Equity Research Report
,

October, 31, 2009 Bobby Kelley ,

Kellogg Company
K: Bobby's Company Report -

(K-NYSE) HOLD OUTLOOK
Kellogg Company, the leader in ready-to-eat cereals, has successfully executed the Volume to Value and Manage for Cash strategies. In 2006, management adopted additional programs, namely, Sustainable Growth and People Passion and Pride . By focusing on brand building and profitability, Kellogg is reporting consistent sales and earnings growth, reducing debt, and repurchasing shares. However, recent commodity inflation and increased investment in advertising expenditures have pressured the gross and operating margins.

Current Recommendation

Hold

Current Price (10/30/09) Twelve-Month Target Price

$51.54 $55.13

SUMMARY DATA
52-Week High 52-Week Low One-Year Return (%) Beta Average Daily Volume (sh) Shares Outstanding (mil) Market Capitalization ($mil) Short Interest Ratio (days) Institutional Ownership (%) Insider Ownership (%) Annual Cash Dividend Dividend Yield (%) 5-Yr. Historical Growth Rates Sales (%) Earnings Per Share (%) Dividend (%) P/E using TTM EPS P/E using 2009 Estimate P/E using 2010 Estimate $53.39 $35.64 17.54 0.51 3,909,678 383 $19,731 3.25 82 2 $1.50 2.91 7.4 8.0 7.0 16.5 16.5 13.8 Risk Level Type of Stock Industry Low Large-Growth Food-Misc./Diversified

BOBBY'S ESTIMATES
Revenue
(in millions of $)

Q1 (Mar) 2007 2008 2009 2010 2,963 A 3,258 A 3,169 A 3,366 E

Q2 (Jun) 3,015 A 3,343 A 3,229 A

Q3 (Sep) 3,004 A 3,290 A 3,277 A

Q4 (Dec) 2,794 A 2,933 A 2,950 E

Year (Dec) 11,766 A 12,822 A 12,627 E 13,355 E

Earnings per Share
(EPS is operating earnings before non recurring items)

2007 2008 2009 2010

Q1 (Mar) $0.70 A $0.81 A $0.84 A $0.94 E

Q2 (Jun) $0.75 A $0.82 A $0.92 A

Q3 (Sep) $0.76 A $0.90 A $0.94 A

Q4 (Dec) $0.44 A $0.53 A $0.56 E

Year (Dec) $2.66 A $3.05 A $3.20 E $3.46 E 9 9

* see DISCLOSURES for footnotes

Bobby's Projected EPS Growth Rate Next 5 Years % Consensus Projected EPS Growth - Next 5 Years %

OVERVIEW
Headquartered in Battle Creek, Michigan, Kellogg Company (K) manufactures and markets ready-to-eat cereals and convenience foods (including cookies, crackers, toaster pastries, cereal bars, and frozen waffles). The company is the world's leading producer and distributor of cereal with its products manufactured in 18 countries and marketed across 180 countries. Kellogg holds a dominant 40% market share in global volumes for breakfast cereals. Cereals (Kellogg's Corn Flakes, Rice Krispies, Special K, Frosted Flakes, All-Bran, Corn Pops, Raisin Bran, and Frosted Mini-Wheats, among others) account for 53% of the company s sales. With net sales of approximately $12.8 billion in 2008, the company is a leading producer of convenience foods, including the brands of Keebler, Pop-Tarts, Eggo, Cheez-It, Nutri-Grain, Murray, Austin, Morningstar Farms, Famous Amos, Carr's, Plantation, Ready Crust, and Kashi. The company is divided into two geographic divisions: Kellogg North America and Kellogg International. Kellogg North America (approximately 66% of total 2008 sales) includes retail cereal, retail snacks, and frozen and specialty channels in both the U.S and Canada. Kellogg International is divided into three operating segments: Europe (20%), Latin America (8%), and the Asia Pacific (6%).

BULL STORY
In 2005, management had two operating principles ( Volume to Value and Manage for Cash ). The Volume to Value strategy concentrates on profits (value) rather than market share (volume). Kellogg has focused on brand building through new product innovation and improving the product mix by concentrating on optimal price/mix combinations. Marketing efforts are aimed towards the more profitable cereals and snacks business, in order to increase sales and expand margins. In 2006, management adopted two other strategies: Sustainable Growth , and People, Passion and Pride . Sustainable Growth focuses on the generation of profitable sales growth, through investments in brand building, innovations, and by supporting the existing products and promotional programs. People, Passion, and Pride is focused on maximizing the effectiveness of employees and the organization. Over the three years ending January 3, 2009, the company has attained cumulative annual savings of $1.0 billion through lean manufacturing, indirect procurement savings, and overhead discipline. In the Manage for Cash initiative, working capital was reduced by effective inventory management and cost cutting, especially by consolidating capacity in the U.S. snacks bakery division from 2005 to mid2006. Capital spending projects have been prioritized such as construction of a new manufacturing facility in Ontario, Canada, resulting in a 150 basis point improvement in ROIC (return on invested capital), which increased to 10.6% in 2007. The resulting incremental profits are being utilized to reduce debt and repurchase shares, along with funding additional brand-building initiatives. Kellogg s cash flow (cash from operating activities less capital expenditures) has risen substantially over the last three years. In 2008, cash flow less capital expenditures increased to $1.1 billion, including a $300 million year-end contribution to pension plans. Management s long-term goal is to pay down debt by approximately $300 million per year. Kellogg continues to market brands that generate higher margins, part of the Volume to Value (V2V) strategy. Management is intensifying the brand-building program with increased advertising and promotional expenditures in line with the goal of increasing brand-building spending at twice the rate of sales growth. Since 2002, research and development expenditures have increased by 68% from $106.4 million to $179.3 million in 2007. In the three years between 2005 and 2007 under the Volume to Value strategy, the company increased investments in brand building by 23%, which contributed to a gross profit increase of $864 million, generated an internal sales increase of over 20%, and improved price and mix by over 10%. At the same time between 2005 and 2007, the company increased advertising expenses by almost 30%. In 2007, the advertising expenditures were $1.06 billion, a 16% increase from 2006. However, in 2008, the advertising expenses only increased 1.3% over 2007 to $1.08 billion, but still the company leads the industry with 8% of sales being committed to investments in advertising.

Page 2

Product innovation is a key to increasing volume growth and enhancing pricing. Product innovation has always been a key to growth at Kellogg s, providing customers with wider options. Management evaluates innovation as a percentage of sales on a three-year rolling basis. In 2008, the company generated 5% of sales (or approximately $2 billion) through new product innovation. The company s strong track record of delivering results through innovations has led to introductions in two prime categories: Health and Wellness, and Convenient Solutions for both adults and children. Product launches in 2006 included Smart Start Healthy Heart Maple Brown Sugar, Frosted Mini-Wheats, and Frosted Mini-Wheat Strawberry Delight. In the first half of 2007, the company introduced Cereal Straws, Corn Pops Peanut Butter, new versions of Fruit Loops, Carr s Cheese Melts, and Right Bites variety packs. Kashi (the company s stand-alone business focused on natural and organic category) also benefited from new products, including Vive and GoLean Crunch Honey Almond Flax. During the third quarter of 2007, the company introduced Fruit Loops Smoothie and Cinnamon Streusel Mini Wheats in the cereal category. In the Kashi line, the company introduced Mini Wheats Strawberry, Special K Fruit and Yogurt, and Vanilla Rice Krispies. In 2008, the company has introduced Frosted Flakes Gold, AllBran Strawberry Medley, Kashi Granolas, and Kashi U for adults, along with reintroducing Hydrox. In addition, the company also rolled out Special K Cinnamon Pecan Bars, Sandies Dark chocolate cookies, and White Cheddar Reduced Fat Cheez-Its. New products like Fruit Harvest, Cinnamon Krunchers, low carb Special K, Special K Cinnamon Pecan cereal, Eggo French Toaster sticks, Eggo French Toast Waffles, Eggo Muffin Tops, Cheez-It Parmesan, Chips Deluxe, Fudge Shoppe, Kashi TLC granola bars, and Eggo Mini Muffin Tops are adding to the sales momentum. In 2009, the company intends to introduce Special K Blueberry Mutton and Frosted Mini- Wheats Little Bites, Nature s Pleasure, and Special K Chocolate in the cereals category, along with Kashi 7 Grain CLC cracker packs, Right Bites Cookies n Cream 100 calories packs, Cheez-It Scrabble Junior, and Chip Deluxe Original Chocolate Chips Cookies in the snacks category. Kellogg is focused not only on growth with innovative products, but also on integrating infrastructure, reducing costs, and creating optimal price/mix combinations. In 2006, the company began implementing a multi-year European manufacturing optimization plan in order to improve utilization of its facility in Manchester, England, and to better align production in Europe. In 2009 management plans to implement Kellogg LEAN (Lean Efficient Agile Network), a manufacturing optimization program designed to improve manufacturing utilization, reduce waste, and develop best practices across all manufacturing facilities. Acquisitions have augmented the company s portfolio of branded products. In November 2007, Kellogg s acquired Bear Naked, Inc. a leading seller of natural granola products, and certain assets and liabilities of the Wholesome & Hearty Foods Company (a U.S. manufacturer of veggie foods marketed under the Gardenburger ® brand). The company paid a total of approximately $122 million in cash for the businesses. In January 2008, the company acquired United Bakers Group, one of Russia s largest cracker, biscuit, and breakfast cereals manufacturers. Geographically, Kellogg expects emerging markets like Russia, Turkey, Latin America and Asia to be instrumental for the company s growth in the long-term. In June 2008, the company acquired Zhenghang Foods Company Ltd. (Navigable Foods), a leading manufacturer of cookies and crackers in the north and north-eastern regions of China. Founded in 1993, Navigable Foods markets cookies and crackers under the ZhengHang brand. The acquisition inlcuded two manufacturing facilities located in Yishui, Shandong province, and Fushun, Liaoning province, along with a distribution network. In September 2008, the company acquired IndyBake Products and Brownie Products Company, a privately held contract manufacturing business that produces crackers, cookies and frozen dough products. The acquisition of IndyBake includes two manufacturing facilities in Indiana and Illinois. Also in September, Kellogg s acquired Specialty Cereals Pty Limited, a privately-owned manufacturer of natural ready-to-eat cereals in Sydney, Australia. In December 2008, the company acquired the trademarks and recipes of Mother s Cake & Cookie Company, a regional brand with loyal consumers in the Western U.S. Management plans to expand the Mother's Cookies business using Kellogg s existing distribution infrastructure. During 2006, the company repurchased common stock worth $650 million, and in 2007, the Board of Directors authorized a share repurchase plan for another $650 million for 2008. In April 2007, the Board increased the dividend by 6.5% to $0.31 per share. During 2007, the company repurchased

Page 3

approximately $650 million worth of its shares, and during the first quarter of 2008, the company repurchased 12.8 million shares of its common stock, completing the $650 million share repurchase program. In July 2008, the Board announced an additional $500 million share repurchase authorization. In February 2009, a follow-on $650 million share repurchase authorization was announced.

BEAR STORY
The gross margin was negatively affected by 150 basis points (bps) in 2005, 60 bps in 2006, 24 bps in 2007, and 212 bps in 2008, mostly stemming from significant fuel, energy, and commodity price inflation. Although the majority of the inflationary pressures between 2005 and 2007 was commodity and energydriven, employee benefit costs also increased during the period, with total active and retired employee benefits expense having risen to $300 million in 2008 versus from $285 million in 2007. Therefore, like all food processors, the company is feeling the pressure of rising commodity costs. Despite cost saving initiatives and pricing actions, the gross margin in 2008, the gross margin declined 212 bps to 41.9%. In addition, upfront spending on cost savings initiatives (including plant closings, relocations, and SAP software implementation) is exerting pressure on margins. Cereal processing ovens at domestic and international facilities are fuelled by natural gas or propane, which are obtained from local utilities or other local suppliers. Short-term stand-by propane storage exists at several plants for use in case of interruption in natural gas supplies. Oil is also used to fuel certain operations at various plants. In addition, considerable amounts of diesel fuel are used in connection with the distribution of Kellogg s products. The cost of fuel, which is often subject to economic and political conditions, government policy and regulation, war, and/or other unforeseen circumstances, could adversely affect the company s operating results and/or financial condition. Product recalls occasionally impact earnings. In 2008, the company recalled certain Austin and Keebler branded peanut butter sandwich crackers and certain Famous Amos and Keebler branded peanut butter cookies as a result of potential contamination from ingredients supplied by the Peanut Corporation of America, a supplier to Kellogg. The recall was expanded in late January and February 2009 to include Bear Naked, Kashi, and Special K products which were impacted by that same supplier s ingredients. The costs of the recall negatively impacted the gross margin and operating profits in 2008. Management expects the recall to negatively impact earnings by $0.12, of which $0.06 was already incurred in 2008. During the first quarter of 2009, the recall impact was $0.05 per share. Kellogg s largest customer, Wal-Mart Stores, accounted for approximately 20% of net sales during 2008, comprising principally of sales within the United States. As of January 3, 2009, approximately 17% of the consolidated receivables balance and 27% of U.S. receivables balance were comprised by amounts owed by Wal-Mart. In addition, during 2008, the top five customers, collectively, accounted for approximately 33% of the company s net sales and approximately 42% of U.S. net sales. As the retail grocery trade continues to consolidate and mass marketers become larger, the company s large retail customers may seek to leverage their position to improve their profitability at the expense of Kellogg s.

RECENT NEWS
On July 30, 2009, Kellogg Company reported results for the second quarter of 2009 ending July 4, 2009. Earnings were $0.92 per diluted share, up 12.2% from $0.82 reported in the prior-year period. Earnings were $0.10 above expectations, but the stock lost $0.34 or 0.8% on the news. Net sales declined 3.4% year-over-year to $3.2 billion as the benefits from price/mix (+3.1%) and acquisitions (0.4%) were more than offset by the declines in tonnage (-0.5%) and currency translations (-6.4%). Internal sales, which exclude the effect of currency translations, increased 2.6%. In North America, net sales increased 2.3% (internal sales grew 3%) driven by growth in the Cereals, Snacks, Frozen, and Specialty categories.

Page 4

Kellogg s International operations experienced a net sales decline of 13.0% (internal sales increased 2%). The overall gross margin expanded 29 basis points (bps) to 43.5% compared to 43.2%, primarily as the effects of higher commodity prices were more than offset by pricing and cost savings initiatives. The operating margin expanded 128 bps to 17.1%. Cash flow for the first six months of 2009 was $510 million. Concurrent with the earnings release, management raised guidance for 2009. Earnings growth is now expected to be in the range of 8% to 10% on a currency-neutral basis. The guidance excludes the effects of foreign currency translation. Based on current rates, the company now expects a negative impact from foreign currency exchange of approximately 6% to earnings for the full year. Kellogg's guidance for the year includes a substantial increase in up-front charges for cost reduction initiatives of approximately $0.26 per share, higher than initial expectations of $0.14 per share.

VALUATION
During the last five years, a period of relatively stable and modest earnings growth, Kellogg s stock has traded in a narrow P/E range of 16.6 to 21.7 until the last quarter of 2008 when the global economic crisis impacted the financial markets. Ultimately, the stock s P/E multiple declined to 11.7. The stock is currently trading at a P/E multiple of 14.9. We expect agricultural commodity inflation to re-emerge in 2009. Hence, the target price is $51.00 based on a 16 P/E multiple on trailing 12 month earnings.

Description

Market Captalization

P/E

ROE%

Net Profit Margin (mmr)

Header

Header

Zacks Inve

Page 5

www.zacks.com

PROJECTED INCOME STATEMENT & BALANCE SHEET

Kellogg Company
Income Statement and Balance Sheet (Dollars in millions, except EPS data) 12/04 9,614 5,299 2,634 0 790 891 891 2.14 2.14 417 2,122 2,846 3,893 2,257 12/05 10,177 5,612 2,815 0 770 980 980 2.36 2.36 219 2,197 3,163 3,703 2,284 12/06 10,907 6,082 3,059 0 761 1,004 1,004 2.51 2.51 411 2,427 4,020 3,053 2,069 12/07 11,776 6,597 3,311 0 765 1,063 1,103 2.66 2.76 524 2,717 4,044 3,270 2,526 12/08 12,822 7,455 3,414 0 805 1,175 1,148 3.05 2.98 255 2,521 3,552 4,068 1,448 12/09E 12,627 7,341 3,362 0 793 1,224 1,224 3.20 3.20 423 2,466 4,000 3,843 1,773

Sales Cost of Goods Sold SG&A Other operating expenses Interest and other Zacks Adjusted Income before NRI Net Income Diluted EPS before NRI Reported EPS Cash & Marketable Securities Current Assets Current Liabilities Long Term Debt Shareholder's Equity

HISTORICAL ZACKS RECOMMENDATIONS

Zacks Investment Research

Page 6

www.zacks.com

DISCLOSURES
The analysts contributing to this report do not hold any shares of K. Zacks EPS and revenue forecasts are not consensus forecasts. Additionally, the analysts contributing to this report certify that the views expressed herein accurately reflect the analysts personal views as to the subject securities and issuers. Zacks certifies that no part of the analysts compensation was, is, or will be, directly or indirectly, related to the specific recommendation or views expressed by the analyst in the report. Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Because of individual objectives, the report should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions expressed herein are subject to change. This report is not to be construed as an offer or the solicitation of an offer to buy or sell the securities herein mentioned. Zacks or its officers, employees or customers may have a position long or short in the securities mentioned and buy or sell the securities from time to time. Zacks uses the following rating system for the securities it covers. Buy- Zacks expects that the subject company will outperform the broader U.S. equity market over the next one to two quarters. HoldZacks expects that the company will perform in line with the broader U.S. equity market over the next one to two quarters. Sell- Zacks expects the company will under perform the broader U.S. Equity market over the next one to two quarters. The current distribution of Zacks Ratings is as follows on the 1044 companies covered: Buy- 23.8%, Hold- 67.6%, Sell 8.1%. Data is as of midnight on the business day immediately prior to this publication. * FOOTNOTES: 2007 & 2008 quarterly EPS do not add up to the annual figure due to rounding. 2008 quarterly revenues do not add up to the annual figure due to rounding.

Zacks Investment Research

Page 7

www.zacks.com