e10vq
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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)
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended October 1, 2005
OR
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     
Commission file number 1-4171
KELLOGG COMPANY
State of Incorporation—Delaware    IRS Employer Identification No. 38-0710690
One Kellogg Square, P.O. Box 3599, Battle Creek, MI 49016-3599
Registrant’s telephone number: 269-961-2000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by 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  þ  No  o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
  Yes  þ  No  o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
  Yes  o  No  þ
Common Stock outstanding as of October 28, 2005 – 414,235,942 shares
 
 

 


Table of Contents

KELLOGG COMPANY
INDEX
         
    Page  
PART I — Financial Information
       
 
       
Item 1:
       
    2  
 
       
    3  
 
       
    4  
 
       
    5-13  
 
       
       
Management’s Discussion and Analysis of Financial Condition and Results of Operations
    14-21  
 
       
       
Quantitative and Qualitative Disclosures about Market Risk
    22  
 
       
       
Controls and Procedures
    22  
 
       
       
 
       
       
Unregistered Sales of Equity Securities and Use of Proceeds
    23  
 
       
       
Exhibits
    23  
 
       
    24  
 
       
    25  
 Rule 13a-14(e)/15d-14(a) Certification from James M. Jenness
 Rule 13a-14(e)/15d-14(a) Certification from Jeffrey M. Boromisa
 Section 1350 Certification from James M. Jenness
 Section 1350 Certification from Jeffrey M. Boromisa

 


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Kellogg Company and Subsidiaries
CONSOLIDATED BALANCE SHEET
(millions, except per share data)
                 
    October 1,   January 1,
    2005   2005
    (unaudited)   *
 
Current assets
               
Cash and cash equivalents
  $ 463.5     $ 417.4  
Accounts receivable, net
    1,026.0       776.4  
Inventories:
               
Raw materials and supplies
    191.4       188.0  
Finished goods and materials in process
    485.3       493.0  
Other current assets
    254.2       247.0  
 
 
               
Total current assets
    2,420.4       2,121.8  
Property, net of accumulated depreciation
               
of $3,842.4 and $3,778.8
    2,606.4       2,715.1  
Goodwill
    3,445.3       3,445.5  
Other intangibles, net of accumulated amortization
               
of $47.2 and $46.1
    1,440.5       1,442.2  
Other assets
    794.3       837.3  
 
 
               
Total assets
  $ 10,706.9     $ 10,561.9  
 
Current liabilities
               
Current maturities of long-term debt
  $ 284.3     $ 278.6  
Notes payable
    1,026.1       750.6  
Accounts payable
    818.1       726.3  
Accrued advertising and promotion
    390.3       322.0  
Other current liabilities
    835.0       768.5  
 
 
               
Total current liabilities
    3,353.8       2,846.0  
 
               
Long-term debt
    3,162.7       3,892.6  
Deferred income taxes
    918.6       959.1  
Pension benefits
    206.0       181.1  
Nonpension postretirement benefits
    257.6       269.7  
Other liabilities
    148.0       156.2  
 
               
Shareholders’ equity
               
Common stock, $.25 par value
    104.6       103.8  
Capital in excess of par value
    66.7        
Retained earnings
    3,186.1       2,701.3  
Treasury stock, at cost
    (205.7 )     (108.0 )
Accumulated other comprehensive income (loss)
    (491.5 )     (439.9 )
 
 
               
Total shareholders’ equity
    2,660.2       2,257.2  
 
 
               
Total liabilities and shareholders’ equity
  $ 10,706.9     $ 10,561.9  
 
* Condensed from audited financial statements.

Refer to Notes to Consolidated Financial Statements.

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Kellogg Company and Subsidiaries
CONSOLIDATED EARNINGS
(millions, except per share data)
                                 
    Quarter ended   Year-to-date period ended
    October 1,   Sept. 25,   October 1,   Sept. 25,
(Results are unaudited)   2005   2004   2005   2004
 
Net sales
  $ 2,623.4     $ 2,445.3     $ 7,782.9     $ 7,223.1  
 
Cost of goods sold
    1,437.4       1,319.1       4,262.4       3,981.7  
Selling and administrative expense
    720.3       669.4       2,114.5       1,926.0  
 
 
                               
Operating profit
    465.7       456.8       1,406.0       1,315.4  
 
                               
Interest expense
    68.0       76.2       233.1       230.5  
Other income (expense), net
    (5.7 )     (3.5 )     (19.2 )     (9.8 )
 
 
                               
Earnings before income taxes
    392.0       377.1       1,153.7       1,075.1  
Income taxes
    117.7       130.1       365.7       370.9  
 
 
                               
Net earnings
  $ 274.3     $ 247.0     $ 788.0     $ 704.2  
 
 
                               
Net earnings per share:
                               
Basic
  $ .66     $ .60     $ 1.91     $ 1.71  
Diluted
  $ .66     $ .59     $ 1.89     $ 1.69  
 
                               
Dividends per share
  $ .2775     $ .2525     $ .7825     $ .7575  
 
 
                               
Average shares outstanding:
                               
Basic
    413.4       412.4       412.8       411.7  
 
Diluted
    416.7       416.7       416.4       415.8  
 
 
                               
Actual shares outstanding at period end
                    413.9       412.6  
 
Refer to Notes to Consolidated Financial Statements.

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Kellogg Company and Subsidiaries
CONSOLIDATED STATEMENT OF CASH FLOWS
(millions)
                 
    Year-to-date period ended
    October 1,   Sept. 25,
(unaudited)   2005   2004
 
Operating activities
               
Net earnings
  $ 788.0     $ 704.2  
Adjustments to reconcile net earnings to operating cash flows:
               
Depreciation and amortization
    291.8       311.2  
Deferred income taxes
    (61.9 )     7.6  
Other (a)
    171.6       79.0  
Postretirement benefit plan contributions
    (89.2 )     (140.7 )
Changes in operating assets and liabilities
    34.4       67.8  
 
 
               
Net cash provided by operating activities
    1,134.7       1,029.1  
 
 
               
Investing activities
               
Additions to properties
    (220.0 )     (169.5 )
Acquisitions of businesses
    (30.2 )      
Other
    7.4       1.0  
 
 
               
Net cash used in investing activities
    (242.8 )     (168.5 )
 
 
               
Financing activities
               
Net issuances (reductions) of notes payable
    275.5       223.9  
Issuances of long-term debt
          7.0  
Reductions of long-term debt
    (726.9 )     (503.0 )
Net issuances of common stock
    206.7       242.0  
Common stock repurchases
    (263.1 )     (229.3 )
Cash dividends
    (322.8 )     (313.1 )
Other
    5.3       (2.7 )
 
 
               
Net cash used in financing activities
    (825.3 )     (575.2 )
 
 
               
Effect of exchange rate changes on cash
    (20.5 )     (3.6 )
 
 
               
Increase in cash and cash equivalents
    46.1       281.8  
Cash and cash equivalents at beginning of period
    417.4       141.2  
 
 
               
Cash and cash equivalents at end of period
  $ 463.5     $ 423.0  
 
(a) Consists principally of non-cash expense accruals for employee benefit obligations
Refer to Notes to Consolidated Financial Statements.

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Notes to Consolidated Financial Statements
for the quarter and year-to-date periods ended October 1, 2005 (unaudited)
Note 1 Accounting policies
Basis of presentation
The unaudited interim financial information included in this report reflects normal recurring adjustments that management believes are necessary for a fair statement 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 34 to 53 of the Company’s 2004 Annual Report. The accounting policies used in preparing these financial statements are the same as those summarized in the Company’s 2004 Annual Report. Certain amounts for 2004 have been reclassified to conform to current-period classifications. The results of operations for the quarterly and year-to-date periods ended October 1, 2005, are not necessarily indicative of the results to be expected for other interim periods or the full year.
The Company’s fiscal year normally ends on the last Saturday of December and as a result, a 53rd week is added every fifth or sixth year. The Company’s 2004 fiscal year ended on January 1, 2005, and included a 53rd week. Quarters normally consist of 13-week periods, with the fourth quarter of fiscal 2004 including a 14th week.
Stock compensation
The Company uses various equity-based compensation programs to provide long-term performance incentives for its global workforce. Currently, these incentives consist of stock options, performance units and shares, restricted stock grants, and stock purchase plans with various preferred terms. The Company also awards stock options and restricted stock to its outside directors. These awards are administered through several plans, as described in Note 8 within Notes to Consolidated Financial Statements on pages 43 and 44 of the Company’s 2004 Annual Report.
The Company currently uses the intrinsic value method prescribed by Accounting Principles Board Opinion (APB) No. 25 “Accounting for Stock Issued to Employees,” to account for its employee stock options and other stock-based compensation. Under this method, because the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of the grant, no compensation expense is recognized. The following table presents the pro forma results for the current and prior periods, as if the Company had used the alternate fair value method of accounting for stock-based compensation, prescribed by SFAS No. 123 “Accounting for Stock-Based Compensation” (as amended by SFAS No. 148). Under this pro forma method, the fair value of each option grant (net of estimated unvested forfeitures) was estimated at the date of grant using a binomial option-pricing model and was recognized over the vesting period, generally two years. Pricing model assumptions included expected terms of 3-5 years; and risk-free interest rates, dividend yields, and volatility assumptions consistent with the expected terms and particular grant dates.

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    Quater ended   Year-to-date period ended
    October 1,   September 25,   October 1,   September 25,
(millions, except per share data)   2005   2004   2005   2004
 
Stock-based compensation expense,
                               
net of tax:
                               
As reported
  $ 3.2     $ 2.3     $ 9.4     $ 6.7  
Pro forma
  $ 10.5     $ 11.1     $ 34.9     $ 31.5  
 
                               
Net earnings:
                               
As reported
  $ 274.3     $ 247.0     $ 788.0     $ 704.2  
Pro forma
  $ 267.0     $ 238.2     $ 762.5     $ 679.4  
 
                               
Basic net earnings per share:
                               
As reported
  $ 0.66     $ 0.60     $ 1.91     $ 1.71  
Pro forma
  $ 0.65     $ 0.58     $ 1.85     $ 1.65  
 
                               
Diluted net earnings per share:
                               
As reported
  $ 0.66     $ 0.59     $ 1.89     $ 1.69  
Pro forma
  $ 0.64     $ 0.57     $ 1.83     $ 1.64  
Stock compensation — SFAS No. 123(Revised)
In December 2004, the FASB issued SFAS No. 123(Revised) “Share-Based Payment,” which generally requires public companies to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value and to recognize this cost over the requisite service period. The standard also provides that any corporate tax benefit realized upon exercise of an award in excess of that previously recognized in earnings will be presented in the Statement of Cash Flows as a financing (rather than an operating) cash flow.
The standard is effective for public companies for annual periods beginning after June 15, 2005, with several transition options regarding prospective versus retrospective application. The Company plans to adopt SFAS No. 123(Revised) as of the beginning of its 2006 fiscal year, using the modified prospective method. Accordingly, prior years will not be restated, but 2006 results will be presented as if the Company had applied the fair value method of accounting for stock-based compensation from its 1996 fiscal year. If this standard had been adopted in 2005, management believes full-year net earnings per share would have been reduced by approximately $.08. However, the impact on 2006 will, in part, depend on the particular structure of stock-based awards granted in that year and various market factors that affect the fair value of awards. The Company currently plans to record the pre-tax equivalent compensation expense in selling, general, and administrative expense within its corporate operations.
Stock compensation — expense attribution
Certain of the Company’s equity-based compensation plans contain provisions that accelerate vesting of awards upon retirement, disability, or death of eligible employees and directors. The Company has historically applied the “nominal vesting period approach” for expense attribution of these awards. Under this method, expense is initially recognized over the stated vesting period, with any unamortized expense recognized upon actual retirement, disability, or death. Existing authoritative literature, as well as SFAS 123(Revised), specifies that a stock-based award is vested when the employee’s retention of the award is no longer contingent on providing subsequent service. In view of this literature, the FASB staff and SEC staff have recently advised that the related compensation cost should be recognized immediately for awards granted to retirement eligible individuals or over the period from the grant date to the date retirement eligibility is achieved, if less than the nominal vesting period. Notwithstanding this guidance, the SEC staff has advised that companies following the nominal vesting approach should continue to follow that method until SFAS No. 123(Revised) is adopted. Upon adoption of SFAS 123(Revised), the Company will prospectively revise its expense attribution method to apply the “non-substantive vesting period approach” described above. Management expects the impact of this change in expense attribution method will be immaterial.

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Note 2 Acquisitions
In order to support the continued growth of its North American fruit snacks business, in June 2005, the Company acquired a fruit snacks manufacturing facility and related assets from Kraft Foods Inc. for approximately $30 million in cash, including related transaction costs. The facility is located in Chicago, Illinois and employs approximately 400 active hourly and salaried employees. Beginning in 2006, management plans to in-source some of the Company’s fruit snacks production to the Chicago facility. The consolidated balance sheet as of October 1, 2005, reflects approximately $20 million in property attributable to this acquisition, with the remainder of the purchase price allocated principally to inventory.
Note 3 Cost-reduction initiatives
The Company views its continued spending on cost-reduction initiatives as part of its ongoing financial strategy to reinvest earnings so as to provide greater reliability in meeting long-term growth targets. Initiatives undertaken must meet certain pay-back and internal rate of return (IRR) targets. Each cost-reduction initiative is of relatively short duration, and normally begins to deliver cash savings and/or reduced depreciation during the first year of implementation, which is then used to fund new initiatives. To implement these programs, the Company has incurred various up-front costs, including asset write-offs, exit charges, and other project expenditures.
Cost of goods sold for the quarter and year-to-date periods ended October 1, 2005, includes total program-related charges of approximately $24 million and $71 million, respectively. The total year-to-date amount is comprised of approximately $16 million for a multi-employer pension plan withdrawal liability, $34 million of asset write-offs, and $21 million for severance and other cash expenditures. All of the charges were recorded in the Company’s North American operating segment.
Operating profit for the quarter and year-to-date periods ended September 25, 2004, includes total program-related charges of $32 million and $61 million, respectively. The total year-to-date amount is comprised of approximately $32 million of asset write-offs and $29 million for severance, relocation, and other cash expenditures. Approximately 50% of these charges were recorded in cost of goods sold, with the balance recorded in selling, general, and administrative expense. These charges impacted the Company’s operating segments as follows (in millions): North America-$31; Europe-$30.
Exit cost reserves were approximately $12 million at October 1, 2005 and $11 million at January 1, 2005. The balance at October 1, 2005, substantially consists of severance obligations associated with projects commenced in 2005, which are expected to be paid out in 2005 and 2006.
2005 activities
To improve operational efficiency and better position its North American snacks business for future growth, the Company plans to close its Des Plaines, Illinois bakery by the end of 2005 and its Macon, Georgia bakery by mid-2006. Production at these two bakeries, which collectively employ approximately 750 hourly and salaried employees, is being relocated principally to other Company facilities. In August 2005, the Company sold its Des Plaines bakery, subject to an arrangement that allows the Company to use the facility through the end of 2005. The Company currently expects to incur approximately $110 million of up-front costs to complete this initiative, with approximately $80 million to be recognized in 2005. The total up-front costs are expected to include approximately $45 million in accelerated depreciation and other asset write-offs and $65 million of cash costs, including severance, removals, and a pension plan withdrawal liability. The pension plan withdrawal liability is related to trust asset under-performance in a multi-employer plan that covers the majority of the Company’s union employees in the Macon bakery and is payable over a period not to exceed 20 years. The final amount of the pension plan withdrawal liability will not be determinable until early 2008. Results for the year-to-date period ended October 1, 2005, include management’s current estimate of this liability of approximately $16 million, which is subject to adjustment through early 2008 based on trust asset performance, employer contributions, employee hours attributable to the Company’s participation in this plan, and other factors.
During the first half of 2005, the Company substantially completed an initiative to consolidate meat alternatives manufacturing at its Zanesville, Ohio facility, resulting in the closure and sale of its Worthington, Ohio facility. As a result of this closing, approximately 280 employee positions were eliminated through separation and attrition. The

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Company recognized approximately $20 million of up-front costs related to this initiative in 2004 and recorded an additional $10 million of asset write-offs and cash costs in 2005.
2004 activities
Major initiatives commenced in 2004 were the global rollout of the SAP information technology system, reorganization of pan-European operations, consolidation of the aforementioned U.S. meat alternatives manufacturing operations, and relocation of the Company’s U.S. snacks business unit to Battle Creek, Michigan. Up-front costs recognized during the comparable period of 2004 related to these new initiatives as well as various manufacturing initiatives continuing from 2003.
Note 4 Other income (expense), net
Other income (expense), net includes non-operating items such as interest income, foreign exchange gains and losses, charitable donations, and gains on asset sales. Other income (expense) for the year-to-date period ended October 1, 2005, includes a charge of $6 million for a donation to the Kellogg’s Corporate Citizenship Fund, a private trust established for charitable giving, and a charge of approximately $7 million to reduce the carrying value of a corporate commercial facility to estimated selling value. The carrying value of all held-for-sale assets at October 1, 2005, was insignificant.
Other income (expense) for the year-to-date period ended September, 2004, includes a charge of approximately $8 million for a donation to the Kellogg’s Corporate Citizenship Fund.
Note 5 Debt
On July 1, 2005, the Company redeemed $723.4 million of long-term debt, representing the remaining principal balance of its 6.0% U.S. Dollar Notes due April 1, 2006. A related charge of approximately $14 million, primarily representing redemption premium, was recorded in interest expense during the year-to-date period ended October 1, 2005. On October 17, 2005, the Company repaid $200 million of maturing 4.875% U.S. Dollar Notes. These payments were funded principally through issuance of U.S. Dollar short-term debt.
Note 6 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. Basic net earnings per share is reconciled to diluted net earnings per share as follows:

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Quarter           Average   Net
(millions, except   Net   shares   earnings
per share data)   earnings   outstanding   per share
 
2005
                       
Basic
  $ 274.3       413.4     $ .66  
Dilutive potential
                       
common shares
          3.3        
 
Diluted
  $ 274.3       416.7     $ .66  
 
2004
                       
Basic
  $ 247.0       412.4     $ .60  
Dilutive potential
                       
common shares
          4.3       (.01 )
 
Diluted
  $ 247.0       416.7     $ .59  
 
                         
Year-to-date           Average   Net
(millions, except   Net   shares   earnings
per share data)   earnings   outstanding   per share
 
2005
                       
Basic
  $ 788.0       412.8     $ 1.91  
Dilutive potential
                       
common shares
          3.6       (.02 )
 
Diluted
  $ 788.0       416.4     $ 1.89  
 
2004
                       
Basic
  $ 704.2       411.7     $ 1.71  
Dilutive potential
                       
common shares
          4.1       (.02 )
 
Diluted
  $ 704.2       415.8     $ 1.69  
 
During the quarter and year-to-date periods ended October 1, 2005, the Company issued .9 million and 6.8 million shares, respectively, for employee stock option exercises, performance share awards, and similar transactions pursuant to various equity-based compensation programs. These awards are administered through several plans, as described in Note 8 within Notes to Consolidated Financial Statements on pages 43 and 44 of the Company’s 2004 Annual Report. To offset these issuances and for general corporate purposes, during the corresponding periods, the Company repurchased 0.0 and 6.0 million shares, respectively, under an existing Board of Director authorization.
Comprehensive Income
Comprehensive income includes net earnings and all other changes in equity during a period except those resulting from investments by or distributions to shareholders. Accumulated other comprehensive income for the periods presented consists of foreign currency translation adjustments pursuant to SFAS No. 52 “Foreign Currency Translation,” unrealized gains and losses on cash flow hedges pursuant to SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities,” and minimum pension liability adjustments pursuant to SFAS No. 87 “Employers’ Accounting for Pensions.”

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Quarter
                         
    Pre-tax   Tax (expense)   After-tax
(millions)   amount   or benefit   amount
 
2005
                       
Net earnings
                  $ 274.3  
Other comprehensive income:
                       
Foreign currency translation adjustments
    (6.5 )           (6.5 )
Cash flow hedges:
                       
Unrealized gain (loss) on cash flow hedges
    (2.9 )     1.0       (1.9 )
Reclassification to net earnings
    6.6       (3.0 )     3.6  
Minimum pension liability adjustments
    (2.4 )     0.8       (1.6 )
 
 
    (5.2 )     (1.2 )     (6.4 )
 
Total comprehensive income
                  $ 267.9  
 
                         
    Pre-tax   Tax (expense)   After-tax
(millions)   amount   or benefit   amount
 
2004
                       
Net earnings
                  $ 247.0  
Other comprehensive income:
                       
Foreign currency translation adjustments
    1.2             1.2  
Cash flow hedges:
                       
Unrealized gain (loss) on cash flow hedges
    (5.8 )     1.8       (4.0 )
Reclassification to net earnings
    3.0       (1.0 )     2.0  
Minimum pension liability adjustments
    0.6             0.6  
 
 
    (1.0 )     0.8       (0.2 )
 
Total comprehensive income
                  $ 246.8  
 
Year-to-date
                         
    Pre-tax   Tax (expense)   After-tax
(millions)   amount   or benefit   amount
 
2005
                       
Net earnings
                  $ 788.0  
Other comprehensive income:
                       
Foreign currency translation adjustments
    (63.1 )           (63.1 )
Cash flow hedges:
                       
Unrealized gain (loss) on cash flow hedges
    (3.1 )     1.4       (1.7 )
Reclassification to net earnings
    20.6       (7.8 )     12.8  
Minimum pension liability adjustments
    0.6       (0.2 )     0.4  
 
 
    (45.0 )     (6.6 )     (51.6 )
 
Total comprehensive income
                  $ 736.4  
 
                         
    Pre-tax   Tax (expense)   After-tax
(millions)   amount   or benefit   amount
 
2004
                       
Net earnings
                  $ 704.2  
Other comprehensive income:
                       
Foreign currency translation adjustments
    (9.1 )           (9.1 )
Cash flow hedges:
                       
Unrealized gain (loss) on cash flow hedges
    (8.0 )     2.7       (5.3 )
Reclassification to net earnings
    13.4       (4.9 )     8.5  
Minimum pension liability adjustments
    (5.4 )     1.7       (3.7 )
 
 
    (9.1 )     (0.5 )     (9.6 )
 
Total comprehensive income
                  $ 694.6  
 

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Accumulated other comprehensive income (loss) as of October 1, 2005, and January 1, 2005, consisted of the following:
                 
    Oct. 1,   January 1,
(millions)   2005   2005
 
Foreign currency translation adjustments
  $ (397.4 )   $ (334.3 )
Cash flow hedges — unrealized net loss
    (35.5 )     (46.6 )
Minimum pension liability adjustments
    (58.6 )     (59.0 )
 
 
               
Total accumulated other comprehensive income (loss)
  $ (491.5 )   $ (439.9 )
 
Note 7 Employee benefits
The Company sponsors a number of U.S. and foreign pension, other postretirement and postemployment plans to provide various benefits for its employees. These plans are described on pages 44-47 of the Company’s 2004 Annual Report. Components of Company plan benefit expense for the periods presented are included in the tables below.
Pension
                                 
    Quarter ended   Year-to-date period ended
(millions)   Oct. 1, 2005   Sept. 25, 2004   Oct. 1, 2005   Sept. 25, 2004
 
Service cost
  $ 19.8     $ 18.4     $ 60.1     $ 55.4  
Interest cost
    39.9       38.2       120.5       114.5  
Expected return on plan assets
    (57.2 )     (58.4 )     (173.0 )     (175.1 )
Amortization of unrecognized prior service cost
    2.0       2.0       6.0       5.8  
Recognized net loss
    16.2       12.6       49.3       38.0  
Curtailment and special termination benefits — net (gain) loss
          (1.2 )           0.6  
Other
    0.4             1.3        
 
Total pension expense — Company plans
  $ 21.1     $ 11.6     $ 64.2     $ 39.2  
 
Additionally, during the year-to-date period ended October 1, 2005, the Company recorded its estimate of a multi-employer plan withdrawal liability of approximately $16 million, which is further described in Note 3.
Other nonpension postretirement
                                 
    Quarter ended   Year-to-date period ended
(millions)   Oct. 1, 2005   Sept. 25, 2004   Oct. 1, 2005   Sept. 25, 2004
 
Service cost
  $ 3.5     $ 3.0     $ 10.4     $ 9.0  
Interest cost
    14.6       13.9       43.7       41.6  
Expected return on plan assets
    (10.3 )     (9.9 )     (30.8 )     (29.8 )
Amortization of unrecognized prior service cost
    (0.8 )     (0.8 )     (2.2 )     (2.2 )
Recognized net loss
    4.9       3.7       14.8       11.1  
Curtailment and special termination benefits — net gain
          0.3             0.3  
 
Postretirement benefit expense
  $ 11.9     $ 10.2     $ 35.9     $ 30.0  
 

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Postemployment
                                 
    Quarter ended   Year-to-date period ended
(millions)   Oct. 1, 2005   Sept. 25, 2004   Oct. 1, 2005   Sept. 25, 2004
 
Service cost
  $ 1.1     $ 0.9     $ 3.3     $ 2.6  
Interest cost
    0.5       0.4       1.5       1.4  
Recognized net loss
    1.1       0.9       3.4       2.6  
 
Postemployment benefit expense
  $ 2.7     $ 2.2     $ 8.2     $ 6.6  
 
The Company’s original plan was to contribute approximately $42 million to its defined benefit pension plans and $62 million to its retiree health and welfare benefit plans during 2005, for a total of $104 million. The Company has recently decided to make additional contributions of up to $300 million during the fourth quarter of 2005. The allocation of this additional amount between pension and other postretirement benefit plans has not yet been determined. During 2004, the Company contributed approximately $140 million to defined benefit pension plans and $64 million to retiree health and welfare benefit plans, for a total of $204 million. Plan funding strategies are periodically modified to reflect management’s current evaluation of tax deductibility, market conditions, and competing investment alternatives.
Note 8 Operating segments
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, and meat alternatives. Kellogg products are manufactured and marketed globally. The Company currently manages its operations based on the geographic regions of North America, Europe, Latin America, and Asia Pacific. This organizational structure is the basis of the operating segment data presented below.
                                 
    Quarter ended   Year-to-date period ended
(millions)   October 1,   Sept. 25,   October 1,   Sept. 25,
(Results are unaudited)   2005   2004   2005   2004
 
Net sales
                               
North America
  $ 1,753.8     $ 1,610.3     $ 5,176.2     $ 4,776.1  
Europe
    506.8       510.5       1,570.6       1,517.7  
Latin America
    223.7       192.9       620.0       547.1  
Asia Pacific (a)
    139.1       131.6       416.1       382.2  
 
Consolidated
  $ 2,623.4     $ 2,445.3     $ 7,782.9     $ 7,223.1  
 
 
                               
Segment operating profit
                               
North America
  $ 326.6     $ 317.4     $ 979.9     $ 906.4  
Europe
    85.2       97.1       274.4       275.5  
Latin America
    59.7       54.2       160.2       150.5  
Asia Pacific (a)
    21.8       19.4       73.0       62.2  
Corporate
    (27.6 )     (31.3 )     (81.5 )     (79.2 )
 
Consolidated
  $ 465.7     $ 456.8     $ 1,406.0     $ 1,315.4  
 
(a)   Includes Australia and Asia.

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Note 9 Supplemental information on goodwill and other intangible assets
During the year-to-date period ended October 1, 2005, the Company reclassified $578.9 million attributable to its direct store-door (DSD) delivery system from indefinite-lived intangible assets to goodwill, net of an associated deferred tax liability of $228.5 million. Prior periods were likewise reclassified.
 
Intangible assets subject to amortization
    Gross carrying amount   Accumulated amortization
    October 1,   January 1,   October 1,   January 1,
(millions)   2005   2005   2005   2005
 
Trademarks
  $ 29.5     $ 29.5     $ 20.2     $ 19.4  
Other
    29.1       29.1       27.0       26.7  
 
Total
  $ 58.6     $ 58.6     $ 47.2     $ 46.1  
 
                 
    October 1,   September 25,
Amortization expense (a):   2005   2004 (b)
 
Quarter
  $ 0.3     $ 8.6  
 
Year-to-date
  $ 1.1     $ 10.2  
 
(a) The currently estimated aggregate amortization expense for each of the 5 succeeding fiscal years is approximately $1.5 per year.
(b) Includes impairment loss of approximately $7.9 million.
 
Intangible assets not subject to amortization
    Total carrying amount
    October 1,   January 1,
(millions)   2005   2005
 
Trademarks
  $ 1,404.0     $ 1,404.0  
Other
    25.1       25.7  
 
Total
  $ 1,429.1     $ 1,429.7  
 
 
Changes in the carrying amount of goodwill
                                         
                            Asia Pacific    
(millions)   United States   Europe   Latin America   (c)   Consolidated
 
January 1, 2005
  $ 3,443.3     $ 0.0     $ 0.0     $ 2.2     $ 3,445.5  
Other
    (0.2 )                       (0.2 )
 
October 1, 2005
  $ 3,443.1     $ 0.0     $ 0.0     $ 2.2     $ 3,445.3  
 
(c) Includes Australia and Asia.

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KELLOGG COMPANY
PART I — FINANCIAL INFORMATION
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Results of operations
Overview
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, and meat alternatives. Kellogg products are manufactured and marketed globally. We currently manage our operations based on the geographic regions of North America, Europe, Latin America, and Asia Pacific. This organizational structure is the basis of the operating segment data presented in this report.
For the quarter ended October 1, 2005, the Company reported net earnings per share of $.66, a 12% increase over the prior-period amount of $.59. This earnings growth resulted primarily from continued strong sales momentum, particularly in the Americas, and a decline in the consolidated effective income tax rate. Consolidated net sales increased approximately 7% and operating profit grew approximately 2%.
Net sales and operating profit

The following tables provide an analysis of net sales and operating profit performance for the third quarter of 2005 versus 2004:
                                                 
    North           Latin   Asia Pacific        
(dollars in millions)   America   Europe   America   (a)   Corporate   Consolidated
 
2005 net sales
  $ 1,753.8     $ 506.8     $ 223.7     $ 139.1     $     $ 2,623.4  
 
2004 net sales
  $ 1,610.3     $ 510.5     $ 192.9     $ 131.6     $     $ 2,445.3  
 
% change — 2005 vs. 2004:
                                               
Volume (tonnage) (b)
    6.8 %     0.6 %     6.5 %     2.7 %           5.5 %
Pricing/mix
    1.5 %     0.7 %     3.8 %     -1.6 %           1.1 %
 
Subtotal — internal business
    8.3 %     1.3 %     10.3 %     1.1 %           6.6 %
Foreign currency impact
    0.6 %     -2.0 %     5.6 %     4.8 %           0.7 %
 
Total change
    8.9 %     -0.7 %     15.9 %     5.9 %           7.3 %
 
                                                 
    North           Latin   Asia Pacific        
(dollars in millions)   America   Europe   America   (a)   Corporate   Consolidated
 
2005 operating profit
  $ 326.6     $ 85.2     $ 59.7     $ 21.8     $ (27.6 )   $ 465.7  
 
2004 operating profit
  $ 317.4     $ 97.1     $ 54.2     $ 19.4     $ (31.3 )   $ 456.8  
 
% change — 2005 vs. 2004:
                                               
Internal business
    2.2 %     -10.3 %     5.4 %     7.9 %     11.9 %     1.1 %
Foreign currency impact
    0.7 %     -2.0 %     4.7 %     4.8 %     0.0 %     0.8 %
 
Total change
    2.9 %     -12.3 %     10.1 %     12.7 %     11.9 %     1.9 %
 
(a) Includes Australia and Asia.
(b) We measure the volume impact (tonnage) on revenues based on the stated weight of our product shipments.

During the third quarter of 2005, consolidated net sales increased approximately 7%. Internal net sales (which excludes the impact of currency and, if applicable, acquisitions, dispositions, and shipping day differences) also grew nearly 7%, which was on top of nearly 5% growth in the year-ago period.

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During the quarter, successful innovation and brand-building investment continued to drive strong growth across our North American business units, which collectively reported an 8% increase in net sales versus the prior period. Internal net sales of our North America retail cereal business increased 11%, with strong performance in both the United States and Canada.
Internal net sales of our North America retail snacks business (consisting of wholesome snacks, cookies, crackers, and toaster pastries) increased 6% on top of 9% growth in the prior period. This growth was attributable principally to sales of fruit snacks, cereal bars, cracker products, and major cookie brands. Partially offsetting this growth was the impact of proactively managing discontinuation of marginal cookie innovations, as well as lower toaster pastry sales after double-digit growth in the third quarter of 2004.
Internal net sales of our North America frozen and specialty channel (which includes food service, vending, convenience, drug stores, and custom manufacturing) businesses collectively increased approximately 8%, led by solid contributions from both our Eggo frozen foods, Morningstar Farms veggie products, and food service businesses.
Net sales in our European operating segment declined nearly 1%; excluding the impact of unfavorable foreign exchange movements, net sales increased over 1% versus the prior period. Internal net sales performance was dampened by competitive pressures on our U.K. business unit, leading to heavy tactical pricing activity and a decline in cereal sales within that market. Results in our Nordics markets were also weak, primarily due to the tailing effects of a now-resolved temporary delisting by a major customer. These unfavorable factors were offset by increased sales of snack products in the U.K. and cereal sales growth in most other European markets.
Strong performance in Latin America resulted in net sales growth of 16%, with internal sales growth at 10%. Most of this growth was due to strong performance by our Mexico and Venezuela business units, although sales increased in virtually all the Latin American markets in which we do business.
Net sales in our Asia Pacific operating segment increased approximately 6%, principally attributable to a favorable foreign exchange impact of 5%. Despite a solid tonnage recovery versus weak prior-period performance, unfavorable pricing and mix movements held internal net sales growth to 1%. This pricing/mix impact resulted largely from increased spending on competitive merchandising by our Australian business unit. We expect this intense competitive environment in Australia to continue through the remainder of this year.
Consolidated operating profit increased 2% during the quarter, with internal growth of approximately 1%. Current-period operating profit results were negatively impacted by a decline in gross margin, as discussed on pages 17-18, and a significant increase in brand-building investment as a percentage of sales. While below our target mid-single digit growth rate for operating profit, these quarterly results bring year-to-date performance in line with long-term objectives. During the quarter, we increased our consolidated brand-building (advertising and consumer promotion) expenditures at over twice the rate of net sales growth.
The following tables provide an analysis of net sales and operating profit performance for the year-to-date period ended October 1, 2005, versus the comparable prior-year period:

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    North           Latin   Asia Pacific            
(dollars in millions)   America   Europe   America   (a)   Corporate   Consolidated
 
2005 net sales
  $ 5,176.2     $ 1,570.6     $ 620.0     $ 416.1     $     $ 7,782.9  
 
2004 net sales
  $ 4,776.1     $ 1,517.7     $ 547.1     $ 382.2     $     $ 7,223.1  
 
% change — 2005 vs. 2004:
                                               
Volume (tonnage) (b)
    5.6 %     0.4 %     7.5 %     3.0 %           4.7 %
Pricing/mix
    2.2 %     1.3 %     2.4 %     1.2 %           1.8 %
 
Subtotal — internal business
    7.8 %     1.7 %     9.9 %     4.2 %           6.5 %
Foreign currency impact
    0.6 %     1.8 %     3.4 %     4.7 %           1.3 %
 
Total change
    8.4 %     3.5 %     13.3 %     8.9 %           7.8 %
 
                                                 
    North           Latin   Asia Pacific            
(dollars in millions)   America   Europe   America   (a)   Corporate   Consolidated
 
2005 operating profit
  $ 979.9     $ 274.4     $ 160.2     $ 73.0     $ (81.5 )   $ 1,406.0  
 
2004 operating profit
  $ 906.4     $ 275.5     $ 150.5     $ 62.2     $ (79.2 )   $ 1,315.4  
 
% change — 2005 vs. 2004:
                                               
Internal business
    7.4 %     -1.5 %     3.8 %     12.8 %     -3.0 %     5.7 %
Foreign currency impact
    0.7 %     1.1 %     2.7 %     4.7 %     0.0 %     1.2 %
 
Total change
    8.1 %     -0.4 %     6.5 %     17.5 %     -3.0 %     6.9 %
 
 
(a)   Includes Australia and Asia
 
(b)   We measure the volume impact (tonage) on revenues based on the stated weight of our product shipments.
Cost reduction initiatives
We view our continued spending on cost-reduction initiatives as part of our ongoing financial strategy to reinvest earnings so as to provide greater reliability in meeting long-term growth targets. Initiatives undertaken must meet certain pay-back and internal rate of return (IRR) targets. Each cost-reduction initiative is of relatively short duration, and normally begins to deliver cash savings and/or reduced depreciation during the first year of implementation, which is then used to fund new initiatives. To implement these programs, the Company has incurred various up-front costs, including asset write-offs, exit charges, and other project expenditures, which we include in our measure of operating segment profitability.
Cost of goods sold for the quarter and year-to-date periods ended October 1, 2005, includes total program-related charges of approximately $24 million and $71 million, respectively. The total year-to-date amount is comprised of approximately $16 million for a multi-employer pension plan withdrawal liability, $34 million of asset write-offs, and $21 million for severance and other cash expenditures. All of the charges were recorded in our North American operating segment.
Operating profit for the quarter and year-to-date periods ended September 25, 2004, includes total program-related charges of $32 million and $61 million, respectively. The total year-to-date amount is comprised of approximately $32 million of asset write-offs and $29 million for severance, relocation, and other cash expenditures. Approximately 50% of these charges were recorded in cost of goods sold, with the balance recorded in selling, general, and administrative expense. These charges impacted our operating segments as follows (in millions): North America-$31; Europe-$30.
Exit cost reserves were approximately $12 million at October 1, 2005 and $11 million at January 1, 2005. The balance at October 1, 2005, substantially consists of severance obligations associated with projects commenced in 2005, which are expected to be paid out in 2005 and 2006.
To improve operational efficiency and better position our North American snacks business for future growth, we plan to close our Des Plaines, Illinois bakery by the end of 2005 and our Macon, Georgia bakery by mid-2006. Production at these two bakeries, which collectively employ approximately 750 hourly and salaried employees, is being relocated principally to other Company facilities. In August 2005, we sold our Des Plaines bakery, subject to an arrangement that allows us to use the facility through the end of 2005. We currently expect to incur

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approximately $110 million of up-front costs to complete this initiative, with approximately $80 million to be recognized in 2005. The total up-front costs are expected to include approximately $45 million in accelerated depreciation and other asset write-offs and $65 million of cash costs, including severance, removals, and a pension plan withdrawal liability. The pension plan withdrawal liability is related to trust asset under-performance in a multi-employer plan that covers the majority of our union employees in the Macon bakery and is payable over a period not to exceed 20 years. The final amount of the pension plan withdrawal liability will not be determinable until early 2008. Results for the year-to-date period ended October 1, 2005, include our current estimate of this liability of approximately $16 million, which is subject to adjustment through early 2008 based on trust asset performance, employer contributions, employee hours attributable to our participation in this plan, and other factors.
During the first half of 2005, we substantially completed an initiative to consolidate meat alternatives manufacturing at its Zanesville, Ohio facility, resulting in the closure and sale of our Worthington, Ohio facility. As a result of this closing, approximately 280 employee positions were eliminated through separation and attrition. We recognized approximately $20 million of up-front costs related to this initiative in 2004 and recorded an additional $10 million of asset write-offs and cash costs in 2005.
Major initiatives commenced in 2004 were the global rollout of the SAP information technology system, reorganization of pan-European operations, consolidation of the aforementioned U.S. meat alternatives manufacturing operations, and relocation of our U.S. snacks business unit to Battle Creek, Michigan. Up-front costs recognized during the comparable period of 2004 related to these new initiatives as well as various manufacturing initiatives continuing from 2003.
Employee benefits
Our Company sponsors a number of defined benefit plans for employees in the United States and various foreign locations, including pension, retiree health and welfare, active health care, severance and other post-employment. We also participate in a number of multi-employer pension plans for certain of our manufacturing locations. Our major pension plans and U.S. retiree health and welfare plans are funded, with trust assets invested in a globally diversified portfolio of equity securities with smaller holdings of bonds, real estate, and other investments.
The annual cost of providing these benefits is significant, with consolidated full-year 2005 benefits expense currently expected to be nearly $300 million, not including the $16 million multi-employer pension plan withdrawal liability discussed in the “Cost-reduction initiative” section in pages 16-17. This current full-year estimate represents a substantial 15-20% increase over the fiscal 2004 amount. This increase results from several major factors including: 1) a reduction in the assumed rate of return on major plan assets from 9.3% in 2004 to 8.9% in 2005; 2) a decrease in the weighted average discount rate used to measure obligations at year-end 2004; and 3) continuing health care cost inflation.
Margin performance
Margin performance for the third quarter and year-to-date periods of 2005 versus 2004 was:
                         
                    Change
                    vs. prior
Quarter   2005   2004   year (pts.)
 
Gross margin
    45.2 %     46.1 %     -0.9  
 
SGA% (a)
    -27.4 %     -27.4 %     0.0  
 
Operating margin
    17.8 %     18.7 %     -0.9  
 
                         
Year-to-date   2005   2004   Change
 
Gross margin
    45.2 %     44.9 %     0.3  
 
SGA% (a)
    -27.1 %     -26.7 %     -0.4  
 
Operating margin
    18.1 %     18.2 %     -0.1  
 
(a)   Selling, general, and administrative expense as a percentage of net sales.

For the quarter, our consolidated gross margin declined 90 basis points versus the prior period, primarily reflecting a year-over-year shift in the allocation of up-front costs (refer to “Cost reduction initiatives” section, on pages 16-17) from SGA to cost of goods sold and the aforementioned competitive pressures on our U.K. and Australian business units. On a year-to-date basis, the positive impact of consolidated sales growth, mix improvements, and productivity

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savings, continued to outpace these and other continuing unfavorable factors such as higher employee benefit costs, resulting in consolidated gross margin expansion of 30 basis points.
As discussed on page 29 of the of the Company’s 2004 Annual Report, we are exposed to market fluctuations in the prices of commodities, packaging, fuel, and energy. We manage these risks through a combination of contractual means, hedging strategies where available, and technological initiatives to reduce the cost of product ingredients and packaging. Versus the prior year, we have experienced sharply higher fuel and energy costs, but thus far, have been able to offset these margin exposures primarily through technological reductions in raw and packaging costs. During the remainder of the year, we expect fuel and energy price pressures to outpace savings achieved in other areas, thereby limiting further 2005 gross margin expansion on a full-year basis, as compared to the full-year 2004 gross margin of 44.9%.
For the quarter, our operating margin also fell by 90 basis points, reflecting the gross margin decline as well as a double-digit increase in brand-building expenditures. Year-to-date, our operating margin was relatively even with prior-period results, as we reinvested the gross margin expansion in brand-building and innovation expenditures. Our strategy is to continue to reinvest in brand building, innovation, and cost reduction initiatives, so as to maintain a relatively steady operating margin versus the full-year 2004 level of 17.5%.
In October 2005, members of the major union representing the hourly employees at our U.S. cereal plants ratified a wage and benefits agreement with the Company covering the four-year period ended October 2009. As part of this agreement, the Company will make a lump-sum payment to union members, totaling approximately $11 million, which we will recognize in cost of goods sold during our fiscal fourth quarter of 2005.
Interest expense
Interest expense for the year-to-date period was $233.1 million, which includes a charge of approximately $14 million for early redemption of Notes due April 1, 2006. This incremental expense is expected to be largely recovered through lower short-term interest rates over the original remaining term of the 2006 Notes. These results are in comparison to interest expense for the prior year-to-date period of $230.5 million. We currently expect total year 2005 interest expense to be approximately $300 million, as compared to the 2004 full-year amount of $308.6 million.
Other income (expense), net
Other income (expense), net includes non-operating items such as interest income, foreign exchange gains and losses, charitable donations, and gains on asset sales. Other income (expense) for the year-to-date period ended October 1, 2005, includes a charge of $6 million for a donation to the Kellogg’s Corporate Citizenship Fund, a private trust established for charitable giving, and a charge of approximately $7 million to reduce the carrying value of a corporate commercial facility to estimated selling value. The carrying value of all held-for-sale assets at October 1, 2005, was insignificant.
Other income (expense) for the year-to-date period ended June 26, 2004, includes a charge of approximately $8 million for a donation to the Kellogg’s Corporate Citizenship Fund.
Income taxes
The consolidated effective income tax rate for the year-to-date period was 31.7%, which is below our previously communicated 2005 expectation of approximately 33%. The year-to-date rate was favorably impacted by several discrete items recorded during the third quarter of 2005, related principally to adjustment of reserves for tax return positions and other deferred tax liabilities. Taking into account the impact of these adjustments, as well as other factors, we currently expect our full-year 2005 effective income tax rate to be approximately 32%. As compared to the prior-period rates (34.5% year-to-date and 34.8% for full-year 2004), the 2005 consolidated effective income tax rate is benefiting from the 2004 reorganization of our European operations as well as U.S. tax legislation enacted in 2004.
As discussed on page 27 of our 2004 Annual Shareholders Report, during 2005, we currently plan to elect to repatriate dividends from foreign subsidiaries which qualify for the temporary dividends-received-deduction available under the American Jobs Creation Act. Our current plan is to repatriate approximately $1.1 billion of foreign earnings in 2005 for a net tax cost of approximately $41 million, which was provided for in 2004.

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Liquidity and capital resources
Our principal source of liquidity is operating cash flows, supplemented by borrowings for major acquisitions and other significant transactions. This cash-generating capability is one of our fundamental strengths and provides us with substantial financial flexibility in meeting operating and investing needs. The principal source of our operating cash flow is net earnings, meaning cash receipts from the sale of our products, net of costs to manufacture and market our products. Our cash conversion cycle is relatively short; although receivable collection patterns vary around the world, in the United States, our days sales outstanding (DSO) averages 18-19 days. As a result, the growth in our operating cash flow should generally reflect the growth in our net earnings over time, although the specific performance for any interim period may be significantly affected by the level of benefit plan contributions, working capital movements (operating assets and liabilities), and other factors.
                         
    Year-to-date period ended    
    October 1,   September 25,   Change versus
(dollars in millions)   2005   2004   prior year
 
Operating activities
                       
Net earnings
  $ 788.0     $ 704.2       11.9 %
 
                       
Items in net earnings not requiring (providing) cash:
                       
Depreciation and amortization
    291.8       311.2          
Deferred income taxes
    (61.9 )     7.6          
Other (a)
    171.6       79.0          
         
Net earnings after non-cash items
    1,189.5       1,102.0       7.9 %
         
 
                       
Pension and other postretirement benefit plan contributions
    (89.2 )     (140.7 )        
Changes in operating assets and liabilities:
                       
Core working capital (b)
    (104.0 )     (41.1 )        
Other working capital
    138.4       108.9          
         
 
    34.4       67.8          
         
Net cash provided by operating activities
  $ 1,134.7     $ 1,029.1       10.3 %
 
 
(a)   Consists principally of non-cash expense accruals for employee benefit obligations
 
(b)   Inventory and trade receivables less trade payables
Year-to-date, operating cash flow was approximately $106 million higher than the prior period. Nearly one-half of this increase is attributable to a year-over-year reduction in the level of benefit plan contributions. Our original plan for full-year 2005 was to contribute approximately $104 million to benefit plans, which represents a $100 million reduction from the 2004 funding level. We have recently decided to make additional contributions of up to $300 million during the fourth quarter of 2005. Taking into account tax deductibility, the cash flow reduction associated with this additional plan funding would be up to $240 million.
The remainder of the year-to-date cash flow increase was principally attributable to earnings growth, partially offset by unfavorable core working capital movements. This movement was related primarily to trade receivables, which returned to historical levels (in relation to sales) by the end of the first quarter from lower levels at the end of 2004. We believe these lower levels were related to the timing of our 53rd week over the holiday period and we expect that this phenomenon could impact the core working capital component of our operating cash flow for the remainder of the year. Despite the unfavorable movement in the absolute balance, core working capital as a percentage of sales was favorable versus the prior year. For the 52-week period ended October 1, 2005, average core working capital as a percentage of sales was 7.1%, compared to 7.3% for the fiscal year ended January 1, 2005.

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Our management measure of cash flow is defined as net cash provided by operating activities reduced by expenditures for property additions. We use this measure of cash flow to focus management and investors on the amount of cash available for debt repayment, dividend distributions, acquisition opportunities, and share repurchase. Our cash flow metric is reconciled to GAAP-basis operating cash flow as follows:
                         
    Year-to-date period ended   Change
    October 1,   September 25,   versus
(dollars in millions)   2005   2004   prior year
 
Net cash provided by operating activities
  $ 1,134.7     $ 1,029.1          
Additions to properties
    (220.0 )     (169.5 )        
 
Cash flow
  $ 914.7     $ 859.6       6.4 %
 
Our 2005 year-to-date cash flow increased approximately 6% versus the prior-year period, attributable to our operating cash flow performance as discussed above, partially offset by increased spending for selective capacity expansions to accommodate our Company’s strong recent and projected sales growth. We expect this trend to continue in the near term, with full-year 2005 and 2006 property expenditures representing approximately 3.5% and 4.0% of net sales, respectively, as compared to full-year 2004 property expenditures at 2.9% of net sales. Our long-term target is to expand cash flow in line with net earnings growth, although current-year results could be lower due to the aforementioned additional benefit plan contributions during the fourth quarter of 2005.
In order to support the continued growth of our North American fruit snacks business, in June 2005, we acquired a fruit snacks manufacturing facility and related assets from Kraft Foods Inc. for approximately $30 million in cash, including related transaction costs. The facility is located in Chicago, Illinois and employs approximately 400 active hourly and salaried employees. Beginning in 2006, we plan to in-source some of our fruit snacks production to the Chicago facility. The consolidated balance sheet as of October 1, 2005, reflects approximately $20 million in property attributable to this acquisition, with the remainder of the purchase price allocated principally to inventory. Separately, we have entered into an agreement with the cable Nickelodeon network to license their characters in conjunction with our fruit snacks products.
For 2005, our Board of Directors had originally authorized stock repurchases for general corporate purposes and to offset issuances for employee benefit programs of up to $400 million, of which we had spent $263.1 million to repurchase approximately 6.0 million shares as of October 1, 2005. On October 28, 2005, our Board of Directors approved an increase in the authorized amount of 2005 stock repurchases to $675 million and an additional $650 million for 2006.
In April 2005, our Board of Directors authorized an increase of approximately 10% in the recent shareholder dividend level from $.2525 to $.2775 per share, beginning with the distribution in September 2005.
On July 1, 2005, we redeemed $723.4 million of long-term debt, representing the remaining principal balance of our 6.0% U.S. Dollar Notes due April 1, 2006. On October 17, 2005, we repaid $200 million of maturing 4.875% U.S. Dollar Notes. These payments were funded principally through issuance of U.S. Dollar short-term debt.
During the fourth quarter of 2005, subsidiaries of Kellogg Company are planning to issue approximately one billion dollars of short- and long-term debt in offerings outside of the United States. These debt issuances are to be guaranteed by the Company and net proceeds will be used primarily for the payment of dividends pursuant to the American Jobs Creation Act and the purchase of stock and assets of other direct or indirect subsidiaries of the Company, as well as for general corporate purposes.
At October 1, 2005, our total debt was approximately $4.5 billion, down from $4.9 billion at year-end 2004. Due to the aforementioned increase in benefit plan funding and share repurchase authorization, we currently expect our year-end debt position to rise slightly from the balance at the end of the current period. By the end of 2005, we expect to have reduced our total debt position by over $2.0 billion, versus the high of $6.8 billion just after the acquisition of Keebler Foods Company in early 2001. As a result of shifting priorities, we no longer expect to reduce debt at this recent historical rate, but remain committed to net debt reduction (total debt less cash) over the long term.
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, including the pursuit of selected

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growth opportunities, through our strong cash flow, our program of issuing short-term debt, and maintaining credit facilities on a global basis. Our significant long-term debt issues do not contain acceleration of maturity clauses that are dependent on credit ratings. A change in the Company’s credit ratings could limit its access to the U.S. short-term debt market and/or increase the cost of refinancing long-term debt in the future. However, even under these circumstances, we would continue to have access to our credit facilities, which are in amounts sufficient to cover the outstanding short-term debt balance and debt principal repayments through 2006.
Future outlook & forward-looking statements
Our long-term annual growth targets are low single-digit for internal net sales and high single-digit for net earnings per share. In addition, we remain committed to growing our brand-building investment faster than the rate of sales growth. We currently expect our 2005 internal net sales growth to slightly exceed and other results to be consistent with these targets. In addition, we will continue to reinvest in cost-reduction initiatives and other growth opportunities.
In December 2004, the FASB issued SFAS No. 123(Revised) “Share-Based Payment,” which we plan to adopt as of the beginning of our 2006 fiscal year, using the modified prospective method. Accordingly, prior years will not be restated, but 2006 results will be presented as if we had applied the fair value method of accounting for stock-based compensation from our 1996 fiscal year. If this standard had been adopted in 2005, we believe full-year net earnings per share would have been reduced by approximately $.08. However, the impact on 2006 will, in part, depend on the particular structure of stock-based awards granted in that year and various market factors that affect the fair value of awards. We currently plan to record the pre-tax equivalent compensation expense in selling, general, and administrative expense within our corporate operations.
Our Management’s Discussion and Analysis contains “forward-looking statements” with projections concerning, among other things, our strategy, financial principles, and plans; initiatives, improvements, and growth; sales, gross margins, brand-building expenditures and other costs, operating profit, and earnings per share; asset write-offs and expenditures related to cost-reduction initiatives; the impact of accounting changes and significant accounting estimates; our ability to meet interest and debt principal repayment obligations; future common stock repurchases; debt issuances or reduction; effective income tax rate; cash flow and core working capital improvements; capital expenditures; interest expense; and employee benefit plan costs and funding. 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 addition, our future results could be affected by a variety of other factors, including:
§   the impact of competitive conditions;
 
§   the effectiveness of pricing, advertising, and promotional programs;
 
§   the success of innovation and new product introductions;
 
§   the recoverability of the carrying value of goodwill and other intangibles;
 
§   the success of productivity improvements and business transitions;
 
§   raw material commodity, packaging, and energy prices, and labor costs;
 
§   the availability of and interest rates on short-term financing;
 
§   actual market performance of benefit plan trust investments;
 
§   the levels of spending on systems initiatives, properties, business opportunities, integration of acquired businesses, and other general and administrative costs;
 
§   changes in consumer behavior and preferences;
 
§   the effect of U.S. and foreign economic conditions on items such as interest rates, taxes and tariffs, currency conversion and availability;
 
§   legal and regulatory factors; and,
 
§   business disruption or other losses from war, terrorist acts, or political unrest.
Forward-looking statements speak only as of the date they were made, and we undertake no obligation to publicly update them.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk
Refer to disclosures contained on pages 28-29 of the Company’s 2004 Annual Report.
Item 4. Controls and Procedures
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer as appropriate, to allow timely decisions regarding required disclosure based on management’s interpretation of the definition of “disclosure controls and procedures,” in Rules 13a-15(e) and 15d-15(e). In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable, rather than absolute, assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As of October 1, 2005, management carried out an evaluation under the supervision and with the participation of the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective at a reasonable level of assurance.
During the last fiscal quarter, except as indicated below, there have been no changes in the Company’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. As has been previously reported, the Company is in the process of rolling out its SAP information technology system on a global basis. Effective at the beginning of its 2005 fiscal year, the Company finished the implementation of a major initiative to improve the organizational design and effectiveness of its pan-European operations and completed the transitioning of its European operations to the SAP information technology system. Management does not, however, currently believe that this has adversely affected the Company’s internal control over financial reporting.

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KELLOGG COMPANY
PART II — OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
(e) Issuer Purchases of Equity Securities
(millions, except per share data)
                                 
                            (d) Approximate
                    (c) Total Number of   Dollar Value of
                    Shares Purchased as   Shares that May Yet
    (a) Total           Part of Publicly   Be Purchased Under
    Number of Shares   (b) Average Price   Announced Plans or   the Plans or
Period   Purchased   Paid per Share   Programs   Programs
Month #1:
                               
7/3/05-7/30/05
    0.1     $ 44.65       0.1     $ 136.9  
Month #2:
                               
7/31/05-8/27/05
    0.2       45.30       0.2       136.9  
Month #3:
                               
8/28/05-10/1/05
    0.2       45.53       0.2       136.9  
 
                             
Total (1)
    0.5       45.32       0.5          
 
                             
 
(1)   Shares included in the table above were purchased as part of publicly announced plans or programs, as follows:
  a.   No shares were purchased during the periods presented under a program authorized by the Company’s Board of Directors to repurchase for general corporate purposes and to offset issuances for employee benefit programs up to $400 million in Kellogg common stock during 2005. This repurchase program was publicly announced in a press release on December 7, 2004. On October 28, 2005, the Board of Directors approved an increase in the authorized amount of 2005 stock repurchases to $675 million and an additional $650 million for 2006. This repurchase program was publicly announced in a press release on October 31, 2005.
 
  b.   Approximately 0.5 million shares were purchased from employees and directors in stock swap and similar transactions pursuant to various shareholder-approved equity-based compensation plans described on pages 43-44 of the Company’s 2004 Annual Report to Shareholders, filed as exhibit 13.01 to the Company’s 2004 Form 10-K.
Item 6. Exhibits
     
     (a) Exhibits:    
31.1
  Rule 13a-14(e)/15d-14(a) Certification from James M. Jenness
31.2
  Rule 13a-14(e)/15d-14(a) Certification from Jeffrey M. Boromisa
32.1
  Section 1350 Certification from James M. Jenness
32.2
  Section 1350 Certification from Jeffrey M. Boromisa

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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/ J.M. Boromisa    
  J.M. Boromisa
Principal Financial Officer;
Senior Vice President – Chief Financial Officer 
 
 
     
  /s/ A.R. Andrews    
  A.R. Andrews
Principal Accounting Officer;
Vice President – Corporate Controller 
 
 
Date: November 7, 2005

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KELLOGG COMPANY
EXHIBIT INDEX
         
        Electronic (E)
        Paper (P)
        Incorp. By
Exhibit No.   Description   Ref. (IBRF)
31.1
  Rule 13a-14(e)/15d-14(a) Certification from James M. Jenness   E
 
       
31.2
  Rule 13a-14(e)/15d-14(a) Certification from Jeffrey M. Boromisa   E
 
       
32.1
  Section 1350 Certification from James M. Jenness   E
 
       
32.2
  Section 1350 Certification from Jeffrey M. Boromisa   E

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