 | ||||
Finished goods and materials in process | 877 | 923 | ||||
Other prepaid assets | 189 | 191 | ||||
Total current assets | 3,146 | 2,940 | ||||
Property, net of accumulated depreciation of $5,397 and $5,280 | 3,576 | 3,569 | ||||
Investments in unconsolidated entities | 440 | 438 | ||||
Goodwill | 5,084 | 5,166 | ||||
Other intangibles, net of accumulated amortization of $56 and $54 | 2,442 | 2,369 | ||||
Other assets | 739 | 629 | ||||
Total assets | $ | 15,427 | $ | 15,111 | ||
Current liabilities | ||||||
Current maturities of long-term debt | $ | 632 | $ | 631 | ||
Notes payable | 629 | 438 | ||||
Accounts payable | 1,995 | 2,014 | ||||
Accrued advertising and promotion | 464 | 436 | ||||
Accrued income taxes | 141 | 47 | ||||
Accrued salaries and wages | 251 | 318 | ||||
Other current liabilities | 620 | 590 | ||||
Total current liabilities | 4,732 | 4,474 | ||||
Long-term debt | 6,715 | 6,698 | ||||
Deferred income taxes | 456 | 525 | ||||
Pension liability | 1,008 | 1,024 | ||||
Other liabilities | 494 | 464 | ||||
Commitments and contingencies | ||||||
Equity | ||||||
Common stock, $.25 par value | 105 | 105 | ||||
Capital in excess of par value | 817 | 806 | ||||
Retained earnings | 6,650 | 6,571 | ||||
Treasury stock, at cost | (4,078 | ) | (3,997 | ) | ||
Accumulated other comprehensive income (loss) | (1,488 | ) | (1,575 | ) | ||
Total Kellogg Company equity | 2,006 | 1,910 | ||||
Noncontrolling interests | 16 | 16 | ||||
Total equity | 2,022 | 1,926 | ||||
Total liabilities and equity | $ | 15,427 | $ | 15,111 | ||
* Condensed from audited financial statements.
Refer to Notes to Consolidated Financial Statements.
3
Kellogg Company and Subsidiaries
CONSOLIDATED STATEMENT OF INCOME
(millions, except per share data)
Quarter ended | ||||||
(Results are unaudited) | April 1, 2017 | April 2, 2016 | ||||
Net sales | $ | 3,254 | $ | 3,395 | ||
Cost of goods sold | 2,050 | 2,150 | ||||
Selling, general and administrative expense | 844 | 807 | ||||
Operating profit | 360 | 438 | ||||
Interest expense | 61 | 217 | ||||
Other income (expense), net | 3 | — | ||||
Income before income taxes | 302 | 221 | ||||
Income taxes | 42 | 47 | ||||
Earnings (loss) from unconsolidated entities | 2 | 1 | ||||
Net Income | $ | 262 | $ | 175 | ||
Per share amounts: | ||||||
Basic earnings | $ | 0.75 | $ | 0.50 | ||
Diluted earnings | $ | 0.74 | $ | 0.49 | ||
Dividends | $ | 0.52 | $ | 0.50 | ||
Average shares outstanding: | ||||||
Basic | 351 | 351 | ||||
Diluted | 354 | 355 | ||||
Actual shares outstanding at period end | 350 | 350 | ||||
Refer to Notes to Consolidated Financial Statements.
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Kellogg Company and Subsidiaries
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
(millions)
Quarter ended April 1, 2017 | |||||||||
(Results are unaudited) | Pre-tax amount | Tax (expense) benefit | After-tax amount | ||||||
Net income | $ | 262 | |||||||
Other comprehensive income (loss): | |||||||||
Foreign currency translation adjustments | 76 | 9 | 85 | ||||||
Cash flow hedges: | |||||||||
Reclassification to net income | 2 | (1 | ) | 1 | |||||
Postretirement and postemployment benefits: | |||||||||
Reclassification to net income: | |||||||||
Net experience loss | 1 | — | 1 | ||||||
Other comprehensive income (loss) | $ | 79 | $ | 8 | $ | 87 | |||
Comprehensive income | $ | 349 | |||||||
Quarter ended April 2, 2016 | |||||||||
(Results are unaudited) | Pre-tax amount | Tax (expense) benefit | After-tax amount | ||||||
Net income | $ | 175 | |||||||
Other comprehensive income (loss): | |||||||||
Foreign currency translation adjustments | (55 | ) | 29 | (26 | ) | ||||
Cash flow hedges: | |||||||||
Unrealized gain (loss) on cash flow hedges | (57 | ) | 23 | (34 | ) | ||||
Reclassification to net income | 2 | (1 | ) | 1 | |||||
Postretirement and postemployment benefits: | |||||||||
Reclassification to net income: | |||||||||
Net experience loss | 1 | — | 1 | ||||||
Other comprehensive income (loss) | $ | (109 | ) | $ | 51 | $ | (58 | ) | |
Comprehensive income | $ | 117 | |||||||
Refer to Notes to Consolidated Financial Statements.
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Kellogg Company and Subsidiaries
CONSOLIDATED STATEMENT OF EQUITY
(millions)
Common stock | Capital in excess of par value | Retained earnings | Treasury stock | Accumulated other comprehensive income (loss) | Total Kellogg Company equity | Non-controlling interests | Total equity | |||||||||||||||||||||
(unaudited) | shares | amount | shares | amount | ||||||||||||||||||||||||
Balance, January 2, 2016 | 420 | $ | 105 | $ | 745 | $ | 6,597 | 70 | $ | (3,943 | ) | $ | (1,376 | ) | $ | 2,128 | $ | 10 | $ | 2,138 | ||||||||
Common stock repurchases | 6 | (426 | ) | (426 | ) | (426 | ) | |||||||||||||||||||||
Net income | 694 | 694 | 1 | 695 | ||||||||||||||||||||||||
Acquisition of noncontrolling interest | — | 5 | 5 | |||||||||||||||||||||||||
Dividends | (716 | ) | (716 | ) | (716 | ) | ||||||||||||||||||||||
Other comprehensive loss | (199 | ) | (199 | ) | — | (199 | ) | |||||||||||||||||||||
Stock compensation | 63 | 63 | 63 | |||||||||||||||||||||||||
Stock options exercised and other | (2 | ) | (4 | ) | (7 | ) | 372 | 366 | 366 | |||||||||||||||||||
Balance, December 31, 2016 | 420 | $ | 105 | $ | 806 | $ | 6,571 | 69 | $ | (3,997 | ) | $ | (1,575 | ) | $ | 1,910 | $ | 16 | $ | 1,926 | ||||||||
Common stock repurchases | 2 | (125 | ) | (125 | ) | (125 | ) | |||||||||||||||||||||
Net income | 262 | 262 | 262 | |||||||||||||||||||||||||
Dividends | (182 | ) | (182 | ) | (182 | ) | ||||||||||||||||||||||
Other comprehensive income | 87 | 87 | 87 | |||||||||||||||||||||||||
Stock compensation | 17 | 17 | 17 | |||||||||||||||||||||||||
Stock options exercised and other | (6 | ) | (1 | ) | (1 | ) | 44 | 37 | 37 | |||||||||||||||||||
Balance, April 1, 2017 | 420 | $ | 105 | $ | 817 | $ | 6,650 | 70 | $ | (4,078 | ) | $ | (1,488 | ) | $ | 2,006 | $ | 16 | $ | 2,022 | ||||||||
Refer to notes to Consolidated Financial Statements.
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Kellogg Company and Subsidiaries
CONSOLIDATED STATEMENT OF CASH FLOWS
(millions)
Quarter ended | ||||||
(unaudited) | April 1, 2017 | April 2, 2016 | ||||
Operating activities | ||||||
Net income | $ | 262 | $ | 175 | ||
Adjustments to reconcile net income to operating cash flows: | ||||||
Depreciation and amortization | 121 | 115 | ||||
Postretirement benefit plan expense (benefit) | (56 | ) | (28 | ) | ||
Deferred income taxes | (67 | ) | — | |||
Stock compensation | 17 | 15 | ||||
Other | 30 | (27 | ) | |||
Postretirement benefit plan contributions | (24 | ) | (17 | ) | ||
Changes in operating assets and liabilities, net of acquisitions: | ||||||
Trade receivables | (192 | ) | (201 | ) | ||
Inventories | 58 | 49 | ||||
Accounts payable | 11 | 89 | ||||
Accrued income taxes | 92 | (13 | ) | |||
Accrued interest expense | 48 | 12 | ||||
Accrued and prepaid advertising and promotion | 18 | 12 | ||||
Accrued salaries and wages | (71 | ) | (113 | ) | ||
All other current assets and liabilities | (36 | ) | (63 | ) | ||
Net cash provided by (used in) operating activities | 211 | 5 | ||||
Investing activities | ||||||
Additions to properties | (130 | ) | (144 | ) | ||
Acquisitions, net of cash acquired | — | (18 | ) | |||
Other | (1 | ) | 7 | |||
Net cash provided by (used in) investing activities | (131 | ) | (155 | ) | ||
Financing activities | ||||||
Net issuances (reductions) of notes payable | 191 | (485 | ) | |||
Issuances of long-term debt | — | 1,382 | ||||
Reductions of long-term debt | (1 | ) | (473 | ) | ||
Net issuances of common stock | 40 | 164 | ||||
Common stock repurchases | (125 | ) | (198 | ) | ||
Cash dividends | (182 | ) | (176 | ) | ||
Other | — | — | ||||
Net cash provided by (used in) financing activities | (77 | ) | 214 | |||
Effect of exchange rate changes on cash and cash equivalents | 15 | (5 | ) | |||
Increase (decrease) in cash and cash equivalents | 18 | 59 | ||||
Cash and cash equivalents at beginning of period | 280 | 251 | ||||
Cash and cash equivalents at end of period | $ | 298 | $ | 310 | ||
Supplemental cash flow disclosures | ||||||
Interest paid | $ | 16 | $ | 199 | ||
Income taxes paid | $ | 16 | $ | 59 | ||
Supplemental cash flow disclosures of non-cash investing activities: | ||||||
Additions to properties included in accounts payable | $ | 106 | $ | 88 | ||
Refer to Notes to Consolidated Financial Statements.
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Notes to Consolidated Financial Statements
for the quarter ended April 1, 2017 (unaudited)
Note 1 Accounting policies
Basis of presentation
The unaudited interim financial information of Kellogg Company (the Company) included in this report reflects all adjustments, all of which are of a normal and recurring nature, that management believes are necessary for a fair statement of the results of operations, comprehensive income, financial position, equity and cash flows for the periods presented. This interim information should be read in conjunction with the financial statements and accompanying footnotes within the Company’s 2016 Annual Report on Form 10-K.
The condensed balance sheet information at December 31, 2016 was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States. The results of operations for the quarterly period ended April 1, 2017 are not necessarily indicative of the results to be expected for other interim periods or the full year.
Accounts payable
The Company has agreements with certain third parties to provide accounts payable tracking systems which facilitates participating suppliers’ ability to monitor and, if elected, sell payment obligations from the Company to designated third-party financial institutions. Participating suppliers may, at their sole discretion, make offers to sell one or more payment obligations of the Company prior to their scheduled due dates at a discounted price to participating financial institutions. The Company’s goal in entering into these agreements is to capture overall supplier savings, in the form of payment terms or vendor funding, created by facilitating suppliers’ ability to sell payment obligations, while providing them with greater working capital flexibility. We have no economic interest in the sale of these suppliers’ receivables and no direct financial relationship with the financial institutions concerning these services. The Company’s obligations to its suppliers, including amounts due and scheduled payment dates, are not impacted by suppliers’ decisions to sell amounts under these arrangements. However, the Company’s right to offset balances due from suppliers against payment obligations is restricted by this agreement for those payment obligations that have been sold by suppliers. As of April 1, 2017, $731 million of the Company’s outstanding payment obligations had been placed in the accounts payable tracking system, and participating suppliers had sold $543 million of those payment obligations to participating financial institutions. As of December 31, 2016, $677 million of the Company’s outstanding payment obligations had been placed in the accounts payable tracking system, and participating suppliers had sold $507 million of those payment obligations to participating financial institutions.
New accounting standards
Income Taxes. In October 2016, the FASB, as part of their simplification initiative, issued an ASU to improve the accounting for income tax consequences of intra-entity transfers of assets other than inventory. Current Generally Accepted Accounting Principles (GAAP) prohibit recognition of current and deferred income taxes for intra-entity asset transfers until the asset has been sold to an outside party, which is an exception to the principle of comprehensive recognition of current and deferred income taxes in GAAP. The amendments in the ASU eliminate the exception, such that entities should recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. Early adoption is permitted, as of the beginning of an annual reporting period for which financial statements have not been issued or made available for issuance. That is, early adoption should be the first interim period if an entity issues interim financial statements. The amendments in this ASU should be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the period of adoption. The Company early adopted the ASU in the first quarter of 2017. As a result of an intercompany transfer of intellectual property, the Company recorded a $38 million reduction in income tax expense in the quarter ended April 1, 2017. Upon adoption, there was no cumulative effect adjustment to retained earnings.
Accounting standards to be adopted in future periods
Improving the Presentation of net Periodic Pension Cost and net Periodic Postretirement Benefit Cost. In March 2017, the FASB issued an ASU to improve the presentation of net periodic pension cost and net periodic postretirement benefit cost. The ASU requires that an employer report the service cost component in the same line item or items as other compensation costs arising from services rendered by the pertinent employees during the
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period. The other components of net benefit cost are required to be presented in the income statement separately from the service cost component and outside a subtotal of income from operations, if one is presented. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. Early adoption is permitted, as of the beginning of an annual reporting period for which financial statements (interim or annual) have not been issued or made available for issuance. That is, early adoption should be the first interim period if an entity issues interim financial statements. The amendments in this ASU should be applied retrospectively for the presentation of the service cost component and the other components of net periodic pension cost and net periodic postretirement benefit cost in the income statement and prospectively, on and after the effective date, for the capitalization of the service cost component of net periodic pension cost and net periodic postretirement benefit in assets. The Company will adopt the ASU in the first quarter of 2018. See further discussion in Accounting policies to be adopted in future periods section of MD&A.
Simplifying the test for goodwill impairment. In January 2017, the FASB issued an ASU to simplify how an entity is required to test goodwill for impairment by eliminating Step 2 from the goodwill impairment test. Step 2 measures a goodwill impairment loss by comparing the implied fair value of a reporting unit's goodwill with the carrying amount of that goodwill. The ASU is effective for an entity's annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The amendments in this ASU should be applied on a prospective basis. The Company is currently assessing the impact and timing of adoption of this ASU.
Statement of Cash Flows. In August 2016, the FASB issued an ASU to provide cash flow statement classification guidance for certain cash receipts and payments including (a) debt prepayment or extinguishment costs; (b) contingent consideration payments made after a business combination; (c) insurance settlement proceeds; (d) distributions from equity method investees; (e) beneficial interests in securitization transactions and (f) application of the predominance principle for cash receipts and payments with aspects of more than one class of cash flows. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. Early adoption is permitted, including adoption in an interim period, in which case adjustments should be reflected as of the beginning of the fiscal year that includes the interim period. The amendments in this ASU should be applied retrospectively. The Company will adopt the new ASU in the first quarter of 2018. The Company doesn't expect material impacts to the financial statements upon adoption, activities impacted by adoption of this ASU will continue to be monitored throughout its 2017 fiscal year.
Leases. In February 2016, the FASB issued an ASU which will require the recognition of lease assets and lease liabilities by lessees for all leases with terms greater than 12 months. The distinction between finance leases and operating leases will remain, with similar classification criteria as current GAAP to distinguish between capital and operating leases. The principal difference from current guidance is that the lease assets and lease liabilities arising from operating leases will be recognized on the Consolidated Balance Sheet. Lessor accounting remains substantially similar to current GAAP. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018. Early adoption is permitted. The Company will adopt the ASU in the first quarter of 2019, and is currently evaluating the impact that implementing this ASU will have on its financial statements.
Recognition and measurement of financial assets and liabilities. In January 2016, the FASB issued an ASU which primarily affects the accounting for equity investments, financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. The ASU is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. Early adoption can be elected for all financial statements of fiscal years and interim periods that have not yet been issued or that have not yet been made available for issuance. Entities should apply the update by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The Company will adopt the updated standard in the first quarter of 2018. The Company does not expect the adoption of this ASU to have a significant impact on its financial statements.
Revenue from contracts with customers. In May 2014, the FASB issued an ASU, as amended, which provides guidance for accounting for revenue from contracts with customers. The core principle of this ASU is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration the entity expects to be entitled to in exchange for those goods or services. To achieve that core principle, an entity would be required to apply the following five steps: 1) identify the contract(s) with a customer; 2) identify the performance obligations in the contract; 3) determine the transaction price; 4) allocate the transaction price to the performance obligations in the contract and 5) recognize revenue when (or as) the entity
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satisfies a performance obligation. When the ASU was originally issued it was effective for fiscal years, and interim periods within those years, beginning after December 15, 2016, and early adoption was not permitted. On July 9, 2015, the FASB decided to delay the effective date of the new revenue standard by one year. The updated standard will be effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. Entities will be permitted to adopt the new revenue standard early, but not before the original effective date. Entities will have the option to apply the final standard retrospectively or use a modified retrospective method, recognizing the cumulative effect of the ASU in retained earnings at the date of initial application. An entity will not restate prior periods if it uses the modified retrospective method, but will be required to disclose the amount by which each financial statement line item is affected in the current reporting period by the application of the ASU as compared to the guidance in effect prior to the change, as well as reasons for significant changes. The Company will adopt the updated standard in the first quarter of 2018, using a modified retrospective transition method, and the adoption is not expected to have a significant impact on its historical financial statements.
Note 2 Sale of accounts receivable
In March 2016, the Company entered into an agreement (the “Receivable Sales Agreement”), to sell, on a revolving basis, certain trade accounts receivable balances to a third party financial institution. Transfers under this agreement are accounted for as sales of receivables resulting in the receivables being de-recognized from the Consolidated Balance Sheet. The Receivable Sales Agreement provides for the continuing sale of certain receivables on a revolving basis until terminated by either party; however the maximum receivables that may be sold at any time is $700 million. During the quarters ended April 1, 2017 and April 2, 2016 approximately $535 million and $53 million, respectively, of accounts receivable have been sold via this arrangement. Accounts receivable sold of $611 million and $562 million remained outstanding under this arrangement as of April 1, 2017 and December 31, 2016, respectively. The proceeds from these sales of receivables are included in cash from operating activities in the Consolidated Statement of Cash Flows. The recorded net loss on sale of receivables was immaterial for the quarters ended April 1, 2017 and April 2, 2016 and is included in Other income and expense.
In July 2016, the Company entered into a U.S. accounts receivable securitization program with a third party financial institution. Under the program, we receive cash consideration of up to $600 million and a deferred purchase price asset for the remainder of the purchase price. Transfers under this agreement are accounted for as sales of receivables resulting in the receivables being de-recognized from the Consolidated Balance Sheet. This securitization program utilizes Kellogg Funding Company (Kellogg Funding), a wholly-owned subsidiary of the Company. Kellogg Funding's sole business consists of the purchase of receivables, from its parent or other subsidiary and subsequent transfer of such receivables and related assets to financial institutions. Although Kellogg Funding is included in our consolidated financial statements, it is a separate legal entity with separate creditors who will be entitled, upon its liquidation, to be satisfied out of Kellogg Funding assets prior to any assets or value in Kellogg Funding becoming available to the Company or its subsidiaries. The assets of Kellogg Funding are not available to pay creditors of the Company or its subsidiaries. This program expires in July 2017 but can be renewed with consent from the parties to the program.
During the quarter ended April 1, 2017, $595 million of accounts receivable were sold via the accounts receivable securitization program. As of April 1, 2017, approximately $353 million of accounts receivable sold to Kellogg Funding under the securitization program remained outstanding, for which the Company received net cash proceeds of approximately $303 million and a deferred purchase price asset of approximately $50 million. As of December 31, 2016, approximately $292 million of accounts receivable sold to Kellogg Funding under the securitization program remained outstanding, for which the Company received net cash proceeds of approximately $255 million and a deferred purchase price asset of approximately $37 million. The portion of the purchase price for the receivables which is not paid in cash by the financial institutions is a deferred purchase price asset, which is paid to Kellogg Funding as payments on the receivables are collected from customers. The deferred purchase price asset represents a beneficial interest in the transferred financial assets and is recognized at fair value as part of the sale transaction. The deferred purchase price asset is included in Other prepaid assets on the Consolidated Balance Sheet. The proceeds from these sales of receivables are included in cash from operating activities in the Consolidated Statement of Cash Flows. The recorded net loss on sale of receivables for the quarter ended April 1, 2017 is included in Other income and expense and is not material.
The Company has no retained interests in the receivables sold under the programs above which primarily enables the Company to extend customers payment terms for a net economic benefit attained on a cash flow neutral basis. The Company does have collection and administrative responsibilities for the sold receivables. The Company has
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not recorded any servicing assets or liabilities as of April 1, 2017 and December 31, 2016 for these agreements as the fair value of these servicing arrangements as well as the fees earned were not material to the financial statements.
Additionally, from time to time certain of the Company's foreign subsidiaries will transfer, without recourse, accounts receivable balances of certain customers to financial institutions. These transactions are accounted for as sales of the receivables resulting in the receivables being de-recognized from the Consolidated Balance Sheet. During the quarter ended April 1, 2017, $55 million of accounts receivable have been sold via these programs. Accounts receivable sold of $50 million and $124 million remained outstanding under these programs as of April 1, 2017 and December 31, 2016, respectively. The recorded net loss on the sale of these receivables is included in Other income and expense and is not material.
Note 3 Goodwill and other intangible assets
Parati acquisition
In December 2016, the Company acquired Ritmo Investimentos, controlling shareholder of Parati S/A, Afical Ltda and Padua Ltda ("Parati Group"), a leading Brazilian food group for approximately BRL 1.38 billion ($381 million) or $379 million, net of cash and cash equivalents. The purchase price is subject to certain working capital and net debt adjustments based on the actual working capital and net debt existing on the acquisition date compared to targeted amounts. The acquisition was accounted for under the purchase price method and was financed with cash on hand and short-term borrowings. The assets and liabilities of the Parati Group are included in the Consolidated Balance Sheet as of April 1, 2017 within the Latin America segment. The acquired assets and assumed liabilities include the following:
(millions) | December 1, 2016 | ||||
Current assets | $ | 44 | |||
Property | 72 | ||||
Goodwill | 145 | ||||
Intangible assets | 179 | ||||
Current liabilities | (48 | ) | |||
Non-current deferred tax liability and other | (13 | ) | |||
$ | 379 | ||||
The above amounts represent the allocation of purchase price as of April 1, 2017 and are subject to revision when the working capital and net debt adjustments to the purchase price are agreed between the parties and appraisals are finalized for property and intangible assets. These items will be finalized during 2017.
As of April 1, 2017, the Company had finalized plans to merge the acquired and pre-existing Brazilian legal entities, which will result in tax basis of the acquired intangible assets. Accordingly, deferred tax liabilities and goodwill were both reduced by $41 million in the quarter ended April 1, 2017. In addition, during the first quarter, the value of intangible assets subject to amortization increased $57 million and intangible assets not subject to amortization increased $4 million with an offsetting $61 million adjustment to goodwill in conjunction with the updated allocation of the purchase price.
A portion of the acquisition price aggregating $67 million was placed in escrow in favor of the seller for general representations and warranties, as well as pending resolution of certain contingencies arising from the business prior to the acquisition. The Company is still evaluating these amounts, which could result in the recognition of certain contingent liabilities along with corresponding receivables from the escrow account.
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Changes in the carrying amount of goodwill, intangible assets subject to amortization, consisting primarily of customer lists, and indefinite-lived intangible assets, consisting of brands, are presented in the following tables:
Carrying amount of goodwill
(millions) | U.S. Morning Foods | U.S. Snacks | U.S. Specialty | North America Other | Europe | Latin America | Asia Pacific | Consoli- dated | ||||||||||||||||
December 31, 2016 | $ | 131 | $ | 3,568 | $ | 82 | $ | 457 | $ | 376 | $ | 328 | $ | 224 | $ | 5,166 | ||||||||
Purchase price allocation adjustment | — | — | — | — | — | (102 | ) | — | (102 | ) | ||||||||||||||
Currency translation adjustment | — | — | — | 1 | 7 | 9 | 3 | 20 | ||||||||||||||||
April 1, 2017 | $ | 131 | $ | 3,568 | $ | 82 | $ | 458 | $ | 383 | $ | 235 | $ | 227 | $ | 5,084 | ||||||||
Intangible assets subject to amortization
Gross carrying amount | ||||||||||||||||||||||||
(millions) | U.S. Morning Foods | U.S. Snacks | U.S. Specialty | North America Other | Europe | Latin America | Asia Pacific | Consoli- dated | ||||||||||||||||
December 31, 2016 | $ | 8 | $ | 42 | $ | — | $ | 5 | $ | 40 | $ | 36 | $ | 10 | $ | 141 | ||||||||
Purchase price allocation adjustment | — | — | — | — | — | 57 | — | 57 | ||||||||||||||||
Currency translation adjustment | — | — | — | — | 1 | 4 | — | 5 | ||||||||||||||||
April 1, 2017 | $ | 8 | $ | 42 | $ | — | $ | 5 | $ | 41 | $ | 97 | $ | 10 | $ | 203 | ||||||||
Accumulated Amortization | ||||||||||||||||||||||||
December 31, 2016 | $ | 8 | $ | 19 | $ | — | $ | 4 | $ | 14 | $ | 6 | $ | 3 | $ | 54 | ||||||||
Amortization | — | 1 | — | — | 1 | — | — | 2 | ||||||||||||||||
April 1, 2017 | $ | 8 | $ | 20 | $ | — | $ | 4 | $ | 15 | $ | 6 | $ | 3 | $ | 56 | ||||||||
Intangible assets subject to amortization, net | ||||||||||||||||||||||||
December 31, 2016 | $ | — | $ | 23 | $ | — | $ | 1 | $ | 26 | $ | 30 | $ | 7 | $ | 87 | ||||||||
Purchase price allocation adjustment | — | — | — | — | — | 57 | — | 57 | ||||||||||||||||
Currency translation adjustment | — | — | — | — | 1 | 4 | — | 5 | ||||||||||||||||
Amortization | — | (1 | ) | — | — | (1 | ) | — | — | (2 | ) | |||||||||||||
April 1, 2017 | $ | — | $ | 22 | $ | — | $ | 1 | $ | 26 | $ | 91 | $ | 7 | $ | 147 | ||||||||
For intangible assets in the preceding table, amortization was $2 million and $2 million for the quarters ended April 1, 2017 and April 2, 2016, respectively. The currently estimated aggregate annual amortization expense for full-year 2017 is approximately $8 million.
Intangible assets not subject to amortization
(millions) | U.S. Morning Foods | U.S. Snacks | U.S. Specialty | North America Other | Europe | Latin America | Asia Pacific | Consoli- dated | ||||||||||||||||
December 31, 2016 | $ | — | $ | 1,625 | $ | — | $ | 176 | $ | 383 | $ | 98 | $ | — | $ | 2,282 | ||||||||
Purchase price allocation adjustment | — | — | — | — | — | 4 | — | 4 | ||||||||||||||||
Currency translation adjustment | — | — | — | — | 5 | 4 | — | 9 | ||||||||||||||||
April 1, 2017 | $ | — | $ | 1,625 | $ | — | $ | 176 | $ | 388 | $ | 106 | $ | — | $ | 2,295 | ||||||||
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Note 4 Restructuring and cost reduction activities
The Company views its restructuring and cost reduction activities as part of its operating principles to provide greater visibility in achieving its long-term profit growth targets. Initiatives undertaken are currently expected to recover cash implementation costs within a five-year period of completion. Upon completion (or as each major stage is completed in the case of multi-year programs), the project begins to deliver cash savings and/or reduced depreciation.
Total Projects
During the quarter ended April 1, 2017, the Company recorded total charges of $142 million across all restructuring and cost reduction activities. The charges were comprised of $15 million recorded in cost of goods sold (COGS) and $127 million recorded in selling, general and administrative (SG&A) expense.
During the quarter ended April 2, 2016, the Company recorded total charges of $52 million across all restructuring and cost reduction activities. The charges consist of $18 million recorded in COGS and $34 million recorded in SG&A expense.
Project K
In February 2017, the Company announced an expansion and an extension to its previously-announced global efficiency and effectiveness program (“Project K”), to reflect additional and changed initiatives. Project K is expected to continue generating a significant amount of savings that may be invested in key strategic areas of focus for the business or utilized to achieve our 2018 Margin Expansion target. The Company expects that these savings may be used to improve operating margins or drive future growth in the business.
In addition to the original program’s focus on strengthening existing businesses in core markets, increasing growth in developing and emerging markets, and driving an increased level of value-added innovation, the extended program will also focus on implementing a more efficient go-to-market model for certain businesses and creating a more efficient organizational design in several markets. Since inception, Project K has provided significant benefits and is expected to continue to provide a number of benefits in the future, including an optimized supply chain infrastructure, the implementation of global business services, a new global focus on categories, increased agility from a more efficient organization design, and improved effectiveness in go-to-market strategies.
The Company currently anticipates that Project K will result in total pre-tax charges, once all phases are approved and implemented, of $1.5 to $1.6 billion, with after-tax cash costs, including incremental capital investments, estimated to be to $1.1 billion. Based on current estimates and actual charges to date, the Company expects the total project charges will consist of asset-related costs of approximately $500 million which will consist primarily of asset impairments, accelerated depreciation and other exit-related costs; employee-related costs of approximately $500 million which will include severance, pension and other termination benefits; and other costs of approximately $600 million which consists primarily of charges related to the design and implementation of global business capabilities and a more efficient go-to-market model.
The Company currently expects that total pre-tax charges will impact reportable segments as follows: U.S. Morning Foods (approximately 13%), U.S. Snacks (approximately 35%), U.S. Specialty (approximately 1%), North America Other (approximately 11%), Europe (approximately 21%), Latin America (approximately 1%), Asia-Pacific (approximately 6%), and Corporate (approximately 12%).
Since the inception of Project K, the Company has recognized charges of $1,258 million that have been attributed to the program. The charges consist of $6 million recorded as a reduction of revenue, $705 million recorded in COGS and $547 million recorded in SG&A expense.
Other Projects
In 2015 the Company implemented a zero-based budgeting (ZBB) program in its North America business that has deliver ongoing annual savings. During 2016, ZBB was expanded to include the international segments of the business. In support of the ZBB initiative, the Company incurred pre-tax charges of approximately $1 million and $7 million during the quarters ended April 1, 2017 and April 2, 2016, respectively. Total charges of $38 million have been recognized since the inception of the ZBB program.
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The tables below provide the details for charges across all restructuring and cost reduction activities incurred during the quarter and year-to-date periods ended April 1, 2017 and April 2, 2016 and program costs to date for programs currently active as of April 1, 2017.
Quarter ended | Program costs to date | |||||||||
(millions) | April 1, 2017 | April 2, 2016 | April 1, 2017 | |||||||
Employee related costs | $ | 111 | $ | 14 | $ | 479 | ||||
Asset related costs | 10 | 10 | 202 | |||||||
Asset impairment | — | — | 155 | |||||||
Other costs | 21 | 28 | 460 | |||||||
Total | $ | 142 | $ | 52 | $ | 1,296 | ||||
Quarter ended | Program costs to date | |||||||||
(millions) | April 1, 2017 | April 2, 2016 | April 1, 2017 | |||||||
U.S. Morning Foods | $ | 1 | $ | 5 | $ | 242 | ||||
U.S. Snacks | 120 | 20 | 322 | |||||||
U.S. Specialty | — | 2 | 19 | |||||||
North America Other | 7 | 9 | 135 | |||||||
Europe | 6 | 14 | 305 | |||||||
Latin America | 1 | — | 25 | |||||||
Asia Pacific | 1 | — | 82 | |||||||
Corporate | 6 | 2 | 166 | |||||||
Total | $ | 142 | $ | 52 | $ | 1,296 | ||||
For the quarters ended April 1, 2017 and April 2, 2016 employee related costs consist primarily of severance and other termination related benefits, asset related costs consist primarily of accelerated depreciation, and other costs consist primarily of third-party incremental costs related to the development and implementation of global business capabilities and a more efficient go-to-market model.
At April 1, 2017 total exit cost reserves were $204 million, related to severance payments and other costs of which a substantial portion will be paid out in 2017 and 2018. The following table provides details for exit cost reserves.
Employee Related Costs | Asset Impairment | Asset Related Costs | Other Costs | Total | |||||||||||
Liability as of December 31, 2016 | $ | 102 | $ | — | $ | — | $ | 29 | $ | 131 | |||||
2017 restructuring charges | 111 | — | 10 | 21 | 142 | ||||||||||
Cash payments | (16 | ) | — | — | (39 | ) | (55 | ) | |||||||
Non-cash charges and other | (4 | ) | — | (10 | ) | — | (14 | ) | |||||||
Liability as of April 1, 2017 | $ | 193 | $ | — | $ | — | $ | 11 | $ | 204 | |||||
Note 5 Equity
Earnings per share
Basic earnings per share is determined by dividing net income by the weighted average number of common shares outstanding during the period. Diluted 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 consist principally of employee stock options issued by the Company, and to a lesser extent, certain contingently issuable performance shares. Basic earnings per share is reconciled to diluted earnings per share in the following table. There were 4 million and 2 million anti-dilutive potential common shares excluded from the reconciliation for the quarters ended April 1, 2017 and April 2, 2016, respectively.
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Quarters ended April 1, 2017 and April 2, 2016:
(millions, except per share data) | Net income | Average shares outstanding | Earnings per share | |||||
2017 | ||||||||
Basic | $ | 262 | 351 | $ | 0.75 | |||
Dilutive potential common shares | 3 | (0.01 | ) | |||||
Diluted | $ | 262 | 354 | $ | 0.74 | |||
2016 | ||||||||
Basic | $ | 175 | 351 | $ | 0.50 | |||
Dilutive potential common shares | 4 | (0.01 | ) | |||||
Diluted | $ | 175 | 355 | $ | 0.49 | |||
In December 2015, the board of directors approved a new authorization to repurchase of up to $1.5 billion of our common stock beginning in 2016 through December 2017. As of April 1, 2017, $949 million remains available under the authorization.
During the quarter ended April 1, 2017, the Company repurchased approximately 2 million shares of common stock for a total of $125 million. During the quarter ended April 2, 2016, the Company repurchased 3 million shares of common stock for a total of $210 million.
Comprehensive income
Comprehensive income includes net income and all other changes in equity during a period except those resulting from investments by or distributions to shareholders. Other comprehensive income consists of foreign currency translation adjustments, fair value adjustments associated with cash flow hedges and adjustments for net experience losses and prior service cost related to employee benefit plans.
15
Reclassifications out of AOCI for the quarter ended April 1, 2017 consisted of the following:
(millions) | |||||||
Details about AOCI components | Amount reclassified from AOCI | Line item impacted within Income Statement | |||||
Quarter ended April 1, 2017 | Quarter ended April 2, 2016 | ||||||
(Gains) losses on cash flow hedges: | |||||||
Foreign currency exchange contracts | $ | (1 | ) | $ | (7 | ) | COGS |
Foreign currency exchange contracts | — | — | SG&A | ||||
Interest rate contracts | 2 | 6 | Interest expense | ||||
Commodity contracts | — | 3 | COGS | ||||
$ | 1 | $ | 2 | Total before tax | |||
— | (1 | ) | Tax expense (benefit) | ||||
$ | 1 | $ | 1 | Net of tax | |||
Amortization of postretirement and postemployment benefits: | |||||||
Net experience loss | $ | 1 | $ | 1 | See Note 8 for further details | ||
Prior service cost | — | — | See Note 8 for further details | ||||
$ | 1 | $ | 1 | Total before tax | |||
— | — | Tax expense (benefit) | |||||
$ | 1 | $ | 1 | Net of tax | |||
Total reclassifications | $ | 2 | $ | 2 | Net of tax | ||
Accumulated other comprehensive income (loss) as of April 1, 2017 and December 31, 2016 consisted of the following:
(millions) | April 1, 2017 | December 31, 2016 | ||||
Foreign currency translation adjustments | $ | (1,420 | ) | $ | (1,505 | ) |
Cash flow hedges — unrealized net gain (loss) | (66 | ) | (67 | ) | ||
Postretirement and postemployment benefits: | ||||||
Net experience loss | (13 | ) | (14 | ) | ||
Prior service cost | 11 | 11 | ||||
Total accumulated other comprehensive income (loss) | $ | (1,488 | ) | $ | (1,575 | ) |
Note 6 Debt
The following table presents the components of notes payable at April 1, 2017 and December 31, 2016:
April 1, 2017 | December 31, 2016 | ||||||||||
(millions) | Principal amount | Effective interest rate (a) | Principal amount | Effective interest rate (a) | |||||||
U.S. commercial paper | $ | 242 | 0.85 | % | $ | 80 | 0.61 | % | |||
Europe commercial paper | 315 | (0.17 | )% | 306 | (0.18 | )% | |||||
Bank borrowings | 72 | 52 | |||||||||
Total | $ | 629 | $ | 438 | |||||||
(a) Negative effective interest rates on certain borrowings in Europe are the result of efforts by the European Central Bank to stimulate the economy in the eurozone.
16
The Company has entered into interest rate swaps with notional amounts totaling $2.2 billion, which effectively converts a portion of the associated U.S. Dollar Notes from fixed rate to floating rate obligations. These derivative instruments are designated as fair value hedges. The effective interest rates on debt obligations resulting from the Company’s interest rate swaps as of April 1, 2017 were as follows: (a) five-year 1.75% U.S. Dollar Notes due 2017 – 1.94%; (b) seven-year 3.25% U.S. Dollar Notes due 2018 – 2.56%; (c) ten-year 4.15% U.S. Dollar Notes due 2019 – 3.53%; (d) ten-year 4.00% U.S. Dollar Notes due 2020 – 2.91%; (e) ten-year 3.125% U.S. Dollar Notes due 2022 – 2.32%; (f) ten-year 2.75% U.S. Dollar Notes due 2023 – 2.47%; (g) seven-year 2.65% U.S. Dollar Notes due 2023 – 2.23%; (h) eight-year 1.00% Euro Notes due 2024 – 0.74% and (i) ten-year 3.25% U.S. Notes due 2026 – 3.52%.
Note 7 Stock compensation
The Company uses various equity-based compensation programs to provide long-term performance incentives for its global workforce. Currently, these incentives consist principally of stock options, restricted stock units, and to a lesser extent, executive performance shares and restricted stock grants. The Company also sponsors a discounted stock purchase plan in the United States and matching-grant programs in several international locations. Additionally, the Company awards restricted stock to its outside directors. The interim information below should be read in conjunction with the disclosures included within the stock compensation footnote of the Company’s 2016 Annual Report on Form 10-K.
The Company classifies pre-tax stock compensation expense in COGS and SG&A expense principally within its Corporate segment. For the periods presented, compensation expense for all types of equity-based programs and the related income tax benefit recognized was as follows:
Quarter ended | ||||||
(millions) | April 1, 2017 | April 2, 2016 | ||||
Pre-tax compensation expense | $ | 18 | $ | 16 | ||
Related income tax benefit | $ | 6 | $ | 6 | ||
As of April 1, 2017, total stock-based compensation cost related to non-vested awards not yet recognized was $145 million and the weighted-average period over which this amount is expected to be recognized was 2 years.
Stock options
During the quarters ended April 1, 2017 and April 2, 2016, the Company granted non-qualified stock options to eligible employees as presented in the following activity tables. Terms of these grants and the Company’s methods for determining grant-date fair value of the awards were consistent with that described within the stock compensation footnote in the Company’s 2016 Annual Report on Form 10-K.
Quarter ended April 1, 2017:
Employee and director stock options | Shares (millions) | Weighted- average exercise price | Weighted- average remaining contractual term (yrs.) | Aggregate intrinsic value (millions) | ||||||
Outstanding, beginning of period | 15 | $ | 62 | |||||||
Granted | 2 | 73 | ||||||||
Exercised | (1 | ) | 56 | |||||||
Forfeitures and expirations | — | — | ||||||||
Outstanding, end of period | 16 | $ | 64 | 7.2 | $ | 147 | ||||
Exercisable, end of period | 11 | $ | 60 | 6.3 | $ | 140 | ||||
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Quarter ended April 2, 2016:
Employee and director stock options | Shares (millions) | Weighted- average exercise price | Weighted- average remaining contractual term (yrs.) | Aggregate intrinsic value (millions) | ||||||
Outstanding, beginning of period | 19 | $ | 58 | |||||||
Granted | 3 | 76 | ||||||||
Exercised | (3 | ) | 55 | |||||||
Forfeitures and expirations | — | — | ||||||||
Outstanding, end of period | 19 | $ | 61 | 7.4 | $ | 306 | ||||
Exercisable, end of period | 12 | $ | 57 | 6.4 | $ | 242 | ||||
The weighted-average grant date fair value of options granted was $10.14 per share and $9.45 per share for the quarters ended April 1, 2017 and April 2, 2016, respectively. The fair value was estimated using the following assumptions:
Weighted- average expected volatility | Weighted- average expected term (years) | Weighted- average risk-free interest rate | Dividend yield | ||||
Grants within the quarter ended April 1, 2017: | 18 | % | 6.6 | 2.26 | % | 2.80 | % |
Grants within the quarter ended April 2, 2016: | 17 | % | 6.9 | 1.60 | % | 2.60 | % |
The total intrinsic value of options exercised was $12 million and $50 million for the quarters ended April 1, 2017 and April 2, 2016, respectively.
Performance shares
In the first quarter of 2017, the Company granted performance shares to a limited number of senior executive-level employees, which entitle these employees to receive a specified number of shares of the Company’s common stock upon vesting. The number of shares earned could range between 0 and 200% of the target amount depending upon performance achieved over the three year vesting period. The performance conditions of the award include currency-neutral comparable operating margin and total shareholder return (TSR) of the Company’s common stock relative to a select group of peer companies.
A Monte Carlo valuation model was used to determine the fair value of the awards. The TSR performance metric is a market condition. Therefore, compensation cost of the TSR condition is fixed at the measurement date and is not revised based on actual performance. The TSR metric was valued as a multiplier of possible levels of currency-neutral comparable operating margin expansion. Compensation cost related to currency-neutral comparable operating margin performance is revised for changes in the expected outcome. The 2017 target grant currently corresponds to approximately 189,000 shares, with a grant-date fair value of $67 per share.
Based on the market price of the Company’s common stock at April 1, 2017, the maximum future value that could be awarded to employees on the vesting date for all outstanding performance share awards was as follows:
(millions) | April 1, 2017 | ||
2015 Award | $ | 23 | |
2016 Award | $ | 26 | |
2017 Award | $ | 27 | |
The 2014 performance share award, payable in stock, was settled at 35% of target in February 2017 for a total dollar equivalent of $5 million.
Other stock-based awards
During the quarter ended April 1, 2017, the Company granted restricted stock units and a nominal number of restricted stock awards to eligible employees as presented in the following table. Terms of these grants and the
18
Company’s method of determining grant-date fair value were consistent with that described within the stock compensation footnote in the Company’s 2016 Annual Report on Form 10-K.
Quarter ended April 1, 2017:
Employee restricted stock and restricted stock units | Shares (thousands) | Weighted-average grant-date fair value | |||
Non-vested, beginning of year | 1,166 | $ | 63 | ||
Granted | 629 | 67 | |||
Vested | (25 | ) | 55 | ||
Forfeited | (22 | ) | 64 | ||
Non-vested, end of period | 1,748 | $ | 65 | ||
Quarter ended April 2, 2016:
Employee restricted stock and restricted stock units | Shares (thousands) | Weighted-average grant-date fair value | |||
Non-vested, beginning of year | 806 | $ | 58 | ||
Granted | 547 | 70 | |||
Vested | (47 | ) | 55 | ||
Forfeited | (15 | ) | 56 | ||
Non-vested, end of period | 1,291 | $ | 63 | ||
Note 8 Employee benefits
The Company sponsors a number of U.S. and foreign pension plans as well as other nonpension postretirement and postemployment plans to provide various benefits for its employees. These plans are described within the footnotes to the Consolidated Financial Statements included in the Company’s 2016 Annual Report on Form 10-K. Components of Company plan benefit expense for the periods presented are included in the tables below.
Pension
Quarter ended | ||||||
(millions) | April 1, 2017 | April 2, 2016 | ||||
Service cost | $ | 25 | $ | 24 | ||
Interest cost | 41 | 44 | ||||
Expected return on plan assets | (90 | ) | (89 | ) | ||
Amortization of unrecognized prior service cost | 2 | 3 | ||||
Recognized net loss | 3 | — | ||||
Curtailment loss | 1 | — | ||||
Total pension (income) expense | $ | (18 | ) | $ | (18 | ) |
19
Other nonpension postretirement
Quarter ended | ||||||
(millions) | April 1, 2017 | April 2, 2016 | ||||
Service cost | $ | 5 | $ | 5 | ||
Interest cost | 9 | 10 | ||||
Expected return on plan assets | (24 | ) | (22 | ) | ||
Amortization of unrecognized prior service cost (credit) | (2 | ) | (3 | ) | ||
Recognized net (gain) loss | (29 | ) | — | |||
Curtailment loss | 3 | — | ||||
Total postretirement benefit (income) expense | $ | (38 | ) | $ | (10 | ) |
Postemployment
Quarter ended | ||||||
(millions) | April 1, 2017 | April 2, 2016 | ||||
Service cost | $ | 1 | $ | 2 | ||
Interest cost | 1 | 1 | ||||
Recognized net loss | 1 | 1 | ||||
Total postemployment benefit expense | $ | 3 | $ | 4 | ||
During the quarter ended April 1, 2017, the Company recognized curtailment losses of $1 million and $3 million within pension and nonpension postretirement plans, respectively, in conjunction with Project K restructuring activity. In addition, the Company remeasured the benefit obligation for impacted pension and nonpension postretirement plans. The remeasurement resulted in a mark-to-market loss of $3 million on a pension plan due primarily to a lower discount rate and a $29 million gain on a nonpension postretirement plan primarily due to plan asset investment returns slightly mitigated by the impact of a lower discount rate.
Company contributions to employee benefit plans are summarized as follows:
(millions) | Pension | Nonpension postretirement | Total | ||||||
Quarter ended: | |||||||||
April 1, 2017 | $ | 21 | $ | 3 | $ | 24 | |||
April 2, 2016 | $ | 13 | $ | 4 | $ | 17 | |||
Full year: | |||||||||
Fiscal year 2017 (projected) | $ | 26 | $ | 16 | $ | 42 | |||
Fiscal year 2016 (actual) | $ | 18 | $ | 15 | $ | 33 | |||
Plan funding strategies may be modified in response to management’s evaluation of tax deductibility, market conditions, and competing investment alternatives.
Additionally, during the quarter ended April 1, 2017, the Company recognized expense totaling $26 million related to the exit of several multi-employer plans associated with Project K restructuring activity. This amount represents management's best estimate, actual results could differ. The cash obligation is payable over a maximum 20-year period; management has not determined the actual period over which the payments will be made.
Note 9 Income taxes
The consolidated effective tax rate for the quarter ended April 1, 2017 was 14% as compared to the prior year’s rate of 21%. For the quarter ended April 1, 2017, the effective tax rate benefited from a deferred tax benefit of $38 million resulting from an intercompany transfer of intellectual property under the application of the newly adopted standard. See discussion regarding the adoption of ASU 2016-16, Intra-Entity Transfers of Assets Other Than Inventory, in Note 1.
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The effective tax rate for 2016 benefited from excess tax benefits from share-based compensation, the completion of certain tax examinations partially offset by the establishment of a valuation allowance for certain deferred tax assets.
As of April 1, 2017, the Company classified $11 million of unrecognized tax benefits as a net current liability. Management’s estimate of reasonably possible changes in unrecognized tax benefits during the next twelve months consists of the current liability balance expected to be settled within one year, offset by approximately $6 million of projected additions related primarily to ongoing intercompany transfer pricing activity. Management is currently unaware of any issues under review that could result in significant additional payments, accruals or other material deviation in this estimate.
Following is a reconciliation of the Company’s total gross unrecognized tax benefits for the quarter ended April 1, 2017; $40 million of this total represents the amount that, if recognized, would affect the Company’s effective income tax rate in future periods.
(millions) | |||
December 31, 2016 | $ | 63 | |
Tax positions related to current year: | |||
Additions | 1 | ||
Reductions | — | ||
Tax positions related to prior years: | |||
Additions | 1 | ||
Reductions | (5 | ) | |
Settlements | — | ||
Lapse in statute of limitations | — | ||
April 1, 2017 | $ | 60 | |
The accrual balance for tax-related interest was $20 million at April 1, 2017.
Note 10 Derivative instruments and fair value measurements
The Company is exposed to certain market risks such as changes in interest rates, foreign currency exchange rates, and commodity prices, which exist as a part of its ongoing business operations. Management uses derivative financial and commodity instruments, including futures, options, and swaps, where appropriate, to manage these risks. Instruments used as hedges must be effective at reducing the risk associated with the exposure being hedged.
The Company designates derivatives as cash flow hedges, fair value hedges, net investment hedges, and uses other contracts to reduce volatility in interest rates, foreign currency and commodities. As a matter of policy, the Company does not engage in trading or speculative hedging transactions.
Total notional amounts of the Company’s derivative instruments as of April 1, 2017 and December 31, 2016 were as follows:
(millions) | April 1, 2017 | December 31, 2016 | ||||
Foreign currency exchange contracts | $ | 1,385 | $ | 1,396 | ||
Interest rate contracts | 2,190 | 2,185 | ||||
Commodity contracts | 608 | 437 | ||||
Total | $ | 4,183 | $ | 4,018 | ||
Following is a description of each category in the fair value hierarchy and the financial assets and liabilities of the Company that were included in each category at April 1, 2017 and December 31, 2016, measured on a recurring basis.
21
Level 1 – Financial assets and liabilities whose values are based on unadjusted quoted prices for identical assets or liabilities in an active market. For the Company, level 1 financial assets and liabilities consist primarily of commodity derivative contracts.
Level 2 – Financial assets and liabilities whose values are based on quoted prices in markets that are not active or model inputs that are observable either directly or indirectly for substantially the full term of the asset or liability. For the Company, level 2 financial assets and liabilities consist of interest rate swaps and over-the-counter commodity and currency contracts.
The Company’s calculation of the fair value of interest rate swaps is derived from a discounted cash flow analysis based on the terms of the contract and the interest rate curve. Over-the-counter commodity derivatives are valued using an income approach based on the commodity index prices less the contract rate multiplied by the notional amount. Foreign currency contracts are valued using an income approach based on forward rates less the contract rate multiplied by the notional amount. The Company’s calculation of the fair value of level 2 financial assets and liabilities takes into consideration the risk of nonperformance, including counterparty credit risk.
Level 3 – Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset or liability. The Company did not have any level 3 financial assets or liabilities as of April 1, 2017 or December 31, 2016.
The following table presents assets and liabilities that were measured at fair value in the Consolidated Balance Sheet on a recurring basis as of April 1, 2017 and December 31, 2016:
Derivatives designated as hedging instruments
April 1, 2017 | December 31, 2016 | ||||||||||||||||||
(millions) | Level 1 | Level 2 | Total | Level 1 | Level 2 | Total | |||||||||||||
Assets: | |||||||||||||||||||
Foreign currency exchange contracts: | |||||||||||||||||||
Other prepaid assets | $ | — | $ | — | $ | — | $ | — | $ | 2 | $ | 2 | |||||||
Interest rate contracts: | |||||||||||||||||||
Other assets (a) | — | — | — | — | 1 | 1 | |||||||||||||
Total assets | $ | — | $ | — | $ | — | $ | — | $ | 3 | $ | 3 | |||||||
Liabilities: | |||||||||||||||||||
Interest rate contracts: | |||||||||||||||||||
Other liabilities (a) | — | (68 | ) | (68 | ) | — | (65 | ) | (65 | ) | |||||||||
Total liabilities | $ | — | $ | (68 | ) | $ | (68 | ) | $ | — | $ | (65 | ) | $ | (65 | ) | |||
(a) The fair value of the related hedged portion of the Company's long-term debt, a level 2 liability, was $2.3 billion and $2.2 billion as of April 1, 2017 and December 31, 2016, respectively.
22
Derivatives not designated as hedging instruments
April 1, 2017 | December 31, 2016 | ||||||||||||||||||
(millions) | Level 1 | Level 2 | Total | Level 1 | Level 2 | Total | |||||||||||||
Assets: | |||||||||||||||||||
Foreign currency exchange contracts: | |||||||||||||||||||
Other prepaid assets | $ | — | $ | 11 | $ | 11 | $ | — | $ | 25 | $ | 25 | |||||||
Commodity contracts: | |||||||||||||||||||
Other prepaid assets | 3 | — | 3 | 13 | — | 13 | |||||||||||||
Total assets | $ | 3 | $ | 11 | $ | 14 | $ | 13 | $ | 25 | $ | 38 | |||||||
Liabilities: | |||||||||||||||||||
Foreign currency exchange contracts: | |||||||||||||||||||
Other current liabilities | $ | — | $ | (8 | ) | $ | (8 | ) | $ | — | $ | (11 | ) | $ | (11 | ) | |||
Commodity contracts: | |||||||||||||||||||
Other current liabilities | (17 | ) | — | (17 | ) | $ | (7 | ) | $ | — | $ | (7 | ) | ||||||
Total liabilities | $ | (17 | ) | $ | (8 | ) | $ | (25 | ) | $ | (7 | ) | $ | (11 | ) | $ | (18 | ) | |
The Company has designated a portion of its outstanding foreign currency denominated long-term debt as a net investment hedge of a portion of the Company’s investment in its subsidiaries’ foreign currency denominated net assets. The carrying value of this debt was approximately $1.8 billion as of April 1, 2017 and December 31, 2016, respectively.
The Company has elected not to offset the fair values of derivative assets and liabilities executed with the same counterparty that are generally subject to enforceable netting agreements. However, if the Company were to offset and record the asset and liability balances of derivatives on a net basis, the amounts presented in the Consolidated Balance Sheet as of April 1, 2017 and December 31, 2016 would be adjusted as detailed in the following table:
As of April 1, 2017: | ||||||||||||
Gross Amounts Not Offset in the Consolidated Balance Sheet | ||||||||||||
Amounts Presented in the Consolidated Balance Sheet | Financial Instruments | Cash Collateral Received/ Posted | Net Amount | |||||||||
Total asset derivatives | $ | 14 | $ | (12 | ) | $ | — | $ | 2 | |||
Total liability derivatives | $ | (93 | ) | $ | 12 | $ | 59 | $ | (22 | ) | ||
As of December 31, 2016: | ||||||||||||
Gross Amounts Not Offset in the Consolidated Balance Sheet | ||||||||||||
Amounts Presented in the Consolidated Balance Sheet | Financial Instruments | Cash Collateral Received/ Posted | Net Amount | |||||||||
Total asset derivatives | $ | 41 | $ | (24 | ) | $ | — | $ | 17 | |||
Total liability derivatives | $ | (83 | ) | $ | 24 | $ | 48 | $ | (11 | ) | ||
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The effect of derivative instruments on the Consolidated Statements of Income and Comprehensive Income for the quarters ended April 1, 2017 and April 2, 2016 was as follows:
Derivatives in fair value hedging relationships
(millions) | Location of gain (loss) recognized in income | Gain (loss) recognized in income (a) | ||||||
April 1, 2017 | April 2, 2016 | |||||||
Interest rate contracts | Interest expense | $ | 5 | $ | 6 | |||
Total | $ | 5 | $ | 6 | ||||
(a) | Includes the ineffective portion and amount excluded from effectiveness testing. |
Derivatives in cash flow hedging relationships
(millions) | Gain (loss) recognized in AOCI | Location of gain (loss) reclassified from AOCI | Gain (loss) reclassified from AOCI into income | Location of gain (loss) recognized in income (a) | Gain (loss) recognized in income (a) | ||||||||||||||||||
April 1, 2017 | April 2, 2016 | April 1, 2017 | April 2, 2016 | April 1, 2017 | April 2, 2016 | ||||||||||||||||||
Foreign currency exchange contracts | $ | — | $ | 10 | COGS | $ | 1 | $ | 7 | Other income (expense), net | $ | — | $ | — | |||||||||
Interest rate contracts | — | (66 | ) | Interest expense | (2 | ) | (6 | ) | N/A | — | — | ||||||||||||
Commodity contracts | — | (1 | ) | COGS | — | (3 | ) | Other income (expense), net | — | — | |||||||||||||
Total | $ | — | $ | (57 | ) | $ | (1 | ) | $ | (2 | ) | $ | — | $ | — | ||||||||
(a) | Includes the ineffective portion and amount excluded from effectiveness testing. |
Derivatives and non-derivatives in net investment hedging relationships
(millions) | Gain (loss) recognized in AOCI | ||||||
April 1, 2017 | April 2, 2016 | ||||||
Foreign currency denominated long-term debt | $ | (25 | ) | $ | (58 | ) | |
Foreign currency exchange contracts | — | (22 | ) | ||||
Total | $ | (25 | ) | $ | (80 | ) | |
Derivatives not designated as hedging instruments
(millions) | Location of gain (loss) recognized in income | Gain (loss) recognized in income | ||||||
April 1, 2017 | April 2, 2016 | |||||||
Foreign currency exchange contracts | COGS | $ | (9 | ) | $ | (9 | ) | |
Foreign currency exchange contracts | Other income (expense), net | (5 | ) | 11 | ||||
Commodity contracts | COGS | (13 | ) | 4 | ||||
Commodity contracts | SG&A | 1 | — | |||||
Total | $ | (26 | ) | $ | 6 | |||
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During the next 12 months, the Company expects $7 million of net deferred losses reported in AOCI at April 1, 2017 to be reclassified to income, assuming market rates remain constant through contract maturities.
Certain of the Company’s derivative instruments contain provisions requiring the Company to post collateral on those derivative instruments that are in a liability position if the Company’s credit rating is at or below BB+ (S&P), or Baa1 (Moody’s). The fair value of all derivative instruments with credit-risk-related contingent features in a liability position on April 1, 2017 was $67 million. If the credit-risk-related contingent features were triggered as of April 1, 2017, the Company would be required to post collateral of $43 million. In addition, certain derivative instruments contain provisions that would be triggered in the event the Company defaults on its debt agreements. There were no collateral posting as of April 1, 2017 triggered by credit-risk-related contingent features.
Financial instruments
The carrying values of the Company’s short-term items, including cash, cash equivalents, accounts receivable, accounts payable, notes payable and current maturities of long-term debt approximate fair value. The fair value of the Company’s long-term debt, which are level 2 liabilities, is calculated based on broker quotes. The fair value and carrying value of the Company's long-term debt was $6,961 million and $7,347 million, respectively, as of April 1, 2017.
Counterparty credit risk concentration and collateral requirements
The Company is exposed to credit loss in the event of nonperformance by counterparties on derivative financial and commodity contracts. Management believes a concentration of credit risk with respect to derivative counterparties is limited due to the credit ratings and use of master netting and reciprocal collateralization agreements with the counterparties and the use of exchange-traded commodity contracts.
Master netting agreements apply in situations where the Company executes multiple contracts with the same counterparty. Certain counterparties represent a concentration of credit risk to the Company. If those counterparties fail to perform according to the terms of derivative contracts, this would result in a loss to the Company. As of April 1, 2017, the Company was not in a significant net asset position with any counterparties with which a master netting agreement would apply.
For certain derivative contracts, reciprocal collateralization agreements with counterparties call for the posting of collateral in the form of cash, treasury securities or letters of credit if a fair value loss position to the Company or its counterparties exceeds a certain amount. In addition, the Company is required to maintain cash margin accounts in connection with its open positions for exchange-traded commodity derivative instruments executed with the counterparty that are subject to enforceable netting agreements. As of April 1, 2017, the Company posted $24 million related to reciprocal collateralization agreements. As of April 1, 2017 the Company posted $35 million in margin deposits for exchange-traded commodity derivative instruments, which was reflected as an increase in accounts receivable, net on the Consolidated Balance Sheet.
Management believes concentrations of credit risk with respect to accounts receivable is limited due to the generally high credit quality of the Company’s major customers, as well as the large number and geographic dispersion of smaller customers. However, the Company conducts a disproportionate amount of business with a small number of large multinational grocery retailers, with the five largest accounts encompassing approximately 27% of consolidated trade receivables at April 1, 2017.
Note 11 Reportable segments
Kellogg Company is the world’s leading producer of cereal, second largest producer of cookies and crackers, and a leading producer of savory snacks and frozen foods. Additional product offerings include toaster pastries, cereal bars, fruit-flavored snacks and veggie foods. Kellogg products are manufactured and marketed globally. Principal markets for these products include the United States and United Kingdom.
The Company manages its operations through nine operating segments that are based on product category or geographic location. These operating segments are evaluated for similarity with regards to economic characteristics, products, production processes, types or classes of customers, distribution methods and regulatory environments to determine if they can be aggregated into reportable segments. The reportable segments are discussed in greater detail below.
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The U.S. Morning Foods operating segment includes cereal, toaster pastries, and health and wellness beverages and bars.
U.S. Snacks includes cookies, crackers, cereal bars, savory snacks and fruit-flavored snacks.
U.S. Specialty primarily represents food away from home channels, including food service, convenience, vending, Girl Scouts and food manufacturing. The food service business is mostly non-commercial, serving institutions such as schools and hospitals. The convenience business includes traditional convenience stores as well as alternate retail outlets.
North America Other includes the U.S. Frozen, Kashi and Canada operating segments. As these operating segments are not considered economically similar enough to aggregate with other operating segments and are immaterial for separate disclosure, they have been grouped together as a single reportable segment.
The three remaining reportable segments are based on geographic location – Europe which consists principally of European countries; Latin America which consists of Central and South America and includes Mexico; and Asia Pacific which consists of Sub-Saharan Africa, Australia and other Asian and Pacific markets.
The measurement of reportable segment results is based on segment operating profit which is generally consistent with the presentation of operating profit in the Consolidated Statement of Income. Intercompany transactions between operating segments were insignificant in all periods presented.
Quarter ended | ||||||
(millions) | April 1, 2017 | April 2, 2016 | ||||
Net sales | ||||||
U.S. Morning Foods | $ | 719 | $ | 767 | ||
U.S. Snacks | 781 | 832 | ||||
U.S. Specialty | 395 | 376 | ||||
North America Other | 393 | 414 | ||||
Europe | 512 | 598 | ||||
Latin America | 222 | 192 | ||||
Asia Pacific | 232 | 216 | ||||
Consolidated | $ | 3,254 | $ | 3,395 | ||
Operating profit | ||||||
U.S. Morning Foods | $ | 160 | $ | 148 | ||
U.S. Snacks | (44 | ) | 83 | |||
U.S. Specialty | 96 | 86 | ||||
North America Other | 49 | 45 | ||||
Europe | 66 | 70 | ||||
Latin America | 33 | 23 | ||||
Asia Pacific | 22 | 17 | ||||
Total Reportable Segments | 382 | 472 | ||||
Corporate (a) | (22 | ) | (34 | ) | ||
Consolidated | $ | 360 | $ | 438 | ||
(a) | Includes mark-to-market adjustments for pension and postretirement plans, commodity and foreign currency contracts totaling ($21) million and ($24) million for the quarters ended April 1, 2017 and April 2, 2016, respectively. |
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KELLOGG COMPANY
PART I—FINANCIAL INFORMATION
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Business overview
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to help the reader understand Kellogg Company, our operations and our present business environment. MD&A is provided as a supplement to, and should be read in conjunction with, our Consolidated Financial Statements and the accompanying notes thereto contained in Item 1 of this report.
For more than 100 years, consumers have counted on Kellogg for great-tasting, high-quality and nutritious foods. Kellogg is the world’s leading producer of cereal, second largest producer of cookies and crackers, and a leading producer of savory snacks and frozen foods. Additional product offerings include toaster pastries, cereal bars, fruit-flavored snacks and veggie foods. Kellogg products are manufactured and marketed globally.
Corporate responsibility and sustainability
As a grain-based food company, our success is dependent on timely access to high quality, low cost ingredients, and water and energy for our global manufacturing operations. We rely on natural capital including energy for product manufacturing and distribution, water as an ingredient, for facility cleaning and steam power, and food crops and commodities as an ingredient. These natural capital dependencies are at risk of shortage, price volatility, regulation, and quality impacts due to climate change which is assessed as part of our overall enterprise risk management program. Due to these risks, we have implemented major short and long-term initiatives to mitigate and adapt to these environmental pressures, as well as the resulting challenges of food security.
To address these risks, we partner with suppliers, customers, governments and non-governmental organizations, including the World Business Council for Sustainable Development and the Consumer Goods Forum. We are also committed to improving efficiency and technologies in our owned manufacturing footprint by reducing water use, total waste, energy use, and greenhouse gas (GHG) emissions as well as working across our supply chain with the goal of reducing risk of disruptions from unexpected constraints in natural resource availability or impacts on raw material pricing. In addition, we established third-party approved science-based targets to measure progress against our goal to significantly reduce absolute GHG emissions across our own footprint and that of our suppliers. In 2016, we expanded our global signature cause platform, Breakfasts for Better Days, with the intent to help address hunger relief and food security.
We have incorporated the risks and opportunities of climate change and food security into the Global 2020 Growth Strategy and Global Heart and Soul Strategy by continuing to identify risk, incorporating environmental and social indicators into strategic priorities and reporting regularly to leadership, the board of directors, and publicly. Future reporting on our environmental and social risks and performance against targets will be included in our Annual Report on Form 10-K.
Segments
We manage our operations through nine operating segments that are based on product category or geographic location. These operating segments are evaluated for similarity with regards to economic characteristics, products, production processes, types or classes of customers, distribution methods and regulatory environments to determine if they can be aggregated into reportable segments. We report results of operations in the following reportable segments: U.S. Morning Foods; U.S. Snacks; U.S. Specialty; North America Other; Europe; Latin America; and Asia Pacific. The reportable segments are discussed in greater detail in Note 11 within Notes to Consolidated Financial Statements.
Operating margin expansion through 2018
In 2016 we announced a plan to increase and accelerate our currency-neutral comparable operating margin. Specifically, we are targeting an expansion of 350 basis points during 2016 through 2018. There are four elements to this margin expansion plan:
• | Productivity and savings - In addition to annual productivity savings to offset inflation, we have expanded our Project K restructuring program, and we have expanded our zero-based budgeting initiative in the U.S. and our international regions. We also are working on additional Project K initiatives. The result of these initiatives should be higher annual savings. |
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• | Price and Mix - We have established a more formal Revenue Growth Management discipline around the world, to help us ensure our products and pack-sizes are priced correctly, and that we are generating a positive mix of sales volume. |
• | Investing for Impact - We are updating our investment model to align with today's consumer and technology in order to optimize the return on investment in our brands. |
• | On-Trend Foods - We are adopting a more impactful approach to renovation and innovation of our foods. |
During this time period, we will be working to stabilize net sales, with an aim to returning to growth. Accordingly, our margin expansion target incorporates continued investment in food and packaging, investment in new capabilities, and an increase in brand investment in our U.S. Snacks business. These margin-expansion actions are expected to drive accelerated growth in currency-neutral comparable operating profit and currency neutral comparable earnings per share in 2017 and 2018.
In March 2017, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) changing the presentation of net periodic pension and postretirement benefit costs within the income statement. The ASU requires all components of net periodic benefit cost, other than service cost, be presented in the income statement outside of income from operations. We expect to adopt the ASU retrospectively in the first quarter of 2018. The impact of adoption, when applied retrospectively, is expected to reduce our 2015 currency-neutral comparable operating margin, the basis for our 350 basis point improvement target, by approximately 175-185 basis points. The adoption is anticipated to only impact the Corporate segment, and not expected to impact our ability to achieve 350 basis points of currency-neutral comparable operation margin expansion from this new base by the end of 2018. See the Accounting standards to be adopted in future periods section of the MD&A for additional information regarding the impact of this ASU.
Guidance on operating profit margin expansion and net sales growth outlook is provided on a non-GAAP, currency-neutral comparable basis only because certain information necessary to calculate such measures on a GAAP basis is unavailable, dependent on future events outside of our control and cannot be predicted without unreasonable efforts by the Company. Please refer to the "Non-GAAP Financial Measures" section for a further discussion of our use of non-GAAP measures, including quantification of known expected adjustment items.
Non-GAAP financial measures
This filing includes non-GAAP financial measures that we provide to management and investors that exclude certain items that we do not consider part of on-going operations. Items excluded from our non-GAAP financial measures are discussed in the "Significant items impacting comparability" section of this filing. Our management team consistently utilizes a combination of GAAP and non-GAAP financial measures to evaluate business results, to make decisions regarding the future direction of our business, and for resource allocation decisions, including incentive compensation. As a result, we believe the presentation of both GAAP and non-GAAP financial measures provides investors with increased transparency into financial measures used by our management team and improves investors’ understanding of our underlying operating performance and in their analysis of ongoing operating trends. All historic non-GAAP financial measures have been reconciled with the most directly comparable GAAP financial measures.
Non-GAAP financial measures used include comparable net sales, comparable gross margin, comparable SG&A, comparable operating profit, comparable operating profit margin, comparable effective tax rate, comparable net income, comparable diluted EPS, and cash flow. These non-GAAP financial measures are also evaluated for year-over-year growth and on a currency-neutral basis to evaluate the underlying growth of the business and to exclude the effect of foreign currency. We determine currency-neutral operating results by dividing or multiplying, as appropriate, the current-period local currency operating results by the currency exchange rates used to translate our financial statements in the comparable prior-year period to determine what the current period U.S. dollar operating results would have been if the currency exchange rate had not changed from the comparable prior-year period. These non-GAAP financial measures may not be comparable to similar measures used by other companies.
• | Comparable net sales: We adjust the GAAP financial measures to exclude the pre-tax effect of acquisitions, and divestitures. We excluded the items which we believe may obscure trends in our underlying net sales performance. By providing this non-GAAP net sales measure, management intends to |
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provide investors with a meaningful, consistent comparison of net sales performance for the Company and each of our reportable segments for the periods presented. Management uses this non-GAAP measure to evaluate the effectiveness of initiatives behind net sales growth, price realization, and the impact of mix on our business results. This non-GAAP measure is also used to make decisions regarding the future direction of our business, and for resource allocation decisions. Currency-neutral comparable net sales represents comparable net sales excluding the impact of foreign currency.
• | Comparable gross profit, comparable gross margin, comparable SG&A, comparable SG&A%, comparable operating profit, comparable operating profit margin, comparable net income, and comparable diluted EPS: We adjust the GAAP financial measures to exclude the effect of Project K and cost reduction activities, acquisitions, divestitures, integration costs, mark-to-market adjustments for pension plans, commodities and certain foreign currency contracts, costs associated with the early redemption of debt outstanding, and impacts of the prior-year Venezuela remeasurement and deconsolidation. We excluded the items which we believe may obscure trends in our underlying profitability. The impact of acquisitions and divestitures are not excluded from comparable diluted EPS. By providing these non-GAAP profitability measures, management intends to provide investors with a meaningful, consistent comparison of the Company's profitability measures for the periods presented. Management uses these non-GAAP financial measures to evaluate the effectiveness of initiatives intended to improve profitability, such as Project K, ZBB and Revenue Growth Management, as well as to evaluate the impacts of inflationary pressures and decisions to invest in new initiatives within each of our segments. Currency-neutral comparable represents comparable excluding foreign currency impact. |
Comparable effective tax rate: We adjust the GAAP financial measure to exclude tax effect of Project K and cost reduction activities, divestitures, integration costs, mark-to-market adjustments for pension plans, commodities and certain foreign currency contracts, costs associated with the early redemption of debt outstanding, and costs associated with prior-year Venezuela remeasurement. We excluded the items which we believe may obscure trends in our pre-tax income and the related tax effect of those items on our underlying tax rate. By providing this non-GAAP measure, management intends to provide investors with a meaningful, consistent comparison of the Company's effective tax rate, excluding the pre-tax income and tax effect of the items noted above, for the periods presented. Management uses this non-GAAP measure to monitor the effectiveness of initiatives in place to optimize our global tax rate.
• | Cash flow: Defined as net cash provided by operating activities reduced by expenditures for property additions. Cash flow does not represent the residual cash flow available for discretionary expenditures. We use this non-GAAP financial measure of cash flow to focus management and investors on the amount of cash available for debt repayment, dividend distributions, acquisition opportunities, and share repurchases once all of the Company’s business needs and obligations are met. Additionally, certain performance-based compensation includes a component of this non-GAAP measure. |
These measures have not been calculated in accordance with GAAP and should not be viewed as a substitute for GAAP reporting measures.
Significant items impacting comparability
Project K and cost reduction activities
In February 2017, the Company announced an expansion and an extension to its previously-announced global efficiency and effectiveness program ("Project K"). Project K is expected to continue generating a significant amount of savings that may be invested in key strategic areas of focus for the business. The Company expects that these savings may be used to drive future growth in the business. We recorded pre-tax charges related to this program of $141 million and $45 million for the quarters ended April 1, 2017 and April 2, 2016, respectively.
In 2015 we initiated the implementation of a Zero-Based Budgeting (ZBB) program in our North America business. During 2016 ZBB was expanded to include international segments of the business. In support of the ZBB initiative, we incurred pre-tax charges of $1 million and $7 million for the quarters ended April 1, 2017 and April 2, 2016, respectively.
See the Restructuring and cost reduction activities section for more information.
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Acquisitions
In December 2016, the Company acquired Ritmo Investimentos, controlling shareholder of Parati S/A, Afical Ltda and Padua Ltda ("Parati Group"), a leading Brazilian food group for approximately BRL 1.38 billion ($381 million) or $379 million, net of cash and cash equivalents. The purchase price is subject to certain working capital and net debt adjustments based on the actual working capital and net debt existing on the acquisition date compared to targeted amounts. In our Latin America reportable segment, for the quarter ended April 1, 2017 the acquisition added $47 million in net sales and $8 million of operating profit (before integration costs) that impacted the comparability of our reported results.
Integration costs
We have incurred integration costs related to the integration of the 2016 acquisition of Parati Group, the 2015 acquisitions of Bisco Misr and Mass Foods, and the 2015 entry into a joint venture with Tolaram Africa as we move these businesses into the Kellogg business model. We recorded pre-tax integration costs that were approximately $1 million for the quarters ended April 1, 2017 and April 2, 2016.
Mark-to-market accounting for pension plans, commodities and certain foreign currency contracts
We recognize mark-to-market adjustments for pension plans, commodity contracts, and certain foreign currency contracts as incurred. Actuarial gains/losses for pension plans are recognized in the year they occur. Changes between contract and market prices for commodities contracts and certain foreign currency contracts result in gains/losses that are recognized in the quarter they occur. We recorded total pre-tax mark-to-market charges of $21 million and $24 million for the quarters ended April 1, 2017 and April 2, 2016, respectively. Within this total, the pre-tax mark-to-market charges for pension and postretirement plans were ($1) million and $34 million for the quarters ended April 1, 2017 and April 2, 2016, respectively.
Other costs impacting comparability
During the quarter ended April 2, 2016, we redeemed $475 million of our 7.45% U.S. Dollar Debentures due 2031. In connection with the debt redemption, we incurred $153 million of interest expense, consisting primarily of a premium on the tender offer and also including accelerated losses on pre-issuance interest rate hedges, acceleration of fees and debt discount on the redeemed debt and fees related to the tender offer.
Venezuela
There was a material change in the business environment, including a worsening of our access to key raw materials subject to restrictions, and a related significant drop in production volume in the fourth quarter of 2016. These supply chain disruptions, along with other factors such as the worsening economic environment in Venezuela and the limited access to dollars to import goods through the use of any of the available currency mechanisms, have impaired our ability to effectively operate and fully control our Venezuelan subsidiary.
As of December 31, 2016, we deconsolidated and changed to the cost method of accounting for our Venezuelan subsidiary. The deconsolidation reduced net sales by $9 million and operating profit by $5 million which impacted the comparability of our reported results for the quarter ended April 1, 2017 compared to the quarter ended April 2, 2016.
In 2016 certain non-monetary assets related to our Venezuelan subsidiary continued to be remeasured at historical exchange rates. As these assets were utilized by our Venezuelan subsidiary during 2016 they were recognized in the income statement at historical exchange rates resulting in an unfavorable impact. We experienced an unfavorable pre-tax impact of approximately $6 million during the quarter ended April 2, 2016 related to the utilization of these remaining non-monetary assets, primarily impacting COGS.
Foreign currency translation
We evaluate the operating results of our business on a currency-neutral basis. We determine currency-neutral operating results by dividing or multiplying, as appropriate, the current-period local currency operating results by the currency exchange rates used to translate our financial statements in the comparable prior-year period to determine what the current period U.S. dollar operating results would have been if the currency exchange rate had not changed from the comparable prior-year period.
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Financial results
For the quarter ended April 1, 2017, our reported net sales declined by 4.1% due to the translational impact of foreign currency and lower volume as a result of trade-inventory reductions in the U.S. and unexpectedly soft consumption trends across most categories during the quarter. These declines were partially offset by the impact of the Parati acquisition, and growth in U.S. Specialty and Asia-Pacific. Currency-neutral comparable net sales were down 4.4% after eliminating the impact of acquisitions, foreign currency, and prior year Venezuela results.
Reported operating profit decreased 17.6%, primarily the result of increased restructuring charges and foreign currency, partially offset by expanded margins across all regions resulting from Project K and ZBB savings and the Parati acquisition. Currency-neutral comparable operating profit increased by 2.2% after eliminating the impact of higher restructuring charges and foreign currency.
Reported operating margin for the quarter was unfavorable 180 basis points due primarily to increased Project K restructuring charges. These impacts were partially offset by COGS and SG&A savings realized from Project K and ZBB initiatives. Currency-neutral comparable operating margin was favorable 110 basis points after excluding the year-over-year impact of restructuring, mark-to-market, prior year Venezuela remeasurement, prior year Venezuela results, and foreign currency.
Reported diluted EPS of $.74 for the quarter was up 51% compared to the prior year of $.49. Reported diluted EPS for the first quarter was higher due to costs related to the bond tender in the first quarter of 2016 and a lower tax rate partially offset by higher restructuring charges. Currency-neutral comparable diluted EPS of $1.09 increased by 13.5% compared to prior year of $.96, ahead of our expectations, due to higher profit margins driven by productivity initiatives, ZBB savings and a lower effective tax rate.
Reconciliation of certain non-GAAP Financial Measures
Quarter ended | ||||||
Consolidated results (dollars in millions, except per share data) | April 1, 2017 | April 2, 2016 | ||||
Reported net income | $ | 262 | $ | 175 | ||
Mark-to-market (pre-tax) | (21 | ) | (24 | ) | ||
Project K and cost reduction activities (pre-tax) | (142 | ) | (52 | ) | ||
Other costs impacting comparability (pre-tax) | — | (153 | ) | |||
Integration and transaction costs (pre-tax) | (1 | ) | (1 | ) | ||
Venezuela operations impact (pre-tax) | — | 5 | ||||
Venezuela remeasurement (pre-tax) | — | (6 | ) | |||
Income tax benefit applicable to adjustments, net* | 50 | 67 | ||||
Comparable net income | $ | 376 | $ | 339 | ||
Foreign currency impact | (9 | ) | ||||
Currency-neutral comparable net income | $ | 385 | ||||
Reported diluted EPS | $ | 0.74 | $ | 0.49 | ||
Mark-to-market (pre-tax) | (0.06 | ) | (0.07 | ) | ||
Project K and cost reduction activities (pre-tax) | (0.40 | ) | (0.14 | ) | ||
Other costs impacting comparability (pre-tax) | — | (0.43 | ) | |||
Venezuela operations impact (pre-tax) | — | 0.01 | ||||
Venezuela remeasurement (pre-tax) | — | (0.02 | ) | |||
Income tax benefit applicable to adjustments, net* | 0.14 | 0.18 | ||||
Comparable diluted EPS | $ | 1.06 | $ | 0.96 | ||
Foreign currency impact | (0.03 | ) | ||||
Currency-neutral comparable diluted EPS | $ | 1.09 | ||||
Currency-neutral comparable diluted EPS growth | 13.5 | % | 2.1 | % | ||
* Represents the estimated income tax effect on the reconciling items, using weighted-average statutory tax rates, depending upon the applicable jurisdiction.
For more information on the reconciling items in the table above, please refer to the Significant items impacting comparability section.
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Net sales and operating profit
The following tables provide an analysis of net sales and operating profit performance for the first quarter of 2017 versus 2016:
Quarter ended April 1, 2017 | ||||||||||||||||||||||||||||||||||||
(millions) | U.S. Morning Foods | U.S. Snacks | U.S. Specialty | North America Other | Europe | Latin America | Asia Pacific | Corporate | Kellogg Consolidated | |||||||||||||||||||||||||||
Reported net sales | ||||||||||||||||||||||||||||||||||||