Letter to Shareowners

Letter to Shareowners

February 21, 2018

Steve Cahillane

Let me begin by expressing how grateful and humbled I am to have the opportunity to lead this great Company. From the minute I arrived, it was immediately obvious that this is a special Company, and the attributes that have made it so successful for over a century are still relevant today:

  • High quality foods;
  • Big, relevant brands;
  • A heritage of health and wellness, and of putting smiles on consumers' faces;
  • A long-standing global presence;
  • A commitment to social responsibility; and
  • Talented employees who live our Company's values, are passionate about our brands, and possess a will to win in the marketplace.

Changing industry dynamics require changing priorities, developing new capabilities, and changing the ways we help people flourish and thrive. But make no mistake: Our foundation for growth is as strong as ever.

2017: A Year of Progress

While our entire industry was challenged for sales growth, particularly in the first half of the year, we were pleased with the progress we made in 2017. Among the highlights:

  • We delivered on our financial guidance. This included strong profit-margin expansion, earnings growth, and cash flow. It also included a meaningful improvement in our net sales performance in the second half.
  • We took major actions to reduce our cost structure. Principally under our Project K restructuring program, we continued to consolidate our global supply chain network, and we thinned out layers of management. We also executed what may have been the most complex undertaking in the industry this year, the exit from Direct-Store Distribution in our U.S. Snacks division, freeing up resources to invest in growth across more of our brands and channels. The result is a more optimal cost structure, and you can see it in our improved profit margins.
  • We expanded our presence in emerging markets. We continued to extend Pringles' presence throughout Asia, Latin America, and the Middle East. Also, we integrated and grew Parati, our newly acquired business in Brazil. Parati triples our scale in this important emerging market, diversifies our portfolio, and provides opportunity for both revenue and cost synergies. And we worked with our partners to rapidly expand our joint ventures in Africa and in China. Their strong double-digit growth does not show up in our consolidated net sales, but they are widening the reach and awareness of Kellogg brands, and they represent a key element of our strategy to expand in emerging markets.
  • We acquired RXBAR, which not only fills a white space in our snacking portfolio, but also becomes a new growth platform for us. RXBAR is growing rapidly, and we're operating it as a stand-alone entity, in order to preserve its entrepreneurial approach. We can leverage Kellogg's considerable resources to expand its product lines, distribution, and markets, and we can look for ways to utilize it as a platform for other foods and brands.
  • We continued to enhance our capabilities for today's digital age. Our e-commerce sales grew by more than 40% in 2017, and we leveraged digital and social media in exciting new ways that drove growth for their respective brands.

Around the globe, and across our portfolio, we saw "green shoots" of progress in 2017, tangible signs of returning to top-line growth. Among them:

  • Sustained growth in U.S. Specialty Channels and in Asia-Pacific. The former benefited from pushing our reach in key channels like foodservice, vending, and convenience stores. The latter benefited from continued growth in Asia. Both enjoy solid fundamentals heading into 2018.
  • Renewed growth in U.S. Frozen Foods. Strong brand building, renovation of food, and new products all contributed to an impressive return to growth for both Eggo and Morningstar Farms. These are on-trend brands in on-trend categories, and both carry strong momentum into 2018.
  • Stabilized cereal sales and share in core international developed markets. By effectively marrying strong brand-building ideas with relevant food news, we were able to stabilize sales and share in what had been challenging markets: Canada, Australia, and the United Kingdom.
  • Resumed Pringles growth after a temporary disruption early in the year. Prolonged negotiations over pricing actions resulted in lost merchandising activity in Europe during the first half of the year, but the strength of the brand was evident as it returned to growth once these negotiations were resolved.
  • Improved underlying trends in U.S. Snacks in the second half. The exit from Direct-Store Delivery included a substantial reduction in stock-keeping units, as well as the elimination of a price-premium we had previously charged for DSD services. Excluding this largely mechanical impact on net sales, our U.S. Snacks business stabilized and grew its sales in the second half, with ramped-up brand support improving our brands' sales velocities on shelf.
  • Continued emerging markets expansion and organic growth. Despite some unusual circumstances in our Caribbean/Central America sub-region, we grew organically in emerging markets, led by Pringles, while integrating our growing Parati business in Brazil, and sustaining strong double-digit growth in our joint ventures in Africa and China.

Better Growth Ahead

With our cost structure reduced, we now must pivot to sales growth. And we're approaching growth with the same relentless focus we placed on cost reduction in recent years. Profit-margin expansion will continue via ongoing productivity, the completion of Project K, and even the development of new sources of cost savings. It just may be more gradual, as we invest more behind our brands and our capabilities. After all, nothing is more sustainably profitable over time than top-line growth.

Our guidance for 2018, off a recast 2017 base, is for flat net sales on a currency-neutral basis, a prudent view that incorporates the negative mechanical impact of the DSD exit, the positive addition of rapidly growing RXBAR, and sequential improvement in our underlying business. Project K and Zero-Based Budgeting enable us to both offset budding cost inflation and boost our investment in Brand Building for growth, while still delivering mid single-digit growth in operating profit. U.S. tax reform gives us the opportunity to deliver stronger earnings growth, even after using its cash-flow benefits to improve our financial flexibility via deleveraging our capital structure and taking a more conservative approach to our pension funds.

Beyond 2018, we believe we are on a trajectory of modest growth, based on our current portfolio and the initiatives we have in place. Here's a simple way to view this current trajectory:

  • Developed-Markets Snacks. This portion of our portfolio represents a little less than half of our global sales, and is on track to grow at a low single-digit rate once we get past the DSD transition in 2018. We have every right to win amidst a global snacking trend. Pringles grows consistently in these markets, and there is so much more we can do with its pack formats, in-store racking, innovation, and fun brand-building ideas like flavor stacking. Meanwhile, in the U.S., our transition out of DSD allows our Snacks business unit to shift resources into demand-driving Brand Building. This means more support for power brands like Cheez-It and Club crackers, Rice Krispies Treats, and Pringles, but it also means support for other brands like Keebler, Nutri-Grain, and Famous Amos. And now we have RXBAR in our portfolio. This is a brand that has barely scratched the surface in terms of distribution, and we look at this business as a new, entrepreneurial, growth platform for us.
  • Developed-Markets Cereal. This accounts for just under a third of our global sales, and should be stable over time. In these markets, cereal is a highly penetrated category that tends to grow and decline in cycles. These cycles are driven by changes in food beliefs and levels of innovation, with the category ending up being somewhat flat over time. In recent years, consumer trends away from low-calorie/low-fat definitions of weight management (and toward high protein and prepared meals) have put developed-markets cereals on one of its cyclical downturns. This has pulled down the so-called Health & Wellness segment of this category, and we over-index in that segment. We have every reason to be confident we will stabilize our Developed-Markets Cereal sales. After all, we stabilized our three largest international markets in 2017, and we did that the way we know best – with relevant food news, coupled with effective brand building, and tying it all together with strong in-store execution. There is no reason we cannot do even better going forward. We have stronger innovation and renovation planned. We are expanding eating occasions (like snacking occasions where cereal has shown it has relevance), and we are influencing food beliefs with a strong push behind digestive health. So, it's not unreasonable to expect this portion of our portfolio to be somewhere around flat over time – up slightly in some years and perhaps down modestly in others. Even if it consistently declined slightly, we could still deliver top-line growth as a Company.
  • Developed-Markets Frozen Foods. Principally focused on the U.S., and representing less than 10% of our total Company sales, this segment of our portfolio should be able to deliver low single-digit sales growth. Our Eggo brand of frozen waffles and pancakes is growing faster than that today, propelled by the removal of artificial colors and flavors and innovation launches of Disney shapes. And our Morningstar Farms brand of frozen veggie foods, is also benefiting from on-trend foods and a focus on our core items. We have every intention and opportunity to continue to innovate and renovate, emphasizing simple ingredients, versatility of our foods, and plant protein. So, it's actually a bit conservative to assume a current trajectory of only a low single-digit organic growth rate over time.
  • Emerging Markets. These markets represent nearly 15% of our total Company sales, excluding our joint ventures. They offer population growth, rising disposable incomes, and pronounced snacking trends. In the past, our portfolio in these markets was almost solely focused on one category, ready-to-eat cereal, and we lacked the scale and economics to make these markets a true growth driver for us. In recent years, though, we have been building scale and presence, particularly in snacking. As a result, we've been able to grow organically in recent years, despite difficult macro-economic conditions. And we're just getting started. Pringles has momentum, as we enter new markets, and as we launch new foods and pack formats. We're using the Kellogg Masterbrand to launch granola and wholesome snacks in Asia and Africa. We've built a stronger Middle East foothold through our cereal and biscuits acquisitions in Egypt. We're integrating and growing Parati which triples our size in Brazil and gets us into the biscuits category. It's reasonable to assume an organic growth trajectory in the mid single digits for our wholly-owned emerging markets business – which is precisely what we delivered in our latest quarter. And remember – this doesn't even include our Joint Ventures, which are growing at a very strong double-digit rate.

On top of this current trajectory, we believe we can deliver more growth by applying what we call "Deploy for Growth." Depicted below, Deploy for Growth takes our previous 2020 Growth Plan and evolves it to drive more focus on growth – more focus on execution and on investing where the growth is.

deploy for growth

Before I discuss what we'll do differently, let me point out what does not change:

  • Our Vision and our Purpose do not change. They absolutely capture what we are all about.
  • Our so-called "Heart & Soul" strategy remains the same, with our core values and commitment to social responsibility as important as ever.
  • And our financial guideposts don't change: Growing sales and share, expanding our Operating Profit margin, and delivering top-quartile Total Shareowner Return remain vitally important.

What do change are our Growth boosters:

  • Win Through Occasions. This Company's roots are in the breakfast occasion, and so many of our products – and categories – were developed with breakfast in mind. But "winning through occasions" means delivering the right food, in the right packaging, at the right time for any particular occasion. In effect, we've been moving beyond breakfast for some time, but we have a lot further to go. Focusing on occasions already has us innovating behind four key pillars: Hyper-convenience, which targets on-the-go occasions with single-serve offerings or time-strapped occasions with fast-preparation items; digestive wellness, which can cut across a variety of occasions; strength and energy, for pick-me-up occasions; and next-generation natural, for yet other consumers and occasions. This can drive better growth for us going forward.
  • Shape a Growth Portfolio. We're more actively shifting our resources toward growth. For instance, we're adding capacity for Pringles in Brazil, because its growth in South America is outstripping our supply. We see growth in U.S. snacking categories, so we've exited DSD to free up resources that can be used to ramp up investment in the innovation and brand building that drive those categories. Frozen foods are on trend right now, and as we've invested, we've seen our growth momentum build. Bear Naked hits a granola trend, and we've been investing in the offerings and distribution of this wonderful brand, which has become the #1 granola brand in the U.S. We're also pushing into white-space opportunities. For instance, we're launching wholesome snacks in Asia and Africa, because there is an emerging consumer opportunity opening up for these kinds of products. We also view mergers and acquisitions as an important way that we can shift our portfolio's growth profile. Our most likely hunting grounds for M&A are the ones you've seen us explore in recent years: Health & Wellness in developed markets and Snacking in emerging markets. We have developed a strong M&A capability, and we see bolt-ons, white-space opportunities, and emerging-markets expansion as promising ways to improve our portfolio's growth profile.
  • Build World-Class Marketing. We're challenging ourselves to improve the way we build and market our brands. It starts with actionable insights, followed by great ideas that delight the consumer. You've gotten a glimpse of this bolder effort even within the past few months. We converted a behavioral insight – that only with Pringles can a consumer stack different flavored crisps to create an entirely different taste and experience – into a major Super Bowl event, ranging from social and digital elements, to television advertising, and huge in-store activity. In a recent digital campaign for Rice Krispies Treats, we leveraged consumer data to customize our messaging depending on consumers' individual search topics. In the U.K., we reminded consumers why they love our oldest brand by driving consumer conversation about how they create their perfect bowl of Corn Flakes. And each of these brands responded with accelerated consumption and share growth. That's the power of effective brand building, and you'll see more of this from us going forward.
  • Deliver Perfect Service, Perfect Store. As customers work to reduce inventory and drive efficiency, they are rightly demanding better service. We welcome this, as it is in both of our interests to get better and better. Our move out of DSD was a great example of how we are changing our game – it puts all of our U.S. business on a single, more efficient warehouse-distribution system, which allows us to improve service levels. Project K realigned our network, and now we're in the process of modernizing and digitizing our plants. We've been smoothing out our end-to-end supply chain, taking steps to improve our S&OP process, getting better at integrating demand signals, and even trimming our line-up of SKUs. If we get the service right, we can get the store right. And on that front, we're getting more ambitious and creative about our aisles. We're testing new in-store racks, and, following our exit from DSD, we're executing cross-category promotions for the first time in the U.S. Perfect store can take many shapes, depending on the channel. New channels are evolving, and we have been building our capabilities and presence in these channels – high-frequency stores in the emerging markets, for instance, and vending around the world. And, of course, e-commerce, where our big brands and new capabilities enable us to reach the coveted "first page" more frequently than others can.

To make all this happen, we need to invest in capabilities and build a high-performance culture. So, we're backing up our growth strategy with increased investment, not only in brand building but also in our talent, tools, and technology. We've even modified our bonus compensation to tie more to sales growth than in the past, and we've changed our performance evaluation methodology to better differentiate rewards.

By balancing profitability with investment, we believe Deploy for Growth can lift our current trajectory and achieve a long-term growth algorithm that looks something like this:

long term growth

Our Company is on solid financial footing. With a reduced cost structure and categories that are profitable, we are already on a positive earnings growth trend. And by improving our working capital, we've been able to consistently demonstrate a strong and durable cash flow. Simply put, we have the financial flexibility to both invest in growth and return cash to shareowners in the form of an attractive dividend and share repurchases.

A Company With Heart & Soul

Even with this emphasis on growth, we will not lose what makes Kellogg special. Our K-Values are as important today as ever – the underpinning of our unique culture. Part of that culture, and our heritage, is Social Responsibility. We view being a leading corporate citizen as doing the right thing each and every day. Social Responsibility is important to our consumers, our customers, our employees, and our shareowners. You can be sure that, even as we deploy for growth, we will not lose sight of this.

In Conclusion

I'm incredibly excited about our Company's prospects. Our heritage, our foods, our brands, and our people give us a foundation for growth, a right to win the marketplace. We've also made some key strategic moves – we've reduced our cost structure, we've built capabilities, we've exited DSD in the U.S. to free up brand investment, and we've built scale in emerging markets. Now we're going to put the same focus on growth that we put on reducing our cost structure in recent years. I'm sure you'll agree: Our plan is pragmatic, and there's nothing pie-in-the-sky about our outlook. At the same time, it's inspiring and energizing for the organization, and it puts us on the right track toward steady, dependable, profitable growth.

It's important to recognize the achievements of John Bryant, who has retired from Kellogg after a remarkable 20-year career at Kellogg, the last seven as Chairman and CEO. Under his leadership, our cost structure was optimized, we shifted the portfolio toward snacking, and we built up our emerging markets – all of which will benefit us in the years to come. John clearly left his mark on our Company.

I'd also like to thank Kellogg's 33,000 talented and hard-working employees – for welcoming me into the Company and for their unwavering passion for doing the right things for our business. And I thank you, our shareowners, for believing in this great Company. Your trust will be rewarded.

 

Steve Cahillane

Steve Cahillane

Chairman & Chief Executive Officer

2017 Annual Report

2017 Recast Financial Statements

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