Attached files
| file | filename |
|---|---|
| EX-32.2 - EXHIBIT 32.2 - KELLOGG CO | k-2017q2ex322.htm |
| EX-32.1 - EXHIBIT 32.1 - KELLOGG CO | k-2017q2ex321.htm |
| EX-31.2 - EXHIBIT 31.2 - KELLOGG CO | k-2017q2ex312.htm |
| EX-31.1 - EXHIBIT 31.1 - KELLOGG CO | k-2017q2ex311.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 July 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 July 29, 2017 — 345,134,700 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 | |
Legal Proceedings | |
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)
July 1, 2017 (unaudited) | December 31, 2016 * | |||||
Current assets | ||||||
Cash and cash equivalents | $ | 334 | $ | 280 | ||
Accounts receivable, net | 1,427 | 1,231 | ||||
Inventories: | ||||||
Raw materials and supplies | 324 | 315 | ||||
Finished goods and materials in process | 877 | 923 | ||||
Other prepaid assets | 205 | 191 | ||||
Total current assets | 3,167 | 2,940 | ||||
Property, net of accumulated depreciation of $5,530 and $5,280 | 3,613 | 3,569 | ||||
Investments in unconsolidated entities | 435 | 438 | ||||
Goodwill | 5,127 | 5,166 | ||||
Other intangibles, net of accumulated amortization of $58 and $54 | 2,423 | 2,369 | ||||
Other assets | 770 | 629 | ||||
Total assets | $ | 15,535 | $ | 15,111 | ||
Current liabilities | ||||||
Current maturities of long-term debt | $ | 411 | $ | 631 | ||
Notes payable | 724 | 438 | ||||
Accounts payable | 2,057 | 2,014 | ||||
Accrued advertising and promotion | 512 | 436 | ||||
Accrued income taxes | 48 | 47 | ||||
Accrued salaries and wages | 269 | 318 | ||||
Other current liabilities | 667 | 590 | ||||
Total current liabilities | 4,688 | 4,474 | ||||
Long-term debt | 7,123 | 6,698 | ||||
Deferred income taxes | 401 | 525 | ||||
Pension liability | 997 | 1,024 | ||||
Other liabilities | 476 | 464 | ||||
Commitments and contingencies | ||||||
Equity | ||||||
Common stock, $.25 par value | 105 | 105 | ||||
Capital in excess of par value | 836 | 806 | ||||
Retained earnings | 6,752 | 6,571 | ||||
Treasury stock, at cost | (4,364 | ) | (3,997 | ) | ||
Accumulated other comprehensive income (loss) | (1,495 | ) | (1,575 | ) | ||
Total Kellogg Company equity | 1,834 | 1,910 | ||||
Noncontrolling interests | 16 | 16 | ||||
Total equity | 1,850 | 1,926 | ||||
Total liabilities and equity | $ | 15,535 | $ | 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 | Year-to-date period ended | ||||||||||||
(Results are unaudited) | July 1, 2017 | July 2, 2016 | July 1, 2017 | July 2, 2016 | |||||||||
Net sales | $ | 3,187 | $ | 3,268 | $ | 6,441 | $ | 6,663 | |||||
Cost of goods sold | 1,922 | 1,998 | 3,972 | 4,148 | |||||||||
Selling, general and administrative expense | 812 | 821 | 1,656 | 1,628 | |||||||||
Operating profit | 453 | 449 | 813 | 887 | |||||||||
Interest expense | 63 | 68 | 124 | 285 | |||||||||
Other income (expense), net | (6 | ) | 4 | (3 | ) | 4 | |||||||
Income before income taxes | 384 | 385 | 686 | 606 | |||||||||
Income taxes | 102 | 106 | 144 | 153 | |||||||||
Earnings (loss) from unconsolidated entities | — | 1 | 2 | 2 | |||||||||
Net Income | $ | 282 | $ | 280 | $ | 544 | $ | 455 | |||||
Per share amounts: | |||||||||||||
Basic earnings | $ | 0.81 | $ | 0.80 | $ | 1.56 | $ | 1.30 | |||||
Diluted earnings | $ | 0.80 | $ | 0.79 | $ | 1.54 | $ | 1.29 | |||||
Dividends | $ | 0.52 | $ | 0.50 | $ | 1.04 | $ | 1.00 | |||||
Average shares outstanding: | |||||||||||||
Basic | 349 | 350 | 350 | 350 | |||||||||
Diluted | 352 | 354 | 353 | 354 | |||||||||
Actual shares outstanding at period end | 346 | 349 | |||||||||||
Refer to Notes to Consolidated Financial Statements.
4
Kellogg Company and Subsidiaries
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
(millions)
Quarter ended July 1, 2017 | Year-to-date period ended July 1, 2017 | |||||||||||||||||
(Results are unaudited) | Pre-tax amount | Tax (expense) benefit | After-tax amount | Pre-tax amount | Tax (expense) benefit | After-tax amount | ||||||||||||
Net income | $ | 282 | $ | 544 | ||||||||||||||
Other comprehensive income (loss): | ||||||||||||||||||
Foreign currency translation adjustments | (66 | ) | 57 | (9 | ) | 10 | 66 | 76 | ||||||||||
Cash flow hedges: | ||||||||||||||||||
Reclassification to net income | 2 | — | 2 | 4 | (1 | ) | 3 | |||||||||||
Postretirement and postemployment benefits: | ||||||||||||||||||
Reclassification to net income: | ||||||||||||||||||
Net experience loss | — | — | — | 1 | — | 1 | ||||||||||||
Other comprehensive income (loss) | $ | (64 | ) | $ | 57 | $ | (7 | ) | $ | 15 | $ | 65 | $ | 80 | ||||
Comprehensive income | $ | 275 | $ | 624 | ||||||||||||||
Quarter ended July 2, 2016 | Year-to-date period ended July 2, 2016 | |||||||||||||||||
(Results are unaudited) | Pre-tax amount | Tax (expense) benefit | After-tax amount | Pre-tax amount | Tax (expense) benefit | After-tax amount | ||||||||||||
Net income | $ | 280 | $ | 455 | ||||||||||||||
Other comprehensive income (loss): | ||||||||||||||||||
Foreign currency translation adjustments | (48 | ) | (16 | ) | (64 | ) | (103 | ) | 13 | (90 | ) | |||||||
Cash flow hedges: | ||||||||||||||||||
Unrealized gain (loss) on cash flow hedges | (3 | ) | 1 | (2 | ) | (60 | ) | 24 | (36 | ) | ||||||||
Reclassification to net income | 6 | (2 | ) | 4 | 8 | (3 | ) | 5 | ||||||||||
Postretirement and postemployment benefits: | ||||||||||||||||||
Amount arising during the period: | ||||||||||||||||||
Prior service cost | (1 | ) | — | (1 | ) | (1 | ) | — | (1 | ) | ||||||||
Reclassification to net income: | ||||||||||||||||||
Net experience loss | 1 | — | 1 | 2 | — | 2 | ||||||||||||
Prior service cost | 2 | — | 2 | 2 | — | 2 | ||||||||||||
Other comprehensive income (loss) | $ | (43 | ) | $ | (17 | ) | $ | (60 | ) | $ | (152 | ) | $ | 34 | $ | (118 | ) | |
Comprehensive income | $ | 220 | $ | 337 | ||||||||||||||
Refer to Notes to Consolidated Financial Statements.
5
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 | 6 | (435 | ) | (435 | ) | (435 | ) | |||||||||||||||||||||
Net income | 544 | 544 | 544 | |||||||||||||||||||||||||
Dividends | (363 | ) | (363 | ) | (363 | ) | ||||||||||||||||||||||
Other comprehensive income | 80 | 80 | — | 80 | ||||||||||||||||||||||||
Stock compensation | 36 | 36 | 36 | |||||||||||||||||||||||||
Stock options exercised and other | (6 | ) | — | (1 | ) | 68 | 62 | 62 | ||||||||||||||||||||
Balance, July 1, 2017 | 420 | $ | 105 | $ | 836 | $ | 6,752 | 74 | $ | (4,364 | ) | $ | (1,495 | ) | $ | 1,834 | $ | 16 | $ | 1,850 | ||||||||
Refer to notes to Consolidated Financial Statements.
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Kellogg Company and Subsidiaries
CONSOLIDATED STATEMENT OF CASH FLOWS
(millions)
Year-to-date period ended | ||||||
(unaudited) | July 1, 2017 | July 2, 2016 | ||||
Operating activities | ||||||
Net income | $ | 544 | $ | 455 | ||
Adjustments to reconcile net income to operating cash flows: | ||||||
Depreciation and amortization | 240 | 251 | ||||
Postretirement benefit plan expense (benefit) | (96 | ) | (56 | ) | ||
Deferred income taxes | (67 | ) | 7 | |||
Stock compensation | 36 | 30 | ||||
Other | 30 | 11 | ||||
Postretirement benefit plan contributions | (28 | ) | (23 | ) | ||
Changes in operating assets and liabilities, net of acquisitions: | ||||||
Trade receivables | (148 | ) | (159 | ) | ||
Inventories | 63 | 17 | ||||
Accounts payable | 70 | 157 | ||||
Accrued income taxes | — | 54 | ||||
Accrued interest expense | (13 | ) | (2 | ) | ||
Accrued and prepaid advertising and promotion | 56 | 10 | ||||
Accrued salaries and wages | (56 | ) | (87 | ) | ||
All other current assets and liabilities, net | 23 | (17 | ) | |||
Net cash provided by (used in) operating activities | 654 | 648 | ||||
Investing activities | ||||||
Additions to properties | (268 | ) | (249 | ) | ||
Acquisitions, net of cash acquired | 4 | (15 | ) | |||
Investments in unconsolidated entities, net proceeds | 6 | 29 | ||||
Other | (4 | ) | (15 | ) | ||
Net cash provided by (used in) investing activities | (262 | ) | (250 | ) | ||
Financing activities | ||||||
Net issuances (reductions) of notes payable | 287 | (424 | ) | |||
Issuances of long-term debt | 655 | 2,061 | ||||
Reductions of long-term debt | (626 | ) | (1,227 | ) | ||
Net issuances of common stock | 65 | 233 | ||||
Common stock repurchases | (390 | ) | (386 | ) | ||
Cash dividends | (363 | ) | (351 | ) | ||
Other | — | — | ||||
Net cash provided by (used in) financing activities | (372 | ) | (94 | ) | ||
Effect of exchange rate changes on cash and cash equivalents | 34 | (24 | ) | |||
Increase (decrease) in cash and cash equivalents | 54 | 280 | ||||
Cash and cash equivalents at beginning of period | 280 | 251 | ||||
Cash and cash equivalents at end of period | $ | 334 | $ | 531 | ||
Supplemental cash flow disclosures | ||||||
Interest paid | $ | 138 | $ | 284 | ||
Income taxes paid | $ | 205 | $ | 85 | ||
Supplemental cash flow disclosures of non-cash investing activities: | ||||||
Additions to properties included in accounts payable | $ | 82 | $ | 89 | ||
Refer to Notes to Consolidated Financial Statements.
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Notes to Consolidated Financial Statements
for the quarter ended July 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 July 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 July 1, 2017, $769 million of the Company’s outstanding payment obligations had been placed in the accounts payable tracking system, and participating suppliers had sold $556 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
8
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. If the Company adopted the ASU in the first quarter of 2017, cash flow from operations would have decreased $24 million and cash flow from investing activities would have increased $24 million for the year-to-date period ended July 1, 2017.
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. Based upon the Company's preliminary assessment, there will be some limited timing and classification differences upon adoption. 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 financial statements.
Note 2 Sale of accounts receivable
In 2016, the Company entered into a Receivable Sales Agreement and a separate U.S. accounts receivable securitization program (the "securitization program"), both described below, which primarily enable the Company to extend customers payment terms in exchange for elimination of the discount the Company offered for early payment. The agreements are intended to directly offset the impact that extended customer payment terms would have on the days-sales-outstanding (DSO) metric that is critical to the effective management of the Company's accounts receivable balance and overall working capital. See further discussion in the Liquidity and capital resources section of MD&A.
In March 2016, the Company entered into a 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 year-to-date periods ended July 1, 2017 and July 2, 2016 approximately $1.1 billion and $529 million, respectively, of accounts receivable have been sold via this arrangement. Accounts receivable sold of $655 million and $562 million remained outstanding under this arrangement as of July 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 loss on sale of receivables was $3 million and $5 million for the quarter and year-to-date period ended July 1, 2017, respectively, and was immaterial for the 2016 periods. The recorded loss is included in Other income and expense.
In July 2016, the Company entered into the securitization program with a third party financial institution. Under the program, the Company receives 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 the Company's 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 2018 but can be renewed with consent from the parties to the program.
During the year-to-date period ended July 1, 2017, $1.3 billion of accounts receivable were sold via the accounts receivable securitization program. As of July 1, 2017, approximately $443 million of accounts receivable sold to Kellogg Funding under the securitization program remained outstanding, for which the Company received net cash proceeds of approximately $404 million and a deferred purchase price asset of approximately $39 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
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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 loss on sale of receivables was $2 million and $3 million for the quarter and year-to-date periods ended July 1, 2017, respectively. The recorded loss is included in Other income and expense.
The Company has no retained interests in the receivables sold under the programs above. The Company does have collection and administrative responsibilities for the sold receivables. The Company has not recorded any servicing assets or liabilities as of July 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 year-to-date period ended July 1, 2017, $94 million of accounts receivable have been sold via these programs. Accounts receivable sold of $35 million and $124 million remained outstanding under these programs as of July 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 was 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. These adjustments were finalized during the quarter ended July 1, 2017 and resulted in a purchase price reduction of BRL 14 million ($4 million). The acquisition was accounted for under the purchase price method and was financed with cash on hand and short-term borrowings.
In our Latin America reportable segment, for the quarter ended July 1, 2017 the acquisition added $46 million in net sales and $4 million of operating profit. For the year-to-date period ended July 1, 2017 the acquisition added $93 million in net sales and $12 million of operating profit.
The assets and liabilities of the Parati Group are included in the Consolidated Balance Sheet as of July 1, 2017 within the Latin America segment. The acquired assets and assumed liabilities include the following:
(millions) | December 1, 2016 | ||||
Current assets | $ | 46 | |||
Property | 72 | ||||
Goodwill | 177 | ||||
Intangible assets | 147 | ||||
Current liabilities | (48 | ) | |||
Non-current deferred tax liability and other | (19 | ) | |||
$ | 375 | ||||
During the year-to-date period ended July 1, 2017, the value of intangible assets subject to amortization increased $38 million and intangible assets not subject to amortization decreased $11 million with an offsetting $27 million adjustment to goodwill in conjunction with an 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. During the quarter ended July 1, 2017, the Company recognized $4 million for certain pre-acquisition contingencies which are considered to be probable of being incurred, which increased goodwill. The Company is still evaluating other potential contingencies, which could result in the recognition of certain contingent liabilities along with corresponding receivables from the escrow account.
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During the quarter ended April 1, 2017, the Company finalized plans to merge the acquired and pre-existing Brazilian legal entities, which resulted in tax basis of the acquired intangible assets. Accordingly, deferred tax liabilities and goodwill were both reduced by $41 million during the first quarter of 2017.
The amounts in the above table represent the allocation of purchase price as of July 1, 2017 and are subject to revision when appraisals are finalized for intangible assets and the evaluation of pre-acquisition contingencies are completed, which will be finalized during 2017.
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 | — | — | — | — | — | (64 | ) | — | (64 | ) | ||||||||||||||
Purchase price adjustment | — | — | — | — | — | (4 | ) | — | (4 | ) | ||||||||||||||
Currency translation adjustment | — | — | — | 1 | 24 | — | 4 | 29 | ||||||||||||||||
July 1, 2017 | $ | 131 | $ | 3,568 | $ | 82 | $ | 458 | $ | 400 | $ | 260 | $ | 228 | $ | 5,127 | ||||||||
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 | — | — | — | — | — | 38 | — | 38 | ||||||||||||||||
Currency translation adjustment | — | — | — | — | 1 | — | — | 1 | ||||||||||||||||
July 1, 2017 | $ | 8 | $ | 42 | $ | — | $ | 5 | $ | 41 | $ | 74 | $ | 10 | $ | 180 | ||||||||
Accumulated Amortization | ||||||||||||||||||||||||
December 31, 2016 | $ | 8 | $ | 19 | $ | — | $ | 4 | $ | 14 | $ | 6 | $ | 3 | $ | 54 | ||||||||
Amortization | — | 2 | — | — | 1 | 1 | — | 4 | ||||||||||||||||
July 1, 2017 | $ | 8 | $ | 21 | $ | — | $ | 4 | $ | 15 | $ | 7 | $ | 3 | $ | 58 | ||||||||
Intangible assets subject to amortization, net | ||||||||||||||||||||||||
December 31, 2016 | $ | — | $ | 23 | $ | — | $ | 1 | $ | 26 | $ | 30 | $ | 7 | $ | 87 | ||||||||
Purchase price allocation adjustment | — | — | — | — | — | 38 | — | 38 | ||||||||||||||||
Currency translation adjustment | — | — | — | — | 1 | — | — | 1 | ||||||||||||||||
Amortization | — | (2 | ) | — | — | (1 | ) | (1 | ) | — | (4 | ) | ||||||||||||
July 1, 2017 | $ | — | $ | 21 | $ | — | $ | 1 | $ | 26 | $ | 67 | $ | 7 | $ | 122 | ||||||||
For intangible assets in the preceding table, amortization was $4 million for the year-to-date periods ended July 1, 2017 and July 2, 2016. The currently estimated aggregate annual amortization expense for full-year 2017 is approximately $8 million.
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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 | — | — | — | — | — | (11 | ) | — | (11 | ) | ||||||||||||||
Currency translation adjustment | — | — | — | — | 31 | (1 | ) | — | 30 | |||||||||||||||
July 1, 2017 | $ | — | $ | 1,625 | $ | — | $ | 176 | $ | 414 | $ | 86 | $ | — | $ | 2,301 | ||||||||
Note 4 Investments in unconsolidated entities
In 2015, the Company acquired, for a final net purchase price of $418 million, a 50% interest in Multipro Singapore Pte. Ltd. (Multipro), a leading distributor of a variety of food products in Nigeria and Ghana and also obtained a call option to acquire 24.5% of an affiliated food manufacturing entity under common ownership based on a fixed multiple of future earnings as defined in the agreement (Purchase Option). The acquisition of the 50% interest is accounted for under the equity method of accounting. The Purchase Option, is recorded at cost and has been monitored for impairment through July 1, 2017 with no impairment being required. In July 2017, the Company received notification that the entity, through June 30, 2017, had achieved the level of earnings as defined in the agreement for the purchase option to become exercisable for a one year period. During the exercise period, the Company will validate the information provided in the notification and evaluate whether to exercise its right to acquire the 24.5% interest. While no decision to exercise the option has been made by the Company, if the option is exercised, the Company would acquire 24.5% of the affiliated food manufacturing entity for approximately $400 million.
Note 5 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 July 1, 2017, the Company recorded total charges of $96 million across all restructuring and cost reduction activities. The charges were comprised of $20 million recorded in cost of goods sold (COGS) and $76 million recorded in selling, general and administrative (SG&A) expense. During the year-to-date period ended July 1, 2017, the Company recorded total charges of $238 million across all restructuring and cost reduction activities. The charges were comprised of $35 million recorded in cost of goods sold (COGS) and $203 million recorded in selling, general and administrative (SG&A) expense.
During the quarter ended July 2, 2016, the Company recorded total charges of $72 million across all restructuring and cost reduction activities. The charges consist of $36 million recorded in COGS and $36 million recorded in SG&A expense. During the year-to-date period ended July 2, 2016, the Company recorded total charges of $124 million across all restructuring and cost reduction activities. The charges consist of $54 million recorded in COGS and $70 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 to drive future growth or utilized to achieve our 2018 Margin Expansion target.
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
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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 approximately $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 $1,354 million that have been attributed to the program. The charges consist of $6 million recorded as a reduction of revenue, $725 million recorded in COGS and $623 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 delivered 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 $17 million during the year-to-date periods ended July 1, 2017 and July 2, 2016, respectively. Total charges of $38 million have been recognized since the inception of the ZBB program.
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 July 1, 2017 and July 2, 2016 and program costs to date for programs currently active as of July 1, 2017.
Quarter ended | Year-to-date period ended | Program costs to date | |||||||||||||||
(millions) | July 1, 2017 | July 2, 2016 | July 1, 2017 | July 2, 2016 | July 1, 2017 | ||||||||||||
Employee related costs | $ | 25 | $ | 6 | $ | 136 | $ | 20 | $ | 504 | |||||||
Asset related costs | 20 | 17 | 30 | 27 | 222 | ||||||||||||
Asset impairment | — | 16 | — | 16 | 155 | ||||||||||||
Other costs | 51 | 33 | 72 | 61 | 511 | ||||||||||||
Total | $ | 96 | $ | 72 | $ | 238 | $ | 124 | $ | 1,392 | |||||||
Quarter ended | Year-to-date period ended | Program costs to date | |||||||||||||||
(millions) | July 1, 2017 | July 2, 2016 | July 1, 2017 | July 2, 2016 | July 1, 2017 | ||||||||||||
U.S. Morning Foods | $ | 1 | $ | 4 | $ | 2 | $ | 9 | $ | 243 | |||||||
U.S. Snacks | 79 | 34 | 199 | 54 | 401 | ||||||||||||
U.S. Specialty | 1 | 1 | 1 | 3 | 20 | ||||||||||||
North America Other | 2 | 4 | 9 | 13 | 137 | ||||||||||||
Europe | 2 | 14 | 8 | 28 | 307 | ||||||||||||
Latin America | 3 | 4 | 4 | 4 | 28 | ||||||||||||
Asia Pacific | 3 | 4 | 4 | 4 | 85 | ||||||||||||
Corporate | 5 | 7 | 11 | 9 | 171 | ||||||||||||
Total | $ | 96 | $ | 72 | $ | 238 | $ | 124 | $ | 1,392 | |||||||
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For the quarters ended July 1, 2017 and July 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 lease termination costs as well as third-party incremental costs related to the development and implementation of global business capabilities and a more efficient go-to-market model.
At July 1, 2017 total exit cost reserves were $221 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 | 136 | — | 30 | 72 | 238 | ||||||||||
Cash payments | (52 | ) | — | (8 | ) | (67 | ) | (127 | ) | ||||||
Non-cash charges and other | 1 | — | (22 | ) | — | (21 | ) | ||||||||
Liability as of July 1, 2017 | $ | 187 | $ | — | $ | — | $ | 34 | $ | 221 | |||||
Note 6 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 5 million anti-dilutive potential common shares excluded from the reconciliation for the quarter and year-to-date periods ended July 1, 2017. There were 3 million and 2 million anti dilutive potential common shares excluded from the reconciliation for the quarter and year-to-date periods ended July 2, 2016, respectively.
Quarters ended July 1, 2017 and July 2, 2016:
(millions, except per share data) | Net income | Average shares outstanding | Earnings per share | |||||
2017 | ||||||||
Basic | $ | 282 | 349 | $ | 0.81 | |||
Dilutive potential common shares | 3 | (0.01 | ) | |||||
Diluted | $ | 282 | 352 | $ | 0.80 | |||
2016 | ||||||||
Basic | $ | 280 | 350 | $ | 0.80 | |||
Dilutive potential common shares | 4 | (0.01 | ) | |||||
Diluted | $ | 280 | 354 | $ | 0.79 | |||
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Year-to-date periods ended July 1, 2017 and July 2, 2016:
(millions, except per share data) | Net income | Average shares outstanding | Earnings per share | |||||
2017 | ||||||||
Basic | $ | 544 | 350 | $ | 1.56 | |||
Dilutive potential common shares | 3 | (0.02 | ) | |||||
Diluted | $ | 544 | 353 | $ | 1.54 | |||
2016 | ||||||||
Basic | $ | 455 | 350 | $ | 1.30 | |||
Dilutive potential common shares | 4 | (0.01 | ) | |||||
Diluted | $ | 455 | 354 | $ | 1.29 | |||
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 July 1, 2017, $639 million remains available under the authorization.
During the year-to-date period ended July 1, 2017, the Company repurchased approximately 6 million shares of common stock for a total of $435 million, of which $390 million was paid and $45 million was payable at July 1, 2017. During the year-to-date period ended July 2, 2016, the Company repurchased 5 million shares of common stock for a total of $386 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.
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Reclassifications out of AOCI for the quarter and year-to-date periods ended July 1, 2017 and July 2, 2016, consisted of the following:
(millions) | |||||||
Details about AOCI components | Amount reclassified from AOCI | Line item impacted within Income Statement | |||||
Quarter ended July 1, 2017 | Year-to-date period ended July 1, 2017 | ||||||
(Gains) losses on cash flow hedges: | |||||||
Foreign currency exchange contracts | $ | — | $ | (1 | ) | COGS | |
Foreign currency exchange contracts | — | — | SG&A | ||||
Interest rate contracts | 2 | 5 | Interest expense | ||||
Commodity contracts | — | — | COGS | ||||
$ | 2 | $ | 4 | Total before tax | |||
— | (1 | ) | Tax expense (benefit) | ||||
$ | 2 | $ | 3 | Net of tax | |||
Amortization of postretirement and postemployment benefits: | |||||||
Net experience loss | $ | — | $ | 1 | See Note 9 for further details | ||
Prior service cost | — | — | See Note 9 for further details | ||||
$ | — | $ | 1 | Total before tax | |||
— | — | Tax expense (benefit) | |||||
$ | — | $ | 1 | Net of tax | |||
Total reclassifications | $ | 2 | $ | 4 | Net of tax | ||
(millions) | |||||||
Details about AOCI components | Amount reclassified from AOCI | Line item impacted within Income Statement | |||||
Quarter ended July 2, 2016 | Year-to-date period ended July 2, 2016 | ||||||
(Gains) losses on cash flow hedges: | |||||||
Foreign currency exchange contracts | $ | — | $ | (7 | ) | COGS | |
Foreign currency exchange contracts | — | — | SGA | ||||
Interest rate contracts | 2 | 8 | Interest expense | ||||
Commodity contracts | 4 | 7 | COGS | ||||
$ | 6 | $ | 8 | Total before tax | |||
(2 | ) | (3 | ) | Tax expense (benefit) | |||
$ | 4 | $ | 5 | Net of tax | |||
Amortization of postretirement and postemployment benefits: | |||||||
Net experience loss | $ | 1 | $ | 2 | See Note 9 for further details | ||
Prior service cost | 2 | 2 | See Note 9 for further details | ||||
$ | 3 | $ | 4 | Total before tax | |||
— | — | Tax expense (benefit) | |||||
$ | 3 | $ | 4 | Net of tax | |||
Total reclassifications | $ | 7 | $ | 9 | Net of tax | ||
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Accumulated other comprehensive income (loss) as of July 1, 2017 and December 31, 2016 consisted of the following:
(millions) | July 1, 2017 | December 31, 2016 | ||||
Foreign currency translation adjustments | $ | (1,429 | ) | $ | (1,505 | ) |
Cash flow hedges — unrealized net gain (loss) | (64 | ) | (67 | ) | ||
Postretirement and postemployment benefits: | ||||||
Net experience loss | (13 | ) | (14 | ) | ||
Prior service cost | 11 | 11 | ||||
Total accumulated other comprehensive income (loss) | $ | (1,495 | ) | $ | (1,575 | ) |
Note 7 Debt
The following table presents the components of notes payable at July 1, 2017 and December 31, 2016:
July 1, 2017 | December 31, 2016 | ||||||||||
(millions) | Principal amount | Effective interest rate (a) | Principal amount | Effective interest rate (a) | |||||||
U.S. commercial paper | $ | 229 | 1.15 | % | $ | 80 | 0.61 | % | |||
Europe commercial paper | 423 | (0.23 | )% | 306 | (0.18 | )% | |||||
Bank borrowings | 72 | 52 | |||||||||
Total | $ | 724 | $ | 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.
In May 2017, the Company issued €600 million (approximately $685 million USD at July 1, 2017, which reflects the discount and translation adjustments) of five-year 0.80% Euro Notes due 2022, resulting in aggregate net proceeds after debt discount of $656 million. The proceeds from these Notes were used for general corporate purposes, including, together with cash on hand and additional commercial paper borrowings, repayment of the Company's $400 million, five-year 1.75% U.S. Dollar Notes due 2017 at maturity. The Notes contain customary covenants that limit the ability of the Company and its restricted subsidiaries (as defined) to incur certain liens or enter into certain sale and lease-back transactions, as well as a change of control provision. The Notes were designated as a net investment hedge of the Company's investment in its Europe subsidiary when issued.
During the second quarter of 2017, the Company repaid its Cdn.$300 million three year 2.05% Canadian Dollar Notes.
In the second quarter of 2017, the Company entered into interest rate swaps with notional amounts totaling approximately €600 million which effectively converted €600 million of its 1.25% Euro Notes due 2025 from fixed to floating rate obligations. The U.S. Dollar interest rate swaps were settled during the quarter for an unrealized loss of $14 million which will be amortized to interest expense over the remaining term of the related Notes.
In March 2016, the Company redeemed $475 million of its 7.45% U.S. Dollar Debentures due 2031. In connection with the debt redemption, the Company 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.
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 and Euro 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 July 1, 2017 were as follows: (a) seven-year 3.25% U.S. Dollar Notes due 2018 – 2.75%; (b) ten-year 4.15% U.S. Dollar Notes due 2019 – 3.52%; (c) ten-year 4.00% U.S. Dollar Notes due 2020 – 3.41%; (d) ten-year 3.125% U.S. Dollar Notes due 2022 – 2.46%; (e) ten-year 2.75% U.S. Dollar Notes due 2023 – 2.61%; (f) seven-year 2.65% U.S. Dollar Notes due 2023 – 2.30%; (g) eight-year 1.00% Euro Notes due 2024 – 0.75%; (h) ten-year 1.25% Euro Notes due 2025 - 1.27% and (i) ten-year 3.25% U.S. Notes due 2026 – 3.58%.
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Note 8 Stock compensation
The Company uses various equity-based compensation programs to provide long-term performance incentives for its global workforce. Currently, these incentives 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 | Year-to-date period ended | ||||||||||||
(millions) | July 1, 2017 | July 2, 2016 | July 1, 2017 | July 2, 2016 | |||||||||
Pre-tax compensation expense | $ | 21 | $ | 17 | $ | 39 | $ | 33 | |||||
Related income tax benefit | $ | 8 | $ | 6 | $ | 14 | $ | 12 | |||||
As of July 1, 2017, total stock-based compensation cost related to non-vested awards not yet recognized was $125 million and the weighted-average period over which this amount is expected to be recognized was 2 years.
Stock options
During the year-to-date periods ended July 1, 2017 and July 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.
Year-to-date period ended July 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 | ) | 57 | |||||||
Forfeitures and expirations | — | — | ||||||||
Outstanding, end of period | 16 | $ | 64 | 7.0 | $ | 109 | ||||
Exercisable, end of period | 11 | $ | 60 | 6.1 | $ | 104 | ||||
Year-to-date period ended July 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 | (4 | ) | 56 | |||||||
Forfeitures and expirations | — | — | ||||||||
Outstanding, end of period | 18 | $ | 61 | 7.2 | $ | 335 | ||||
Exercisable, end of period | 10 | $ | 57 | 6.2 | $ | 247 | ||||
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The weighted-average grant date fair value of options granted was $10.14 per share and $9.44 per share for the year-to-date periods ended July 1, 2017 and July 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 year-to-date period ended July 1, 2017: | 18 | % | 6.6 | 2.26 | % | 2.80 | % |
Grants within the year-to-date period ended July 1, 2016: | 17 | % | 6.9 | 1.60 | % | 2.60 | % |
The total intrinsic value of options exercised was $17 million and $79 million for the year-to-date periods ended July 1, 2017 and July 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 186,000 shares, with a grant-date fair value of $67 per share.
Based on the market price of the Company’s common stock at July 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) | July 1, 2017 | ||
2015 Award | $ | 22 | |
2016 Award | $ | 24 | |
2017 Award | $ | 26 | |
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 year-to-date period ended July 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 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.
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Year-to-date period ended July 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 | 654 | 67 | |||
Vested | (35 | ) | 57 | ||
Forfeited | (72 | ) | 65 | ||
Non-vested, end of period | 1,713 | $ | 65 | ||
Year-to-date period ended July 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 | 574 | 70 | |||
Vested | (51 | ) | 55 | ||
Forfeited | (55 | ) | 62 | ||
Non-vested, end of period | 1,274 | $ | 63 | ||
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Note 9 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 | Year-to-date period ended | ||||||||||||
(millions) | July 1, 2017 | July 2, 2016 | July 1, 2017 | July 2, 2016 | |||||||||
Service cost | $ | 25 | $ | 25 | $ | 50 | $ | 49 | |||||
Interest cost | 42 | 44 | 83 | 88 | |||||||||
Expected return on plan assets | (90 | ) | (90 | ) | (180 | ) | (179 | ) | |||||
Amortization of unrecognized prior service cost | 2 | 4 | 4 | 7 | |||||||||
Recognized net (gain) loss | (2 | ) | — | 1 | — | ||||||||
Curtailment (gain) loss | (3 | ) | — | (2 | ) | — | |||||||
Total pension (income) expense | $ | (26 | ) | $ | (17 | ) | $ | (44 | ) | $ | (35 | ) | |
Other nonpension postretirement
Quarter ended | Year-to-date period ended | ||||||||||||
(millions) | July 1, 2017 | July 2, 2016 | July 1, 2017 | July 2, 2016 | |||||||||
Service cost | $ | 4 | $ | 5 | $ | 9 | $ | 10 | |||||
Interest cost | 9 | 9 | 18 | 19 | |||||||||
Expected return on plan assets | (25 | ) | (23 | ) | (49 | ) | (45 | ) | |||||
Amortization of unrecognized prior service (gain) | (2 | ) | (2 | ) | (4 | ) | (5 | ) | |||||
Recognized net (gain) loss | — | — | (29 | ) | — | ||||||||
Curtailment loss | — | — | 3 | — | |||||||||
Total postretirement benefit (income) expense | $ | (14 | ) | $ | (11 | ) | $ | (52 | ) | $ | (21 | ) | |
Postemployment
Quarter ended | Year-to-date period ended | ||||||||||||
(millions) | July 1, 2017 | July 2, 2016 | July 1, 2017 | July 2, 2016 | |||||||||
Service cost | $ | 2 | $ | 2 | $ | 3 | $ | 4 | |||||
Interest cost | 1 | 1 | 2 | 2 | |||||||||
Recognized net loss | — | 1 | 1 | 2 | |||||||||
Total postemployment benefit expense | $ | 3 | $ | 4 | $ | 6 | $ | 8 | |||||
During the second quarter of 2017, the Company recognized a curtailment gain of $3 million within a pension plan in conjunction with Project K restructuring activity. The Company remeasured the benefit obligation for the impacted pension plan resulting in a mark-to-market gain of $2 million. The gain was due primarily to plan asset returns in excess of the expected rate of return.
During the first quarter of 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.
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Company contributions to employee benefit plans are summarized as follows:
(millions) | Pension | Nonpension postretirement | Total | ||||||
Quarter ended: | |||||||||
July 1, 2017 | $ | 2 | $ | 2 | $ | 4 | |||
July 2, 2016 | $ | 2 | $ | 4 | $ | 6 | |||
Year-to-date period ended: | |||||||||
July 1, 2017 | $ | 23 | $ | 5 | $ | 28 | |||
July 2, 2016 | $ | 15 | $ | 8 | $ | 23 | |||
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 first quarter of 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 10 Income taxes
The consolidated effective tax rate for the quarter ended July 1, 2017 was 26% as compared to the prior year’s rate of 27%. The consolidated effective tax rates for the year-to-date periods ended July 1, 2017 and July 2, 2016 were 21% and 25%, respectively. For the year-to-date period ended July 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.
The effective tax rate for the first half of 2016 benefited from excess tax benefits from share-based compensation and the completion of certain tax examinations.
As of July 1, 2017, the Company classified $8 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 $5 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.
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Following is a reconciliation of the Company’s total gross unrecognized tax benefits for the quarter ended July 1, 2017; $38 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 | 2 | ||
Reductions | — | ||
Tax positions related to prior years: | |||
Additions | 2 | ||
Reductions | (6 | ) | |
Settlements | (4 | ) | |
Lapse in statute of limitations | — | ||
July 1, 2017 | $ | 57 | |
The accrual balance for tax-related interest was $20 million at July 1, 2017.
Note 11 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 July 1, 2017 and December 31, 2016 were as follows:
(millions) | July 1, 2017 | December 31, 2016 | ||||
Foreign currency exchange contracts | $ | 2,253 | $ | 1,396 | ||
Interest rate contracts | 2,197 | 2,185 | ||||
Commodity contracts | 423 | 437 | ||||
Total | $ | 4,873 | $ | 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 July 1, 2017 and December 31, 2016, measured on a recurring basis.
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
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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 July 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 July 1, 2017 and December 31, 2016:
Derivatives designated as hedging instruments
July 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) | — | (46 | ) | (46 | ) | — | (65 | ) | (65 | ) | |||||||||
Total liabilities | $ | — | $ | (46 | ) | $ | (46 | ) | $ | — | $ | (65 | ) | $ | (65 | ) | |||
(a) The fair value of the related hedged portion of the Company's long-term debt, a level 2 liability, was $2.2 billion and $2.2 billion as of July 1, 2017 and December 31, 2016, respectively.
Derivatives not designated as hedging instruments
July 1, 2017 | December 31, 2016 | ||||||||||||||||||
(millions) | Level 1 | Level 2 | Total | Level 1 | Level 2 | Total | |||||||||||||
Assets: | |||||||||||||||||||
Foreign currency exchange contracts: | |||||||||||||||||||
Other prepaid assets | $ | — | $ | 16 | $ | 16 | $ | — | $ | 25 | $ | 25 | |||||||
Commodity contracts: | |||||||||||||||||||
Other prepaid assets | 13 | — | 13 | 13 | — | 13 | |||||||||||||
Total assets | $ | 13 | $ | 16 | $ | 29 | $ | 13 | $ | 25 | $ | 38 | |||||||
Liabilities: | |||||||||||||||||||
Foreign currency exchange contracts: | |||||||||||||||||||
Other current liabilities | $ | — | $ | (21 | ) | $ | (21 | ) | $ | — | $ | (11 | ) | $ | (11 | ) | |||
Commodity contracts: | |||||||||||||||||||
Other current liabilities | (5 | ) | — | (5 | ) | $ | (7 | ) | $ | — | $ | (7 | ) | ||||||
Total liabilities | $ | (5 | ) | $ | (21 | ) | $ | (26 | ) | $ | (7 | ) | $ | (11 | ) | $ | (18 | ) | |
The Company has designated 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 $2.6 billion and $1.8 billion as of July 1, 2017 and December 31, 2016, respectively.
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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 July 1, 2017 and December 31, 2016 would be adjusted as detailed in the following table:
As of July 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 | $ | 29 | $ | (18 | ) | $ | — | $ | 11 | |||
Total liability derivatives | $ | (72 | ) | $ | 18 | $ | 18 | $ | (36 | ) | ||
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 July 1, 2017 and July 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) | ||||||
July 1, 2017 | July 2, 2016 | |||||||
Interest rate contracts | Interest expense | $ | 5 | |||||