Edgar Filing: KELLOGG CO

e10-q

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)

		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
		SECURITIES EXCHANGE ACT OF 1934

		For the quarterly period ended September 30, 2001

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: 616-961-2000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 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 IN BALLOT BOX No

Common Stock outstanding October 31, 2001 – 406,476,332 shares

TABLE OF CONTENTS


PART I — FINANCIAL INFORMATION
ITEM 1:
	CONSOLIDATED BALANCE SHEET — SEPTEMBER 30, 2001, AND DECEMBER 31, 2000
	CONSOLIDATED EARNINGS — THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2001 AND 2000
	CONSOLIDATED STATEMENT OF CASH FLOWS — NINE MONTHS ENDED SEPTEMBER 30, 2001 AND 2000
	NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
ITEM 2.
	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
PART II — OTHER INFORMATION
ITEM 4.
	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
ITEM 6.
	EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURES

KELLOGG COMPANY

INDEX


PART I - Financial Information			Page

Item 1:
	Consolidated Balance Sheet – September 30, 2001, and
	December 31, 2000			2

	Consolidated Statement of Earnings – three and nine months
	ended September 30, 2001 and 2000			3

	Consolidated Statement of Cash Flows — nine months
	ended September 30, 2001 and 2000			4

	Notes to Consolidated Financial Statements			5-18
Item 2:
	Management’s Discussion and Analysis of Financial Condition
		and Results of Operations		19-31

PART II — Other Information

Item 4:
	Submission of Matters to a Vote of Security Holders			32

Item 6:
	Exhibits and Reports on Form 8-K			32

Signatures				33

Kellogg Company and Subsidiaries
CONSOLIDATED BALANCE SHEET
(millions, except per share data)


		September 30,			December 31,
		2001			2000
		(unaudited)			*

Current assets
Cash and cash equivalents		$	327.0		$	204.4
Accounts receivable, net			901.0			685.3
Inventories:
	Raw materials and supplies		172.1			138.2
	Finished goods and materials in process		363.6			305.6
Other current assets			306.8			273.3

Total current assets			2,070.5			1,606.8
Property, net of accumulated depreciation of $2,654.5 and $2,508.3			2,954.8			2,526.9
Goodwill,net of accumulated amortization of $50.5 and $10.5			3,074.3			208.2
Other intangibles, net of accumulated amortization of $52.8 and $18.6			2,063.6			199.2
Other assets			424.6			355.2

Total assets		$	10,587.8		$	4,896.3

Current liabilities
Current maturities of long-term debt		$	8.3		$	901.1
Notes payable			1,016.5			485.2
Accounts payable			529.1			388.2
Income taxes			83.8			130.8
Other current liabilities			1,075.1			587.3

Total current liabilities			2,712.8			2,492.6

Long-term debt			5,328.9			709.2
Nonpension postretirement benefits			481.7			408.5
Deferred income taxes and other liabilities			1,192.4			388.5

Shareholders’ equity
Common stock, $.25 par value			103.8			103.8
Capital in excess of par value			91.5			102.0
Retained earnings			1,541.8			1,501.0
Treasury stock, at cost			(342.0	)		(374.0	)
Accumulated other comprehensive income			(523.1	)		(435.3	)

Total shareholders’ equity			872.0			897.5

Total liabilities and shareholders’ equity		$	10,587.8		$	4,896.3

^* Condensed from audited financial statements

Refer to Notes to Consolidated Financial Statements

Kellogg Company and Subsidiaries
CONSOLIDATED EARNINGS
(millions, except per share data)


		Three months ended				Nine months ended
		September 30,				September 30,

(Results are unaudited)		2001		2000		2001			2000

Net sales		$	2,590.1	$	1,845.7	$	6,640.3		$	5,398.7
Cost of goods sold			1,180.7		875.7		3,106.0			2,562.1
Selling and administrative expense			1,062.4		661.9		2,630.5			1,963.4
Restructuring charges			—		—		48.3			21.3

Operating profit			347.0		308.1		855.5			851.9
Interest expense			104.2		36.4		251.8			102.4
Other income (expense), net			1.1		0.2		(5.9	)		7.8

Earnings before income taxes			243.9		271.9		597.8			757.3
Income taxes			93.6		90.0		240.4			262.8

Earnings before extraordinary loss and cumulative effect of accounting change			150.3		181.9		357.4			494.5
Extraordinary loss (net of tax)			—		—		(7.4	)		—
Cumulative effect of accounting change (net of tax)			—		—		(1.0	)		—

Net earnings		$	150.3	$	181.9	$	349.0		$	494.5

Per share amounts (basic and diluted):
	Earnings before extraordinary loss and cumulative effect of accounting change	$	.37	$	.45	$	.88		$	1.22
	Extraordinary loss (net of tax)		—		—	$	(.02	)		—
	Cumulative effect of accounting change (net of tax)		—		—		—			—

	Net earnings per share (basic and diluted)	$	.37	$	.45	$	.86		$	1.22

Dividends per share		$	.2525	$	.2525	$	.7575		$	.7425

Average shares outstanding			406.2		405.6		405.9			405.6

Actual shares outstanding at period end							406.5			405.6

Refer to Notes to Consolidated Financial Statements

Kellogg Company and Subsidiaries
CONSOLIDATED STATEMENT OF CASH FLOWS
(millions)


		Nine months ended
		September 30,

(Results are unaudited)		2001			2000

Operating activities
Net earnings		$	349.0		$	494.5
Items in net earnings not requiring cash:
	Depreciation and amortization		319.6			217.3
	Deferred income taxes		7.0			34.1
	Restructuring charges, net of cash paid		45.9			17.8
	Other		(68.2	)		16.8
Postretirement benefit plan contributions			(58.1	)		(61.9	)
Changes in operating assets and liabilities			259.6			(88.5	)

Net cash provided by operating activities			854.8			630.1

Investing activities
Additions to properties			(153.9	)		(172.5	)
Acquisitions of businesses			(3,857.7	)		(135.3	)
Other			(3.0	)		(4.7	)

Net cash used in investing activities			(4,014.6	)		(312.5	)

Financing activities
Net issuances of notes payable			533.2			55.1
Issuances of long-term debt			4,626.4			—
Reductions of long-term debt			(1,589.7	)		(1.1	)
Net issuances of common stock			21.4			4.5
Cash dividends			(308.3	)		(301.2	)
Other			0.6			—

Net cash provided by (used in) financing activities			3,283.6			(242.7	)

Effect of exchange rate changes on cash			(1.2	)		(9.2	)

Increase in cash and cash equivalents			122.6			65.7
Cash and cash equivalents at beginning of period			204.4			150.6

Cash and cash equivalents at end of period		$	327.0		$	216.3

Refer to Notes to Consolidated Financial Statements

Notes to Consolidated Financial Statements
for the three and nine months ended September 30, 2001 (unaudited)

1. Accounting policies

The unaudited interim financial information included in this report reflects normal recurring adjustments that management believes are necessary for a fair presentation of the results of operations, financial position, and cash flows for the periods presented. This interim information should be read in conjunction with the financial statements and accompanying notes contained on pages 24 to 39 of the Company’s 2000 Annual Report. The accounting policies used in preparing these financial statements are the same as those summarized in the Company’s 2000 Annual Report, except as discussed in Note 6 below. Certain amounts for 2000 have been reclassified to conform to current-period classifications.

The results of operations for the three and nine months ended September 30, 2001, are not necessarily indicative of the results to be expected for other interim periods or the full year.

2. Acquisitions

Keebler acquisition

On March 26, 2001, the Company completed its acquisition of Keebler Foods Company (“Keebler”) in a transaction entered into with Keebler and with Flowers Industries, Inc., the majority shareholder of Keebler. Keebler, headquartered in Elmhurst, Illinois, ranks second in the United States in the cookie and cracker categories and has the third largest food direct store door (DSD) delivery system in the United States.

Under the purchase agreement, the Company paid $42 in cash for each common share of Keebler or approximately $3.65 billion, including $66 million of related acquisition costs. The Company also assumed $208 million in obligations to cash out employee and director stock options, resulting in a total cash outlay for Keebler stock of approximately $3.86 billion. Additionally, the Company assumed $696 million of Keebler debt, bringing the total value of the transaction to $4.56 billion. Of the debt assumed, $560 million was refinanced on the acquisition date.

The acquisition was accounted for under the purchase method and was financed through a combination of short-term and long-term debt. The assets and liabilities of the acquired business were included in the consolidated balance sheet as of March 31, 2001. For purposes of consolidated reporting during 2001, Keebler’s interim results of operations are being reported for the periods ended March 24, 2001, June 16, 2001, October 6, 2001, and December 29, 2001. Therefore, Keebler results from the date of acquisition to June 16, 2001, were included in the Company’s second quarter 2001 results.

As of September 30, 2001, the components of intangible assets included in the allocation of purchase price, along with the related straight-line amortization periods, are presented in the following table. The process of finalizing valuations of assets and obligations that existed as of the acquisition date is virtually complete. However, management’s estimate of “exit liabilities” (discussed below) could change as plans for exit of certain activities and

functions of Keebler are refined over the next six months, thus impacting the amount of residual goodwill attributable to this acquisition.


	Amount		Amortization
	(millions)		period (yrs.)

Trademarks and tradenames	$	1,310.0		40
Direct store door (DSD) delivery system		590.0		40
Goodwill		2,905.1		40

Total	$	4,805.1

As of September 30, 2001, the purchase price allocation included $88.9 million of liabilities related to management’s plans to exit certain activities and operations of the acquired company (“exit liabilities”), as presented in the table below. Cash outlays related to these exit plans are projected to be approximately $30 million in 2001, with the remaining amounts spent during 2002 and 2003.


								Lease & other
		Employee			Employee			contract			Facility closure
millions		severance benefits			relocation			termination			costs			Total

Total reserve at March 26, 2001:
	Original estimate	$	59.3		$	8.6		$	12.3		$	10.4		$	90.6
	Purchase accounting adjustments		1.0			—			(2.7	)					(1.7	)

	Adjusted	$	60.3		$	8.6		$	9.6		$	10.4		$	88.9
Amounts utilized during 2001			(19.6	)		(0.7	)		(0.5	)		(1.8	)		(22.6	)

Remaining reserve at September 30, 2001		$	40.7		$	7.9		$	9.1		$	8.6		$	66.3

Exit plans implemented thus far include separation of approximately 75 Keebler administrative employees and closing of a bakery in Denver, Colorado, eliminating approximately 470 employee positions. During June 2001, the Company communicated plans to transfer portions of Keebler’s Grand Rapids, Michigan, bakery production to other plants in the United States during the next 12 months. As a result, the previous workforce of approximately 675 employees is being reduced by an as-yet-undetermined amount during a one-year transition period. During October 2001, the Company communicated plans to consolidate and expand Keebler’s ice cream cone production operation in Chicago, Illinois, which will result in the closure of one facility at this location during 2002.

The following tables include the unaudited pro forma combined results as if Kellogg Company had acquired Keebler Foods Company as of the beginning of either 2001 or 2000, instead of March 26, 2001. The first table also includes consolidated results for the third quarter of 2001 for comparison purposes only (Keebler was part of Kellogg Company for this entire period.)

Each pro forma period presented below includes separate company results of Keebler Foods Company as follows:


Pro forma periods		Keebler periods

Three months ended September 30, 2000		16 weeks ended October 7, 2000
Nine months ended September 30, 2000		40 weeks ended October 7, 2000
Nine months ended September 30, 2001		12 weeks ended March 24, 2001


	Three months ended September 30,

(millions, except per share data)	2001		2000

Net sales	$	2,590.1	$	2,677.4
Earnings before extraordinary loss and
cumulative effect of accounting change	$	150.3	$	177.3
Net earnings	$	150.3	$	177.3
Net earnings per share	$	0.37	$	0.44


	Nine months ended September 30,

(millions, except per share data)	2001		2000

Net sales	$	7,287.1	$	7,456.5
Earnings before extraordinary loss and
cumulative effect of accounting change	$	309.7	$	430.1
Net earnings	$	301.3	$	430.1
Net earnings per share	$	0.74	$	1.06

The pro forma results include amortization of the intangibles presented above and interest expense on debt assumed issued to finance the purchase. The pro forma results are not necessarily indicative of what actually would have occurred if the acquisition had been completed as of the beginning of each of the fiscal periods presented, nor are they necessarily indicative of future consolidated results.

Prior-year acquisitions

During 2000, the Company paid cash for several business acquisitions. In January, the Company purchased certain assets and liabilities of the Mondo Baking Company Division of Southeastern Mills, Inc., a convenience foods manufacturing operation, for approximately $93 million. In June, the Company acquired the outstanding stock of Kashi Company, a U.S. natural foods company, for approximately $33 million. In July, the Company purchased certain assets and liabilities of The Healthy Snack People business, an Australian convenience foods operation, for approximately $12 million.

3. Restructuring charges

During the past several years, management has commenced major productivity and operational streamlining initiatives in an effort to optimize the Company’s cost structure. The incremental costs of these programs have been reported during these years as restructuring charges. Refer to pages 30-31 of the Company’s 2000 Annual Report for more information on these initiatives.

Operating profit for the nine months ended September 30, 2001, includes restructuring charges of $48.3 million ($30.3 million after tax or $.07 per share), related to preparing Kellogg for the Keebler integration and continued actions supporting the Company’s “focus and align” strategy. Specific initiatives included a headcount reduction of about 30 in U.S. and global Company management, rationalization of product offerings and other actions to combine the Kellogg and Keebler logistics systems, and further reductions in convenience

foods capacity in South East Asia. Approximately 70% of the charges were comprised of asset write-offs, with the remainder consisting of employee severance and other cash costs.

Operating profit for the nine months ended September 30, 2000, includes restructuring charges of $21.3 million ($14.7 million after tax or $.04 per share) for a supply chain efficiency initiative in Europe. The charges were comprised principally of voluntary employee retirement and separation benefits related to an hourly and salaried headcount reduction of approximately 190 during 2000.

Total cash outlays during the September 2001 year-to-date period for ongoing streamlining initiatives were approximately $30 million, compared to $42 million in 2000. Expected cash outlays are approximately $7 million for the remainder of 2001. With numerous multi-year streamlining programs nearing completion, management is currently assessing reserve needs for post-2001 periods.

The components of restructuring charges, as well as reserve balance changes, during the nine months ended September 30, 2001, were:


		Employee
		retirement &
		severance			Asset			Asset			Other
millions		benefits (a)			write-offs			removal			costs			Total

Remaining reserve at December 31, 2000		$	23.3		$	—		$	16.9		$	—		$	40.2
	2001 restructuring charges		8.5			33.7			5.9			0.2			48.3
	Amounts utilized during 2001		(20.4	)		(33.7	)		(10.6	)		(0.2	)		(64.9	)

	Remaining reserve at September 30, 2001	$	11.4		$	—		$	12.2		$	—		$	23.6

(a)

Charges include approximately $1 of pension and postretirement health care special termination benefits.

As a result of the Keebler acquisition, the Company assumed $14.9 million of reserves for severance and facility closures, related to Keebler’s ongoing restructuring and acquisition-related synergy initiatives.


	Employee
	retirement &
	severance			Asset
millions	benefits			removal			Total

Acquisition-related	$	3.3		$	10.9		$	14.2
Restructuring-related		0.6			0.1			0.7

Total reserve at March 26, 2001	$	3.9		$	11.0		$	14.9
Amounts utilized during 2001		(2.4	)		(1.4	)		(3.8	)

Remaining reserve at September 30, 2001	$	1.5		$	9.6		$	11.1

The restructuring-related reserves are attributable to the closing of Keebler’s manufacturing facility in Sayreville, New Jersey, in 1999, and are expected to be utilized during the remainder of 2001. The acquisition-related reserves are attributable primarily to the closing of various distribution and manufacturing facilities. Of the acquisition-related reserves, approximately $6 million is expected to be utilized in 2001. The remaining balance of approximately $8 million is attributable primarily to non-cancelable lease obligations extending through 2006.

4. Equity

Earnings per share

Basic net earnings per share is determined by dividing net earnings by the weighted average number of common shares outstanding during the period. Diluted net 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 are comprised principally of employee stock options issued by the Company and had an insignificant impact on earnings per share during the periods presented. Basic net earnings per share is reconciled to diluted net earnings per share as follows:


				Average		Net
		Net		shares		earnings
(millions, except per share data)		earnings		outstanding		per share

Quarter
2001
	Basic	$	150.3		406.2	$	0.37
	Dilutive employee stock options		—		2.1		—

	Diluted	$	150.3		408.3	$	0.37

2000
	Basic	$	181.9		405.6	$	0.45
	Dilutive employee stock options		—		.3		—

	Diluted	$	181.9		405.9	$	0.45

Year-to-date
2001
	Basic	$	349.0		405.9	$	0.86
	Dilutive employee stock options		—		.8		—

	Diluted	$	349.0		406.7	$	0.86

2000
	Basic	$	494.5		405.6	$	1.22
	Dilutive employee stock options		—		.2		—

	Diluted	$	494.5		405.8	$	1.22

Comprehensive Income

Comprehensive income includes all changes in equity during a period except those resulting from investments by or distributions to shareholders. Comprehensive income for the periods presented consists of net earnings, unrealized gains and losses on cash flow hedges pursuant to SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities”, and foreign currency translation adjustments pursuant to SFAS No. 52 “Foreign Currency Translation” as follows:


			Before-tax			Tax (expense)			Net-of-tax
(millions)			amount			or benefit			amount

Quarter
2001
Net earnings			$	150.3		$	—		$	150.3
Other comprehensive income (loss):
	Foreign currency translation adjustment			10.6						10.6
	Cash flow hedges:
		Unrealized gain on cash flow hedges		1.4			(0.6	)		0.8
		Reclassification to net earnings		3.3			(1.2	)		2.1

				15.3			(1.8	)		13.5

Total comprehensive income			$	165.5		$	(1.8	)	$	163.8

2000
Net earnings			$	181.9		$	—		$	181.9
Other comprehensive income (loss):
	Foreign currency translation adjustment			(36.1	)					(36.1	)
	Cash flow hedges:
		Unrealized loss on cash flow hedges		—			—			—
		Reclassification to net earnings		—			—			—

				(36.1	)		—			(36.1	)

Total comprehensive income			$	145.8		$	—		$	145.8



			Before-tax			Tax (expense)			Net-of-tax
(millions)			amount			or benefit			amount

Year-to-date
2001
Net earnings			$	349.0		$	—		$	349.0
Other comprehensive income (loss):
	Foreign currency translation adjustment			(34.2	)					(34.2	)
	Cash flow hedges:
		Unrealized loss on cash flow hedges		(90.0	)		32.8			(57.2	)
		Reclassification to net earnings		5.7			(2.1	)		3.6

				(118.5	)		30.7			(87.8	)

Total comprehensive income			$	230.5		$	30.7		$	261.2

2000
Net earnings			$	494.5		$	—		$	494.5
Other comprehensive income (loss):
	Foreign currency translation adjustment			(102.4	)					(102.4	)
	Cash flow hedges:
		Unrealized loss on cash flow hedges		—			—			—
		Reclassification to net earnings		—			—			—

				(102.4	)		—			(102.4	)

Total comprehensive income			$	392.1		$	—		$	392.1

Accumulated other comprehensive income (loss) as of September 30, 2001, and December 31, 2000 consisted of the following:


	September 30,			December 31,
(millions)	2001			2000

Minimum pension liability adjustments	$	(6.5	)	$	(6.5	)
Foreign currency translation adjustments		(463.0	)		(428.8	)
Cash flow hedges — unrealized net loss		(53.6	)		—

Total accumulated other comprehensive income (loss)	$	(523.1	)	$	(435.3	)

5. Debt

Notes payable at September 30, 2001, consist primarily of commercial paper borrowings in the United States in the amount of $992.3 million with an effective interest rate of 3.5%. U.S. commercial paper borrowings have increased from the year-end 2000 level of $429.8 million, due primarily to repayments during the quarter of $500 million of Euro Dollar Notes and $130 million of Senior Subordinated Notes (assumed from the Keebler acquisition).

Long-term debt consists primarily of fixed rate issuances of U.S. and Euro Dollar Notes, as follows:


(millions)		Sept. 30, 2001			Dec. 31, 2000

	4.875% U.S. Dollar Notes due 2005	$	200.0		$	200.0
	6.625% Euro Dollar Notes due 2004		500.0			500.0
	6.125% Euro Dollar Notes due 2001		—			500.0
(a)	5.75% U.S. Dollar Notes due 2001		—			400.0
(b)	5.5% U.S. Dollar Notes due 2003		998.0			—
(b)	6.0% U.S. Dollar Notes due 2006		994.2			—
(b)	6.6% U.S. Dollar Notes due 2011		1,491.6			—
(b)	7.45% U.S. Dollar Debentures due 2031		1,085.1			—
	Other		68.3			10.3

			5,337.2			1,610.3
	Less current maturities		(8.3	)		(901.1	)

	Balance	$	5,328.9		$	709.2

(a)		These Notes, originally due in February 2001, provided an option to holders to extend the obligation for an additional four years at a predetermined interest rate of 5.63% plus the Company’s then-current credit spread. In February 2001, the Company paid holders $11.6 million (in addition to the principal amount and accrued interest) to extinguish the Notes prior to the extension date. Thus, for the nine months ended September 30, 2001, the Company reported an extraordinary loss, net of tax, of $7.4 million.

(b)		On March 29, 2001, the Company issued $4.6 billion of long-term debt instruments, further described in the table below, primarily to finance the acquisition of Keebler Foods Company (refer to Note 2). Initially, these instruments were privately placed, or sold outside the United States, in reliance on exemptions from registration under the Securities Act of 1933, as amended (the “1933 Act”). The Company then exchanged new debt securities for these initial debt instruments, with the new debt securities being substantially identical in all respects to the initial debt instruments, except for being registered under the 1933 Act. These debt securities contain standard events of default and covenants. The Notes due 2006 and 2011, and the Debentures due 2031 may be redeemed in whole or part by the Company at any time at prices determined under a formula (but not less than 100% of the principal amount plus unpaid interest to the redemption date).

In conjunction with this issuance, the Company settled $1.9 billion notional amount of forward-starting interest rate swaps for approximately $88 million in cash. The swaps effectively fixed a portion of the interest rate on an equivalent amount of debt prior to issuance. The swaps were designated as cash flow hedges pursuant to SFAS No. 133 (refer to Note 6). As a result, the loss on settlement was recorded in other comprehensive income, net of tax benefit of approximately $32 million, and is being amortized to interest expense over periods of 5 to 30 years. The effective interest rates presented in the table below reflect this amortization expense, as well as discount on the debt.


	Principal				Effective
millions	amount		Net proceeds		interest rate

5.5% U.S. Dollar Notes due 2003	$	1,000.0	$	997.4		5.64	%
6.0% U.S. Dollar Notes due 2006		1,000.0		993.5		6.39	%
6.6% U.S. Dollar Notes due 2011		1,500.0		1,491.2		7.08	%
7.45% U.S. Dollar Debentures due 2031		1,100.0		1,084.9		7.62	%

Total	$	4,600.0	$	4,567.0

In order to provide additional short-term liquidity in connection with the Keebler Foods Company acquisition referenced above, the Company entered into a 364-Day Credit Agreement, expiring in January 2002 (subject to a renewal option), and a Five-Year Credit Agreement, expiring in January 2006. Each of these agreements permits the Company or certain subsidiaries to borrow up to $1.15 billion (or certain amounts in foreign currencies under the Five-Year Credit Agreement). These two credit agreements contain standard warranties, events of default, and covenants. They also require the maintenance of a specified amount of consolidated net worth and a specified consolidated interest expense coverage ratio, and limit capital lease obligations and subsidiary debt. These credit facilities were unused at September 30, 2001.

6. Accounting for derivative instruments and hedging activities

On January 1, 2001, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 133 “Accounting for Derivative Instruments and Hedging Activities.” This statement requires that all derivative instruments be recorded on the balance sheet at fair value and establishes criteria for designation and effectiveness of hedging relationships. For the nine months ended September 30, 2001, the Company reported a charge to earnings of $1.0 million (net of tax benefit of $.6 million) and a charge to other comprehensive income of $14.9 million (net of tax benefit of $8.6 million) in order to recognize the fair value of derivative instruments as either assets or liabilities on the balance sheet. The charge to earnings relates to the component of the derivative instruments’ net loss that has been excluded from the assessment of hedge effectiveness.

The Company is exposed to certain market risks which exist as a part of its ongoing business operations and uses derivative financial and commodity instruments, where appropriate, to manage these risks. In general, instruments used as hedges must be effective at reducing the risk associated with the exposure being hedged and must be designated as a hedge at the inception of the contract. The Company designates derivatives as either cash flow hedges, fair value hedges, net investment hedges, or other contracts used to reduce volatility in the translation of foreign currency earnings to U.S. Dollars. The fair values of all hedges are recorded in accounts receivable or other current

liabilities. Gains and losses related to the ineffective portion of any hedge are recorded in other income (expense), net. This amount was insignificant during the nine months ended September 30, 2001.

Cash flow hedges

Qualifying derivatives are accounted for as cash flow hedges when the hedged item is a forecasted transaction. Gains and losses on these instruments are recorded in other comprehensive income until the underlying transaction is recorded in earnings. When the hedged item is realized, gains or losses are reclassified from accumulated other comprehensive income to the Statement of Earnings on the same line item as the underlying transaction.

The total net loss attributable to cash flow hedges recorded in accumulated other comprehensive income at September 30, 2001, was $53.6 million, related primarily to forward-starting interest rate swaps (refer to Note 5), which are being reclassified into interest expense over periods of 5 to 30 years beginning in the second quarter of 2001. Other insignificant amounts related to foreign currency and commodity price cash flow hedges will be reclassified into earnings during the next 12 months.

Fair value hedges

Qualifying derivatives are accounted for as fair value hedges when the hedged item is a recognized asset, liability, or firm commitment. Gains and losses on these instruments are recorded in earnings, offsetting gains and losses on the hedged item.

Net investment hedges

Qualifying derivative and non-derivative financial instruments held by the parent company are accounted for as net investment hedges when the hedged item is a foreign currency investment in a subsidiary. Gains and losses on these instruments are recorded as a foreign currency translation adjustment in other comprehensive income.

Other contracts

The Company also enters into foreign currency forward contracts to reduce volatility in the translation of foreign currency earnings to U.S. Dollars. Gains and losses on these instruments are recorded in other income (expense), net, generally reducing the exposure to translation volatility during a full-year period.

Foreign exchange risk

The Company is exposed to fluctuations in foreign currency cash flows related primarily to third-party purchases, intercompany product shipments, and intercompany loans. The Company is also exposed to fluctuations in the value of foreign currency investments in subsidiaries and cash flows related to repatriation of these investments. Additionally, the Company is exposed to volatility in the translation of foreign currency earnings to U.S. Dollars. The Company assesses foreign currency risk based on transactional cash flows and enters into forward contracts, all of generally less than 12 months duration, to reduce fluctuations in net long or short currency positions.

For foreign currency cash flow and fair value hedges, the assessment of effectiveness is based on changes in spot rates. Changes in time value are reported in other income (expense), net.

Interest rate risk

The Company is exposed to interest rate volatility with regard to future issuances of fixed rate debt and existing issuances of variable rate debt. The Company currently uses interest rate swaps, including forward-starting swaps, to reduce interest rate volatility and funding costs associated with certain debt issues, and to achieve a desired proportion of variable versus fixed rate debt, based on current and projected market conditions.

Variable-to-fixed interest rate swaps are accounted for as cash flow hedges and the assessment of effectiveness is based on changes in the present value of interest payments on the underlying debt. Fixed-to-variable interest rate swaps are accounted for as fair value hedges and the assessment of effectiveness is based on changes in the fair value of the underlying debt, using incremental borrowing rates currently available on loans with similar terms and maturities.

Price risk

The Company is exposed to price fluctuations primarily as a result of anticipated purchases of raw and packaging materials. The Company uses the combination of long cash positions with suppliers, and exchange-traded futures and option contracts to reduce price fluctuations in a desired percentage of forecasted purchases over a duration of generally less than one year.

Commodity contracts are accounted for as cash flow hedges. The assessment of effectiveness is based on changes in futures prices.

7. Operating Segments

The Company is managed in two major divisions — the United States and International — with International further delineated into Europe, Latin America, Canada, Australia, and Asia. This organizational structure is the basis of the operating segment data presented below.


		Three months ended September 30,						Nine months ended September 30,

(millions)		2001			2000			2001			2000

Net sales
	United States	$	1,883.9		$	1,102.8		$	4,568.9		$	3,184.1
	Europe		361.1			373.0			1,037.6			1,129.6
	Latin America		165.3			166.2			492.8			473.4
	All other operating segments		179.8			198.6			541.0			599.5
	Corporate		—			5.1			—			12.1

	Consolidated	$	2,590.1		$	1,845.7		$	6,640.3		$	5,398.7

Operating profit excluding restructuring charges and Keebler amortization expense
	United States	$	298.6		$	207.1		$	706.6		$	605.1
	Europe		69.3			71.7			190.5			192.2
	Latin America		45.8			45.5			128.7			121.5
	All other operating segments		21.7			17.0			71.8			69.5
	Corporate		(52.3	)		(33.2	)		(130.7	)		(115.1	)

	Consolidated		383.1			308.1			966.9			873.2
	Keebler amortization expense		(36.1	)		—			(63.1	)		—
	Restructuring charges		—			—			(48.3	)		(21.3	)

Operating profit as reported		$	347.0		$	308.1		$	855.5		$	851.9

The measurement of operating segment results is generally consistent with the presentation of the Consolidated Statement of Earnings. Intercompany transactions between reportable operating segments were insignificant in the periods presented.

8. Recently issued pronouncements

Revenue measurement

In April 2001, the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB) reached consensus on Issue No. 00-25 “Vendor Income Statement Characterization of Consideration to a Purchaser of the Vendor’s Products or Services.” The EITF also delayed the effective date of previously finalized Issue No. 00-14 “Accounting for Certain Sales Incentives” to coincide with the effective date of Issue No. 00-25. This guidance will now be effective for Kellogg Company beginning January 1, 2002.

Both of these Issues (later codified as Issue 01-09) provide guidance primarily on income statement classification of consideration from a vendor to a purchaser of the vendor’s products, including both customers and consumers. Generally, cash consideration is to be classified as a reduction of revenue, unless specific criteria are met regarding goods or services that the vendor may receive in return for this consideration. Generally, non-cash consideration is to be classified as a cost of sales.

This guidance is applicable to Kellogg Company in several ways. First, it applies to payments made by the Company to its customers (the retail trade) primarily for conducting consumer promotional activities, such as in-store display and feature price discounts on the Company’s products. Second, it applies to discount coupons and other cash redemption offers that the Company provides directly to consumers. Third, it applies to promotional items such as toys that the Company inserts in or attaches to its product packages (“package inserts”). Consistent with industry practice, the Company has historically classified these items as promotional expenditures within selling, general, and administrative expense (SG&A), and has generally recognized the cost as the related revenue is earned.

Effective January 1, 2002, the Company will reclassify promotional payments to its customers and the cost of consumer coupons and other cash redemption offers from SG&A to net sales. The Company will reclassify the cost of package inserts from SG&A to cost of sales. All comparative periods will be restated. Based on historical proforma information, management believes that combined net sales could be reduced up to 15%, with approximately 95% of this impact reflected in the U.S. operating segment. Combined cost of goods sold could be increased by approximately 1.5%. SG&A would be correspondingly reduced such that net earnings would not be affected.

Business combinations

In July 2001, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 141 “Business Combinations” and SFAS No. 142 “Goodwill and Other Intangible Assets.” Both of these Standards provide guidance on how companies account for acquired businesses and related disclosure issues.

Chief among the provisions of these standards are 1) elimination of the “pooling of interest” method for transactions initiated after June 30, 2001, 2) elimination of amortization of goodwill and “indefinite-lived” intangible assets effective for Kellogg Company on January 1, 2002, and 3) annual impairment testing and potential loss recognition for goodwill and non-amortized intangible assets, also effective for the Company on January 1, 2002.

Regarding the elimination of goodwill and indefinite-lived intangible amortization, this change will be made prospectively upon adoption of the new standard as of January 1, 2002. Prior-period financial results will not be restated. However, earnings information for prior periods will be disclosed, exclusive of comparable amortization expense that is eliminated in post-2001 periods.

Management is currently assessing the impact of these provisions. However, management believes substantially all of the Company’s total after-tax amortization expense will be eliminated under these new guidelines. Based on acquisitions completed to date, management expects total after-tax amortization expense in 2002 (before impact of the new Standards) of approximately $110-$115 million.

Accounting for long-lived assets

In October 2001, the FASB issued SFAS No. 144 “Accounting for Impairment or Disposal of Long-lived Assets.” This Standard will generally be effective for the Company on a prospective basis, beginning January 1, 2002.

SFAS No. 144 clarifies and revises existing guidance on accounting for impairment of plant, property, and equipment, amortized intangibles, and other long-lived assets not specifically addressed in other accounting literature. Significant changes include 1) establishing criteria beyond those previously specified in existing literature for determining when a long-lived asset is held for sale, and 2) requiring that the depreciable life of a long-lived asset to be abandoned is revised. These provisions could be expected to have the general effect of reducing or delaying recognition of future impairment losses on assets to be disposed, offset by higher depreciation during the remaining holding period. However, management does not expect the adoption of this Standard to have a significant impact on the Company’s 2002 financial results. SFAS No. 144 also broadens the presentation of discontinued operations to include a component of an entity (rather than only a segment of a business).

KELLOGG COMPANY

PART I — FINANCIAL INFORMATION

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Results of operations

Kellogg Company is the world’s leading producer of cereal and a leading producer of convenience foods, including cookies, crackers, toaster pastries, cereal bars, frozen waffles, meat alternatives, pie crusts, and ice cream cones. Kellogg products are manufactured in 19 countries and marketed in more than 160 countries around the world. The Company is managed in two major divisions — the United States and International — with International further delineated into Europe, Latin America, Canada, Australia, and Asia. This organizational structure is the basis of the operating segment data presented in this filing.

During the first quarter of 2001, we completed our acquisition of Keebler Foods Company (the “Keebler acquisition”), making Kellogg Company a leader in the U.S. cookie and cracker categories. Primarily as a result of the Keebler contribution, third quarter 2001 net sales and operating profit increased significantly. Despite these increases, net earnings and earnings per share were down versus the prior year, due primarily to increased amortization, interest, and tax expense related to the Keebler acquisition, the business impact of Keebler integration activities, and unfavorable foreign currency movements. We believe that these results reflect, in part, the significant amount of change occurring at our company this year and somewhat mask the progress we are making in changing our business for better execution. During the quarter, our dollar share of the U.S. cereal category continued to increase, our base U.S. cereal volume was strong, and gross margin improved due to favorable pricing and mix factors. Also, our internal measure of third quarter and September year-to-date “cash flow” (net cash provided by operating activities less expenditures for property additions) increased significantly over the prior year.

The following items have been excluded from all applicable amounts presented in this section for purposes of comparison between historical, current, and future periods:

•		Subsequent to the acquisition of Keebler, we have incurred costs and experienced other financial impacts related to integration of the Kellogg and Keebler business models. As a result, we estimate that operating profit was reduced by $21.5 million ($13.5 million after tax or $.03 per share) for the third quarter and by $43.0 million ($26.8 million after tax or $.07 per share) for the year-to-date period.

•		During the first quarter of 2001, we reported restructuring charges of $48.3 million ($30.3 million after tax or $.07 per share) related to preparing Kellogg for the Keebler integration and continued actions supporting our “focus and align” strategy. First quarter 2001 net earnings also included an extraordinary loss related to extinguishment of long-term debt and a charge to net earnings for the cumulative effect of an accounting change.

•

During the second quarter of 2000, we reported restructuring charges of $21.3 million ($14.7 million after tax or $.04 per share) for a supply chain efficiency initiative in Europe.

Reported results for the quarter and year-to-date periods are reconciled to comparable results, as follows:


Quarter	Net earnings (millions)							Net earnings per share (a)

	2001		2000		Change			2001		2000		Change

Reported consolidated results	$	150.3	$	181.9				$	.37	$	.45
Integration impact		13.5		—					.03		—

Comparable consolidated results	$	163.8	$	181.9		-10.0	%	$	.40	$	.45		-11.1	%



Year-to-date	Net earnings (millions)							Net earnings per share (a)

	2001		2000		Change			2001		2000		Change

Reported consolidated results	$	349.0	$	494.5				$	.86	$	1.22
Restructuring charges		30.3		14.7					.07		.04
Integration impact		26.8		—					.07		—
Extraordinary loss		7.4		—					.02		—
Cumulative effect of accounting change		1.0		—					—		—

Comparable consolidated results	$	414.5	$	509.2		-18.6	%	$	1.02	$	1.26		-19.0	%

(a)

Represents both basic and diluted earnings per share.

The year-to-date decrease in comparable earnings per share of $.24 was primarily the result of $.23 from incremental interest expense, $.13 from incremental amortization expense, $.08 from a higher effective tax rate due primarily to the Keebler acquisition, and $.05 from unfavorable foreign currency movements. This was offset by $.25 of favorable business growth, which includes the results of the Keebler business.

The following tables provide an analysis of net sales and operating profit performance for the 2001 third quarter and September year-to-date periods:


									Other
Quarter			United				Latin		operating
(dollars in millions)			States		Europe		America		(b)		Corporate			Consolidated

2001 net sales			$	1,883.9	$	361.1	$	165.3	$	179.8		—		$	2,590.1

2000 net sales			$	1,102.8	$	373.0	$	166.2	$	198.6	$	5.1		$	1,845.7
% change – 2001 vs. 2000:
	Volume			-1.9		-5.6		-2.4		-3.2		—			-3.0
	Pricing/mix			—		+4.2		+3.4		+1.1		—			+1.5
	Acquisitions & dispositions (a)			+72.7		—		—		—		—			+43.4
	Foreign currency impact			—		-1.8		-1.6		-7.3		—			-1.6

	Total change			+70.8		-3.2		-.6		-9.4		—			+40.3

									Other
Quarter			United				Latin		operating
(dollars in millions)			States		Europe		America		(b)		Corporate			Consolidated

2001 operating profit			$	262.5	$	69.3	$	45.8	$	21.7		($52.3	)	$	347.0
Keebler amortization expense			$	36.1		—		—		—		—		$	36.1

2001 operating profit excluding Keebler amortization expense			$	298.6	$	69.3	$	45.8	$	21.7		($52.3	)	$	383.1

2000 operating profit			$	207.1	$	71.7	$	45.5	$	17.0		($33.2	)	$	308.1

% change – 2001 vs. 2000:
		Comparable business		-.8		-1.4		+.4		+36.7		-3.7			+.8
		Integration impact (c)		-6.3		—		—		—		-25.4			-6.9
		Acquisitions & dispositions (a)		+51.3		—		—		—		—			+34.5
		Foreign currency impact		—		-2.0		+.1		-8.8		-28.2			-4.0

		Total change		+44.2		-3.4		+.5		+27.9		-57.3			+24.4

(a)		Includes results from Keebler Foods Company, acquired in March 2001.

(b)		Includes Canada, Australia, and Asia.

(c)		Asset write-offs, accelerated depreciation expense, and incremental costs related to integration of Keebler business. Refer to section below on Keebler acquisition.

		21


								Other
Year-to-date		United				Latin		operating
(dollars in millions)		States		Europe		America		(b)		Corporate		Consolidated

2001 net sales		$	4,568.9	$	1,037.6	$	492.8	$	541.0		—	$	6,640.3

2000 net sales		$	3,184.1	$	1,129.6	$	473.4	$	599.5	$	12.1	$	5,398.7

% change – 2001 vs. 2000:
	Volume		+.1		-6.6		+2.6		-.6		—		-1.5
	Pricing/mix		-1.7		+4.2		+2.4		-1.4		—		+.3
	Integration impact (c)		-.6		—		—		—		—		-.3
	Acquisitions & dispositions (a)		+45.7		—		—		+.8		—		+27.0
	Foreign currency impact		—		-5.7		-.9		-8.5		—		-2.5

	Total change		+43.5		-8.1		+4.1		-9.7		—		+23.0


								Other
Year-to-date		United				Latin		operating
(dollars in millions)		States		Europe		America		(b)		Corporate			Consolidated

2001 operating profit		$	605.3	$	190.5	$	128.7	$	64.8		($133.8	)	$	855.5
2001 restructuring charges (d)			38.2		—		—		7.0		3.1			48.3
Keebler amortization expense			63.1		—		—		—		—			63.1

2001 operating profit excluding restructuring charges and Keebler amortization expense		$	706.6	$	190.5	$	128.7	$	71.8		($130.7	)	$	966.9

2000 operating profit		$	605.1	$	170.9	$	121.5	$	69.5		($115.1	)	$	851.9
2000 restructuring charges (d)			—		21.3		—		—		—			21.3

2000 operating profit
	excluding restructuring charges	$	605.1	$	192.2	$	121.5	$	69.5		($115.1	)	$	873.2

% change – 2001 vs. 2000:
	Comparable business		-7.6		+5.3		+5.8		+12.7		+4.3			-1.7
	Integration impact (c)		-5.7		—		—		—		-7.3			-5.0
	Acquisitions & dispositions (a)		+30.1		—		—		+.6		—			+21.0
	Foreign currency impact		—		-6.2		+.1		-9.9		-10.5			-3.6

	Total change		+16.8		-.9		+5.9		+3.4		-13.5			+10.7

(a)		Includes results from Keebler Foods Company, acquired in March 2001; Kashi Company, a U.S. natural foods company, acquired in June 2000; and The Healthy Snack People business, an Australian convenience foods operation, acquired in July 2000.

(b)		Includes Canada, Australia, and Asia.

(c)		Trade inventory reductions, asset write-offs, accelerated depreciation expense, and incremental costs related to integration of Keebler business. Refer to section below on Keebler acquisition.

(d)		Refer to separate section below for further information.

On a comparable business basis, consolidated net sales for the quarter were down 1.5% (volume decline of 3.0% partially offset by pricing/mix improvement of 1.5%), resulting primarily from a volume decline in U.S. snack sales and sales declines in all international segments except Latin America and Canada. The decline in U.S. snack sales was due primarily to our product rationalization initiative and postponed innovation and marketing support during the integration of this business into the Keebler DSD system. The decline in international sales was driven by the discontinuation of our private-label program in Germany, continued category softness in the United Kingdom and Australia, and trade inventory reductions in Australia. U.S. retail cereal sales were essentially flat, although total U.S. cereal sales, which includes all channels, increased .5%.

On a comparable business basis, consolidated operating profit for the quarter was up nearly 1%. Increased profitability in international businesses offset the comparable sales declines discussed above, as well as the impact of increased marketing investment in the U.S. and United Kingdom cereal businesses, and additional sales force hiring and training costs in the United States.

As presented in the tables above, the impact of Keebler integration activities (“integration impact”) reduced consolidated operating profit by approximately 7% for the quarter and 5% on a year-to-date basis. During the quarter, this integration impact consisted primarily of consulting expenses, employee-related costs such as relocation and retention, and impairment and accelerated depreciation of software assets being abandoned due to the conversion of our U.S. business to the SAP system. In the year-to-date period, this integration impact also included the sales and operating profit effect of working down trade inventories to transfer our snack foods to Keebler’s DSD system. For the quarter, we estimate that these activities decreased gross profit by $1.2 million and increased selling, general, and administrative expense by $20.3 million, for a total operating profit reduction of $21.5 million. For the year-to-date period, we estimate that these activities reduced net sales by $17.8 million, reduced gross profit by $17.6 million, and increased selling, general, and administrative expense by $25.4 million, for a total operating profit reduction of $43.0 million.

As presented in the tables above, the inclusion of the Keebler business in consolidated results increased our net sales for the quarter by over 43% and operating profit (excluding Keebler amortization expense and restructuring charges) by approximately 35%. On a pro forma basis, assuming we had owned Keebler during the prior-year quarter, consolidated net sales would have been down approximately 3%, and excluding the impact of foreign currency movements, down approximately 2%. Pro forma operating profit (excluding Keebler amortization expense, restructuring charges, foreign currency, and integration impacts) would have declined approximately 1% for the quarter. Keebler’s net sales for the quarter (excluding Kellogg snacks integrated into the DSD system) decreased approximately 4% versus the prior year, primarily as a result of our product rationalization initiative and planned lack of new product introductions during the integration process.

Margin performance (excluding restructuring charges but including integration impact) for the quarter and year-to-date periods was:


		Quarter								Year-to-date

		2001			2000			Change		2001			2000			Change

Gross margin			54.4	%		52.6	%		+1.8		53.2	%		52.5	%		+.7

SGA% as reported (e)			41.0	%		35.9	%				39.6	%		36.3	%

	Keebler amortization		-1.4	%		—					-1.0	%		—

SGA% excluding
	Keebler amortization		39.6	%		35.9	%		-3.7		38.6	%		36.3	%		-2.3

Operating margin
	excluding Keebler
	amortization		14.8	%		16.7	%		-1.9		14.6	%		16.2	%		-1.6

(e)

Selling, general, and administrative expense as a percentage of net sales.

Gross interest expense, prior to amounts capitalized, was up versus the prior year, due primarily to interest expense on debt issued late in the first quarter to finance the Keebler acquisition. (Refer to the section below on liquidity and capital resources for further information.)


(dollars in millions)	Quarter							Year-to-date

	2001		2000		Change			2001		2000		Change

Gross interest expense	$	104.4	$	37.1		+181.4	%	$	254.2	$	107.1		+137.3	%

The consolidated effective tax rate increased significantly over the prior year, primarily as a result of the impact of the Keebler acquisition on non-deductible goodwill and the level of U.S. tax on 2001 foreign subsidiary earnings. Additionally, the prior year effective rate was reduced by a $9 million tax benefit, recorded in the third quarter of 2000 based on completing studies with respect to U.S. research and experimentation credits for prior years. The 2001 year-to-date rate currently reflects our expectations for the full year rate.


Effective income
tax rate	Quarter								Year-to-date

	2001			2000			Change		2001			2000			Change

Comparable (f)		38.4	%		33.1	%		+5.3		40.0	%		34.6	%		+5.4

As reported		38.4	%		33.1	%		+5.3		40.2	%		34.7	%		+5.5

(f)

Excludes restructuring charges, extraordinary loss, and cumulative effect of accounting change.

Restructuring charges

During the past several years, we have commenced major productivity and operational streamlining initiatives in an effort to optimize our cost structure. The incremental costs of these programs have been reported during these years as restructuring charges. Refer to pages 30-31 of our 2000 Annual Report for more information on these initiatives.

global management, rationalization of product offerings and other actions to combine the Kellogg and Keebler logistics systems, and further reductions in convenience foods capacity in South East Asia. Approximately 70% of the charges were comprised of asset write-offs, with the remainder consisting of employee severance and other cash costs. Savings generated from certain of these initiatives are expected to contribute to cost synergies related to the Keebler acquisition.

Total incremental pretax savings expected from all streamlining initiatives during 2001 (except those connected with the Keebler integration) are approximately $75 million. Refer to Note 3 within Notes to Consolidated Financial Statements for further information regarding the components of restructuring charges, as well as reserve balance changes, during the nine months ended September 30, 2001.

As a result of the Keebler acquisition, we assumed $14.9 million of reserves for severance and facility closures related to Keebler’s ongoing restructuring and acquisition-related synergy initiatives. Approximately $7 million of those reserves are expected to be fully utilized in 2001, with the remainder being attributable primarily to non-cancelable lease obligations extending through 2006. Refer to Note 3 within Notes to Consolidated Financial Statements for further information on these reserve balances.

Keebler acquisition

On March 26, 2001, we completed our acquisition of Keebler Foods Company in a transaction entered into with Keebler and with Flowers Industries, Inc., the majority shareholder of Keebler. Keebler Foods Company, headquartered in Elmhurst, Illinois, ranks second in the United States in the cookie and cracker categories and has the third largest food direct store door (DSD) delivery system in the United States.

Under the purchase agreement, we paid $42 in cash for each common share of Keebler, or approximately $3.65 billion, including $66 million of related acquisition costs. We also assumed $208 million in obligations to cash out employee and director stock options, resulting in a total cash outlay for Keebler stock of approximately $3.86 billion. Additionally, we assumed $696 million of Keebler debt, bringing the total value of the transaction to $4.56 billion. Of the debt assumed, $560 million was refinanced on the acquisition date.

The acquisition was accounted for under the purchase method and was financed through a combination of short-term and long-term debt. The assets and liabilities of the acquired business were included in the consolidated balance sheet as of March 31, 2001. For purposes of consolidated reporting during 2001, Keebler’s interim results of operations are being reported for the periods ended March 24, 2001, June 16, 2001, October 6, 2001, and December 29, 2001. Therefore, Keebler results from the date of acquisition to June 16, 2001, have been included in our second quarter 2001 results.

As a result of the acquisition, we expect amortization expense to increase by approximately $90 million in 2001 (approximately $75 million after related deferred tax benefit). As a result of a recently issued accounting pronouncement (refer to “Accounting changes” section below), we expect this amortization expense to be eliminated in post-2001 years. The process of finalizing valuations of assets and obligations that existed as of the acquisition date is virtually complete. However, management’s estimate of “exit liabilities” (discussed below) could change as plans for exit of certain activities and functions of Keebler are refined over the next six months, thus impacting the amount of residual goodwill attributable to this acquisition. As a result, the amount of goodwill – and related 2001 amortization expense - could change during the remainder of 2001. Refer to Note 2 within Footnotes to Consolidated Financial Statements for further information on goodwill and the components of intangible assets.

As of September 30, 2001, the purchase price allocation included $88.9 million of liabilities related to our plans to exit certain activities and operations of the acquired company (“exit liabilities”), comprised of Keebler employee severance and relocation, contract cancellation, and facility closure costs (refer to Note 2 within Footnotes to Consolidated Financial Statements for further information). Cash outlays related to these exit plans are projected to be approximately $30 million in 2001, with the remaining amounts spent in 2002 and 2003. Exit plans implemented thus far include separation of approximately 75 Keebler administrative employees and the closing of a bakery in Denver, Colorado, eliminating approximately 470 employee positions. During September 2001, we communicated plans to transfer portions of Keebler’s Grand Rapids, Michigan, bakery production to other plants in the United States during the next 12 months. As a result, the previous workforce of approximately 675 employees is being reduced by an as-yet-undetermined amount during a one-year transition period. During October 2001, the Company communicated plans to consolidate and expand Keebler’s ice cream cone production operation in Chicago, Illinois, which will result in the closure of one facility at this location during 2002. Additional actions, which are expected to be completed by March 2003, will be announced as exit plans are initiated.

As discussed in the “Results of operations” section above, during the third quarter 2001 we incurred integration-related costs for Kellogg employee relocation, employee retention and recruiting, and consolidation of computer systems, manufacturing capacity, and distribution systems. We also recognized impairment losses and accelerated depreciation on software assets being abandoned due to the conversion of our U.S. business to the SAP system. Additionally, during the second quarter 2001, sales and operating profit were negatively impacted by a reduction in trade inventories preceding the transfer of our snack foods to Keebler’s DSD system. During October 2001, we communicated details of separation programs to approximately 75 Kellogg employees affected by the integration of

administrative functions between Kellogg and Keebler. As a result, during the fourth quarter 2001, we will record a pre-tax charge within integration costs of approximately $6 million for severance and early retirement benefits.

As we complete our integration plans, we expect these types of financial impacts to continue, reducing full-year 2001 operating profit by up to $80 million. While the 2002 operating profit impact of continuing integration activity is currently expected to be insignificant, actual results will depend on various factors, primarily the timing of completion of planned supply chain and information technology initiatives. These activities and other actions are expected to result in Keebler-related pre-tax annual cost savings of approximately $170 million by 2003, with supply chain initiatives expected to generate the bulk of these savings.

Prior-year acquisitions

During 2000, we paid cash for several business acquisitions. In January, we purchased certain assets and liabilities of the Mondo Baking Company Division of Southeastern Mills, Inc., a convenience foods manufacturing operation, for approximately $93 million. In June, we acquired the outstanding stock of Kashi Company, a U.S. natural foods company, for approximately $33 million. In July, we purchased certain assets and liabilities of The Healthy Snack People business, an Australian convenience foods operation, for approximately $12 million.

Liquidity and capital resources

For the nine months ended September 30, 2001, net cash provided by operating activities was $854.8 million, up $224.7 million from the prior-year amount of $630.1 million. The increase was due primarily to favorable core working capital (trade receivables, inventory, trade payables) trends, excluding amounts from the Keebler acquisition, with core working capital representing approximately 8.7% of net sales, versus the year-ago level of approximately 10.6%. This favorable trend was offset partially by lower earnings and a payment to settle interest rate hedges, as discussed further below. We expect our measure of full-year “cash flow” (net cash provided by operating activities less expenditures for property additions) to slightly exceed the 2000 level of $650 million.

Net cash used in investing activities was $4.01 billion, up from $312.5 million in 2000, as a result of the Keebler acquisition discussed above. Expenditures for property additions were $153.9 million, $18.6 million less than the prior year. Property expenditures represented 2.3% of net sales compared with 3.2% in 2000. We believe full-year 2001 expenditures for property additions will represent approximately 3% of net sales or approximately $275 million.

Net cash provided by financing activities was $3.28 billion, related primarily to issuance of $4.6 billion of long-term debt instruments to finance the Keebler acquisition, net of $1.59 billion of long-term debt retirements. The debt retirements consisted primarily of $400 million of Extendable Notes due February 2001, $500 million of Euro Dollar Notes due August 2001, and $676.2 million of Notes previously held by Keebler Foods Company.

On October 26, 2001, we declared a dividend of $.2525 per common share, payable December 15, 2001, to shareholders of record at the close of business on November 30, 2001. Our total 2001 per share dividend payment of $1.00, up from $.995 in 2000, represents the 45th consecutive year Kellogg has increased its total dividend pay-out per share.

In February 2001, we paid holders $11.6 million (in addition to the principal amount and accrued interest) to extinguish $400 million of Extendable Notes prior to the extension date. Thus, for the nine months ended September 30, 2001, we reported an extraordinary loss, net of tax, of $7.4 million.

On March 29, 2001, we issued $4.6 billion of long-term debt instruments primarily to finance the Keebler acquisition. Initially, these instruments were privately placed, or sold outside the United States, in reliance on exemptions from registration under the Securities Act of 1933, as amended (the “1933 Act”). We then exchanged new debt securities for these initial debt instruments, with the new debt securities being substantially identical in all respects to the initial debt instruments, except for being registered under the 1933 Act.

In conjunction with this issuance, we settled $1.9 billion notional amount of forward-starting interest rate swaps for approximately $88 million in cash. The swaps effectively fixed a portion of the interest rate on an equivalent amount of debt prior to issuance. The swaps were designated as cash flow hedges pursuant to SFAS No. 133 (refer to Note 6 within Footnotes to Consolidated Financial Statements for further information). As a result, the loss on settlement was recorded in other comprehensive income, net of tax benefit of approximately $32 million, and is being amortized to interest expense over periods of 5 to 30 years. As a result of this amortization expense, as well as discount on the debt, the overall effective interest rate on the total $4.6 billion long-term debt issuance is approximately 6.75% during 2001.

In order to provide additional short-term liquidity in connection with the Keebler acquisition, we entered into a 364-Day Credit Agreement, which expires in January 2002 (subject to a renewal option), and a Five-Year Credit Agreement, which expires in January 2006. Each of these agreements permits the Company or certain subsidiaries to borrow up to $1.15 billion (or certain amounts in foreign currencies under the Five-Year Credit Agreement). They also require the maintenance of a specified amount of consolidated net worth and a specified consolidated interest expense coverage ratio, and limit capital lease obligations and subsidiary debt These credit facilities were unused at September 30, 2001.

Despite the substantial amount of debt incurred to finance the Keebler acquisition, we believe that we will be able to meet our interest and principal repayment obligations and maintain our debt covenants for the foreseeable future, while still meeting our operational needs through our strong cash flow and program of issuing short-term debt and maintaining credit facilities on a global basis.

In October 2001, we filed a registration statement with the SEC which allows Kellogg Company and certain business trusts to issue $2.0 billion of debt or equity securities from time to time.

Accounting changes

Hedging activities

On January 1, 2001, we adopted Statement of Financial Accounting Standards (SFAS) No. 133 “Accounting for Derivative Instruments and Hedging Activities.” This statement requires that all derivative instruments be recorded on the balance sheet at fair value and establishes criteria for designation and effectiveness of hedging relationships. For the nine months ended September 30, 2001, we reported a charge to earnings of $1.0 million (net of tax benefit of $.6 million) and a charge to other comprehensive income of $14.9 million (net of tax benefit of $8.6 million) in order to recognize the fair value of derivative instruments as either assets or liabilities on the balance sheet. The charge to earnings relates to the component of the derivative instruments’ net loss that has been excluded from the assessment of hedge effectiveness.

Revenue measurement

This guidance is applicable to Kellogg Company in several ways. First, it applies to payments we make to our customers (the retail trade) primarily for conducting consumer promotional activities, such as in-store display and feature price discounts on our products. Second, it applies to discount coupons and other cash redemption offers that we provide directly to consumers. Third, it applies to promotional items such as toys that the we insert in or attach to our product packages (“package inserts”). Consistent with industry practice, we have historically classified these items as promotional expenditures within selling, general, and administrative expense (SG&A), and have generally recognized the cost as the related revenue is earned.

Effective January 1, 2002, we will reclassify promotional payments to our customers and the cost of consumer coupons and other cash redemption offers from SG&A to net sales. We will reclassify the cost of package inserts from SG&A to cost of sales. All comparative periods will be restated. We are currently assessing the total combined impact of both Issues, including the pro forma effect of the Keebler acquisition. However, we believe that, based on historical information, combined net sales could be reduced up to 15%, with

approximately 95% of this impact reflected in the U.S. operating segment. Combined cost of goods sold could be increased by approximately 1.5%. SG&A would be correspondingly reduced such that net earnings would not be affected.

Business combinations

In July 2001, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 141 “Business Combinations” and SFAS No. 142 “Goodwill and Intangible Assets.” Both of these Standards provide guidance on how companies account for acquired businesses and related disclosure issues.

Chief among the provisions of these standards are 1) elimination of the “pooling of interest” method for transactions initiated after September 30, 2001, 2) elimination of amortization of goodwill and “indefinite-lived” intangible assets effective for our company on January 1, 2002, and 3) annual impairment testing and potential loss recognition for goodwill and non-amortized intangible assets, also effective for us on January 1, 2002.

We are currently assessing the impact of these provisions. However, we believe substantially all of Kellogg’s total after-tax amortization expense will be eliminated under these new guidelines. Based on acquisitions completed to date, we expect total after-tax amortization expense in 2002 (before impact of the new Standards) of approximately $110-$115 million.

Accounting for long-lived assets

In October 2001, the FASB issued SFAS No. 144 “Accounting for Impairment or Disposal of Long-lived Assets.” This Standard will generally be effective for Kellogg on a prospective basis, beginning January 1, 2002.

SFAS No. 144 clarifies and revises existing guidance on accounting for impairment of plant, property, and equipment, amortized intangibles, and other long-lived assets not specifically addressed in other accounting literature. Significant changes include 1) establishing criteria beyond those previously specified in existing literature for determining when a long-lived asset is held for sale, and 2) requiring that the depreciable life of a long-lived asset to be abandoned is revised. These provisions could be expected to have the general effect of reducing or delaying recognition of future impairment losses on assets to be disposed, offset by higher depreciation during the remaining holding period. However, we do not expect the adoption of this Standard to have a significant impact on our 2002 financial results. SFAS No. 144 also broadens the presentation of discontinued operations to include a component of an entity (rather than only a segment of a business).

Forward-looking statements

Our Management’s Discussion and Analysis contains “forward-looking statements” with projections concerning, among other things, our strategy and plans; integration activities, costs, and savings related to the Keebler acquisition; cash outlays and savings related to restructuring actions; the impact of accounting changes; our ability to meet interest and debt principal repayment obligations; the effect of the Keebler acquisition on factors which impact the effective income tax rate; amortization expense; cash flow; property addition expenditures; reserve utilization; and interest expense. Forward-looking statements include predictions of future results or activities and may contain the words “expect,” “believe,” “will,” “will deliver,” “anticipate,” “project,” “should,” or words or phrases of similar meaning. Our actual results or activities may differ materially from these predictions. In particular, future results or activities could be affected by factors related to the Keebler acquisition, including integration problems, failures to achieve savings, unanticipated liabilities, and the substantial amount of debt incurred to finance the acquisition, which could, among other things, hinder our ability to adjust rapidly to changing market conditions, make us more vulnerable in the event of a downturn and place us at a competitive disadvantage relative to less leveraged competitors. In addition, our future results could be affected by a variety of other factors, including

•		competitive conditions in our markets;

•		marketing spending levels and pricing actions of competitors;

•		the impact of competitive conditions, marketing spending, and/or incremental pricing actions on actual volumes and product mix;

•		effectiveness of advertising and marketing spending or programs;

•		the success of new product introductions;

•		the availability of and interest rates on short-term financing;

•		the levels of spending on systems initiatives, properties, business opportunities, integration of acquired businesses, and other general and administrative costs;

•		commodity price and labor cost fluctuations;

•		changes in consumer preferences;

•		changes in U.S. or foreign regulations affecting the food industry;

•		expenditures necessary to carry out restructuring initiatives and savings derived from these initiatives;

•		U.S. and foreign economic conditions, including currency rate fluctuations; and,

•		business disruption from terrorist acts or our nation’s response to them.

Forward-looking statements speak only as of the date they were made, and we undertake no obligation to publicly update them.

KELLOGG COMPANY

PART II — OTHER INFORMATION


Item 4.		Submission of Matters to a Vote of Security Holders

		There were no submissions of matters to a vote of security holders during the quarter for which the report is filed.

Item 6.		Exhibits and Reports on Form 8-K

	(a) Exhibits:

		No exhibits are included in this filing.

	(b) Reports on Form 8-K:

		No reports on Form 8-K were filed during the quarter for which the report is filed.

KELLOGG COMPANY

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

KELLOGG COMPANY

/s/ T. J. Webb

T. J. Webb
Principal Financial Officer;
Executive Vice President – Chief Financial Officer

/s/ J. M. Boromisa

J. M. Boromisa
Principal Accounting Officer;
Vice President – Corporate Controller

Date: November 9, 2001

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