Item 1. Business.
(a)General Development of Business General
Kraft Foods Inc. ("Kraft") was incorporated in 2000 in the Commonwealth of Virginia. Kraft, through its subsidiaries (Kraft and its subsidiaries are hereinafter referred to as the "Company"), is engaged in the manufacture and sale of packaged foods and beverages in the United States, Canada, Europe, Latin America, Asia Pacific, the Middle East and Africa.
Prior to June 13, 2001, Kraft was a wholly owned subsidiary of Altria Group, Inc. On June 13, 2001, Kraft completed an initial public offering ("IPO") of 280,000,000 shares of its Class A common stock at a price of $31.00 per share. At December 31, 2006, Altria Group, Inc. held 98.5% of the combined voting power of the Company's outstanding capital stock and owned 89.0% of the outstanding shares of the Company's capital stock.
Kraft Spin-Off from Altria Group, Inc.:
On January 31, 2007, the Altria Group, Inc. Board of Directors announced that Altria Group, Inc. plans to spin off all of its remaining interest (89.0%) in the Company on a pro rata basis to Altria Group, Inc. stockholders in a tax-free transaction. The distribution of all the Kraft shares owned by Altria Group, Inc. will be made on March 30, 2007 ("Distribution Date"), to Altria Group, Inc. stockholders of record as of the close of business on March 16, 2007 ("Record Date"). The exact distribution ratio will be calculated by dividing the number of Class A common shares of Kraft held by Altria Group, Inc. by the number of Altria Group, Inc. shares outstanding on the Record Date. Based on the number of shares of Altria Group, Inc. outstanding at December 31, 2006, the distribution ratio would be approximately 0.7 shares of Kraft Class A common stock for every share of Altria Group, Inc. common stock outstanding. Prior to the distribution, Altria Group, Inc. will convert its Class B shares of Kraft common stock, which carry ten votes per share, into Class A shares of Kraft, which carry one vote per share. Following the distribution, only Class A common shares of Kraft will be outstanding and Altria Group, Inc. will not own any shares of Kraft.
Holders of Altria Group, Inc. stock options will be treated as public stockholders and will, accordingly, have their stock awards split into two instruments. Holders of Altria Group, Inc. stock options will receive the following stock options, which, immediately after the spin-off, will have an aggregate intrinsic value equal to the intrinsic value of the pre-spin Altria Group, Inc. options:
•a new Kraft option to acquire the number of shares of Kraft Class A common stock equal to the product of (a) the number of Altria Group, Inc. options held by such person on the Distribution Date and (b) the approximate distribution ratio of 0.7 mentioned above; and
•an adjusted Altria Group, Inc. option for the same number of shares of Altria Group, Inc. common stock with a reduced exercise price.
Holders of Altria Group, Inc. restricted stock or stock rights awarded prior to January 31, 2007, will retain their existing award and will receive restricted stock or stock rights of Kraft Class A common stock. The amount of Kraft restricted stock or stock rights awarded to such holders will be calculated using the same formula set forth above with respect to new Kraft options. All of the restricted stock and stock rights will not vest until the completion of the original restriction period (typically, three years from the date of the original grant). Recipients of Altria Group, Inc. stock rights awarded on January 31, 2007, did not receive restricted stock or stock rights of Kraft. Rather, they will receive additional stock rights of Altria Group, Inc. to preserve the intrinsic value of the original award.
To the extent that employees of the remaining Altria Group, Inc. receive Kraft stock options, Altria Group, Inc. will reimburse the Company in cash for the Black-Scholes fair value of the stock options to be received. To the extent that Kraft employees hold Altria Group, Inc. stock options, the Company will reimburse Altria Group, Inc. in cash for the Black-Scholes fair value of the stock options. To the extent that holders of Altria Group, Inc. stock rights receive Kraft stock rights, Altria Group, Inc. will pay to the Company the fair value of the Kraft stock rights less the value of projected forfeitures. Based upon the number of Altria Group, Inc. stock awards outstanding at December 31, 2006, the net amount of these reimbursements would be a payment of approximately $133 million from the Company to Altria Group, Inc. Based upon the number of Altria Group, Inc. stock awards outstanding at December 31, 2006, the Company would have to issue 28 million stock options and 3 million shares of restricted stock and stock rights. The Company estimates that the issuance of these awards would result in an approximate $0.02 decrease in diluted earnings per share. However, these estimates are subject to change as stock awards vest (in the case of restricted stock) or are exercised (in the case of stock options) prior to the Record Date for the distribution.
As discussed in Note 2 to the Company's consolidated financial statements contained in Part II hereof, the Company is currently included in the Altria Group, Inc. consolidated federal income tax return, and federal income tax contingencies are recorded as liabilities on the balance sheet of Altria Group, Inc. Prior to the distribution of Kraft shares, Altria Group, Inc. will reimburse the Company in cash for these liabilities, which are approximately $300 million, plus interest.
As discussed in Note 4 to the Company's consolidated financial statements contained in Part II hereof, a subsidiary of Altria Group, Inc. currently provides the Company with certain services at cost plus a 5% management fee. After the Distribution Date, the Company will undertake these activities, and any remaining limited services provided by a subsidiary of Altria Group, Inc. will cease in 2007. All intercompany accounts will be settled in cash within 30 days of the Distribution Date.
Other:
In June 2005, the Company sold substantially all of its sugar confectionery business for pre-tax proceeds of approximately $1.4 billion. The Company has reflected the results of its sugar confectionery business prior to the closing date as discontinued operations on the consolidated statements of earnings.
In October 2005, the Company announced that, effective January 1, 2006, its Canadian business would be realigned to better integrate it into the Company's North American business by product category. Beginning in the first quarter of 2006, the operating results of the Canadian business were being reported throughout the North American food segments. In addition, in the first quarter of 2006, the Company's international businesses were realigned to reflect the reorganization announced within Europe in November 2005. The two revised international segments, which are reflected in the consolidated financial statements and notes, are European Union; and Developing Markets, Oceania & North Asia, the latter to reflect the Company's increased management focus on developing markets. Accordingly, prior period segment results have been restated.
In January 2004, the Company announced a three-year restructuring program with the objectives of leveraging the Company's global scale, realigning and lowering its cost structure, and optimizing capacity utilization. In January 2006, the Company announced plans to expand its restructuring efforts through 2008. The entire restructuring program is expected to result in $3.0 billion in pre-tax charges reflecting asset disposals, severance and implementation costs. The decline of $700 million from the $3.7 billion in pre-tax charges previously announced was due primarily to lower than projected severance costs, the cancellation of an initiative intended to generate sales efficiencies, and the sale of one plant that was originally planned to be closed. As part of this program, the Company anticipates the closure of up to 40 facilities and the elimination of approximately 14,000 positions. Approximately $1.9 billion of the $3.0 billion in pre-tax charges are expected to require cash payments. Pre-tax restructuring program charges, including implementation costs, for the years ended December 31, 2006, 2005 and 2004 were $673 million, $297 million and $641 million, respectively. Total pre-tax restructuring charges incurred since the inception of the program in January 2004 were $1.6 billion.
Source of Funds-Dividends
Because Kraft is a holding company, its principal source of funds is dividends from its subsidiaries. Kraft's principal wholly owned subsidiaries currently are not limited by long-term debt or other agreements in their ability to pay cash dividends or make other distributions with respect to their common stock.
(b)Financial Information About Segments The Company manufactures and markets packaged food products, consisting principally of beverages, cheese, snacks, convenient meals and various packaged grocery products. The Company manages and reports operating results through two units: Kraft North America Commercial and Kraft International Commercial. Kraft North America Commercial operates in the United States and Canada, and manages its operations principally by product category, while Kraft International Commercial manages its operations by geographic region. The Company has operations in 72 countries and sells its products in more than 155 countries.
In October 2005, the Company announced that, effective January 1, 2006, its Canadian business will be realigned to better integrate it into the Company's North American business by product category. Beginning in the first quarter of 2006, the operating results of the Canadian business are being reported throughout the North American food segments. Kraft North America Commercial's segments at December 31, 2006 were North America Beverages; North America Cheese & Foodservice; North America Convenient Meals; North America Grocery; and North America Snacks & Cereals. In addition, in the first quarter of 2006, the Company's international businesses were realigned to reflect the reorganization announced within Europe in November 2005. Kraft International Commercial's segments at December 31, 2006 were European Union; and Developing Markets, Oceania & North Asia, the latter to reflect the Company's increased management focus on developing markets. Accordingly, prior period segment results have been restated.
Net revenues and operating companies income* attributable to each segment (together with a reconciliation to consolidated operating income) for each of the last three years are set forth in Note 14 to the Company's consolidated financial statements contained in Part II hereof.
The relative percentages of operating companies income attributable to each reportable segment were as follows:
*The Company's management uses operating companies income, which is defined as operating income before general corporate expenses and amortization of intangibles, to evaluate segment performance and allocate resources. Management believes it is appropriate to disclose this measure to help investors analyze business performance and trends of the various business segments.
(c)Narrative Description of Business Markets and Products
The Company's brands span five consumer sectors, as follows:
•Snacks-primarily cookies, crackers, salted snacks and chocolate confectionery;
•Beverages-primarily coffee, aseptic juice drinks, flavored water and powdered beverages;
•Cheese & Dairy-primarily natural, process and cream cheeses;
•Grocery-primarily ready-to-eat cereals, enhancers and desserts; and
•Convenient Meals-primarily frozen pizza, packaged dinners, lunch combinations and processed meats.
The following table shows each reportable segment's participation in these five core consumer sectors.
(1)The amounts of net revenues, total assets and long-lived assets attributable to each of the Company's geographic regions and the amounts of net revenues and operating companies income of each of the Company's reportable segments for each of the last three years are set forth in Note 14 to the Company's consolidated financial statements contained in Part II hereof.
(2)Percentages are calculated based upon dollars rounded to millions.
Additional Product Disclosure
Products or similar products contributing 10% or more of the Company's consolidated net revenues for each of the three years in the period ended December 31, 2006, were as follows:
The Company's major brands within each reportable segment are as follows:
Kraft North America Commercial:
North America Beverages
Beverages:
Maxwell House, General Foods International, Starbucks (under license), Yuban, Sanka, Nabob, Gevalia, Tassimo, and Seattle's Best (under license) coffees; Capri Sun (under license), Kool-Aid, and Crystal Light aseptic juice drinks; Kool-Aid, Tang, Crystal Light, and Country Time powdered beverages; Veryfine juices; Tazo teas (under license); and Fruit2O water.
North America Cheese & Foodservice
Cheese & Dairy:
Kraft and Cracker Barrel natural cheeses; Philadelphia cream cheese; Kraft, Velveeta, and Cheez Whiz process cheeses; Kraft grated cheeses; Polly-O cheese; Deli Deluxe process cheese slices; and Knudsen and Breakstone's cottage cheese and sour cream.
North America Convenient Meals
Convenient Meals:
DiGiorno, Tombstone, Jack's, Delissio and California Pizza Kitchen (under license) frozen pizzas; Lunchables lunch combinations; Oscar Mayer and Louis Rich cold cuts, hot dogs, and bacon; Boca soy-based meat alternatives; Kraft macaroni & cheese dinners; South Beach Diet (under license) pizzas and meals; Taco Bell Home Originals (under license) meal kits; and Stove Top stuffing mix.
Grocery:
Back to Nature crackers, cookies, cereals and macaroni & cheese dinners.
North America Grocery
Grocery:
Jell-O dry packaged desserts; Cool Whip frozen whipped topping; Jell-O refrigerated gelatin and pudding snacks; Handi-Snacks shelf-stable pudding snacks; Kraft and Miracle Whip spoonable dressings; Kraft and Good Seasons salad dressings; A.1.steak sauce; Kraft and Bull's-Eye barbecue sauces; Grey Poupon premium mustards; Shake' N Bake coatings; and Kraft peanut butter.
North America Snacks &
Cereals
Snacks:
Oreo, Chips Ahoy!, Newtons, Nilla, Nutter Butter, SnackWell's and Peek Freans cookies; Ritz, Premium, Triscuit, Wheat Thins, Cheese Nips, Honey Maid Grahams, and Teddy Grahams crackers; South Beach Diet (under license) crackers, cookies and snack bars; Planters nuts and salted snacks; Handi-Snacks two-compartment snacks; Terry's and Toblerone chocolate confectionery products; and Balance nutrition and energy snacks.
Cheese & Dairy:
Easy Cheese aerosol cheese spread.
Grocery:
Post ready-to-eat cereals.
Kraft International Commercial:
European Union
Snacks:
Milka, Suchard, Côte d'Or, Marabou, Toblerone, Freia, Terry's, Daim / Dime, Figaro, Karuna, Lacta, Pavlides, Twist, Merenda, Meurisse, Prince Polo / Siesta, Mirabell, Pyros Mogyoros, Alpen Gold, Sport / Smash / Jazz, 3-Bit and Belvita chocolate confectionery products; and Estrella and Maarud salted snacks; Oreo, Dorada, Digestive and Chiquilin biscuits.
Beverages:
Jacobs, Gevalia, Carte Noire, Jacques Vabre, Kaffee HAG, Grand' Mère, Kenco, Saimaza, Meisterroestung, Maxwell House, Onko, Splendid, Karat and Tassimo coffees; Tang powdered beverages; and Suchard Express, O'Boy and Kaba chocolate drinks.
Cheese & Dairy:
Kraft, Dairylea, Sottilette, Osella, Mama Luise and El Caserío cheeses; and Philadelphia cream cheese.
Grocery:
Kraft pourable and spoonable salad dressings; Miracel Whip spoonable dressings; and Mirácoli sauces.
Convenient Meals:
Lunchables lunch combinations; Kraft and Mirácoli pasta dinners and sauces; and Simmenthal canned meats.
Developing Markets, Oceania & North Asia
Snacks:
Oreo, Chips Ahoy!, Ritz, Club Social, Express, Kraker, Honey, Aveny, Marbu, Dorada, Pepitos, Variedad, Pacific, Belvita, Cerealitas, Lucky, and Trakinas biscuits; Milka, Toblerone, Lacta, Côte d'Or, Shot, Terrabusi, Suchard, Alpen Gold, Karuna, Korona, Poiana, Svoge, Ukraina, Vozdushny, Chudny Vecher, Terry's, and Gallito chocolate confectionery products; and Estrella, Maarud, Kar, Lux, Planters nuts and salted snacks.
Beverages:
Maxwell House, Maxim, Nova Brasilia and Jacobs coffee; Tang, Clight, Kool-Aid, Verao, Frisco, Q-Refresh-Ko, Royal and Fresh powdered beverages; Maguary juice concentrate and
ready-to-drink beverages; and Capri Sun (under license) aseptic juice drinks.
Cheese & Dairy:
Kraft, Velveeta and Eden process cheeses; Kraft and Philadelphia cream cheese; Kraft natural cheese; and Cheez Whiz process cheese spread.
Grocery:
Royal dry packaged desserts; Post ready-to-eat cereals; Kraft spoonable and pourable salad dressings; Miracle Whip spoonable dressings; Jell-O dessert toppings; Kraft peanut butter; and Vegemite yeast spread.
Convenient Meals:
Kraft macaroni & cheese dinners.
Distribution, Competition and Raw Materials
Kraft North America Commercial's products are generally sold to supermarket chains, wholesalers, supercenters, club stores, mass merchandisers, distributors, convenience stores, gasoline stations, drug stores, value stores and other retail food outlets. In general, the retail trade for food products is consolidating. Food products are distributed through distribution centers, satellite warehouses, company-operated and public cold-storage facilities, depots and other facilities. Most distribution in North America is in the form of warehouse delivery, but biscuits and frozen pizza are distributed through two direct-store delivery systems. The Company supports its selling efforts through three principal sets of activities: consumer advertising in broadcast, print, outdoor, and on-line media; consumer promotions such as coupons and contests; and trade promotions to support price features, displays and other merchandising of our products by our customers. Subsidiaries and affiliates of Kraft International Commercial sell their food products primarily in the same manner and also engage the services of independent sales offices and agents.
Kraft North America Commercial and Kraft International Commercial are subject to competitive conditions in all aspects of their business. Competitors include large national and international companies and numerous local and regional companies. Some competitors may have different profit objectives and some international competitors may be more or less susceptible to currency exchange rates. Products of Kraft North America Commercial and Kraft International Commercial also compete with generic products and retailer brands, wholesalers and cooperatives. Kraft North America Commercial, Kraft International Commercial and their subsidiaries compete primarily on the basis of product quality, brand recognition, brand loyalty, service, marketing, advertising and price. Substantial advertising and promotional expenditures are required to maintain or improve a brand's market position or to introduce a new product.
Kraft North America Commercial and Kraft International Commercial are major purchasers of milk, cheese, nuts, green coffee beans, cocoa, corn products, wheat, pork, poultry, beef, vegetable oil, and sugar and other sweeteners. They also use significant quantities of glass, plastic and cardboard to package their products. They continuously monitor worldwide supply and cost trends of these commodities to enable them to take appropriate action to obtain ingredients and packaging needed for production. Kraft North America Commercial and Kraft International Commercial purchase a substantial portion of their dairy raw material requirements, including milk and cheese, from independent third parties such as agricultural cooperatives and independent processors. The prices for milk and other dairy product purchases are substantially influenced by government programs, as well as by market supply and demand. Dairy commodity costs on average were lower in 2006 than in 2005.
The most significant cost item in coffee products is green coffee beans, which are purchased on world markets. Green coffee bean prices are affected by the quality and availability of supply, trade agreements among producing and consuming nations, the unilateral policies of the producing nations, changes in the value of the United States dollar in relation to certain other currencies and consumer
demand for coffee products. In 2006, coffee bean costs on average were higher than in 2005. A significant cost item in chocolate confectionery products is cocoa, which is purchased on world markets, and the price of which is affected by the quality and availability of supply and changes in the value of the British pound sterling and the United States dollar relative to certain other currencies. In 2006, cocoa bean and cocoa butter costs on average were lower as compared to 2005.
During 2006, aggregate commodity costs continued to rise for the Company, with significant impacts resulting from higher energy, packaging and coffee costs, partially offset by lower cheese and meat costs. For 2006, the Company's commodity costs were approximately $275 million higher than 2005, following an increase of approximately $800 million for 2005 compared with 2004. The Company expects the higher cost environment to continue, particularly for energy and packaging.
The prices paid for raw materials and agricultural materials used in the products of Kraft North America Commercial and Kraft International Commercial generally reflect external factors such as weather conditions, commodity market fluctuations, currency fluctuations and the effects of governmental agricultural programs. Although the prices of the principal raw materials can be expected to fluctuate as a result of these factors, the Company believes such raw materials to be in adequate supply and generally available from numerous sources. The Company uses hedging techniques to minimize the impact of price fluctuations in its principal raw materials. However, it does not fully hedge against changes in commodity prices and these strategies may not protect the Company or its subsidiaries from increases in specific raw material costs.
Regulation
All of Kraft North America Commercial's United States food products and packaging materials are subject to regulations administered by the Food and Drug Administration ("FDA") or, with respect to products containing meat and poultry, the Food Safety and Inspection Service of the United States Department of Agriculture. Among other things, these agencies enforce statutory prohibitions against misbranded and adulterated foods, establish safety standards for food processing, establish ingredients and manufacturing procedures for certain foods, establish standards of identity for certain foods, determine the safety of food additives and establish labeling standards and nutrition labeling requirements for food products.
In addition, states enforce food laws, such as regulating the business of Kraft North America Commercial's operating units by licensing plants, enforcing federal and state standards of identity for selected food products, grading food products, inspecting plants, regulating certain trade practices in connection with the sale of dairy products and imposing their own labeling requirements on food products.
Many of the food commodities on which Kraft North America Commercial's United States businesses rely are subject to governmental agricultural programs. These programs have substantial effects on prices and supplies and are subject to Congressional and administrative review.
Almost all of the activities of the Company's food operations outside of the United States are subject to local and national regulations similar to those applicable to Kraft North America Commercial's United States businesses and, in some cases, international regulatory provisions, such as those of the European Union regarding labeling, packaging, food content, pricing, marketing and advertising and related areas.
The European Union and certain individual countries require that food products containing genetically modified organisms or classes of ingredients derived from them be labeled accordingly. Other countries may adopt similar regulations. The FDA has concluded that there is no basis for similar mandatory labeling under current United States law.
Acquisitions and Divestitures
During the third quarter of 2006, the Company acquired the Spanish and Portuguese operations of United Biscuits ("UB"), and rights to all Nabisco trademarks in the European Union, Eastern Europe, the Middle East and Africa, which UB has held since 2000, for a total cost of approximately $1.1 billion. The Spanish and Portuguese operations of UB include its biscuits, dry desserts, canned meats, tomato and fruit juice businesses as well as seven manufacturing facilities and 1,300 employees. From September 2006 to December 31, 2006, these businesses contributed net revenues of $111 million. The non-cash acquisition was financed by the Company's assumption of $541 million of debt issued by the acquired business immediately prior to the acquisition, as well as $530 million of value for the redemption of the Company's outstanding investment in UB, primarily deep-discount securities. The redemption of the Company's investment in UB resulted in a pre-tax gain on closing of $251 million.
Aside from the debt assumed as part of the acquisition price, the Company acquired assets consisting primarily of goodwill of $734 million, other intangible assets of $217 million, property, plant and equipment of $161 million, receivables of $101 million and inventories of $34 million. These amounts represent the preliminary allocation of purchase price and are subject to revision when appraisals are finalized, which is expected to occur during the first quarter of 2007.
During 2006, the Company sold its rice brand and assets, and its industrial coconut assets. The Company also sold its pet snacks brand and assets in 2006 and recorded tax expense of $57 million related to the sale. In addition, the Company incurred a pre-tax asset impairment charge of $86 million in 2006 in recognition of this sale. Additionally, during 2006, the Company sold certain Canadian assets and a small U.S. biscuit brand, and incurred pre-tax asset impairment charges of $176 million in 2005 in recognition of these sales. Also during 2006, the Company sold a U.S. coffee plant. The aggregate proceeds received from these sales were $946 million, on which the Company recorded pre-tax gains of $117 million.
In January 2007, the Company announced the sale of its hot cereal assets and trademarks. In recognition of the anticipated sale, the Company recorded a pre-tax asset impairment charge of $69 million in 2006 for these assets. This amount represents the preliminary estimates and is subject to revision upon the finalization of the sale, which is expected in the first half of 2007.
In June 2005, the Company sold substantially all of its sugar confectionery business for pre-tax proceeds of approximately $1.4 billion. The sale included the Life Savers, Creme Savers, Altoids, Trolli and Sugus brands. The Company has reflected the results of its sugar confectionery business prior to the closing date as discontinued operations on the consolidated statements of earnings. The Company recorded a loss on sale of discontinued operations of $297 million in the second quarter of 2005, related largely to taxes on the transaction.
During 2005, the Company sold its fruit snacks assets, and incurred a pre-tax asset impairment charge of $93 million in recognition of this sale. Additionally, during 2005, the Company sold its U.K. desserts assets, its U.S. yogurt assets, a small business in Colombia, a minor trademark in Mexico and a small equity investment in Turkey. The aggregate proceeds received from these sales were $238 million, on which the Company recorded pre-tax gains of $108 million.
During 2004, the Company sold a Brazilian snack nuts business and trademarks associated with a candy business in Norway. The aggregate proceeds received from the sales of these businesses were $18 million, on which pre-tax losses of $3 million were recorded.
During 2004, the Company acquired a U.S.-based beverage business for a total cost of $137 million.
The operating results of the businesses acquired and sold, other than the UB acquisition and the divestiture of the sugar confectionery business, in the aggregate, were not material to the Company's consolidated financial position, results of operations or cash flows in any of the periods presented.
Other Matters
Customers
For the years ended December 31, 2006, 2005 and 2004, the Company's five largest customers accounted for approximately 29%, 26% and 28%, respectively, of its net revenues, and the Company's ten largest customers accounted for approximately 40%, 37% and 38%, respectively, of its net revenues. One of the Company's customers, Wal-Mart Stores, Inc., accounted for approximately 15%, 14% and 14% of net revenues for 2006, 2005 and 2004, respectively.
Employees
At December 31, 2006, the Company employed approximately 90,000 people worldwide. Approximately 30% of the Company's 41,000 employees in the United States are represented by labor unions. Most of the unionized workers at the Company's domestic locations are represented under contracts with the Bakery, Confectionery, Tobacco Workers and Grain Millers International Union; the United Food and Commercial Workers International Union; and the International Brotherhood of Teamsters. These contracts expire at various times throughout the next several years. Outside the United States, labor unions or workers' councils represent approximately 55% of the Company's 49,000 employees. The Company's business units are subject to a number of laws and regulations relating to their relationships with their employees. These laws and regulations are specific to the location of each enterprise. In addition, in accordance with European Union requirements, Kraft International Commercial has established European Works Councils composed of management and elected members of its workforce. The Company believes that its relations with employees and their representative organizations are good.
In January 2004, the Company announced a three-year restructuring program. In January 2006, the Company announced plans to expand its restructuring efforts through 2008. The entire restructuring program is expected to result in the elimination of approximately 14,000 positions. At December 31, 2006, approximately 8,400 of these positions have been eliminated.
Research and Development
The Company pursues four objectives in research and development: product safety and quality; growth through new products; superior consumer satisfaction; and reduced costs.
The Company's research and development resources include more than 2,000 food scientists, chemists and engineers, deployed primarily in five key technology centers: East Hanover, New Jersey; Glenview, Illinois; Tarrytown, New York; Banbury, United Kingdom; and Munich, Germany. These technology centers are equipped with pilot plants and state-of-the-art instruments. Research and development expense was $419 million in 2006, $385 million in 2005 and $388 million in 2004.
Trademarks and Intellectual Property
Trademarks are of material importance to the Company's businesses and are protected by registration or otherwise in the United States and most other markets where the related products are sold. The Company has from time to time granted various parties exclusive or non-exclusive licenses to use one or more of its trademarks in particular locations. The Company does not believe that these licensing arrangements have had a material effect on the conduct of its business or operating results.
Some of the Company's products are sold under brands that have been licensed from others on terms that are generally renewable at the Company's discretion. These licensed brands include Starbucks bagged coffee, Seattle's Best coffee, and Torrefazione Italia coffee for sale in United States grocery stores and other distribution channels, Capri Sun aseptic juice drinks for sale in the United States and Canada, Taco Bell Home Originals Mexican style food products for sale in United States grocery stores, California Pizza Kitchen frozen pizzas for sale in grocery stores in the United States and
Canada, Pebbles ready-to-eat cereals, Tazo teas for sale in grocery stores in the United States, and South Beach Diet pizzas, meals, breakfast wraps, lunch wrap kits, crackers, cookies, snack bars, cereals and dressings for sale in grocery stores in the United States. The Company also has a license agreement to make Seattle's Best coffee and Tazo teas T-Discs for use in the Company Tassimo hot beverage system.
Similarly, the Company owns thousands of patents worldwide, and the patent portfolio as a whole is material to the Company's business; however, no one patent or group of related patents is material to the Company. In addition, the Company has proprietary trade secrets, technology, know-how processes and other intellectual property rights that are not registered.
Seasonality
Demand for certain of the Company's products may be influenced by holidays, changes in seasons or other annual events. Due to the offsetting nature of demands for the Company's diversified product portfolio, however, sales of the Company's products are generally evenly balanced throughout the year.
Environmental Regulation
The Company is subject to various federal, state, local and foreign laws and regulations concerning the discharge of materials into the environment, or otherwise related to environmental protection, including, in the United States, the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act and the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (commonly known as "Superfund"), which imposes joint and several liability on each responsible party. As of December 31, 2006, subsidiaries of the Company were involved in 75 active Superfund and other actions in the United States related to current operations and certain former or divested operations for which the Company retains liability.
Outside the United States, the Company is subject to applicable multi-national, national and local environmental laws and regulations in the host countries in which the Company does business. The Company has specific programs across its international business units designed to meet applicable environmental compliance requirements.
Although it is not possible to predict precisely the estimated costs for environmental-related expenditures, compliance with such laws and regulations, including the payment of any remediation costs and the making of such expenditures, has not had, and is not expected to have, a material adverse effect on the Company's results of operations, capital expenditures, financial position, earnings, cash flows or competitive position.
Forward-Looking Statements
The Company and its representatives may from time to time make written or oral forward-looking statements, including statements contained in the Company's filings with the SEC, in its reports to shareholders and in press releases and investor webcasts. One can identify these forward-looking statements by use of words such as "strategy," "expects," "plans," "anticipates," "believes," "will," "continues," "estimates," "intends," "projects," "goals," "targets" and other words of similar meaning. One can also identify them by the fact that they do not relate strictly to historical or current facts. The Company cannot guarantee that any forward-looking statement will be realized, although it believes that it has been prudent in its plans and assumptions. Achievement of future results is subject to risks, uncertainties, and the possibility of inaccurate assumptions. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could vary materially from those anticipated, estimated, or projected. Investors should bear this in mind as they consider forward-looking statements and whether to invest in or remain invested in the Company's securities. In connection with the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, the Company identifies from time to time important factors that could cause actual results and
outcomes to differ materially from those contained in any forward-looking statement made by or on behalf of the Company. These factors include the ones discussed in the "Risk Factors" section below and the "Business Environment" section preceding the discussion of operating results, as well as other factors discussed in filings made by the Company with the SEC. It is not possible to predict or identify all risk factors. Consequently, the risk factors discussed in this document should not be considered a complete discussion of all potential risks or uncertainties. The Company does not undertake to update any forward-looking statement that it may make from time to time.
(d)Financial Information About Geographic Areas The amounts of net revenues, total assets and long-lived assets attributable to each of the Company's geographic segments for each of the last three fiscal years are set forth in Note 14 to the Company's consolidated financial statements contained in Part II hereof.
Kraft's U.S. subsidiaries export coffee products, refreshment beverages products, grocery products, cheese, biscuits, and processed meats. In 2006, exports from the United States by these subsidiaries amounted to approximately $151 million.
(e)Available Information The Company is required to file annual, quarterly and special reports, proxy statements and other information with the SEC. Investors may read and copy any document that the Company files, including this Annual Report on Form 10-K, at the SEC's Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Investors may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet site at www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC, from which investors can electronically access the Company's SEC filings.
The Company makes available free of charge on or through its website (www.kraft.com) its Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after it electronically files such material with, or furnishes the material to, the SEC. Investors can also access the Company's filings with the SEC by visiting http://kraft.com/investors/sec_filings_annual_reports.html. The information on the Company's website is not, and shall not be deemed to be, a part of this Report or incorporated into any other filings the Company makes with the SEC.
Item 1A.
Item 1A. Risk Factors.
The following risk factors should be read carefully in connection with evaluating the Company's business and the forward-looking information contained in this Annual Report on Form 10-K. Any of the following risks could materially adversely affect the Company's business, operating results, financial condition and the actual outcome of matters as to which forward-looking statements are made in this Annual Report on Form 10-K. While the Company believes it has identified and discussed below the key risk factors affecting its business, there may be additional risks and uncertainties that are not presently known or that are not currently believed to be significant that may adversely affect the Company's business, performance or financial condition in the future.
The Company's profitability may suffer as a result of competition in its markets.
The food industry is intensely competitive. Competition in the Company's product categories is based on price, product innovation, product quality, brand recognition and loyalty, effectiveness of marketing, promotional activity and the ability to identify and satisfy consumer preferences. From time to time, the Company may need to reduce the prices for some of its products to respond to competitive and customer pressures and to maintain market share. Such pressures also may restrict the Company's ability to increase prices, including in response to commodity and other cost increases. The Company's results of operations will suffer if profit margins decrease, either as a result of a reduction in prices or increased costs, and the Company is not able to increase sales volumes to offset those margin decreases.
In order to protect existing market share or capture increased market share in this highly competitive environment, the Company may also need to increase its spending on marketing, advertising and new product innovation. The success of marketing, advertising and new product innovation is subject to risks, including uncertainties about trade and consumer acceptance. As a result, increased expenditures by the Company may not maintain or enhance market share and could result in lower profitability.
The Company must leverage its brand value propositions to compete against lower-priced private label items and offset economic downturns.
Retailers are increasingly offering private label products that compete with the Company's products. The willingness of consumers to purchase the Company's products will depend upon the Company's ability to offer brand value propositions-products providing the right bundle of consumer benefits at the right price. This in turn depends in part on the perception that the Company's products are of a higher quality than less expensive alternatives. If the difference in quality between the Company's products and store brands narrows, or if there is a perception of such a narrowing, consumers may choose not to buy the Company's products. Furthermore, in periods of economic uncertainty, consumers tend to purchase more private label or other economy brands, which could result in a reduction in the volume of sales of the Company's higher margin products or a shift in the Company's product mix to lower margin offerings. The Company's ability to maintain or improve its brand value propositions will impact whether these circumstances will result in decreased market share and profitability of the Company.
The consolidation of retail customers may put pressures on the Company's operating margins and profitability.
The Company's customers such as supermarkets, warehouse clubs and food distributors, have consolidated in recent years and consolidation is expected to continue throughout the U.S., the European Union and other major markets. These consolidations have produced large, sophisticated customers with increased buying power who are more capable of operating with reduced inventories, resisting price increases, and demanding lower pricing, increased promotional programs and specifically tailored products. These customers also may use shelf space currently used for the
Company's products for their private label products. If the Company fails to respond to these trends, its volume growth could slow or it may need to lower prices or increase promotional spending for its products, any of which would adversely affect its profitability.
Commodity price increases will increase operating costs and may reduce profitability.
The Company is a major purchaser of milk, cheese, plastic, nuts, green coffee beans, cocoa, corn products, wheat, pork, poultry, beef, vegetable oil, sugar, other sweeteners and numerous other commodities. Commodities such as these often experience price volatility caused by conditions outside of the Company's control, including fluctuations in commodities markets, currency fluctuations and changes in governmental agricultural programs. Commodity prices impact the Company's business directly through the cost of raw materials used to make the Company's products (such as cheese), the cost of inputs used to manufacture and ship the Company's products (such as oil and energy) and the amount the Company pays to produce or purchase packaging for its products (such as cardboard and plastic). For 2006, the Company's commodity costs were approximately $275 million higher than 2005, following an increase of approximately $800 million for 2005 compared with 2004. If, as a result of consumer sensitivity to pricing or otherwise, the Company is unable to increase its prices to offset increased cost of commodities, the Company may experience lower profitability.
Sales of the Company's products are subject to changing consumer preferences, and the Company's success depends upon its ability to predict, identify and interpret changes in consumer preferences and develop and offer new products rapidly enough to meet those changes.
The Company's success depends on its ability to predict, identify and interpret the tastes and dietary habits of consumers and to offer products that appeal to those preferences. Consumer preferences for food products are ever-changing. For example, recently, consumers have been increasingly focused on health and wellness with respect to the food products they buy. As a result, the Company's products have been subject to scrutiny relating to genetically modified organisms and the health implications of obesity and trans-fatty acids. The Company has been and will continue to be impacted by publicity concerning the health implications of its products, which could negatively influence consumer perception and acceptance of the Company's products and marketing programs.
Furthermore, if the Company does not succeed in offering products that consumers want to buy, the Company's sales and market share will decrease, resulting in reduced profitability. A significant challenge for the Company is distinguishing among fads, mid-term trends and lasting changes in the Company's consumer environment. If the Company is unable to accurately predict which shifts in consumer preferences will be long-lasting, or to introduce new and improved products to satisfy those preferences, its sales will decline. In addition, given the variety of backgrounds and identities of consumers in the Company's consumer base, the Company must offer a sufficient array of products to satisfy the broad spectrum of consumer preferences. As such, the Company must be successful in developing innovative products across a multitude of product categories. Finally, if the Company fails to rapidly develop products in faster growing and more profitable categories, the Company could experience reduced demand for its products.
The Company's foreign operations are subject to additional risks.
The Company operates its business and markets its products internationally. In 2006 and 2005, 39% and 38%, respectively, of the Company's sales were generated in foreign countries. The Company's foreign operations are subject to the risks described in this section, as well as risks related to fluctuations in currency values, foreign currency exchange controls, discriminatory fiscal policies, compliance with foreign laws, enforcement of remedies in foreign jurisdictions and other economic or political uncertainties. In particular, the Company's subsidiaries conduct their businesses in local currency and, for purposes of financial reporting, their results are translated into U.S. dollars based on average
exchange rates prevailing during a reporting period. During times of a strengthening U.S. dollar, the Company's reported net revenues and operating income will be reduced because the local currency will translate into fewer U.S. dollars. Additionally, international sales are subject to risks related to imposition of tariffs, quotas, trade barriers and other similar restrictions. All of these risks could result in increased costs or decreased revenues, either of which could adversely affect the Company's profitability.
The Company may not be able to successfully implement its restructuring program.
The Company's future success and earnings growth depend in part on its ability to make products efficiently. In January 2004, the Company announced a three-year restructuring program with the objectives of leveraging the Company's global scale, realigning and lowering its cost structure, and optimizing capacity utilization. In January 2006, the Company announced plans to expand its restructuring efforts through 2008. If the Company is unable to successfully implement the restructuring program, it may not be able to fully recognize the estimated cost benefits. Conversely, if the implementation of the program has a negative impact on the Company's relationships with employees, major customers or vendors, the Company's profitability could be adversely affected.
The Company may not be able to successfully consummate proposed acquisitions or divestitures or integrate acquired businesses.
From time to time, the Company evaluates acquiring other businesses that would strategically fit within the Company. If the Company is unable to consummate, successfully integrate and grow these acquisitions and to realize contemplated revenue synergies and cost savings, its financial results could be adversely affected. In addition, the Company may, from time to time, divest businesses that are less of a strategic fit within its portfolio or do not meet its growth or profitability targets, and the Company's profitability may be impacted by either gains or losses on the sales of, or lost operating income from, those businesses. The Company may also not be able to divest businesses that are not core businesses or may not be able to do so on terms that are favorable to the Company. In addition, the Company may be required to incur asset impairment charges related to acquired or divested businesses which may reduce the Company's profitability. These potential acquisitions or divestitures present financial, managerial and operational challenges, including diversion of management attention from existing businesses, difficulty with integrating or separating personnel and financial and other systems, increased expenses, assumption of unknown liabilities, indemnities and potential disputes with the buyers or sellers.
The Company may experience liabilities or negative effects on its reputation as a result of product recalls, product injuries or other legal claims.
The Company sells products for human consumption, which involves a number of legal risks. Product contamination, spoilage or other adulteration, product misbranding or product tampering could require the Company to recall products. The Company may also be subject to liability if its products or operations violate applicable laws or regulations or in the event its products cause injury, illness or death. In addition, the Company advertises its products and could be the target of claims relating to false or deceptive advertising under U.S. federal and state laws as well as foreign laws, including consumer protection statutes of some states. A significant product liability or other legal judgment against the Company or a widespread product recall may negatively impact the Company's profitability. Even if a product liability or consumer fraud claim is unsuccessful or is not merited or fully pursued, the negative publicity surrounding such assertions regarding the Company's products or processes could adversely affect its reputation and brand image.
New regulations could adversely affect the Company's business.
Food production and marketing are highly regulated by a variety of federal, state, local and foreign agencies, and new regulations and changes to existing regulations are issued regularly. Increased
government regulation of the food industry, such as recent requirements regarding the labeling of trans-fat content, could result in increased costs to the Company and adversely affect its profitability.
The Kraft Spin-Off from Altria Group, Inc. may cause short-term volatility in the trading volume and market price of the Company's common stock.
On January 31, 2007, the Altria Group, Inc. Board of Directors announced that Altria Group, Inc. plans to spin off all of its remaining interest (89.0%) in the Company on a pro rata basis to Altria Group, Inc. stockholders in a tax-free transaction. When the spin-off occurs, it will significantly change the profile of the Company's stockholders. If a number of the Company's new stockholders choose to sell their shares, or if there is a perception that such sales might occur, this may cause short-term volatility in the trading volume and market price of the Company's common stock.
Changes in the Company's credit ratings may have a negative impact on the Company's financing costs.
The Company maintains revolving credit facilities that have historically been used to support the issuance of commercial paper. A downgrade in the Company's credit ratings, particularly its short-term debt rating, would likely reduce the amount of commercial paper the Company could issue, raise the Company's borrowing costs, or both.
Volatility in the equity markets or interest rates could substantially increase the Company's pension costs.
The projected benefit obligation and assets of the Company's defined benefit pension plans as of the end of fiscal 2006 were $10.4 billion and $10.5 billion, respectively. The difference between plan obligations and assets, or the funded status of the plans, is a significant factor in determining the net periodic benefit costs of the Company's pension plans and the ongoing funding requirements of those plans. Changes in interest rates, mortality rates, early retirement rates, investment returns and the market value of plan assets can impact the funded status of these plans and cause volatility in the net periodic benefit cost and future funding requirements of these plans. In addition, any disposition of certain businesses and the terms of those disposition transactions may impact future contributions to the benefit plans and the related net periodic benefit cost. A significant increase in the Company's funding requirements could have a negative impact on its results of operations.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
The Company has 159 manufacturing and processing facilities worldwide. In North America, the Company has 67 facilities, and outside of North America there are 92 facilities located in 41 countries. These manufacturing and processing facilities are located throughout the following territories:
The Company owns 154 and leases 5 of these manufacturing and processing facilities. All of the Company's plants and properties are maintained in good condition, and the Company believes that they are suitable and adequate for its present needs.
The numbers above include 3 facilities in the United States, 5 facilities in the European Union, and 3 facilities in Latin America, for all of which closure or sale has been publicly announced but has not yet been completed.
As of December 31, 2006, the Company's distribution facilities consisted of 327 distribution centers and depots worldwide. In North America, the Company had 313 distribution centers and depots, more than 75% of which support the Company's direct-store-delivery systems. Outside North America, the Company had 14 distribution centers in 8 countries. The Company owns 44 of these distribution centers and 3 of these depots and leases 131 of these distribution centers and 149 of these depots. The Company believes that all of these facilities are in good condition and have sufficient capacity to meet the Company's distribution needs for the foreseeable future.
In January 2004, the Company announced a three-year restructuring program and in January 2006, announced plans to expand its restructuring efforts through 2008. The entire restructuring program is expected to result in the closure of up to 40 facilities. In 2006, the Company announced the closing of 8 plants, for a total of 27 since the commencement of the restructuring program in January 2004.
Item 3.
Item 3. Legal Proceedings.
Legal Proceedings
The Company is party to a variety of legal proceedings arising out of the normal course of business, including the matters discussed below. While the results of litigation cannot be predicted with certainty, management believes that the final outcome of these proceedings will not have a material adverse effect on the Company's consolidated financial position, results of operations or cash flows.
Gaouars matter. In October 2002, Mr. Mustapha Gaouar and five other family members (collectively "the Gaouars") filed suit in the Commercial Court of Casablanca against Kraft Foods Maroc and Mr. Omar Berrada claiming damages of approximately $31 million arising from a non-compete undertaking signed by Mr. Gaouar allegedly under duress. The non-compete clause was contained in an
agreement concluded in 1986 between Mr. Gaouar and Mr. Berrada acting for himself and for his group of companies, including Les Cafes Ennasr (renamed Kraft Foods Maroc), which was acquired by Kraft Foods International, Inc. from Mr. Berrada in 2001. In June 2003, the court issued a preliminary judgment against Kraft Foods Maroc and Mr. Berrada holding that the Gaouars are entitled to damages for being deprived of the possibility of engaging in coffee roasting from 1986 due to such non-compete undertaking. At that time, the court appointed two experts to assess the amount of damages to be awarded. In December 2003, these experts delivered a report concluding that they could see no evidence of loss suffered by the Gaouars. The Gaouars asked the court that this report be set aside and new court experts be appointed. On April 15, 2004, the court delivered a judgment upholding the defenses of Kraft Foods Maroc and rejecting the claims of the Gaouars. The Gaouars appealed this judgment, and in July 2005, the Court of Appeal gave judgment in favor of Kraft Foods Maroc confirming the decision rendered by the Commercial Court. On November 29, 2005, the Gaouars filed their further appeal to the Moroccan Supreme Court. Mr. Berrada did not disclose the existence of the claims of Mr. Gaouar at the time of the Kraft Foods International, Inc. acquisition of Kraft Foods Maroc in 2001. As a result, in the event that the Company is ultimately found liable on appeal for damages to plaintiff in this case, the Company believes that it may have claims against Mr. Berrada for recovery of all or a portion of the amount.
Environmental Matters
In May 2001, the State of Ohio notified the Company that it may be subject to an enforcement action for alleged past violations of the Company's wastewater discharge permit at its former production facility in Farmdale, Ohio. In December 2004, the Company finalized a monetary settlement with the State, which was approved by the Court of Common Pleas for Trumball County on January 3, 2005. The settlement amount is not material to the Company.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
The information called for under this Part II Items 5(a) and (b) of this Form 10-K are hereby incorporated by reference to the paragraph captioned "Quarterly Financial Data (Unaudited)" under Item 8 below.
(c) Issuer Purchases of Equity Securities during the Quarter ended December 31, 2006.
The Company's share repurchase program activity for each of the three months ended December 31, 2006 was as follows:
(1)In March 2006, the Company's Board of Directors approved a share repurchase program of up to $2.0 billion of its Class A common stock. All share repurchases have been made pursuant to this program.
(2)Aggregate number of shares repurchased under the share repurchase program as of the end of the period presented.
(3)Shares tendered to the Company by employees who vested in restricted stock and rights, and used shares to pay the related taxes. The principal stock exchange on which the Company's Class A common stock is listed is the New York Stock Exchange. At January 31, 2007, there were approximately 3,000 holders of record of the Company's Class A common stock.
(d) Performance Graph.
Comparison of Five-Year Cumulative Total Return
The following graph compares the cumulative total return on the Company's common stock with the cumulative total return of the S&P 500 Index and the performance peer group index. The graph assumes the reinvestment of all dividends on a quarterly basis.
The performance peer group index consists of companies considered market competitors of the Company, or that have been selected on the basis of industry, level of management complexity, global focus or industry leadership.
The Kraft performance peer group consists of the following companies considered market competitors of the Company, or that have been selected on the basis of industry, level of management complexity, global focus or industry leadership: Anheuser-Busch Companies, Inc., Cadbury Schweppes plc, Campbell Soup Company, The Clorox Company, The Coca-Cola Company, Colgate-Palmolive Company, ConAgra Foods, Inc., Diageo plc, General Mills, Inc., Groupe Danone, H.J. Heinz Company, Hershey Foods Corporation, Kellogg Company, Nestlé S.A., PepsiCo, Inc., The Procter & Gamble Company, Sara Lee Corporation, and Unilever N.V.
The graph and other information furnished under this Part II Item 5(d) of this Form 10-K shall not be deemed to be "soliciting material" or to be "filed" with the Commission or subject to Regulation 14A or 14C, or to the liabilities of Section 18 of the Exchange Act of 1934, as amended.
Item 6.
Item 6. Selected Financial Data.
KRAFT FOODS INC.
Selected Financial Data-Five Year Review (in millions of dollars, except per share data)
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation.
Description of the Company
Kraft Foods Inc. ("Kraft"), together with its subsidiaries (collectively referred to as the "Company"), manufactures and markets packaged food products, consisting principally of beverages, cheese, snacks, convenient meals and various packaged grocery products. Kraft manages and reports operating results through two units, Kraft North America Commercial and Kraft International Commercial. Reportable segments for Kraft North America Commercial are organized and managed principally by product category. Kraft International Commercial's operations are organized and managed by geographic location. At December 31, 2006, Altria Group, Inc. held 98.5% of the combined voting power of Kraft's outstanding capital stock and owned 89.0% of the outstanding shares of Kraft's capital stock.
Kraft Spin-Off from Altria Group, Inc.:
On January 31, 2007, the Altria Group, Inc. Board of Directors announced that Altria Group, Inc. plans to spin off all of its remaining interest (89.0%) in the Company on a pro rata basis to Altria Group, Inc. stockholders in a tax-free transaction. The distribution of all the Kraft shares owned by Altria Group, Inc. will be made on March 30, 2007 ("Distribution Date"), to Altria Group, Inc. stockholders of record as of the close of business on March 16, 2007 ("Record Date"). The exact distribution ratio will be calculated by dividing the number of Class A common shares of Kraft held by Altria Group, Inc. by the number of Altria Group, Inc. shares outstanding on the Record Date. Based on the number of shares of Altria Group, Inc. outstanding at December 31, 2006, the distribution ratio would be approximately 0.7 shares of Kraft Class A common stock for every share of Altria Group, Inc. common stock outstanding. Prior to the distribution, Altria Group, Inc. will convert its Class B shares of Kraft common stock, which carry ten votes per share, into Class A shares of Kraft, which carry one vote per share. Following the distribution, only Class A common shares of Kraft will be outstanding and Altria Group, Inc. will not own any shares of Kraft.
Holders of Altria Group, Inc. stock options will be treated as public stockholders and will, accordingly, have their stock awards split into two instruments. Holders of Altria Group, Inc. stock options will receive the following stock options, which, immediately after the spin-off, will have an aggregate intrinsic value equal to the intrinsic value of the pre-spin Altria Group, Inc. options:
•a new Kraft option to acquire the number of shares of Kraft Class A common stock equal to the product of (a) the number of Altria Group, Inc. options held by such person on the Distribution Date and (b) the approximate distribution ratio of 0.7 mentioned above; and
•an adjusted Altria Group, Inc. option for the same number of shares of Altria Group, Inc. common stock with a reduced exercise price.
Holders of Altria Group, Inc. restricted stock or stock rights awarded prior to January 31, 2007, will retain their existing award and will receive restricted stock or stock rights of Kraft Class A common stock. The amount of Kraft restricted stock or stock rights awarded to such holders will be calculated using the same formula set forth above with respect to new Kraft options. All of the restricted stock and stock rights will not vest until the completion of the original restriction period (typically, three years from the date of the original grant). Recipients of Altria Group, Inc. stock rights awarded on January 31, 2007, did not receive restricted stock or stock rights of Kraft. Rather, they will receive additional stock rights of Altria Group, Inc. to preserve the intrinsic value of the original award.
To the extent that employees of the remaining Altria Group, Inc. receive Kraft stock options, Altria Group, Inc. will reimburse the Company in cash for the Black-Scholes fair value of the stock options to be received. To the extent that Kraft employees hold Altria Group, Inc. stock options, the Company will
reimburse Altria Group, Inc. in cash for the Black-Scholes fair value of the stock options. To the extent that holders of Altria Group, Inc. stock rights receive Kraft stock rights, Altria Group, Inc. will pay to the Company the fair value of the Kraft stock rights less the value of projected forfeitures. Based upon the number of Altria Group, Inc. stock awards outstanding at December 31, 2006, the net amount of these reimbursements would be a payment of approximately $133 million from the Company to Altria Group, Inc. Based upon the number of Altria Group, Inc. stock awards outstanding at December 31, 2006, the Company would have to issue 28 million stock options and 3 million shares of restricted stock and stock rights. The Company estimates that the issuance of these awards would result in an approximate $0.02 decrease in diluted earnings per share. However, these estimates are subject to change as stock awards vest (in the case of restricted stock) or are exercised (in the case of stock options) prior to the Record Date for the distribution.
As discussed in Note 2. Summary of Significant Accounting Policies, the Company is currently included in the Altria Group, Inc. consolidated federal income tax return, and federal income tax contingencies are recorded as liabilities on the balance sheet of Altria Group, Inc. Prior to the distribution of Kraft shares, Altria Group, Inc. will reimburse the Company in cash for these liabilities, which are approximately $300 million, plus interest.
As discussed in Note 4. Related Party Transactions, a subsidiary of Altria Group, Inc. currently provides the Company with certain services at cost plus a 5% management fee. After the Distribution Date, the Company will undertake these activities, and any remaining limited services provided by a subsidiary of Altria Group, Inc. will cease in 2007. All intercompany accounts will be settled in cash within 30 days of the Distribution Date.
Other:
In October 2005, the Company announced that, effective January 1, 2006, its Canadian business would be realigned to better integrate it into the Company's North American business by product category. Beginning in the first quarter of 2006, the operating results of the Canadian business were being reported throughout the North American food segments. Kraft North America Commercial's segments are North America Beverages; North America Cheese & Foodservice; North America Convenient Meals; North America Grocery; and North America Snacks & Cereals. In addition, in the first quarter of 2006, the Company's international businesses were realigned to reflect the reorganization announced within Europe in November 2005. The two revised international segments are European Union; and Developing Markets, Oceania & North Asia, the latter to reflect the Company's increased management focus on developing markets. Accordingly, prior period segment results have been restated.
In June 2005, the Company sold substantially all of its sugar confectionery business for pre-tax proceeds of approximately $1.4 billion. The Company has reflected the results of its sugar confectionery business prior to the closing date as discontinued operations on the consolidated statements of earnings. The Company recorded a loss on sale of discontinued operations of $297 million in the second quarter of 2005, related largely to taxes on the transaction.
The Company's operating subsidiaries generally report year-end results as of the Saturday closest to the end of each year. This resulted in fifty-three weeks of operating results in the Company's consolidated statement of earnings for the year ended December 31, 2005, versus fifty-two weeks for the years ended December 31, 2006 and 2004.
Executive Summary
The following executive summary is intended to provide significant highlights of the Discussion and Analysis that follows.
Consolidated Operating Results-The changes in the Company's earnings and diluted earnings per share ("EPS") from continuing operations for the year ended December 31, 2006 from the year ended December 31, 2005, were due primarily to the following (in millions, except per share data):
See discussion of events affecting the comparability of statement of earnings amounts in the Consolidated Operating Results section of the following Discussion and Analysis.
The unfavorable net impact of asset impairment, exit and implementation costs on earnings and diluted EPS from continuing operations is due primarily to the following:
Restructuring Program-The Company announced a three-year restructuring program in January 2004. In January 2006, the Company announced plans to expand its restructuring efforts through 2008. During the years ended December 31, 2006 and 2005, the Company recorded pre-tax charges of $673 million ($444 million after-tax) and $297 million ($199 million after-tax), respectively, for the restructuring plan, including pre-tax implementation costs of $95 million and $87 million, respectively.
Asset Impairment Charges-During 2006, the Company incurred a pre-tax asset impairment charge of $86 million ($63 million after-tax) in recognition of the sale of its pet snacks brand and assets. In January 2007, the Company announced the sale of its hot cereal assets and trademarks. In recognition of the anticipated sale, the Company recorded a pre-tax asset impairment charge of $69 million ($49 million after-tax) in 2006 for these assets. These charges, which included the write-off of a portion of the associated goodwill, and intangible and fixed assets, were recorded as asset impairment and exit costs on the consolidated statement of earnings. In addition, during the first quarter of 2006, the Company completed its annual review of goodwill and intangible assets and recorded non-cash pre-tax charges of $24 million ($15 million after-tax) related to an intangible asset impairment for biscuits assets in Egypt and hot cereal assets in the United States. Also during 2006, the Company re-evaluated the
business model for its Tassimo hot beverage system, the revenues of which lagged the Company's projections. This evaluation resulted in a $245 million ($157 million after-tax) non-cash asset impairment charge related to lower utilization of existing manufacturing capacity. These charges were recorded as asset impairment and exit costs on the consolidated statement of earnings. In addition, the Company anticipates that the impairment will result in related cash expenditures of approximately $3 million, primarily related to decommissioning of idle production lines. The Company also anticipates further charges in 2007 related to negotiations with product suppliers.
During 2005, the Company sold its fruit snacks assets and incurred a pre-tax asset impairment charge of $93 million ($60 million after-tax) in recognition of the sale. During December 2005, the Company reached agreements to sell certain assets in Canada and a small biscuit brand in the United States and incurred pre-tax asset impairment charges of $176 million ($80 million after-tax) in recognition of these sales. These transactions closed in the first quarter of 2006. These charges, which included the write-off of all associated intangible assets, were recorded as asset impairment and exit costs on the consolidated statement of earnings.
For further details on the restructuring program or asset impairment and implementation costs, see Note 3 to the Consolidated Financial Statements and the Business Environment section of the following Discussion and Analysis.
Gain on Redemption of United Biscuits Investment-In 2006, the Company realized a pre-tax gain of $251 million ($148 million after-tax) on the redemption of its outstanding investment in United Biscuits. For further details see Note 6 to the Consolidated Financial Statements.
Gains on Sales of Businesses-The 2006 gains on sales of businesses were due primarily to the sale of the Company's rice brand and assets, partially offset by the loss on the sale of a U.S. coffee plant and tax expense of $57 million related to the sale of the Company's pet snacks brand and assets. The 2005 gains on sales of businesses were due primarily to the gain on sale of the Company's U.K. desserts assets.
Income Tax Benefit-The 2006 tax benefit reflects a reimbursement from Altria Group, Inc. in cash for unrequired federal tax reserves of $337 million and pre-tax interest of $46 million ($29 million after-tax), as well as net state tax reversals of $39 million, due to the conclusion of an audit of Altria Group, Inc.'s consolidated federal income tax returns for the years 1996 through 1999. Included within the change in tax rate, among other things, are a benefit of $52 million in 2006 and $82 million in 2005 from the resolution of outstanding items in the Company's international operations. In addition, 2005 income taxes include $24 million from the settlement of an outstanding U.S. tax claim, $33 million in tax impacts associated with the sale of a U.S. biscuit brand and a $53 million aggregate benefit from the domestic manufacturers' deduction provision and the dividend repatriation provision of the American Jobs Creation Act.
Operations-The $73 million increase in results from operations, which includes the 53rd week in 2005, was due primarily to the following:
•Higher income in North America Snacks & Cereals, reflecting higher pricing and lower marketing costs, partially offset by higher commodity costs and increased promotional spending.
•Higher income in Developing Markets, Oceania & North Asia, reflecting higher pricing and favorable volume/mix, partially offset by increased marketing costs, higher product costs, and the 2005 recovery of a previously written-off account receivable.
•Higher income in North America Cheese & Foodservice, reflecting lower commodity costs, partially offset by lower net pricing and lower volume/mix.
•Lower interest and other debt expense, net, reflecting lower debt levels, the redemption of higher coupon Nabisco bonds and interest income on the federal tax reimbursement from Altria Group, Inc., partially offset by higher short-term interest rates.
Partially offset by:
•Lower income in North America Beverages, reflecting higher commodity costs, partially offset by higher pricing.
•Lower income in the European Union, reflecting increased promotional spending, and higher product and marketing costs, partially offset by higher pricing.
For further details, see the Consolidated Operating Results and Operating Results by Business Segment sections of the following Discussion and Analysis.
Discussion and Analysis
Critical Accounting Policies and Estimates
Note 2 to the consolidated financial statements includes a summary of the significant accounting policies and methods used in the preparation of the Company's consolidated financial statements. In most instances, the Company must use an accounting policy or method because it is the only policy or method permitted under accounting principles generally accepted in the United States of America ("U.S. GAAP").
The preparation of all financial statements includes the use of estimates and assumptions that affect a number of amounts included in the Company's financial statements, including, among other things, employee benefit costs and income taxes. The Company bases its estimates on historical experience and other assumptions that it believes are reasonable. If actual amounts are ultimately different from previous estimates, the revisions are included in the Company's consolidated results of operations for the period in which the actual amounts become known. Historically, the aggregate differences, if any, between the Company's estimates and actual amounts in any year have not had a significant impact on the Company's consolidated financial statements.
The selection and disclosure of the Company's critical accounting policies and estimates have been discussed with the Company's Audit Committee. The following is a review of the more significant assumptions and estimates, as well as the accounting policies and methods used in the preparation of the Company's consolidated financial statements:
Employee Benefit Plans. As discussed in Note 15 to the consolidated financial statements, the Company provides a range of benefits to its employees and retired employees, including pensions, postretirement health care benefits and postemployment benefits (primarily severance). The Company records amounts relating to these plans based on calculations specified by U.S. GAAP, which include various actuarial assumptions, such as discount rates, assumed rates of return on plan assets, compensation increases, turnover rates and health care cost trend rates. The Company reviews its actuarial assumptions on an annual basis and makes modifications to the assumptions based on current rates and trends when it is deemed appropriate to do so. As permitted by U.S. GAAP, any effect of the modifications is generally amortized over future periods. The Company believes that the assumptions utilized in recording its obligations under its plans, which are presented in Note 15 to the consolidated financial statements, are reasonable based on its experience and advice from its actuaries.
In September 2006, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans" ("SFAS No. 158"). SFAS No. 158 requires that employers recognize the funded status of their defined benefit pension and other postretirement plans on the consolidated balance sheet and record as a component of other comprehensive income, net of tax, the gains or
losses and prior service costs or credits that have not been recognized as components of net periodic benefit cost. The Company adopted the recognition and related disclosure provisions of SFAS No. 158, prospectively, on December 31, 2006. The adoption resulted in a decrease to total assets of $2,286 million, a decrease to total liabilities of $235 million and a decrease to shareholders' equity of $2,051 million.
SFAS No. 158 also requires an entity to measure plan assets and benefit obligations as of the date of its fiscal year-end statement of financial position for fiscal years ending after December 15, 2008. The Company's non-U.S. pension plans (other than Canadian pension plans) are measured at September 30 of each year. The Company expects to adopt the measurement date provision of SFAS No. 158 and measure these plans as of December 31 of each year beginning December 31, 2008. The Company is presently evaluating the impact of the measurement date change, which is not expected to be significant.
During the years ended December 31, 2006, 2005 and 2004, the Company recorded the following amounts in the consolidated statements of earnings for employee benefit plans:
The 2006 net expense for employee benefit plans of $1,036 million increased by $154 million over the 2005 amount. This cost increase primarily relates to higher postemployment benefit plan costs related to the restructuring program, as well as higher amortization of the unrecognized net loss from experience differences in the U.S. and non-U.S. pension plan costs and postretirement health care costs. The 2005 net expense for employee benefit plans of $882 million increased by $247 million over the 2004 amount. The cost increase primarily related to higher U.S. pension plan costs, including higher amortization of the unrecognized net loss from experience differences, a lower expected return on plan assets, a lower discount rate assumption and higher settlement losses as employees retired or left during 2005.
At December 31, 2006, the Company's discount rate assumption increased from 5.60% to 5.90% for its U.S. pension and postretirement plans. The Company presently anticipates that assumption changes, coupled with the amortization of deferred gains and losses will result in a decrease in 2007 pre-tax U.S. and non-U.S. pension and postretirement expense. While the Company does not presently anticipate a change in its 2007 assumptions, as a sensitivity measure, a fifty-basis point decline (increase) in the Company's discount rate would increase (decrease) the Company's U.S. pension and postretirement expense by approximately $85 million. Similarly, a fifty-basis point decrease (increase) in the expected return on plan assets would increase (decrease) the Company's pension expense for the U.S. pension plans by approximately $32 million. See Note 15 to the consolidated financial statements for a sensitivity discussion of the assumed health care cost trend rates.
Revenue Recognition. As required by U.S. GAAP, the Company recognizes revenues, net of sales incentives, and including shipping and handling charges billed to customers, upon shipment or delivery of goods when title and risk of loss pass to customers. Shipping and handling costs are classified as part of cost of sales. Provisions and allowances for estimated sales returns and bad debts are also recorded in the Company's consolidated financial statements. The amounts recorded for these provisions and
related allowances are not significant to the Company's consolidated financial position or results of operations.
Depreciation, Amortization and Goodwill Valuation. The Company depreciates property, plant and equipment and amortizes definite life intangibles using the straight-line method over the estimated useful lives of the assets.
The Company is required to conduct an annual review of goodwill and intangible assets for potential impairment. Goodwill impairment testing requires a comparison between the carrying value and fair value of each reporting unit. If the carrying value exceeds the fair value, goodwill is considered impaired. The amount of impairment loss is measured as the difference between the carrying value and implied fair value of goodwill, which is determined using discounted cash flows. Impairment testing for non-amortizable intangible assets requires a comparison between the fair value and carrying value of the intangible asset. If the carrying value exceeds fair value, the intangible asset is considered impaired and is reduced to fair value. These calculations may be affected by the market conditions noted below in the Business Environment section and under the "Risk Factors" section in Part 1, Item 1A of this Annual Report on Form 10-K, as well as interest rates, general economic conditions and projected growth rates. During the first quarter of 2006, the Company completed its annual review of goodwill and intangible assets and recorded non-cash pre-tax charges of $24 million related to an intangible asset impairment for biscuits assets in Egypt and hot cereal assets in the United States. Additionally, in 2006, as part of the sale of its pet snacks brand and assets, the Company recorded non-cash pre-tax asset impairment charges of $86 million, which included the write-off of a portion of the associated goodwill and intangible assets of $25 million and $55 million, respectively, as well as $6 million of asset write-downs. In January 2007, the Company announced the sale of its hot cereal assets and trademarks. In anticipation of the sale, the Company recorded a pre-tax asset impairment charge of $69 million in 2006 for these assets, which included the write-off of a portion of the associated goodwill and intangible assets of $15 million and $52 million, respectively, as well as $2 million of asset write-downs. During the first quarter of 2005, the Company completed its annual review of goodwill and intangible assets and no impairment charges resulted from this review. However, as part of the sale of certain Canadian assets and two brands, the Company recorded non-cash pre-tax asset impairment charges of $269 million in 2005, which included impairment of goodwill and intangible assets of $13 million and $118 million, respectively, as well as $138 million of asset write-downs.
Impairment of Long-Lived Assets. The Company reviews long-lived assets, including amortizable intangible assets, for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. The Company performs undiscounted operating cash flow analyses to determine if an impairment exists. These analyses are affected by interest rates, general economic conditions and projected growth rates. For purposes of recognition and measurement of an impairment of assets held for use, the Company groups assets and liabilities at the lowest level for which cash flows are separately identifiable. If an impairment is determined to exist, any related impairment loss is calculated based on fair value. Impairment losses on assets to be disposed of, if any, are based on the estimated proceeds to be received, less costs of disposal. As previously discussed, the Company recorded non-cash pre-tax asset impairment charges of $245 million related to its Tassimo hot beverage business in 2006. The charges are included in asset impairment and exit costs in the consolidated statement of earnings.
Marketing and Advertising Costs. As required by U.S. GAAP, the Company records marketing costs as an expense in the year to which such costs relate. The Company does not defer amounts on its year-end consolidated balance sheet with respect to marketing costs. The Company expenses advertising costs as incurred. Consumer incentive and trade promotion activities are recorded as a reduction of revenues based on amounts estimated as being due to customers and consumers at the end of a period, based principally on historical utilization and redemption rates. For interim reporting
purposes, advertising and consumer incentive expenses are charged to operations as a percentage of volume, based on estimated volume and related expense for the full year.
Related Party Transactions. As discussed in Note 4 to the consolidated financial statements, Altria Group, Inc.'s subsidiary, Altria Corporate Services, Inc., provides the Company with various services, including planning, legal, treasury, auditing, insurance, human resources, office of the secretary, corporate affairs, information technology, aviation and tax services. Billings for these services, which were based on the cost to Altria Corporate Services, Inc. to provide such services and a 5% management fee based on wages and benefits, were $178 million, $237 million and $310 million for the years ended December 31, 2006, 2005 and 2004, respectively. These costs were paid to Altria Corporate Services, Inc. monthly. The Company performed at a similar cost various functions in 2006 and 2005 that previously had been provided by Altria Corporate Services, Inc., resulting in lower service charges in 2006 and 2005. The Company plans to undertake all remaining services currently provided by Altria Corporate Services, Inc. at a similar cost in 2007. Although the cost of these services cannot be quantified on a stand-alone basis, management has assessed that the billings are reasonable based on the level of support provided by Altria Corporate Services, Inc., and that they reflect all services provided. The cost and nature of the services are reviewed annually by the Company's Audit Committee, which is comprised of independent directors. The effects of these transactions are included in operating cash flows in the Company's consolidated statements of cash flows.
During 2006, the Company purchased certain real estate and personal property located in Wilkes Barre, Pennsylvania, from Altria Corporate Services, Inc., for an aggregate purchase price of $9.3 million. In addition, the Company assumed all of Altria Corporate Services, Inc.'s rights under a lease for certain real property located in San Antonio, Texas. The Company also purchased certain personal property located in San Antonio, Texas from Altria Corporate Services, Inc., for an aggregate purchase price of $6.0 million.
Also, see Note 13. Income Taxes regarding the impact to the Company of the closure of an Internal Revenue Service review of Altria Group, Inc.'s consolidated federal income tax return recorded during 2006.
During 2005, the Company repatriated certain foreign earnings as part of Altria Group, Inc.'s dividend repatriation plan under provisions of the American Jobs Creation Act. Increased taxes for this repatriation of $21 million were reimbursed by Altria Group, Inc. The reimbursement was reported in the Company's financial statements as an increase to additional paid-in capital.
In December 2005, the Company purchased an airport hangar and certain personal property located at the hangar in Milwaukee, Wisconsin, from Altria Corporate Services, Inc. for an aggregate purchase price of approximately $3.3 million.
In December 2004, the Company purchased two corporate aircraft from Altria Corporate Services, Inc. for an aggregate purchase price of approximately $47 million. The Company also entered into an Aircraft Management Agreement with Altria Corporate Services, Inc. in December 2004, pursuant to which Altria Corporate Services, Inc. agreed to perform aircraft management, pilot services, maintenance and other aviation services for the Company.
At December 31, 2006 and 2005, the Company had short-term amounts payable to Altria Group, Inc. of $607 million and $652 million, respectively. The amounts payable to Altria Group, Inc. generally include accrued dividends, taxes and service fees. Interest on intercompany borrowings is based on the applicable London Interbank Offered Rate.
Income Taxes. The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes." The U.S. accounts of the Company are included in the consolidated federal income tax return of Altria Group, Inc. Income taxes are generally computed on a separate company basis. To the extent that foreign tax credits, capital losses and other credits generated by the
Company, which cannot currently be utilized on a separate company basis, are utilized in Altria Group, Inc.'s consolidated federal income tax return, the benefit is recognized in the calculation of the Company's provision for income taxes. Based on the Company's current estimate, this benefit is calculated to be approximately $195 million, $225 million and $70 million for the years ended December 31, 2006, 2005 and 2004, respectively. The amounts in 2005 and 2006 include dividend repatriations and the impact of certain legal entity reorganizations. The benefit is dependent on a variety of tax attributes that have a tendency to vary year to year. The Company makes payments to, or is reimbursed by, Altria Group, Inc. for the tax effects resulting from its inclusion in Altria Group, Inc.'s consolidated federal income tax return including current taxes payable and net changes in tax provisions. The Company is assessing opportunities to mitigate the loss of tax benefits upon Altria Group, Inc.'s distribution of its Kraft shares, and currently estimates the annual amount of lost tax benefits to be in the range of $50 million to $75 million.
Significant judgment is required in determining income tax provisions and in evaluating tax positions. The Company establishes additional provisions for income taxes when, despite the belief that existing tax positions are fully supportable, there remain certain positions that are likely to be challenged and that may not be sustained on review by tax authorities. The Company evaluates and potentially adjusts these provisions in light of changing facts and circumstances. The consolidated tax provision includes the impact of changes to accruals that are deemed necessary. The Company expects its effective tax rate to average 35.5% in 2007 (up from 31.7% in 2006), excluding the impact of changes for asset impairment, exit and implementation costs, and one-time gains and losses related to acquisitions and divestitures.
In 2006, the United States Internal Revenue Service concluded its examination of Altria Group, Inc.'s consolidated tax returns for the years 1996 through 1999 and issued a final Revenue Agents Report on March 15, 2006. Consequently, Altria Group, Inc. reimbursed the Company in cash for unrequired federal tax reserves of $337 million and pre-tax interest of $46 million ($29 million after-tax). The Company also recognized net state tax reversals of $39 million, resulting in a total net earnings benefit of $405 million or $0.24 per diluted share during 2006.
In October 2004, the American Jobs Creation Act ("the Jobs Act") was signed into law. The Jobs Act includes a deduction for 85% of certain foreign earnings that are repatriated. In 2005, the Company repatriated approximately $500 million of earnings under the provisions of the Jobs Act. Deferred taxes had previously been provided for a portion of the dividends to be remitted. The reversal of the deferred taxes more than offset the tax costs to repatriate the earnings and resulted in a net tax reduction of $28 million in the consolidated income tax provision during 2005.
In July 2006, the FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109" ("FIN 48"), which will become effective for the Company on January 1, 2007. The Interpretation prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The amount recognized is measured as the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. The adoption of FIN 48 will result in an increase to shareholders' equity as of January 1, 2007 of approximately $200 million to $225 million.
Consolidation. The consolidated financial statements include Kraft Foods Inc., as well as its wholly-owned and majority-owned subsidiaries. Investments in which Kraft Foods Inc. exercises significant influence (20% - 50% ownership interest), are accounted for under the equity method of accounting. Investments in which the Company has an ownership interest of less than 20%, or does not exercise significant influence, are accounted for by the cost method of accounting. All intercompany transactions and balances between and among Kraft's subsidiaries have been eliminated. Transactions between any of the Company's businesses and Altria Group, Inc. and its affiliates are included in the consolidated financial statements.
Business Environment
The Company is subject to a number of challenges that may adversely affect its businesses. These challenges, which are discussed below and under the "Risk Factors" section in Part 1, Item 1A of this Annual Report on Form 10-K, include:
•fluctuations in commodity prices;
•movements of foreign currencies;
•competitive challenges in various products and markets, including price gaps with competitor products and the increasing price-consciousness of consumers;
•a rising cost environment and the limited ability to increase prices;
•a trend toward increasing consolidation in the retail trade and consequent pricing pressure and inventory reductions;
•a growing presence of discount retailers, primarily in Europe, with an emphasis on own-label products;
•changing consumer preferences, including diet and health/wellness trends;
•competitors with different profit objectives and less susceptibility to currency exchange rates; and
•increasing scrutiny of product labeling and marketing practices as well as concerns and/or regulations regarding food safety, quality and health, including genetically modified organisms, trans-fatty acids and obesity. Increased government regulation of the food industry could result in increased costs to the Company.
In the ordinary course of business, the Company is subject to many influences that can impact the timing of sales to customers, including the timing of holidays and other annual or special events, seasonality of certain products, significant weather conditions, timing of Company or customer incentive programs and pricing actions, customer inventory programs, Company initiatives to improve supply chain efficiency, financial condition of customers and general economic conditions.
Fluctuations in commodity costs can lead to retail price volatility and intense price competition, and can influence consumer and trade buying patterns. During 2006, the Company's commodity costs on average were higher than those incurred in 2005 (most notably higher coffee, energy and packaging costs, partially offset by lower cheese and meat costs), and adversely affected earnings. For 2006, the Company's commodity costs were approximately $275 million higher than 2005, following an increase of approximately $800 million for 2005 compared with 2004.
Restructuring:
In January 2004, the Company announced a three-year restructuring program (which is discussed further in Note 3. Asset Impairment, Exit and Implementation Costs) with the objectives of leveraging the Company's global scale, realigning and lowering its cost structure, and optimizing capacity utilization. In January 2006, the Company announced plans to expand its restructuring efforts through 2008. The entire restructuring program is expected to result in $3.0 billion in pre-tax charges, the closure of up to 40 facilities, the elimination of approximately 14,000 positions and annualized cost savings at the completion of the program of approximately $1.0 billion. The decline of $700 million from the $3.7 billion in pre-tax charges previously announced was due primarily to lower than projected severance costs, the cancellation of an initiative intended to generate sales efficiencies, and the sale of one plant that was originally planned to be closed. Approximately $1.9 billion of the $3.0 billion in pre-tax charges are expected to require cash payments. Total pre-tax restructuring program charges incurred, including implementation costs, were $673 million, $297 million and $641 million in 2006, 2005 and 2004,
respectively. Total pre-tax restructuring charges for the program incurred from January 2004 through December 31, 2006 were $1.6 billion and specific programs announced will result in the elimination of approximately 9,800 positions. Approximately 60% of the pre-tax charges to date are expected to require cash payments.
In addition, the Company expects to incur approximately $550 million in capital expenditures to implement the restructuring program. From January 2004 through December 31, 2006, the Company spent $245 million in capital, including $101 million spent in 2006, to implement the restructuring program. Cumulative annualized cost savings as a result of the restructuring program were approximately $540 million and $260 million through December 31, 2006 and 2005, respectively, and are anticipated to reach approximately $700 million by the end of 2007, all of which are expected to be used in support of brand-building initiatives.
Asset Impairment Charges:
As discussed further in Note 3. Asset Impairment, Exit and Implementation Costs, the Company incurred pre-tax asset impairment charges of $424 million, $269 million and $20 million during the years ended December 31, 2006, 2005 and 2004, respectively. These charges were recorded as asset impairment and exit costs on the consolidated statements of earnings.
These asset impairment charges primarily related to various sales of the Company's brands and assets, as well as the 2006 re-evaluation of the business model for the Company's Tassimo hot beverage system, the revenues of which lagged the Company's projections. This evaluation resulted in a $245 million non-cash pre-tax asset impairment charge related to lower utilization of existing manufacturing capacity. In addition, the Company anticipates that the impairment will result in related cash expenditures of approximately $3 million, primarily related to decommissioning of idle production lines. The Company also anticipates further charges in 2007 related to negotiations with product suppliers.
Acquisitions and Dispositions:
One element of the Company's growth strategy is to strengthen its brand portfolios and/or expand its geographic reach through a disciplined program of selective acquisitions and divestitures. The Company is constantly reviewing potential acquisition candidates and from time to time sells businesses to accelerate the shift in its portfolio toward businesses-whether global, regional or local-that offer the Company a sustainable competitive advantage. The impact of any future acquisition or divestiture could have a material impact on the Company's consolidated financial position, results of operations or cash flows, and future sales of businesses could in some cases result in losses on sale.
During 2006, the Company acquired the Spanish and Portuguese operations of United Biscuits ("UB"), and rights to all Nabisco trademarks in the European Union, Eastern Europe, the Middle East and Africa, which UB has held since 2000, for a total cost of approximately $1.1 billion. The Spanish and Portuguese operations of UB include its biscuits, dry desserts, canned meats, tomato and fruit juice businesses as well as seven manufacturing facilities and 1,300 employees. From September 2006 to December 31, 2006, these businesses contributed net revenues of $111 million. The non-cash acquisition was financed by the Company's assumption of $541 million of debt issued by the acquired business immediately prior to the acquisition, as well as $530 million of value for the redemption of the Company's outstanding investment in UB, primarily deep-discount securities. The redemption of the Company's investment in UB resulted in a pre-tax gain on closing of $251 million ($148 million after-tax or $0.09 per diluted share).
Aside from the debt assumed as part of the acquisition price, the Company acquired assets consisting primarily of goodwill of $734 million, other intangible assets of $217 million, property, plant and equipment of $161 million, receivables of $101 million and inventories of $34 million. These amounts
represent the preliminary allocation of purchase price and are subject to revision when appraisals are finalized, which is expected to occur during the first half of 2007.
During 2006, the Company sold its rice brand and assets, and its industrial coconut assets. The Company also sold its pet snacks brand and assets in 2006 and recorded tax expense of $57 million related to the sale. In addition, the Company incurred a pre-tax asset impairment charge of $86 million in 2006 in recognition of this sale. Additionally, during 2006, the Company sold certain Canadian assets and a small U.S. biscuit brand, and incurred pre-tax asset impairment charges of $176 million in 2005 in recognition of these sales. Also during 2006, the Company sold a U.S. coffee plant. The aggregate proceeds received from these sales were $946 million, on which the Company recorded pre-tax gains of $117 million.
In January 2007, the Company announced the sale of its hot cereal assets and trademarks. In recognition of the anticipated sale, the Company recorded a pre-tax asset impairment charge of $69 million in 2006 for these assets.
As previously discussed, the Company sold substantially all of its sugar confectionery business in June 2005 for pre-tax proceeds of approximately $1.4 billion. The sale included the Life Savers, Creme Savers, Altoids, Trolli and Sugus brands. The Company has reflected the results of its sugar confectionery business prior to the closing date as discontinued operations on the consolidated statements of earnings. The Company recorded a loss on sale of discontinued operations of $297 million in the second quarter of 2005, related largely to taxes on the transaction.
During 2005, the Company sold its fruit snacks assets, and incurred a pre-tax asset impairment charge of $93 million in recognition of this sale. Additionally, during 2005, the Company sold its U.K. desserts assets, its U.S. yogurt assets, a small business in Colombia, a minor trademark in Mexico and a small equity investment in Turkey. The aggregate proceeds received from these sales were $238 million, on which the Company recorded pre-tax gains of $108 million.
During 2004, the Company sold a Brazilian snack nuts business and trademarks associated with a candy business in Norway. The aggregate proceeds received from the sales of these businesses were $18 million, on which pre-tax losses of $3 million were recorded.
During 2004, the Company acquired a U.S.-based beverage business for a total cost of $137 million.
The operating results of the businesses acquired and sold, other than the UB acquisition and the divestiture of the sugar confectionery business, in the aggregate, were not material to the Company's consolidated financial position, results of operations or cash flows in any of the periods presented.
Consolidated Operating Results
Operating income was affected by the following items during 2006, 2005 and 2004:
•Asset impairment, exit and implementation costs-As discussed in Note 3 to the consolidated financial statements, during 2006, 2005 and 2004, the Company recorded $1,002 million, $479 million and $603 million, respectively, of asset impairment and exit costs on its consolidated statement of earnings. Additionally, during 2006, 2005 and 2004, the Company recorded pre-tax implementation costs of $95 million, $87 million and $50 million, respectively. During 2004, the Company also recorded $47 million of pre-tax impairment charges related to its equity investment in a joint venture in Turkey.
The pre-tax asset impairment, exit and implementation costs for the years ended December 31, 2006, 2005 and 2004, were included in the operating companies income of the following segments:
•Gain on Redemption of United Biscuits Investment-As more fully discussed in Note 6. Acquisitions, in the third quarter of 2006, the Company acquired the Spanish and Portuguese operations of United Biscuits ("UB") and rights to all Nabisco trademarks in the European Union, Eastern Europe, the Middle East and Africa. The redemption of the Company's outstanding investment in UB resulted in a pre-tax gain on closing of $251 million. This gain is included in the operating companies income of the European Union segment.
•Gains/Losses on Sales of Businesses-During 2006, the Company sold its rice brand and assets, pet snacks brand and assets, industrial coconut assets, certain Canadian assets, a small U.S. biscuit brand and a U.S. coffee plant for aggregate pre-tax gains of $117 million. During 2005, the Company sold its fruit snacks assets, U.K. desserts assets, U.S. yogurt assets, a small business in Colombia, a minor trademark in Mexico and a small equity investment in Turkey for aggregate pre-tax gains of $108 million. During 2004, the Company sold a Brazilian snack nuts business and trademarks associated with a candy business in Norway for aggregate pre-tax losses of $3 million. These pre-tax (gains) losses were included in the operating companies income of the following segments:
As discussed in Note 14 to the consolidated financial statements, the Company's management uses operating companies income, which is defined as operating income before general corporate expenses and amortization of intangibles, to evaluate segment performance and allocate resources. Management believes it is appropriate to disclose this measure to help investors analyze the business performance and trends of the various business segments.
2006 compared with 2005
The following discussion compares consolidated operating results for 2006 with 2005.
The Company's 2005 results included 53 weeks of operating results compared with 52 weeks in 2006. The Company estimates that this extra week positively impacted net revenues and operating income by approximately 2% in 2005 (approximately $625 million and $100 million, respectively), causing a negative comparison to 2006.
Volume decreased 961 million pounds (5.0%), including the 53rd week in 2005 results. Excluding the impact of divestitures, the acquisition of UB and the 53rd week of shipments in 2005, volume decreased 0.4%, due primarily to the discontinuation of certain ready-to-drink and foodservice product lines and lower grocery shipments in North America, partially offset by higher shipments of meat, biscuits and cheese in North America and higher shipments in Developing Markets, Oceania & North Asia.
Net revenues increased $243 million (0.7%), due primarily to favorable volume/mix ($244 million, including the 53rd week in 2005), higher net pricing ($229 million, reflecting commodity-driven pricing, partially offset by increased promotional spending), favorable currency ($145 million) and the acquisition of UB ($111 million), partially offset by the impact of divested businesses ($488 million).
Operating income decreased $226 million (4.8%), due primarily to higher pre-tax asset impairment and exit costs ($523 million), 2005 net gains on the sales of businesses ($108 million), higher marketing costs ($85 million) and the impact of divestitures ($71 million), partially offset by the 2006 gain on redemption of the Company's UB investment ($251 million), the 2006 net gains on sales of businesses ($117 million), higher net pricing ($72 million, reflecting commodity-driven pricing, partially offset by increased promotional spending and higher costs), lower fixed manufacturing costs ($40 million), favorable volume/mix ($32 million, including the 53rd week in 2005), favorable currency ($29 million) and the acquisition of UB ($18 million).
Currency movements increased net revenues by $145 million and operating income by $29 million. These increases were due primarily to the weakness of the U.S. dollar against the Canadian dollar and the Brazilian real, partially offset by the strength of the U.S. dollar against the euro.
Interest and other debt expense, net decreased $126 million (19.8%) due primarily to $46 million of pre-tax interest income associated with the conclusion of a tax audit at Altria Group, Inc., lower debt levels and the redemption of higher coupon Nabisco bonds, partially offset by higher short-term interest rates.
The Company's income tax rate decreased by 5.7 percentage points to 23.7%. The 2006 tax rate includes a reimbursement from Altria Group, Inc. in cash for unrequired federal tax reserves of $337 million, and net state tax reversals of $39 million, due to the conclusion of an audit of Altria Group, Inc.'s consolidated federal income tax returns for the years 1996 through 1999. Included within the change in tax rates, among other things, are a benefit of $52 million in 2006 and $82 million in 2005 from the resolution of outstanding items in the Company's international operations. In addition, in 2005 income taxes include $24 million from the settlement of an outstanding U.S. tax claim, $33 million of tax impacts associated with the sale of a U.S. biscuit brand and a $53 million aggregate benefit from the domestic manufacturers' deduction provision and the dividend repatriation provision of the Jobs Act.
Earnings from continuing operations of $3,060 million increased $156 million (5.4%), due primarily to the tax benefit discussed above and lower interest expense, partially offset by lower operating income (reflecting higher asset impairment and exit costs in 2006). Diluted EPS from continuing operations, which was $1.85, increased by 7.6%.
The loss from discontinued operations, net of income taxes, in 2005 was due primarily to the recording of additional tax expense of $297 million that arose from the sale of the sugar confectionery business in the second quarter of 2005.
Net earnings of $3,060 million increased $428 million (16.3%). Diluted EPS from net earnings, which was $1.85, increased by 19.4%.
2005 compared with 2004
The following discussion compares consolidated operating results for 2005 with 2004.
The Company's 2005 results included 53 weeks of operating results compared with 52 weeks in 2004. The Company estimates that this extra week positively impacted net revenues and operating income by approximately 2% in 2005 (approximately $625 million and $100 million, respectively).
Volume increased 210 million pounds (1.1%), including the benefit of 53 weeks in 2005 results. Excluding all acquisitions and divestitures, and the 53rd week of shipments, volume decreased approximately 1% due primarily to a focus on mix improvement, a SKU reduction program, the impact of higher retail prices on category growth trends in the United States and declines in certain international countries (most notably Germany), partially offset by new product introductions and growth in developing markets.
Net revenues increased $1,945 million (6.0%) due primarily to favorable volume/mix ($1,086 million, including the benefit of the 53rd week), favorable currency ($533 million), higher net pricing ($453 million, reflecting commodity-driven pricing, partially offset by increased promotional spending) and the impact of acquisitions ($42 million), partially offset by the impact of divested businesses ($174 million).
Operating income increased $140 million (3.0%), due primarily to favorable volume/mix ($479 million, including the benefit of the 53rd week), lower asset impairment and exit costs ($124 million), net gains on the sales of businesses ($111 million), favorable currency ($90 million) and a 2004 equity investment impairment charge related to a joint venture in Turkey ($47 million), partially offset by higher marketing, administration and research costs ($420 million, including higher benefit and marketing costs, as well as costs associated with the 53rd week), higher fixed manufacturing costs ($110 million), unfavorable costs, net of higher pricing ($102 million, due primarily to higher commodity costs and increased promotional spending), the net impact of higher implementation costs associated with the restructuring program ($37 million), and the impact of divestitures ($33 million).
Currency movements increased net revenues by $533 million and operating income by $90 million. These increases were due primarily to the weakness of the U.S. dollar against the euro, the Canadian dollar, the Brazilian real and certain other currencies.
The Company's reported effective income tax rate decreased by 2.9 percentage points to 29.4%, due primarily to the settlement of an outstanding U.S. tax claim of $24 million; $82 million from the resolution of outstanding items in the Company's international operations; and $33 million in tax impacts associated with the sale of a U.S. biscuit brand. The 2005 rate also includes a $53 million aggregate benefit from the domestic manufacturers' deduction provision and the dividend repatriation provision of the American Jobs Creation Act. The tax provision in 2004 included the $81 million favorable resolution of an outstanding tax item and the reversal of $35 million of tax accruals that were no longer required due to tax events that occurred during 2004.
Earnings from continuing operations of $2,904 million increased $235 million (8.8%), due primarily to higher operating income and a lower income tax rate. Diluted EPS from continuing operations, which was $1.72, increased by 11.0%.
Loss from discontinued operations, net of income tax, increased $268 million, due primarily to a loss on sale of $297 million in 2005. The loss from discontinued operations was due primarily to the recording
of additional tax expense that arose from the sale of the sugar confectionery business in the second quarter of 2005.
Net earnings of $2,632 million decreased $33 million (1.2%). Diluted EPS from net earnings, which was $1.55, was equal to 2004.
Operating Results by Reportable Segment
2006 compared with 2005
The following discussion compares operating results within each of Kraft's reportable segments for 2006 with 2005.
North America Beverages. Volume decreased 6.8%, including the 53rd week of shipments in 2005 (representing approximately 2 percentage points of decline), due primarily to a decline in refreshment beverages volume resulting from the discontinuation of certain ready-to-drink product lines and lower shipments of coffee.
Net revenues increased $32 million (1.0%), due primarily to higher pricing, net of increased promotional spending ($36 million) and favorable currency ($14 million), partially offset by lower volume/mix ($17 million, including the 53rd week in 2005). Coffee net revenues increased due to higher commodity-based pricing, partially offset by lower shipments. In powdered beverages, favorable mix from new products also drove higher net revenues. Ready-to-drink net revenues declined due to lower shipments and discontinuation of certain products.
Operating companies income decreased $258 million (55.7%), due primarily to the loss on the sale of a U.S. coffee plant ($95 million), higher pre-tax charges for asset impairment and exit costs ($85 million, including $75 million as part of the Tassimo asset impairment) and unfavorable costs, net of higher pricing ($69 million, including higher commodity costs).
North America Cheese & Foodservice. Volume decreased 4.8%, including the 53rd week of shipments in 2005 (representing approximately 2 percentage points of decline), due primarily to the divestitures of Canadian grocery assets, U.S. yogurt assets and industrial coconut assets, and lower volume in foodservice. In foodservice, volume declined due to the discontinuation of lower margin product lines. Cheese volume was flat as higher shipments of natural and cream cheese were offset by the impact of divestitures and the 53rd week of shipments in 2005.
Net revenues decreased $166 million (2.7%), due primarily to lower net pricing ($114 million, representing increased promotional spending, net of higher pricing), lower volume/mix ($60 million, including the 53rd week in 2005) and the impact of divestitures ($53 million), partially offset by favorable currency ($61 million). In foodservice, net revenues decreased due primarily to lower volume, the impact of divestitures and lower cheese pricing, partially offset by favorable currency. Cheese net revenues decreased due primarily to lower net pricing in response to declining cheese costs and the impact of divestitures, partially offset by favorable currency.
Operating companies income decreased $35 million (3.8%), due primarily to higher pre-tax charges for asset impairment and exit costs ($72 million), lower volume/mix ($22 million, including the 53rd week in 2005), higher marketing spending ($20 million), higher implementation costs ($11 million) and the 2006 loss on sale of industrial coconut assets ($8 million), partially offset by favorable costs (primarily cheese commodity costs), net of lower net pricing ($79 million), lower fixed manufacturing costs ($11 million) and favorable currency ($9 million).
North America Convenient Meals. Volume increased 0.5%, despite the 53rd week of shipments in 2005 (representing approximately 2 percentage points of decline), driven by higher meat shipments (cold cuts, hot dogs and bacon) and higher shipments of pizza, partially offset by lower shipments of dinners, due to competition in macaroni and cheese dinners, and the divestiture of the rice brand and assets.
Net revenues increased $144 million (3.1%), due primarily to higher volume/mix ($138 million, including the 53rd week in 2005), favorable currency ($14 million) and higher pricing, net of increased promotional spending ($7 million), partially offset by the impact of divestitures ($15 million). In meats, higher net revenues were driven by continued strong results for new products and higher net pricing. Pizza net revenues increased due to higher shipments and favorable mix from new products, partially offset by higher promotional spending. Dinners net revenues decreased due to the impact of lower volume.
Operating companies income increased $121 million (15.3%), due primarily to the 2006 gain on the sale of the rice brand and assets ($226 million), lower fixed manufacturing costs ($24 million) and favorable currency ($4 million), partially offset by higher pre-tax charges for asset impairment and exit costs ($93 million), higher product costs and promotional spending, net of higher pricing ($24 million), the impact of divestitures ($9 million) and higher implementation costs ($5 million).
North America Grocery. Volume decreased 21.6%, including the 53rd week of shipments in 2005 (representing approximately 2 percentage points of decline), due primarily to the divestitures of fruit snacks and Canadian grocery assets, the discontinuation of certain Canadian condiment product lines and lower shipments of ready-to-eat and dry packaged desserts, and spoonable salad dressings.
Net revenues decreased $293 million (9.7%), due primarily to the impact of divestitures ($266 million) and lower volume/mix ($85 million, including the 53rd week in 2005), partially offset by higher pricing ($30 million) and the impact of favorable currency ($26 million). Ready-to-eat and dry packaged desserts net revenues declined due to lower shipment volume. In spoonable salad dressing, net revenues decreased due to lower shipments, partially offset by lower promotional spending. Pourable salad dressing net revenues declined due to higher promotional spending.
Operating companies income increased $195 million (26.9%), due primarily to lower pre-tax charges for asset impairment and exit costs ($206 million, including the $113 million asset impairment charge in 2005 related to the sale of the Canadian grocery assets and the $93 million asset impairment charge related to the 2005 sale of the fruit snacks assets), lower marketing, administration and research costs ($30 million, including costs associated with the 53rd week in 2005), favorable currency ($8 million) and higher pricing, net of unfavorable costs ($7 million), partially offset by lower volume/mix ($50 million, including the 53rd week in 2005) and the impact of divestitures ($9 million).
North America Snacks & Cereals. Volume decreased 3.4%, including the 53rd week of shipments in 2005 (representing approximately 2 percentage points of decline), due primarily to the divestitures of the pet snacks brand and assets, and a small biscuit brand, and lower shipments of snack nuts, partially offset by higher shipments of biscuits and snack bars.
Net revenues increased $108 million (1.7%), due primarily to favorable volume/mix ($106 million, including the 53rd week in 2005) and higher pricing, net of increased promotional spending ($86 million, reflecting commodity-driven pricing in biscuits and ready-to-eat cereals) and favorable currency ($38 million), partially offset by the impact of divestitures ($123 million). Biscuit net revenues increased due to higher pricing to offset the impact of commodity cost increases in energy and packaging, higher shipment volume and favorable mix. In snack bars, net revenue increases were driven by new product introductions. Canadian snack net revenues also increased due to sales of co-manufactured products related to the 2005 divested confectionery business. Snack nuts net revenues decreased due to lower shipments.
Operating companies income decreased $101 million (10.9%), due primarily to higher pre-tax charges for asset impairment and exit costs ($138 million, including the $86 million asset impairment charge in 2006 related to the sale of the pet snacks brand and assets, the $69 million impairment charge in 2006 related to the sale of the hot cereal assets and trademarks, the $13 million hot cereal intangible asset impairment in 2006 and the $63 million asset impairment charge in 2005 related to the sale of a small biscuit brand), the impact of divestitures ($47 million) and 2006 losses on sales of businesses
($5 million), partially offset by lower marketing spending ($48 million), lower fixed manufacturing costs ($10 million), lower implementation costs ($10 million), higher pricing, net of increased promotional spending and unfavorable product costs ($8 million), favorable volume/mix ($7 million, including the 53rd week in 2005) and favorable currency ($6 million).
European Union. Volume increased 2.0%, despite the 53rd week of shipments in 2005 (representing approximately 2 percentage points of decline), due primarily to the acquisition of UB, partially offset by lower shipments across several sectors and the divestiture of the U.K. desserts assets in the first quarter of 2005. Snacks volume increased due primarily to the acquisition of UB and higher confectionery shipments, particularly in Poland. Convenient meals volume was up due primarily to the acquisition of UB, partially offset by lower shipments in Germany and the Nordic area. Grocery volume declined due primarily to the divestiture of the U.K. desserts assets and lower shipments in Germany, partially offset by the acquisition of UB. In beverages, coffee volume declined across most countries except Germany and refreshment beverages shipments were lower. In cheese & dairy, volume decreased due to lower shipments in Germany and Italy.
Net revenues decreased $42 million (0.6%), due primarily to unfavorable currency ($93 million), unfavorable volume/mix ($53 million, including the 53rd week in 2005) and the impact of divestitures ($12 million), partially offset by the acquisition of UB ($110 million) and higher pricing, net of increased promotional spending ($6 million). In cheese & dairy, net revenues decreased due to lower shipments, unfavorable currency and lower net pricing. Grocery net revenues declined due to unfavorable currency and the impact of the divestiture of the U.K. desserts business, partially offset by the acquisition of UB. In beverages, net revenues declined due to unfavorable currency and lower coffee and refreshment beverage shipments, partially offset by commodity-related pricing and favorable mix in coffee. Convenient meals net revenues also decreased, due to unfavorable currency and lower shipments, partially offset by the impact of the acquisition of UB. Snacks net revenues increased due primarily to the acquisition of UB for biscuits and higher shipments and pricing in confectionery, partially offset by unfavorable currency.
Operating companies income decreased $174 million (24.1%), due primarily to higher pre-tax charges for asset impairment and exit costs ($273 million, including $170 million of asset impairment charges related to Tassimo), the gain on the sale of U.K. desserts assets in 2005 ($115 million), unfavorable costs and increased promotional spending, net of higher pricing ($31 million), higher marketing, administration and research costs ($17 million, including costs associated with the 53rd week in 2005) and unfavorable currency ($14 million), partially offset by the 2006 gain on the redemption of the Company's outstanding investment in UB ($251 million), the impact of the acquisition of UB ($18 million) and lower fixed manufacturing costs ($14 million).
Developing Markets, Oceania & North Asia. Volume decreased 0.9%, including the 53rd week of shipments in 2005 (representing approximately 2 percentage points of decline), as lower volume in Asia Pacific was partially offset by growth in Eastern Europe and Latin America. In cheese and dairy, volume declined in Asia Pacific, partially offset by higher shipments in the Middle East. Grocery volume declined due to lower shipments in Brazil, Mexico, Venezuela and the Middle East. In beverages, volume declined due to the discontinuation of a product line in Mexico and lower shipments in Southeast Asia and the Middle East, partially offset by higher coffee volume in Russia, Ukraine and Romania, and higher refreshment beverage volume in China. Snacks volume increased driven by higher shipments in Brazil reflecting confectionery growth and gains in biscuits, and growth in Venezuela, Russia, Southeast Asia, Romania and Ukraine. Convenient meals volume decreased slightly.
Net revenues increased $460 million (11.2%), due primarily to favorable volume/mix ($215 million, including the 53rd week in 2005), higher pricing ($178 million) and favorable currency ($85 million), partially offset by the impact of divestitures ($19 million). In snacks, net revenues grew due to higher volume as well as favorable pricing in Latin America and favorable currency in Brazil. Confectionery net revenues also increased, due to growth in Russia and Ukraine. Coffee net revenues increased due to
commodity-based pricing, favorable mix and higher shipments in Russia, Ukraine and Romania. In refreshment beverages, higher shipments in Brazil and favorable pricing in Mexico drove higher net revenues. Cheese & dairy net revenue increases were driven by higher shipments in the Middle East. In convenient meals, net revenues were up slightly. Grocery net revenues declined due to the impact of a divestiture in Colombia.
Operating companies income increased $16 million (4.0%), due primarily to higher pricing, net of unfavorable costs ($102 million), favorable volume/mix ($93 million, including the 53rd week in 2005), favorable currency ($16 million), the losses on sales of businesses in 2005 ($5 million) and lower implementation costs ($4 million), partially offset by higher marketing, administration and research costs ($117 million, including costs associated with the 53rd week in 2005, higher marketing spending in 2006 and the 2005 recovery of a previously written-off account receivable of $16 million), higher pre-tax asset impairment and exit costs ($68 million, including the $11 million intangible asset impairment charge for biscuits assets in Egypt) and higher fixed manufacturing costs ($18 million).
2005 compared with 2004
The following discussion compares operating results within each of Kraft's reportable segments for 2005 with 2004.
North America Beverages. Volume increased 4.3% including the 53rd week of shipments (representing approximately 2 percentage points of growth), due primarily to refreshment beverages, partially offset by a decline in coffee. Refreshment beverages volume increased, due primarily to the 2004 acquisition of Veryfine, partially offset by a shift to lower weight sugar-free powdered beverages. In coffee, volume declined due to the impact of commodity-driven price increases on category consumption, although volume grew in premium brand coffee.
Net revenues increased $314 million (11.5%), due primarily to higher pricing and lower promotional spending ($158 million, reflecting commodity-driven pricing in coffee), higher volume/mix ($106 million, including the benefit of the 53rd week), the impact of the 2004 Veryfine acquisition ($34 million) and favorable currency ($14 million). Refreshment beverages net revenues increased, due primarily to expanded distribution of Veryfine and new product introductions in sugar-free powdered beverages. Coffee net revenues increased, due primarily to increased prices and positive mix driven by volume growth in premium brands.
Operating companies income decreased $6 million (1.3%), due primarily to higher marketing, administration and research costs ($101 million, including higher marketing and benefit costs, as well as costs associated with the 53rd week) and higher fixed manufacturing costs ($14 million), partially offset by favorable volume/mix ($73 million, including the benefit of the 53rd week), lower pre-tax charges for asset impairment and exit costs ($25 million) and higher pricing ($14 million, including higher commodity costs).
North America Cheese & Foodservice. Volume decreased 0.1% despite the 53rd week of shipments (representing approximately 2 percentage points of growth), due primarily to the impact of the divestiture of the U.S. yogurt assets, partially offset by gains in foodservice. In cheese, volume declined due primarily to the impact of the yogurt divestiture, partially offset by gains in natural cheese, cream cheese, process loaves and cottage cheese. Volume in the foodservice business increased due primarily to the 2004 acquisition of the Veryfine beverage business.
Net revenues increased $223 million (3.7%), due primarily to favorable volume/mix ($203 million, including the benefit of the 53rd week), favorable currency ($58 million), higher pricing, net of higher promotional spending ($21 million, reflecting commodity-driven pricing in late 2004) and the impact of acquisitions ($7 million), partially offset by the impact of divestitures ($66 million). Cheese net revenues increased, reflecting commodity-driven pricing from 2004 and favorable currency, partially offset by
increased promotional spending and the divestiture of the yogurt assets. In foodservice, net revenues increased, due primarily to favorable currency and the impact of the 2004 Veryfine acquisition.
Operating companies income increased $128 million (16.1%), due primarily to higher pricing and favorable costs ($77 million, net of higher promotional spending), favorable volume/mix ($62 million, including the benefit of the 53rd week), lower pre-tax charges for asset impairment and exit costs ($61 million) and favorable currency ($8 million), partially offset by higher marketing, administration and research costs ($57 million, including higher benefit costs, as well as costs associated with the 53rd week) and higher fixed manufacturing costs ($22 million).
North America Convenient Meals. Volume increased 2.9% including the 53rd week of shipments (representing approximately 2 percentage points of growth), due primarily to higher shipments in meats, pizza and meals. Meats volume increased, aided by higher shipments of cold cuts and new product introductions. Meals volume increased, due primarily to the impact of the 53rd week, partially offset by the discontinuation of a product line. In pizza, volume also increased due primarily to the 53rd week and new product introductions, partially offset by competitive activity.
Net revenues increased $274 million (6.2%), due to higher volume/mix ($238 million, including the benefit of the 53rd week), higher pricing, net of increased promotional spending ($20 million, reflecting commodity-driven pricing in meats and pizza) and favorable currency ($16 million). Meats net revenues increased, due primarily to higher volume and commodity-driven price increases, partially offset by higher promotional spending. Pizza net revenues increased, driven by positive mix from new products and the impact of commodity-driven price increases. In meals, net revenues increased due primarily to improved mix from new products, partially offset by the discontinuation of a product line and increased promotional spending.
Operating companies income decreased $7 million (0.9%), due primarily to higher marketing, administration and research costs ($73 million, including higher marketing and benefit costs, as well as costs associated with the 53rd week) and higher fixed manufacturing costs ($31 million), partially offset by higher volume/mix ($51 million including the benefit of the 53rd week), lower pre-tax charges for asset impairment and exit costs ($28 million), higher pricing, net of higher costs ($17 million, due primarily to higher commodity driven pricing) and favorable currency ($4 million).
North America Grocery. Volume decreased 0.6% due primarily to a decline in Canadian grocery shipments, despite the 53rd week of shipments (representing approximately 2 percentage points of growth), and higher enhancers and desserts volume. Canadian grocery volume declined due primarily to lower vegetable shipments. Enhancers volume increased slightly due primarily to higher shipments of spoonable dressings, partially offset by lower volume in pourable dressings and barbecue sauce due to increased competitive activity. In desserts, volume increased aided by new product introductions in refrigerated ready-to-eat desserts, partially offset by declines in dry packaged desserts and the impact of the fruit snacks divestiture.
Net revenues increased $15 million (0.5%), due primarily to favorable currency ($48 million), partially offset by the impact of divestitures ($31 million).
Operating companies income decreased $299 million (29.2%), due primarily to higher pre-tax charges for asset impairment and exit costs ($211 million), unfavorable costs ($37 million, due primarily to higher commodity costs), higher marketing, administration and research costs ($43 million, including higher benefit costs, as well as costs associated with the 53rd week), lower volume/mix ($8 million), the impact of divestitures ($4 million) and higher fixed manufacturing costs ($4 million), partially offset by favorable currency ($11 million).
North America Snacks & Cereals. Volume increased 3.3% including the 53rd week of shipments (representing approximately 2 percentage points of growth), as gains in biscuits and cereals were partially offset by a decline in salted snacks. In biscuits, volume increased due primarily to new product introductions in cookies. Cereals volume increased due primarily to new product introductions and
expanded distribution in ready-to-eat cereals. In salted snacks, volume declined due to higher commodity-driven pricing on snack nuts and increased competitive activity.
Net revenues increased $407 million (7.0%), due primarily to higher volume/mix ($325 million, including the benefit of the 53rd week), higher pricing, net of increased promotional spending ($42 million, reflecting commodity-driven pricing in snack nuts and cereals) and favorable currency ($36 million). Biscuits net revenues increased, driven by new product introductions and improved mix. Cereals net revenues also increased, due primarily to new product introductions and higher shipments and pricing of ready-to-eat cereals. Salted snacks net revenues increased, as lower volume was offset by higher prices.
Operating companies income increased $145 million (18.5%), due primarily to higher volume/mix ($186 million including the benefit of the 53rd week), lower pre-tax charges for asset impairment and exit costs ($153 million) and favorable currency ($6 million), partially offset by higher marketing, administration and research costs ($93 million, including higher marketing and benefit costs, as well as costs associated with the 53rd week), unfavorable costs, net of higher pricing ($74 million, due primarily to higher commodity costs and increased promotional spending), higher fixed manufacturing costs ($23 million) and the net impact of higher implementation costs associated with the restructuring program ($8 million).
European Union. Volume decreased 3.7% despite the 53rd week of shipments (representing approximately 2 percentage points of growth), due primarily to lower volume in Germany and the divestiture of the U.K. desserts assets in the first quarter of 2005. Beverages volume declined, driven by lower coffee shipments in Germany, due to commodity-driven price increases. In grocery, volume declined, due to the divestiture of the U.K. desserts assets in the first quarter of 2005 and lower results in Germany. In snacks, volume declined due primarily to lower shipments of confectionery products in Germany and the U.K. Convenient meals volume declined, due primarily to lower category performance in the U.K. and lower promotions in Germany. Cheese volume increased due to higher shipments in the U.K. and Italy.
Net revenues increased $210 million (3.2%), due primarily to favorable currency ($198 million) and higher pricing, net of increased promotional spending ($90 million, reflecting commodity-driven pricing in coffee), partially offset by the impact of divestitures ($60 million) and lower volume/mix ($18 million, including the benefit of the 53rd week).
Operating companies income increased $32 million (4.6%), due primarily to net gains on the sale of businesses ($109 million), lower pre-tax charges for asset impairment and exit costs ($53 million), favorable currency ($27 million), favorable volume/mix ($10 million, including the benefit of the 53rd week), lower fixed manufacturing costs ($8 million) and lower marketing, administration and research costs ($7 million, including costs associated with the 53rd week), partially offset by unfavorable costs, net of higher pricing ($145 million, due primarily to higher commodity costs and increased promotional spending), the impact of divestitures ($25 million) and the net impact of higher implementation costs associated with the restructuring program ($12 million).
Developing Markets, Oceania & North Asia. Volume increased 0.8% including the 53rd week of shipments (representing approximately 2 percentage points of growth), due primarily to growth in developing markets, including Russia, Ukraine and Southeast Asia, partially offset by lower shipments in Egypt and China. In beverages, volume increased due primarily to refreshment beverage gains in the Middle East, Southeast Asia, Argentina and Puerto Rico, and higher coffee shipments in Russia and Ukraine. Cheese volume increased due to higher shipments in Southeast Asia and the Middle East. In snacks, volume increased, as gains in confectionery, benefiting from growth in Russia and Ukraine, were partially offset by lower biscuit shipments due to increased competition in China and resizing of biscuit products in Egypt and Latin America. Grocery volume declined, due primarily to lower shipments in Egypt, Brazil and Central America. In convenient meals, volume declined due primarily to lower shipments in Argentina.
Net revenues increased $502 million (13.9%), due primarily to favorable volume/mix ($231 million, including the benefit of the 53rd week), favorable currency ($163 million) and higher pricing, net of increased promotional spending ($124 million), partially offset by the impact of divestitures ($17 million). Net revenues increased in several geographies due to growth in Russia, Ukraine and the Middle East, and increased refreshment beverage and cheese shipments in Southeast Asia. Net revenues declined in China, where the Company faced increased competitive activity in biscuits.
Operating companies income increased $157 million (64.6%), due primarily to favorable volume/mix ($105 million, including the benefit of the 53rd week), a 2004 equity investment impairment charge related to a joint venture in Turkey ($47 million), higher pricing, net of unfavorable costs ($46 million, including increased promotional spending), favorable currency ($32 million) and lower pre-tax charges for asset impairment and exit costs ($15 million), partially offset by higher marketing, administration and research costs ($60 million, including costs associated with the 53rd week, partially offset by a $16 million recovery of receivables previously written off) and higher fixed manufacturing costs ($24 million).
Financial Review
Net Cash Provided by Operating Activities
Net cash provided by operating activities was $3.7 billion in 2006, $3.5 billion in 2005 and $4.0 billion in 2004. The increase in 2006 operating cash flows from 2005 is due primarily to the previously discussed tax reimbursement from Altria Group, Inc. and higher earnings, partially offset by a decrease in amounts due to Altria Group, Inc. and higher pension contributions. The decrease in 2005 operating cash flows from 2004 was due primarily to an increase in income tax payments (primarily related to the sale of the sugar confectionery business), an increase in the use of cash to fund working capital, due primarily to an increase in cash payments associated with the restructuring plan, and lower earnings, partially offset by lower pension plan contributions.
Net Cash Provided by (Used in) Investing Activities
One element of the growth strategy of the Company is to strengthen its brand portfolios and/or expand its geographic reach through disciplined programs of selective acquisitions and divestitures. The Company is constantly reviewing potential acquisition candidates and from time to time sells businesses to accelerate the shift in its portfolio toward businesses-whether global, regional or local-that offer the Company a sustainable competitive advantage. The impact of future acquisitions or divestitures could have a material impact on the Company's cash flows.
During 2006 and 2004, net cash used by investing activities was $116 million and $1.1 billion, respectively, as compared with net cash provided by investing activities of $525 million in 2005. During 2006, the Company used cash for investing activities as the proceeds received from the sales of businesses declined by approximately $720 million from the 2005 level. During 2006, the Company sold its rice brand and assets, pet snacks brand and assets, industrial coconut assets, certain Canadian assets, a small U.S. biscuit brand and a U.S. coffee plant. During 2005, the Company sold its sugar confectionery business, fruit snacks assets, U.K. desserts assets, U.S. yogurt assets, a small business in Colombia, a small equity investment in Turkey and a minor trademark in Mexico.
Capital expenditures, which were funded by operating activities, were $1.2 billion, $1.2 billion and $1.0 billion in 2006, 2005 and 2004, respectively. The 2006 capital expenditures were primarily to modernize manufacturing facilities, implement the restructuring program, and support new product and productivity initiatives. In 2007, capital expenditures are currently expected to be flat to 2006 expenditures, including capital expenditures required for the restructuring program. These expenditures are expected to be funded from operations.
Net Cash Used in Financing Activities
During 2006, net cash of $3.7 billion was used in financing activities, compared with $4.0 billion during 2005. The decrease in net cash used in 2006 was due primarily to a decrease in net debt repayments, partially offset by an increase in the Company's Class A share repurchases and dividend payments.
During 2005, net cash of $4.0 billion was used in financing activities, compared with $3.2 billion during 2004. The increase in cash used in 2005 was due primarily to an increase in the Company's Class A share repurchases and the repayment of debt, partially offset by an increase in amounts due to Altria Group, Inc. and affiliates.
Debt and Liquidity
Debt. The Company's total debt, including amounts due to Altria Group, Inc. and affiliates, was $10.8 billion at December 31, 2006 and $11.2 billion at December 31, 2005. The Company's debt-to-equity ratio was 0.38 at December 31, 2006 and 2005. The Company's debt-to-capitalization ratio was 0.27 at December 31, 2006 and 2005.
The Company has a Form S-3 shelf registration statement on file with the Securities and Exchange Commission ("SEC") under which the Company may sell debt securities and/or warrants to purchase debt securities in one or more offerings up to a total amount of $4.0 billion. At December 31, 2006, the Company had $3.5 billion of capacity remaining under its shelf registration.
At December 31, 2006 and 2005, the Company had short-term amounts payable to Altria Group, Inc. and affiliates of $607 million and $652 million, respectively. The amounts payable to Altria Group, Inc. generally include accrued dividends, taxes and service fees. Interest on intercompany borrowings is based on the applicable London Interbank Offered Rate. The Company had no long-term amounts payable to Altria Group, Inc. and affiliates. As discussed under Kraft Spin-Off from Altria Group, Inc. within the Description of the Company section above, all intercompany accounts will be settled in cash. However, once items arising from the normal course of business, such as dividends and tax deposits, are accounted for, the net settlement arising from the spin-off will be insignificant.
The Company is currently included in the Altria Group, Inc. consolidated federal income tax return, and federal income tax contingencies are recorded as liabilities on the balance sheet of Altria Group, Inc. Prior to the distribution of Kraft shares, Altria Group, Inc. will reimburse the Company in cash for these liabilities, which are approximately $300 million, plus interest.
Credit Ratings. At December 31, 2006, the Company's debt ratings by major credit rating agencies were as follows:
On January 31, 2007, Standard & Poor's placed the Company's long-term and short-term credit ratings on CreditWatch with positive implications. On February 20, 2007, following the announcement of a $5 billion, two year share repurchase program, Standard & Poor's maintained its CreditWatch with positive implications and Moody's placed Kraft's long-term credit ratings under review for possible downgrade.
Credit Lines. The Company maintains revolving credit facilities that have historically been used to support the issuance of commercial paper. At December 31, 2006, the Company has a $4.5 billion, multi-year revolving credit facility that expires in April 2010 on which no amounts were drawn.
The Company's revolving credit facility, which is for its sole use, requires the maintenance of a minimum net worth of $20.0 billion. At December 31, 2006, the Company's net worth was $28.6 billion. The Company expects to continue to meet this covenant. The revolving credit facility does not include any other financial tests, any credit rating triggers or any provisions that could require the posting of collateral. The Company expects to refinance long-term and short-term debt from time to time. As approximately $1.4 billion of the Company's long-term debt matures during the next twelve months, the Company will evaluate whether and how it will refinance these amounts. The nature and amount of the Company's long-term and short-term debt and the proportionate amount of each can be expected to vary as a result of future business requirements, market conditions and other factors.
In addition to the above, certain international subsidiaries of Kraft maintain credit lines to meet the short-term working capital needs of the international businesses. These credit lines, which amounted to approximately $1.1 billion as of December 31, 2006, are for the sole use of the Company's international businesses. Borrowings on these lines amounted to approximately $200 million and $400 million at December 31, 2006 and 2005, respectively. At December 31, 2006 the Company also had approximately $0.3 billion of outstanding short-term debt related to its United Biscuits acquisition discussed in Note 6. Acquisitions.
Off-Balance Sheet Arrangements and Aggregate Contractual Obligations
The Company has no off-balance sheet arrangements other than the guarantees and contractual obligations that are discussed below.
Guarantees. As discussed in Note 18 to the consolidated financial statements, the Company's third-party guarantees, which are primarily derived from acquisition and divestiture activities, approximated $21 million, of which $8 million have no specified expiration dates. Substantially all of the remainder expire through 2016, with no guarantees expiring during 2007. The Company is required to perform under these guarantees in the event that a third party fails to make contractual payments or achieve performance measures. The Company has a liability of $16 million on its consolidated balance sheet at December 31, 2006, relating to these guarantees.
In addition, at December 31, 2006, the Company was contingently liable for $189 million of guarantees related to its own performance. These include surety bonds related to dairy commodity purchases and guarantees related to the payment of customs duties and taxes, and letters of credit.
Guarantees do not have, and are not expected to have, a significant impact on the Company's liquidity.
Aggregate Contractual Obligations. The following table summarizes the Company's contractual obligations at December 31, 2006:
(1)Amounts represent the expected cash payments of the Company's long-term debt and do not include unamortized bond premiums or discounts.
(2)Amounts represent the expected cash payments of the Company's interest expense on its long-term debt. Due to the complex nature of forecasting expected variable rate interest payments on the Company's insignificant balance of variable rate long-term debt, those amounts are not included in the table.
(3)Operating leases represent the minimum rental commitments under non-cancelable operating leases. The Company has no significant capital lease obligations.
(4)Purchase obligations for inventory and production costs (such as raw materials, indirect materials and supplies, packaging, co-manufacturing arrangements, storage and distribution) are commitments for projected needs to be utilized in the normal course of business. Other purchase obligations include commitments for marketing, advertising, capital expenditures, information technology and professional services. Arrangements are considered purchase obligations if a contract specifies all significant terms, including fixed or minimum quantities to be purchased, a pricing structure and approximate timing of the transaction. Most arrangements are cancelable without a significant penalty, and with short notice (usually 30 days). Any amounts reflected on the consolidated balance sheet as accounts payable and accrued liabilities are excluded from the table above.
(5)Other long-term liabilities primarily consist of postretirement health care costs. The following long-term liabilities included on the consolidated balance sheet are excluded from the table above: accrued pension costs, income taxes, minority interest, insurance accruals and other accruals. The Company is unable to estimate the timing of the payments (or contributions in the case of accrued pension costs) for these items. Currently, the Company anticipates making U.S. pension contributions of approximately $16 million in 2007 and non-U.S. pension contributions of approximately $157 million in 2007, based on current tax law (as discussed in Note 15 to the consolidated financial statements).
The Company believes that its cash from operations and existing credit facility will provide sufficient liquidity to meet its working capital needs (including the cash requirements of the restructuring program), planned capital expenditures, future contractual obligations and payment of its anticipated quarterly dividends.
Equity and Dividends
In December 2004, the Company commenced repurchasing shares under a two-year $1.5 billion Class A common stock repurchase program authorized by its Board of Directors. In March 2006, the Company completed the program, acquiring 49.1 million Class A shares at an average price of $30.57 per share. In March 2006, the Company's Board of Directors authorized a new share repurchase program to repurchase up to $2.0 billion of the Company's Class A common stock. This new program is expected to run through 2008. During 2006 and 2005, the Company repurchased 8.5 million and 39.2 million shares, respectively, of its Class A common stock under its $1.5 billion repurchase program at a cost of $250 million and $1.2 billion, respectively. In addition, as of December 31, 2006, the Company repurchased 30.2 million shares of its Class A common stock, under its new $2.0 billion authority, at an aggregate cost of $1.0 billion, bringing total repurchases for 2006 to 38.7 million shares for $1.2 billion.
In February 2007, the Company announced that the Board of Directors authorized a stock repurchase plan pursuant to which the Company may repurchase shares of the Company's Class A common stock having an aggregate value up to $5 billion through March 2009. The repurchase program will become effective immediately following the distribution of the approximately 89% of the Company's outstanding shares owned by Altria Group Inc. The program does not obligate the Company to acquire any particular amount of Class A common stock, it replaces the existing share repurchase program, and it may be suspended at any time at the Company's discretion.
As discussed in Note 11 to the consolidated financial statements, during 2006 and 2005, the Company granted approximately 4.8 million and 4.2 million restricted Class A shares, respectively, to eligible U.S.-based employees, and during 2006 and 2005, also issued to eligible non-U.S. employees rights to receive approximately 2.0 million and 1.8 million Class A equivalent shares, respectively. The market value per restricted share or right was $29.16 and $33.26 on the dates of the 2006 and 2005 grants, respectively. Restrictions on most of the stock and rights granted in 2006 lapse in the first quarter of 2009, while restrictions on grants in 2005 lapse in the first quarter of 2008.
Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123 (Revised 2004), "Share-Based Payment," ("SFAS No. 123(R)") using the modified prospective method, which requires measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation over the service periods for awards expected to vest. The fair value of restricted stock and rights to receive shares of stock is determined based on the number of shares granted and the market value at date of grant. The fair value of stock options is determined using a modified Black-Scholes methodology. The impact of adoption was not material. At December 31, 2006, the number of shares to be issued upon exercise of outstanding stock options and vesting of non-U.S. rights to receive equivalent shares (excluding any options or rights to be issued as part of the Company's spin-off from Altria Group, Inc.) was 17.8 million or 1.1% of total Class A and Class B shares outstanding.
Dividends paid in 2006 and 2005 were $1,562 million and $1,437 million, respectively, an increase of 8.7%, reflecting a higher dividend rate in 2006, partially offset by a lower number of shares outstanding as a result of Class A share repurchases. During the third quarter of 2006, the Company's Board of Directors approved an 8.7% increase in the current quarterly dividend rate to $0.25 per share on its Class A and Class B common stock. As a result, the present annualized dividend rate is $1.00 per common share. The declaration of dividends is subject to the discretion of the Company's Board of Directors and will depend on various factors, including the Company's net earnings, financial condition, cash requirements, future prospects and other factors deemed relevant by the Company's Board of Directors.
On January 31, 2007, the Altria Group, Inc. Board of Directors announced that Altria Group, Inc. plans to spin off all of its remaining interest (89.0%) in the Company on a pro rata basis to Altria
Group, Inc. stockholders in a tax-free transaction. See Kraft Spin-Off from Altria Group, Inc. within the Description of the Company section above for further details.
Market Risk
The Company operates globally, with manufacturing and sales facilities in various locations around the world, and utilizes certain financial instruments to manage its foreign currency and commodity exposures. Derivative financial instruments are used by the Company, principally to reduce exposures to market risks resulting from fluctuations in foreign exchange rates and commodity prices by creating offsetting exposures. The Company is not a party to leveraged derivatives and, by policy, does not use financial instruments for speculative purposes.
During the years ended December 31, 2006, 2005 and 2004, ineffectiveness related to cash flow hedges was not material. At December 31, 2006, the Company was hedging forecasted transactions for periods not exceeding the next fifteen months, and expects substantially all amounts reported in accumulated other comprehensive earnings (losses) at December 31, 2006 to be reclassified to the consolidated statement of earnings within the next twelve months.
Foreign Exchange Rates. The Company uses forward foreign exchange contracts and foreign currency options to mitigate its exposure to changes in exchange rates from third-party and intercompany actual and forecasted transactions. Substantially all of the Company's derivative financial instruments are effective as hedges. The primary currencies to which the Company is exposed, based on the size and location of its businesses, include the euro, Swiss franc, British pound and Canadian dollar. At December 31, 2006 and 2005, the Company had foreign exchange option and forward contracts with aggregate notional amounts of $2.6 billion and $2.2 billion, respectively. The effective portion of unrealized gains and losses associated with forward and option contracts is deferred as a component of accumulated other comprehensive earnings (losses) until the underlying hedged transactions are reported on the Company's consolidated statement of earnings. In 2007, the Company also anticipates entering into additional hedging instruments to mitigate its exposure to changes in exchange rates relating to distributions contemplated in advance of the Kraft Spin-Off from Altria Group, Inc., as referred to within the Description of the Company section above.
Commodities. The Company is exposed to price risk related to forecasted purchases of certain commodities used as raw materials by its businesses. Accordingly, the Company uses commodity forward contracts as cash flow hedges, primarily for coffee, milk, sugar and cocoa. In general, commodity forward contracts qualify for the normal purchase exception under SFAS No. 133 and are, therefore, not subject to the provisions of SFAS No. 133. In addition, commodity futures and options are also used to hedge the price of certain commodities, including milk, coffee, cocoa, wheat, corn, sugar, soybean oil, natural gas and heating oil. For qualifying contracts, the effective portion of unrealized gains and losses on commodity futures and option contracts is deferred as a component of accumulated other comprehensive earnings (losses) and is recognized as a component of cost of sales in the Company's consolidated statement of earnings when the related inventory is sold. Unrealized gains or losses on net commodity positions were immaterial at December 31, 2006 and 2005. At December 31, 2006 and 2005, the Company had net long commodity positions of $533 million and $521 million, respectively.
Value at Risk. The Company uses a value at risk ("VAR") computation to estimate the potential one-day loss in the fair value of its interest rate-sensitive financial instruments and to estimate the potential one-day loss in pre-tax earnings of its foreign currency and commodity price-sensitive derivative financial instruments. The VAR computation includes the Company's debt; short-term investments; foreign currency forwards, swaps and options; and commodity futures, forwards and options. Anticipated transactions, foreign currency trade payables and receivables, and net investments in foreign subsidiaries, which the foregoing instruments are intended to hedge, were excluded from the computation.
The VAR estimates were made assuming normal market conditions, using a 95% confidence interval. The Company used a "variance/co-variance" model to determine the observed interrelationships between movements in interest rates and various currencies. These interrelationships were determined by observing interest rate and forward currency rate movements over the preceding quarter for the calculation of VAR amounts at December 31, 2006 and 2005, and over each of the four preceding quarters for the calculation of average VAR amounts during each year. The values of foreign currency and commodity options do not change on a one-to-one basis with the underlying currency or commodity, and were valued accordingly in the VAR computation.
The estimated potential one-day loss in fair value of the Company's interest rate-sensitive instruments, primarily debt, under normal market conditions and the estimated potential one-day loss in pre-tax earnings from foreign currency and commodity instruments under normal market conditions, as calculated in the VAR model, were as follows (in millions):
This VAR computation is a risk analysis tool designed to statistically estimate the maximum probable daily loss from adverse movements in interest rates, foreign currency rates and commodity prices under normal market conditions. The computation does not purport to represent actual losses in fair value or earnings to be incurred by the Company, nor does it consider the effect of favorable changes in market rates. The Company cannot predict actual future movements in such market rates and does not present these VAR results to be indicative of future movements in such market rates or to be representative of any actual impact that future changes in market rates may have on its future results of operations or financial position.
New Accounting Standards
See Notes 2, 15 and 17 to the consolidated financial statements for a discussion of new accounting standards.
Contingencies
See Note 18 to the consolidated financial statements for a discussion of contingencies.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
See paragraphs captioned "Market Risk" and "Value at Risk" in Item 7 above.
Item 8.
Item 8. Financial Statements and Supplementary Data.
REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. The Company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. The Company's internal control over financial reporting includes those written policies and procedures that:
•pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company;
•provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America;
•provide reasonable assurance that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and
•provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of assets that could have a material effect on the consolidated financial statements.
Internal control over financial reporting includes the controls themselves, monitoring and internal auditing practices and actions taken to correct deficiencies as identified.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2006. Management based this assessment on criteria for effective internal control over financial reporting described in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). Management's assessment included an evaluation of the design of the Company's internal control over financial reporting and testing of the operational effectiveness of the Company's internal control over financial reporting. Management reviewed the results of its assessment with the Audit Committee of the Company's Board of Directors.
Based on this assessment, management determined that, as of December 31, 2006, the Company maintained effective internal control over financial reporting.
PricewaterhouseCoopers LLP, independent registered public accounting firm, who audited and reported on the consolidated financial statements of the Company included in this report, has audited our management's assessment of the effectiveness of the Company's internal control over financial reporting as of December 31, 2006.
February 5,
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of Kraft Foods Inc.:
We have completed integrated audits of Kraft Foods Inc.'s consolidated financial statements and of its internal control over financial reporting as of December 31, 2006, in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Consolidated financial statements
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of earnings, shareholders' equity, and cash flows, present fairly, in all material respects, the financial position of Kraft Foods Inc. and its subsidiaries at December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of Kraft Foods Inc.'s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 15 to the consolidated financial statements, Kraft Foods Inc. changed the manner in which it accounts for pension, postretirement and postemployment plans in fiscal 2006.
Internal control over financial reporting
Also, in our opinion, management's assessment, included in the Report of Management on Internal Control Over Financial Reporting dated February 5, 2007, that Kraft Foods Inc. maintained effective internal control over financial reporting as of December 31, 2006 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, Kraft Foods Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the COSO. Kraft Foods Inc.'s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management's assessment and on the effectiveness of Kraft Foods Inc.'s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for
external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ PRICEWATERHOUSECOOPERS LLP
Chicago, Illinois
February 5, 2007
KRAFT FOODS INC. and SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS, at December 31,
(in millions of dollars)
See notes to consolidated financial statements.
KRAFT FOODS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENTS of EARNINGS
for the years ended December 31,
(in millions of dollars, except per share data)
See notes to consolidated financial statements.
KRAFT FOODS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENTS of SHAREHOLDERS' EQUITY
(in millions of dollars, except per share data)
See notes to consolidated financial statements.
KRAFT FOODS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENTS of CASH FLOWS
for the years ended December 31,
(in millions of dollars)
See notes to consolidated financial statements.
KRAFT FOODS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Background and Basis of Presentation:
Background:
Kraft Foods Inc. ("Kraft") was incorporated in 2000 in the Commonwealth of Virginia. Kraft, through its subsidiaries (Kraft and its subsidiaries are hereinafter referred to as the "Company"), is engaged in the manufacture and sale of packaged foods and beverages in the United States, Canada, Europe, Latin America, Asia Pacific and Middle East and Africa.
Prior to June 13, 2001, the Company was a wholly-owned subsidiary of Altria Group, Inc. On June 13, 2001, the Company completed an initial public offering ("IPO") of 280,000,000 shares of its Class A common stock at a price of $31.00 per share. At December 31, 2006, Altria Group, Inc. held 98.5% of the combined voting power of the Company's outstanding capital stock and owned 89.0% of the outstanding shares of the Company's capital stock.
As further discussed in Note 20. Subsequent Event, on January 31, 2007, Altria Group, Inc.'s Board of Directors approved a tax-free distribution to its stockholders of all of its interest in the Company.
In June 2005, the Company sold substantially all of its sugar confectionery business for pre-tax proceeds of approximately $1.4 billion. The Company has reflected the results of its sugar confectionery business prior to the closing date as discontinued operations on the consolidated statements of earnings.
In October 2005, the Company announced that, effective January 1, 2006, its Canadian business would be realigned to better integrate it into the Company's North American business by product category. Beginning in the first quarter of 2006, the operating results of the Canadian business were being reported throughout the North American food segments. In addition, in the first quarter of 2006, the Company's international businesses were realigned to reflect the reorganization announced within Europe in November 2005. The two revised international segments, which are reflected in these consolidated financial statements and notes, are European Union; and Developing Markets, Oceania & North Asia, the latter to reflect the Company's increased management focus on developing markets. Accordingly, prior period segment results have been restated.
Basis of presentation:
The consolidated financial statements include Kraft, as well as its wholly-owned and majority-owned subsidiaries. Investments in which the Company exercises significant influence (20%-50% ownership interest) are accounted for under the equity method of accounting. Investments in which the Company has an ownership interest of less than 20%, or does not exercise significant influence, are accounted for by the cost method of accounting. All intercompany transactions and balances between and among Kraft's subsidiaries have been eliminated. Transactions between any of the Company's businesses and Altria Group, Inc. and its affiliates are included in these financial statements.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent liabilities at the dates of the financial statements and the reported amounts of net revenues and expenses during the reporting periods. Significant estimates and assumptions include, among other things, pension and benefit plan assumptions, lives and valuation assumptions of goodwill and other intangible assets, marketing programs and income taxes. Actual results could differ from those estimates.
The Company's operating subsidiaries generally report year-end results as of the Saturday closest to the end of each year. This resulted in fifty-three weeks of operating results in the Company's consolidated statement of earnings for the year ended December 31, 2005, versus fifty-two weeks for the years ended December 31, 2006 and 2004.
Classification of certain prior year balance sheet amounts related to pension plans have been reclassified to conform with the current year's presentation.
Note 2. Summary of Significant Accounting Policies:
Cash and cash equivalents:
Cash equivalents include demand deposits with banks and all highly liquid investments with original maturities of three months or less.
Depreciation, amortization and goodwill valuation:
Property, plant and equipment are stated at historical cost and depreciated by the straight-line method over the estimated useful lives of the assets. Machinery and equipment are depreciated over periods ranging from 3 to 20 years, and buildings and building improvements over periods up to 40 years.
Definite life intangible assets are amortized over their estimated useful lives. The Company is required to conduct an annual review of goodwill and intangible assets for potential impairment. Goodwill impairment testing requires a comparison between the carrying value and fair value of each reporting unit. If the carrying value exceeds the fair value, goodwill is considered impaired. The amount of impairment loss is measured as the difference between the carrying value and implied fair value of goodwill, which is determined using discounted cash flows. Impairment testing for non-amortizable intangible assets requires a comparison between the fair value and carrying value of the intangible asset. If the carrying value exceeds fair value, the intangible asset is considered impaired and is reduced to fair value. During the first quarter of 2006, the Company completed its annual review of goodwill and intangible assets and recorded non-cash pre-tax charges of $24 million related to an intangible asset impairment for biscuits assets in Egypt and hot cereal assets in the United States. Additionally, in 2006, as part of the sale of its pet snacks brand and assets, the Company recorded non-cash pre-tax asset impairment charges of $86 million, which included the write-off of a portion of the associated goodwill and intangible assets of $25 million and $55 million, respectively, as well as $6 million of asset write-downs. In January 2007, the Company announced the sale of its hot cereal assets and trademarks. In recognition of the anticipated sale, the Company recorded a pre-tax asset impairment charge of $69 million in 2006 for these assets, which included the write-off of a portion of the associated goodwill and intangible assets of $15 million and $52 million, respectively, as well as $2 million of asset write-downs. During the first quarter of 2005, the Company completed its annual review of goodwill and intangible assets and no impairment charges resulted from this review. However, as part of the sale of certain Canadian assets and two brands, the Company recorded total non-cash pre-tax asset impairment charges of $269 million in 2005, which included impairment of goodwill and intangible assets of $13 million and $118 million, respectively, as well as $138 million of asset write-downs.
At December 31, 2006 and 2005, goodwill by reportable segment was as follows (in millions):
Intangible assets at December 31, 2006 and 2005, were as follows (in millions):
Non-amortizable intangible assets consist substantially of brand names purchased through the Nabisco acquisition. Amortizable intangible assets consist primarily of certain trademark licenses and non-compete agreements. Amortization expense for intangible assets was $7 million, $10 million and $11 million for the years ended December 31, 2006, 2005 and 2004, respectively. Amortization expense for each of the next five years is currently estimated to be approximately $10 million or less.
The movement in goodwill and gross carrying amount of intangible assets is as follows:
The increase in goodwill and intangible assets from acquisitions is related to preliminary allocations of purchase price for the Company's acquisition of certain United Biscuits operations and Nabisco trademarks as discussed in Note 6. Acquisitions. The allocations are based upon preliminary estimates and assumptions and are subject to revision when appraisals are finalized, which is expected to occur during the first half of 2007.
Environmental costs:
The Company is subject to laws and regulations relating to the protection of the environment. The Company provides for expenses associated with environmental remediation obligations on an undiscounted basis when such amounts are probable and can be reasonably estimated. Such accruals are adjusted as new information develops or circumstances change.
While it is not possible to quantify with certainty the potential impact of actions regarding environmental remediation and compliance efforts that the Company may undertake in the future, in the opinion of management, environmental remediation and compliance costs, before taking into account any recoveries from third parties, will not have a material adverse effect on the Company's consolidated financial position, results of operations or cash flows.
Foreign currency translation:
The Company translates the results of operations of its foreign subsidiaries using average exchange rates during each period, whereas balance sheet accounts are translated using exchange rates at the end of each period. Currency translation adjustments are recorded as a component of shareholders' equity. Transaction gains and losses are recorded in the consolidated statements of earnings and were not significant for any of the periods presented.
Guarantees:
The Company accounts for guarantees in accordance with Financial Accounting Standards Board ("FASB") Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." Interpretation No. 45 requires the disclosure of certain guarantees and the recognition of a liability for the fair value of the obligation of qualifying guarantee activities. See Note 18. Contingencies for a further discussion of guarantees.
Hedging instruments:
Derivative financial instruments are recorded at fair value on the consolidated balance sheets as either assets or liabilities. Changes in the fair value of derivatives are recorded each period either in accumulated other comprehensive earnings (losses) or in earnings, depending on whether a derivative is designated and effective as part of a hedge transaction and, if it is, the type of hedge transaction. Gains and losses on derivative instruments reported in accumulated other comprehensive earnings (losses) are reclassified to the consolidated statement of earnings in the periods in which operating results are affected by the hedged item. Cash flows from hedging instruments are classified in the same manner as the affected hedged item in the consolidated statements of cash flows.
Impairment of long-lived assets:
The Company reviews long-lived assets, including amortizable intangible assets, for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. The Company performs undiscounted operating cash flow analyses to determine if an impairment exists. For purposes of recognition and measurement of an impairment for assets held for use, the Company groups assets and liabilities at the lowest level for which cash flows are separately identifiable. If an impairment is determined to exist, any related impairment loss is calculated based on fair value. Impairment losses on assets to be disposed of, if any, are based on the estimated proceeds to be received, less costs of disposal. During 2006, the Company recorded non-cash pre-tax asset impairment charges of $245 million related to its Tassimo hot beverage business. The charges are included in asset impairment and exit costs in the consolidated statement of earnings.
Income taxes:
The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." The U.S. accounts of the Company are included in the consolidated federal income tax return of Altria Group, Inc. Income taxes are generally computed on a separate company basis. To the extent that foreign tax credits, capital losses and other credits generated by the Company, which cannot currently be utilized on a separate company basis, are utilized in Altria Group, Inc.'s consolidated federal income tax return, the benefit is recognized in the calculation of the Company's provision for income taxes. Based on the Company's current estimate, this benefit is calculated to be approximately $195 million, $225 million and $70 million for the years ended December 31, 2006, 2005 and 2004, respectively. The amounts in 2005 and 2006 include dividend repatriations and the impact of certain legal entity reorganizations. The Company makes payments to, or is reimbursed by, Altria Group, Inc. for the tax effects resulting from its inclusion in Altria Group, Inc.'s consolidated federal income tax return, including current taxes payable and net changes in tax provisions. The Company is assessing opportunities to mitigate the loss of tax benefits upon Altria Group, Inc.'s distribution of its Kraft shares, and currently estimates the annual amount of lost tax benefits to be in the range of $50 million to $75 million. Significant judgment is required in determining income tax provisions and in evaluating tax positions. The Company establishes additional provisions for income taxes when, despite the belief that existing tax positions are fully supportable, there remain certain positions that are likely to be challenged and that may not be sustained on review by tax authorities. The Company evaluates and potentially adjusts these provisions in light of changing facts and circumstances. The consolidated tax provision includes the impact of changes to accruals that are deemed necessary.
In July 2006, the FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109" ("FIN 48"), which will become effective for the Company on January 1, 2007. The Interpretation prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The amount recognized is measured as the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. The adoption of FIN 48 will result in an increase to shareholders' equity as of January 1, 2007 of approximately $200 million to $225 million.
Inventories:
Inventories are stated at the lower of cost or market. The last-in, first-out ("LIFO") method is used to cost a majority of domestic inventories. The cost of other inventories is principally determined by the average cost method.
The Company adopted the provisions of SFAS No. 151, "Inventory Costs" prospectively as of January 1, 2006. SFAS No. 151 requires that abnormal idle facility expense, spoilage, freight and handling costs be recognized as current-period charges. In addition, SFAS No. 151 requires that allocation of fixed production overhead costs to inventories be based on the normal capacity of the production facility. The effect of adoption did not have a material impact on the Company's consolidated results of operations, financial position or cash flows.
Marketing costs:
The Company promotes its products with advertising, consumer incentives and trade promotions. Such programs include, but are not limited to, discounts, coupons, rebates, in-store display incentives and volume-based incentives. Advertising costs are expensed as incurred. Consumer incentive and trade promotion activities are recorded as a reduction of revenues based on amounts estimated as
being due to customers and consumers at the end of a period, based principally on historical utilization and redemption rates. For interim reporting purposes, advertising and consumer incentive expenses are charged to operations as a percentage of volume, based on estimated volume and related expense for the full year.
Revenue recognition:
The Company recognizes revenues, net of sales incentives and including shipping and handling charges billed to customers, upon shipment or delivery of goods when title and risk of loss pass to customers. Shipping and handling costs are classified as part of cost of sales.
Software costs:
The Company capitalizes certain computer software and software development costs incurred in connection with developing or obtaining computer software for internal use. Capitalized software costs are included in property, plant and equipment on the consolidated balance sheets and amortized on a straight-line basis over the estimated useful lives of the software, which do not exceed five years.
Stock-based compensation:
Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123 (Revised 2004), "Share-Based Payment," ("SFAS No. 123(R)") using the modified prospective method, which requires measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation over the service periods for awards expected to vest. The fair value of restricted stock and rights to receive shares of stock is determined based on the number of shares granted and the market value at date of grant. The fair value of stock options is determined using a modified Black-Scholes methodology. The impact of adoption was not material.
The adoption of SFAS No. 123(R) resulted in a cumulative effect gain of $6 million, which is net of $3 million in taxes, in the consolidated statement of earnings for the year ended December 31, 2006. This gain resulted from the impact of estimating future forfeitures on restricted stock and rights to receive shares of stock in the determination of periodic expense for unvested awards, rather than recording forfeitures only when they occur. The gross cumulative effect was recorded in marketing, administration and research costs for the year ended December 31, 2006.
The Company previously applied the recognition and measurement principles of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," ("APB 25") and provided the pro forma disclosures required by SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123"). No compensation expense for employee stock options was reflected in net earnings in 2005 and 2004, as all stock options granted under those plans had an exercise price equal to the market value of the common stock on the date of the grant. Historical consolidated statements of earnings already include the compensation expense for restricted stock and rights to receive shares of stock. The following table illustrates the effect on net earnings and earnings per share ("EPS") if the Company had applied the fair value recognition provisions of SFAS No. 123 to measure compensation
expense for stock option awards for the years ended December 31, 2005 and 2004 (in millions, except per share data):
The Company elected to calculate the initial pool of tax benefits resulting from tax deductions in excess of the stock-based employee compensation expense recognized in the statement of earnings under FASB Staff Position 123(R)-3, "Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards." Under SFAS No. 123(R), tax shortfalls occur when actual tax deductible compensation expense is less than cumulative stock-based compensation expense recognized in the financial statements. Tax shortfalls of $8 million were recognized for the year ended December 31, 2006, and were recorded in additional paid-in capital.
Note 3. Asset Impairment, Exit and Implementation Costs:
Restructuring Program:
In January 2004, the Company announced a three-year restructuring program with the objectives of leveraging the Company's global scale, realigning and lowering its cost structure, and optimizing capacity utilization. In January 2006, the Company announced plans to expand its restructuring efforts through 2008. The entire restructuring program is expected to result in $3.0 billion in pre-tax charges reflecting asset disposals, severance and implementation costs. The decline of $700 million from the $3.7 billion in pre-tax charges previously announced was due primarily to lower than projected severance costs, the cancellation of an initiative to generate sales efficiencies, and the sale of one plant that was originally planned to be closed. As part of this program, the Company anticipates the closure of up to 40 facilities and the elimination of approximately 14,000 positions. Approximately $1.9 billion of the $3.0 billion in pre-tax charges are expected to require cash payments. Pre-tax restructuring program charges, including implementation costs for the years ended December 31, 2006, 2005 and 2004 were $673 million, $297 million and $641 million, respectively. Total pre-tax restructuring charges incurred since the inception of the program in January 2004 were $1.6 billion.
During 2006, the Company announced a seven-year, $1.7 billion agreement to receive information technology services from Electronic Data Systems ("EDS"). The agreement, which includes data centers, web hosting, telecommunications and IT workplace services, began on June 1, 2006. Pursuant to the agreement, approximately 670 employees, who provided certain IT support to the Company, were transitioned to EDS. As a result of the agreement, in 2006 the Company incurred pre-tax asset impairment and exit costs of $51 million and implementation costs of $56 million related to the transition. These costs were included in the pre-tax restructuring program charges discussed above.
Restructuring Costs:
During 2006, 2005 and 2004, pre-tax charges under the restructuring program of $578 million, $210 million and $583 million, respectively, were recorded as asset impairment and exit costs on the consolidated statements of earnings. These pre-tax charges resulted from the announcement of the closing of 27 plants since January 2004, of which 8 occurred in 2006, the continuation of a number of workforce reduction programs, and the termination of co-manufacturing agreements in 2004. Approximately $332 million of the pre-tax charges incurred during 2006 will require cash payments.
Pre-tax restructuring liability activity for the years ended December 31, 2006 and 2005, was as follows:
Severance costs in the above schedule, which relate to the workforce reduction programs, include the cost of related benefits. Specific programs announced since 2004, as part of the overall restructuring program, will result in the elimination of approximately 9,800 positions. At December 31, 2006, approximately 8,400 of these positions have been eliminated. Asset write-downs relate to the impairment of assets caused by the plant closings and related activity. Other costs incurred relate primarily to contract termination costs associated with the plant closings and the termination of leasing agreements. Severance costs taken against assets relate to incremental pension costs, which reduce prepaid pension assets.
Implementation Costs:
During 2006, 2005 and 2004, the Company recorded pre-tax implementation costs associated with the restructuring program. These costs include the discontinuance of certain product lines and incremental costs related to the integration and streamlining of functions and closure of facilities.
Substantially all implementation costs incurred in 2006 will require cash payments. These costs were recorded on the consolidated statements of earnings as follows:
Asset Impairment Charges:
During 2006, the Company sold its pet snacks brand and assets, and recorded tax expense of $57 million and incurred a pre-tax asset impairment charge of $86 million in 2006 in recognition of this sale. In January 2007, the Company announced the sale of its hot cereal assets and trademarks. In recognition of the anticipated sale, the Company recorded a pre-tax asset impairment charge of $69 million in 2006 for these assets. These pre-tax asset impairment charges, which included the write-off of a portion of the associated goodwill, and intangible and fixed assets, were recorded as asset impairment and exit costs on the consolidated statement of earnings.
During 2006, the Company completed its annual review of goodwill and intangible assets, and recorded non-cash pre-tax charges of $24 million related to an intangible asset impairment for biscuits assets in Egypt and hot cereal assets in the United States. Also during 2006, the Company re-evaluated the business model for its Tassimo hot beverage system, the revenues of which lagged the Company's projections. This evaluation resulted in a $245 million non-cash pre-tax asset impairment charge related to lower utilization of existing manufacturing capacity. These charges were recorded as asset impairment and exit costs on the consolidated statement of earnings. In addition, the Company anticipates that the impairment will result in related cash expenditures of approximately $3 million, primarily related to decommissioning of idle production lines. During 2005, the Company completed its annual review of goodwill and intangible assets and no charges resulted from this review. During 2004, the Company recorded a $29 million non-cash pre-tax charge related to an intangible asset impairment for a small confectionery business in the United States and certain brands in Mexico. A portion of this charge, $17 million, was reclassified to earnings from discontinued operations on the consolidated statement of earnings in the fourth quarter of 2004. The remaining charge was recorded as asset impairment and exit costs on the consolidated statement of earnings.
During 2005, the Company sold its fruit snacks assets and incurred a pre-tax asset impairment charge of $93 million in recognition of the sale. During December 2005, the Company reached agreements to sell certain assets in Canada and a small biscuit brand in the United States and incurred pre-tax asset impairment charges of $176 million in recognition of these sales. These transactions closed in 2006. These charges, which included the write-off of all associated intangible assets, were recorded as asset impairment and exit costs on the consolidated statement of earnings.
In November 2004, following discussions with the Company's joint venture partner in Turkey and an independent valuation of its equity investment, it was determined that a permanent decline in value had occurred. This valuation resulted in a $47 million non-cash pre-tax charge. This charge was recorded as marketing, administration and research costs on the consolidated statement of earnings. During 2005, the Company's interest in the joint venture was sold.
In June 2005, the Company sold substantially all of its sugar confectionery business for approximately $1.4 billion. In 2004, as a result of the anticipated transaction, the Company recorded non-cash asset impairments totaling $107 million. These charges were included in loss from discontinued operations on the consolidated statement of earnings.
In December 2004, the Company announced the sale of its U.S. yogurt assets, which closed in the first quarter of 2005. In 2004, as a result of the anticipated transaction, the Company recorded asset impairments totaling $8 million. This charge was recorded as asset impairment and exit costs on the consolidated statement of earnings.
Total:
The pre-tax asset impairment, exit and implementation costs discussed above, for the years ended December 31, 2006, 2005 and 2004, were included in the operating companies income of the following segments:
Note 4. Related Party Transactions:
Altria Group, Inc.'s subsidiary, Altria Corporate Services, Inc., provides the Company with various services, including planning, legal, treasury, auditing, insurance, human resources, office of the secretary, corporate affairs, information technology, aviation and tax services. Billings for these services, which were based on the cost to Altria Corporate Services, Inc. to provide such services and a 5% management fee based on wages and benefits, were $178 million, $237 million and $310 million for the years ended December 31, 2006, 2005 and 2004, respectively. The Company performed at a similar cost various functions in 2006 and 2005 that previously had been provided by Altria Corporate Services, Inc., resulting in lower service charges in 2006 and 2005. The Company plans to undertake all remaining services currently provided by Altria Corporate Services, Inc. at a similar cost in 2007. These costs were paid to Altria Corporate Services, Inc. monthly. Although the cost of these services cannot be quantified on a stand-alone basis, management has assessed that the billings are reasonable based on the level of support provided by Altria Corporate Services, Inc., and that they reflect all services provided. The cost and nature of the services are reviewed annually by the Company's Audit Committee, which is comprised of independent directors. The effects of these transactions are included in operating cash flows in the Company's consolidated statements of cash flows.
During 2006, the Company purchased certain real estate and personal property located in Wilkes Barre, Pennsylvania, from Altria Corporate Services, Inc., for an aggregate purchase price of $9.3 million. In addition, the Company assumed all of Altria Corporate Services, Inc.'s rights under a lease for certain real property located in San Antonio, Texas. The Company also purchased certain personal property located in San Antonio, Texas from Altria Corporate Services, Inc., for an aggregate purchase price of $6.0 million.
Also, see Note 13. Income Taxes regarding the favorable impact to the Company of the closure of an Internal Revenue Service review of Altria Group, Inc.'s consolidated federal income tax return recorded during 2006.
During 2005, the Company repatriated certain foreign earnings as part of Altria Group, Inc.'s dividend repatriation plan under provisions of the American Jobs Creation Act. Increased taxes for this repatriation of $21 million were reimbursed by Altria Group, Inc. The reimbursement was reported in the Company's financial statements as an increase to additional paid-in capital.
In December 2005, the Company purchased an airport hangar and certain personal property located at the hangar in Milwaukee, Wisconsin, from Altria Corporate Services, Inc. for an aggregate purchase price of approximately $3.3 million.
In December 2004, the Company purchased two corporate aircraft from Altria Corporate Services, Inc. for an aggregate purchase price of approximately $47 million. The Company also entered into an Aircraft Management Agreement with Altria Corporate Services, Inc. in December 2004, pursuant to which Altria Corporate Services, Inc. agreed to perform aircraft management, pilot services, maintenance and other aviation services for the Company.
At December 31, 2006 and 2005, the Company had short-term amounts payable to Altria Group, Inc. of $607 million and $652 million, respectively. The amounts payable to Altria Group, Inc. generally include accrued dividends, taxes and service fees. Interest on intercompany borrowings is based on the applicable London Interbank Offered Rate.
The fair values of the Company's short-term amounts due to Altria Group, Inc. and affiliates approximate carrying amounts.
Note 5. Divestitures:
Discontinued Operations:
In June 2005, the Company sold substantially all of its sugar confectionery business for pre-tax proceeds of approximately $1.4 billion. The sale included the Life Savers, Creme Savers, Altoids, Trolli and Sugus brands. The Company has reflected the results of its sugar confectionery business prior to the closing date as discontinued operations on the consolidated statements of earnings.
Summary results of operations for the sugar confectionery business were as follows:
The loss on sale of discontinued operations, above, for the year ended December 31, 2005, related largely to taxes on the transaction.
Other:
During 2006, the Company sold its rice brand and assets, and its industrial coconut assets. The Company also sold its pet snacks brand and assets in 2006 and recorded tax expense of $57 million related to the sale. In addition, the Company incurred a pre-tax asset impairment charge of $86 million in 2006 in recognition of this sale. Additionally, during 2006, the Company sold certain Canadian assets and a small U.S. biscuit brand, and incurred pre-tax asset impairment charges of $176 million in 2005 in recognition of these sales. Also during 2006, the Company sold a U.S. coffee plant. The aggregate proceeds received from these sales were $946 million, on which the Company recorded pre-tax gains of $117 million.
During 2005, the Company sold its fruit snacks assets, and incurred a pre-tax asset impairment charge of $93 million in recognition of this sale. Additionally, during 2005, the Company sold its U.K. desserts assets, its U.S. yogurt assets, a small business in Colombia, a minor trademark in Mexico and a small equity investment in Turkey. The aggregate proceeds received from these sales were $238 million, on which the Company recorded pre-tax gains of $108 million.
During 2004, the Company sold a Brazilian snack nuts business and trademarks associated with a candy business in Norway. The aggregate proceeds received from the sale of these businesses were $18 million, on which pre-tax losses of $3 million were recorded.
The operating results of the other divestitures, discussed above, in the aggregate, were not material to the Company's consolidated financial position, results of operations or cash flows in any of the periods presented.
Note 6. Acquisitions:
United Biscuits:
In September 2006, the Company acquired the Spanish and Portuguese operations of United Biscuits ("UB") and rights to all Nabisco trademarks in the European Union, Eastern Europe, the Middle East and Africa, which UB has held since 2000, for a total cost of approximately $1.1 billion.
The Spanish and Portuguese operations of UB include its biscuits, dry desserts, canned meats, tomato and fruit juice businesses as well as seven manufacturing facilities and 1,300 employees. From September 2006 to December 31, 2006, these businesses contributed net revenues of approximately $111 million.
The non-cash acquisition was financed by the Company's assumption of approximately $541 million of debt issued by the acquired business immediately prior to the acquisition, as well as $530 million of value for the redemption of the Company's outstanding investment in UB, primarily deep-discount securities. The redemption of the Company's investment in UB resulted in a pre-tax gain on closing of approximately $251 million ($148 million after-tax or $0.09 per diluted share).
Aside from the debt assumed as part of the acquisition price, the Company acquired assets consisting primarily of goodwill of $734 million, other intangible assets of $217 million, property plant and equipment of $161 million, receivables of $101 million and inventories of $34 million. These amounts represent the preliminary allocation of purchase price and are subject to revision when appraisals are finalized, which is expected to occur during the first half of 2007.
Other:
During 2004, the Company acquired a U.S.-based beverage business for a total cost of $137 million. The effect of this acquisition was not material to the Company's consolidated financial position, results of operations or cash flows in any of the periods presented.
Note 7. Inventories:
The cost of approximately 41% and 40% of inventories in 2006 and 2005, respectively, was determined using the LIFO method. The stated LIFO amounts of inventories were approximately $70 million and $71 million higher than the current cost of inventories at December 31, 2006 and 2005, respectively.
Note 8. Short-Term Borrowings and Borrowing Arrangements:
At December 31, 2006 and 2005, the Company's short-term borrowings and related average interest rates consisted of the following:
The fair values of the Company's short-term borrowings at December 31, 2006 and 2005, based upon current market interest rates, approximate the amounts disclosed above.
The Company maintains revolving credit facilities that have historically been used to support the issuance of commercial paper. At December 31, 2006, the Company had a $4.5 billion, multi-year revolving credit facility that expires in April 2010 on which no amounts were drawn.
The Company's revolving credit facility, which is for its sole use, requires the maintenance of a minimum net worth of $20.0 billion. At December 31, 2006, the Company's net worth was $28.6 billion. The Company expects to continue to meet this covenant. The revolving credit facility does not include any other financial tests, any credit rating triggers or any provisions that could require the posting of collateral.
In addition to the above, certain international subsidiaries of Kraft maintain credit lines to meet the short-term working capital needs of the international businesses. These credit lines, which amounted to approximately $1.1 billion as of December 31, 2006, are for the sole use of the Company's international businesses. Borrowings on these lines amounted to approximately $200 million and $400 million at December 31, 2006 and 2005, respectively. At December 31, 2006 the Company also had approximately $0.3 billion of outstanding short-term debt related to its United Biscuits acquisition discussed in Note 6. Acquisitions.
Note 9. Long-Term Debt:
At December 31, 2006 and 2005, the Company's long-term debt consisted of the following:
Aggregate maturities of long-term debt are as follows (in millions):
Based on market quotes, where available, or interest rates currently available to the Company for issuance of debt with similar terms and remaining maturities, the aggregate fair value of the Company's long-term debt, including the current portion of long-term debt, was $8,706 million and $9,945 million at December 31, 2006 and 2005, respectively.
Note 10. Capital Stock:
The Company's articles of incorporation authorize 3.0 billion shares of Class A common stock, 2.0 billion shares of Class B common stock and 500 million shares of preferred stock. Shares of Class A common stock issued, repurchased and outstanding were as follows:
The Company repurchases its Class A common stock in open market transactions. In March 2006, the Company completed its $1.5 billion two-year Class A common stock repurchase program, acquiring 49.1 million Class A shares at an average price of $30.57 per share. During 2006, repurchases under the $1.5 billion program were 8.5 million shares at a cost of $250 million, or $29.42 per share. Additionally, in March 2006, the Company began a $2.0 billion Class A common stock repurchase program, which is expected to run through 2008. During 2006, the Company repurchased 30.2 million shares of its Class A common stock, under its $2.0 billion authority, at a cost of $1.0 billion, an average price of $33.06 per share. During 2005, the Company repurchased 39.2 million shares of its Class A common stock at a cost of $1.2 billion, an average price of $30.65 per share. During 2004, the Company repurchased 21.5 million shares of its Class A common stock at a cost of $700 million, an average price of $32.49 per share.
Class B common shares issued and outstanding at December 31, 2006 and 2005 were 1.18 billion. Altria Group, Inc. held 276.5 million Class A common shares and all of the Class B common shares at December 31, 2006. There are no preferred shares issued and outstanding. Class A common shares are
entitled to one vote each, while Class B common shares are entitled to ten votes each. Therefore, Altria Group, Inc. held 98.5% of the combined voting power of the Company's outstanding capital stock at December 31, 2006. At December 31, 2006, 161,915,095 shares of common stock were reserved for stock options and other stock awards.
Note 11. Stock Plans:
Under the Kraft 2005 Performance Incentive Plan (the "2005 Plan"), the Company may grant to eligible employees awards of stock options, stock appreciation rights, restricted stock, restricted and deferred stock units, and other awards based on the Company's Class A common stock, as well as performance-based annual and long-term incentive awards. A maximum of 150 million shares of the Company's Class A common stock may be issued under the 2005 Plan, of which no more than 45 million shares may be awarded as restricted stock. In addition, in 2006, the Company's Board of Directors adopted and the stockholders approved, the Kraft 2006 Stock Compensation Plan for Non-Employee Directors (the "2006 Directors Plan"). The 2006 Directors Plan replaced the Kraft 2001 Directors Plan. Under the 2006 Directors Plan, the Company may grant up to 500,000 shares of Class A common stock to members of the Board of Directors who are not full-time employees of the Company or Altria Group, Inc., or their subsidiaries, over a five-year period. Shares available to be granted under the 2005 Plan and the 2006 Directors Plan at December 31, 2006, were 143,669,750 and 481,555, respectively. Restricted shares available for grant under the 2005 Plan at December 31, 2006, were 38,669,750.
Generally, stock options are granted at an exercise price equal to the market value of the underlying stock on the date of the grant, become exercisable on the first anniversary of the grant date and have a maximum term of ten years. However, the Company has not granted stock options to its employees since 2002.
Stock Option Plan:
Stock option activity was as follows for the year ended December 31, 2006:
The total intrinsic value of options exercised was $6.7 million, $0.6 million and $3.4 million during the years ended December 31, 2006, 2005 and 2004, respectively.
Prior to the initial public offering ("IPO"), certain employees of the Company participated in Altria Group, Inc.'s stock compensation plans. Altria Group, Inc. does not intend to issue additional Altria Group, Inc. stock compensation to the Company's employees, except for reloads of previously issued options. The reload feature on Altria Group, Inc. stock options will cease during 2007.
Pre-tax compensation cost and the related tax benefit for Altria stock option awards for reloads totaled $3 million and $1 million, respectively, for the year ended December 31, 2006. The fair value of
the awards was determined using a modified Black-Scholes methodology using the following weighted average assumptions for Altria Group, Inc. common stock:
The Company's employees held options to purchase the following number of shares of Altria Group, Inc. stock at December 31, 2006:
Restricted Stock Plans:
The Company may grant shares of restricted stock and rights to receive shares of stock to eligible employees, giving them in most instances all of the rights of stockholders, except that they may not sell, assign, pledge or otherwise encumber such shares and rights. Such shares and rights are subject to forfeiture if certain employment conditions are not met. Restricted stock generally vests on the third anniversary of the grant date.
The fair value of the restricted shares and rights at the date of grant is amortized to expense ratably over the restriction period. The Company recorded pre-tax compensation expense related to restricted stock and rights of $139 million (including the pre-tax cumulative effect gain of $9 million from the adoption of SFAS No. 123(R)), $148 million and $106 million for the years ended December 31, 2006, 2005 and 2004, respectively. The deferred tax benefit recorded related to this compensation expense was $51 million, $54 million and $39 million for the years ended December 31, 2006, 2005 and 2004, respectively. The unamortized compensation expense related to the Company's restricted stock and rights was $184 million at December 31, 2006 and is expected to be recognized over a weighted average period of 2 years.
The Company's restricted stock and rights activity was as follows for the year ended December 31, 2006:
The weighted-average grant date fair value of restricted stock and rights granted during the years ended December 31, 2006, 2005 and 2004 was $200 million, $200 million and $195 million, respectively, or $29.16, $33.26 and $32.23 per restricted share or right, respectively. The total fair value of restricted stock and rights vested during the years ended December 31, 2006, 2005 and 2004 was $123 million, $2 million and $1 million, respectively.
Note 12. Earnings Per Share:
Basic and diluted EPS from continuing and discontinued operations were calculated using the following:
For the years ended December 31, 2006, 2005 and 2004, the number of stock options excluded from the calculation of weighted average shares for diluted EPS because their effects were antidilutive was immaterial.
Note 13. Income Taxes:
Earnings from continuing operations before income taxes and minority interest, and provision for income taxes consisted of the following for the years ended December 31, 2006, 2005 and 2004:
During 2006, the United States Internal Revenue Service concluded its examination of Altria Group, Inc.'s consolidated tax returns for the years 1996 through 1999 and issued a final Revenue Agents Report on March 15, 2006. Consequently, Altria Group, Inc. reimbursed the Company in cash for unrequired federal tax reserves of $337 million and pre-tax interest of $46 million ($29 million after-tax).
The Company also recognized net state tax reversals of $39 million, resulting in a total net earnings benefit of $405 million for the year ended December 31, 2006.
The loss from discontinued operations for the year ended December 31, 2005, includes additional tax expense of $280 million from the sale of the sugar confectionery business. The loss from discontinued operations for the year ended December 31, 2004, included a deferred income tax benefit of $43 million.
At December 31, 2006, applicable United States federal income taxes and foreign withholding taxes had not been provided on approximately $3.2 billion of accumulated earnings of foreign subsidiaries that are expected to be permanently reinvested.
In October 2004, the American Jobs Creation Act ("the Jobs Act") was signed into law. The Jobs Act includes a deduction for 85% of certain foreign earnings that are repatriated. In 2005, the Company repatriated approximately $500 million of earnings under the provisions of the Jobs Act. Deferred taxes had previously been provided for a portion of the dividends remitted. The reversal of the deferred taxes more than offset the tax costs to repatriate the earnings and resulted in a net tax reduction of $28 million in the consolidated income tax provision during 2005.
The effective income tax rate on pre-tax earnings differed from the U.S. federal statutory rate for the following reasons for the years ended December 31, 2006, 2005 and 2004:
The tax rate in 2006 includes a reimbursement from Altria Group, Inc. in cash for unrequired federal tax reserves of $337 million, and also includes net state tax reversals of $39 million, due to the conclusion of an audit of Altria Group, Inc.'s consolidated federal income tax returns for the years 1996 through 1999 in the first quarter of 2006. Included within the change in tax rates, among other things, are a benefit of $52 million in 2006 from the resolution of outstanding items in the Company's international operations, the majority of which occurred in the first quarter. The tax rate in 2005 includes the settlement of an outstanding U.S. tax claim of $24 million in the second quarter; $82 million from the resolution of outstanding items in the Company's international operations, the majority of which was in the first quarter, and $33 million of tax impacts associated with the sale of a U.S. biscuit brand. The 2005 rate also includes a $53 million aggregate benefit from the domestic manufacturers' deduction provision and the dividend repatriation provision of the Jobs Act. The tax provision in 2004 includes an $81 million favorable resolution of an outstanding tax item, the majority of which occurred in the third quarter of 2004, and the reversal of $35 million of tax accruals that were no longer required due to tax events that occurred during the first quarter of 2004.
As previously discussed in Note 2. Summary of Significant Accounting Policies, the Company's adoption of FIN 48 will result in an increase to shareholders' equity as of January 1, 2007 of approximately $200 million to $225 million.
The tax effects of temporary differences that gave rise to deferred income tax assets and liabilities consisted of the following at December 31, 2006 and 2005:
Note 14. Segment Reporting:
The Company manufactures and markets packaged food products, consisting principally of beverages, cheese, snacks, convenient meals and various packaged grocery products. Kraft manages and reports operating results through two units, Kraft North America Commercial and Kraft International Commercial. Reportable segments for Kraft North America Commercial are organized and managed principally by product category. Kraft North America Commercial's segments are North America Beverages; North America Cheese & Foodservice; North America Convenient Meals; North America Grocery; and North America Snacks & Cereals. Kraft International Commercial's operations are organized and managed by geographic location. Kraft International Commercial's segments are European Union and Developing Markets, Oceania & North Asia.
In October 2005, the Company announced that, effective January 1, 2006, its Canadian business will be realigned to better integrate it into the Company's North American business by product category. Beginning in the first quarter of 2006, the operating results of the Canadian business are being reported throughout the North American food segments. In addition, in the first quarter of 2006, the Company's international businesses were realigned to reflect the reorganization announced within Europe in November 2005. The two revised international segments, which are reflected in these consolidated financial statements and notes, are European Union; and Developing Markets, Oceania & North Asia, the latter to reflect the Company's increased management focus on developing markets. Accordingly, prior period segment results have been restated.
The Company's management uses operating companies income, which is defined as operating income before general corporate expenses and amortization of intangibles, to evaluate segment performance and allocate resources. Management believes it is appropriate to disclose this measure to help investors analyze the business performance and trends of the various business segments. Interest and other debt expense, net, and provision for income taxes are centrally managed and, accordingly, such items are not presented by segment since they are not included in the measure of segment profitability reviewed by management. The Company's assets, which are principally in the United States and Europe, are managed geographically. The accounting policies of the segments are the same as those described in Note 2. Summary of Significant Accounting Policies.
Segment data were as follows:
The Company's largest customer, Wal-Mart Stores, Inc. and its affiliates, accounted for approximately 15%, 14% and 14% of consolidated net revenues for 2006, 2005 and 2004, respectively. These net revenues occurred primarily in the United States and were across all segments.
Net revenues by consumer sector, which includes the separation of Foodservice into sector components and Cereals into the Grocery sector, were as follows for the years ended December 31, 2006, 2005 and 2004:
Items affecting the comparability of the Company's continuing operating results were as follows:
•Asset Impairment, Exit and Implementation Costs-As discussed in Note 3. Asset Impairment, Exit and Implementation Costs, the Company recorded charges for these items of $1,097 million, $566 million and $700 million for the years ended December 31, 2006, 2005 and 2004, respectively. See Note 3 for the breakdown of these pre-tax charges by segment.
•Gain on Redemption of UB Investment-As more fully discussed in Note 6. Acquisitions, in the third quarter of 2006, the Company acquired the Spanish and Portuguese operations of UB and rights to all Nabisco trademarks in the European Union, Eastern Europe, the Middle East and
Africa. The redemption of the Company's outstanding investment in UB resulted in a pre-tax gain on closing of approximately $251 million. This gain is included in the operating companies income of the European Union segment.
•Gains/Losses on Sales of Businesses-During 2006, the Company sold its rice brand and assets, pet snacks brand and assets, industrial coconut assets, certain Canadian assets, a small U.S. biscuit brand and a U.S. coffee plant for aggregate pre-tax gains of $117 million. During 2005, the Company sold its fruit snacks assets, U.K. desserts assets, U.S. yogurt assets, a small business in Colombia, a minor trademark in Mexico and a small equity investment in Turkey for aggregate pre-tax gains of $108 million. During 2004, the Company sold a Brazilian snack nuts business and trademarks associated with a candy business in Norway for aggregate pre-tax losses of $3 million. These pre-tax (gains) losses were included in the operating companies income of the following segments:
See Notes 5 and 6, respectively, regarding divestitures and acquisitions.
Geographic data for net revenues, total assets and long-lived assets (which consist of all non-current assets, other than goodwill, other intangible assets, net, and prepaid pension assets) were as follows:
Note 15. Benefit Plans:
In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans" ("SFAS No. 158"). SFAS No. 158 requires that employers recognize the funded status of their defined benefit pension and other postretirement plans on the consolidated balance sheet and record as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that have not been recognized as components of net periodic benefit cost. The Company adopted the recognition and related disclosure provisions of SFAS No. 158, prospectively, on December 31, 2006.
SFAS No. 158 also requires an entity to measure plan assets and benefit obligations as of the date of its fiscal year-end statement of financial position for fiscal years ending after December 15, 2008. The Company's non-U.S. pension plans (other than Canadian pension plans) are measured at September 30 of each year. The Company expects to adopt the measurement date provision of SFAS No. 158 and measure these plans as of December 31 of each year beginning December 31, 2008. The Company is presently evaluating the impact of the measurement date change, which is not expected to be significant.
The incremental effect of applying SFAS No. 158 on individual line items in the consolidated balance sheet at December 31, 2006 was as follows:
The amounts recorded in accumulated other comprehensive losses at December 31, 2006 consisted of the following:
The Company sponsors noncontributory defined benefit pension plans covering substantially all U.S. employees. Pension coverage for employees of the Company's non-U.S. subsidiaries is provided, to the extent deemed appropriate, through separate plans, many of which are governed by local statutory requirements. In addition, the Company's U.S. and Canadian subsidiaries provide health care and other benefits to substantially all retired employees. Health care benefits for retirees outside the United States and Canada are generally covered through local government plans.
The plan assets and benefit obligations of the Company's U.S. and Canadian pension plans are measured at December 31 of each year and all other non-U.S. pension plans are measured at September 30 of each year. The benefit obligations of the Company's postretirement plans are measured at December 31 of each year.
Pension Plans:
Obligations and Funded Status
The benefit obligations, plan assets and funded status of the Company's pension plans at December 31, 2006 and 2005, were as follows:
The combined U.S. and non-U.S. pension plans resulted in a net prepaid pension asset of $128 million at December 31, 2006 and $2,385 million at December 31, 2005. These amounts were recognized in the Company's consolidated balance sheets at December 31, 2006 and 2005, as follows:
The accumulated benefit obligation, which represents benefits earned to date, for the U.S. pension plans was $5,584 million and $5,580 million at December 31, 2006 and 2005, respectively. The
accumulated benefit obligation for the non-U.S. pension plans was $3,784 million and $3,494 million at December 31, 2006 and 2005, respectively.
For U.S. plans with accumulated benefit obligations in excess of plan assets, the projected benefit obligations, accumulated benefit obligations and the fair value of plan assets were $247 million, $196 million and $11 million, respectively, as of December 31, 2006 and $268 million, $211 million and $14 million, respectively, as of December 31, 2005. The majority of these relate to plans for salaried employees that cannot be funded under IRS regulations. For certain non-U.S. plans, which have accumulated benefit obligations in excess of plan assets, the projected benefit obligation, accumulated benefit obligation and fair value of plan assets were $1,364 million, $1,281 million and $646 million, respectively, as of December 31, 2006, and $2,134 million, $1,993 million and $1,088 million, respectively, as of December 31, 2005.
The following weighted-average assumptions were used to determine the Company's benefit obligations under the plans at December 31:
The Company's 2006 year-end U.S. and Canadian plans discount rates were developed from a model portfolio of high quality, fixed-income debt instruments with durations that match the expected future cash flows of the benefit obligations. The 2006 year-end discount rates for the Company's non-U.S. plans were developed from local bond indices that match local benefit obligations as closely as possible.
Components of Net Periodic Benefit Cost
Net periodic pension cost consisted of the following for the years ended December 31, 2006, 2005 and 2004:
During 2006 and 2005, employees left the Company under workforce reduction programs, resulting in settlement losses of $17 million and $10 million, respectively, for the U.S. plans. In addition, retiring employees elected lump-sum payments, resulting in settlement losses of $49 million, $73 million and $41 million in 2006, 2005 and 2004, respectively. Non-U.S. plant closures and early retirement benefits resulted in curtailment and settlement losses of $13 million, $25 million and $7 million in 2006, 2005 and 2004, respectively.
The estimated net loss and prior service cost for the combined U.S. and non-U.S. pension plans that is expected to be amortized from accumulated other comprehensive income into net periodic benefit cost during 2007 are $203 million and $15 million, respectively.
The following weighted-average assumptions were used to determine the Company's net pension cost for the years ended December 31:
The Company's expected rate of return on plan assets is determined by the plan assets' historical long-term investment performance, current asset allocation and estimates of future long-term returns by asset class.
Kraft and certain of its subsidiaries sponsor employee savings plans, to which the Company contributes. These plans cover certain salaried, non-union and union employees. The Company's contributions and costs are determined by the matching of employee contributions, as defined by the plans. Amounts charged to expense for defined contribution plans totaled $84 million, $94 million and $92 million in 2006, 2005 and 2004, respectively.
Plan Assets
The percentage of fair value of pension plan assets at December 31, 2006 and 2005, was as follows:
The Company's investment strategy is based on an expectation that equity securities will outperform debt securities over the long term. Accordingly, the composition of the Company's U.S. plan assets is broadly characterized as a 70%/30% allocation between equity and debt securities. The strategy utilizes indexed U.S. equity securities, actively managed international equity securities and actively managed investment grade debt securities (which constitute 80% or more of debt securities) with lesser allocations to high yield and international debt securities.
For the plans outside the U.S., the investment strategy is subject to local regulations and the asset/liability profiles of the plans in each individual country. These specific circumstances result in a level of equity exposure that is typically less than the U.S. plans. In aggregate, the actual asset allocations of the non-U.S. plans are virtually identical to their respective asset policy targets.
The Company attempts to mitigate investment risk by rebalancing between equity and debt asset classes as the Company's contributions and monthly benefit payments are made.
The Company presently makes, and plans to make, contributions, to the extent that they are tax deductible or do not generate an excise tax liability, in order to maintain plan assets in excess of the accumulated benefit obligation of its funded U.S. and non-U.S. plans. Currently, the Company anticipates making contributions of approximately $16 million in 2007 to its U.S. plans and
approximately $157 million in 2007 to its non-U.S. plans, based on current tax law. However, these estimates are subject to change as a result of many factors, including changes in tax and other benefit laws, as well as asset performance significantly above or below the assumed long-term rate of return on pension assets, or significant changes in interest rates.
The estimated future benefit payments from the Company's pension plans at December 31, 2006, were as follows:
Postretirement Benefit Plans:
Net postretirement health care costs consisted of the following for the years ended December 31, 2006, 2005 and 2004:
The estimated net loss and prior service cost for the postretirement benefit plans that are expected to be amortized from accumulated other comprehensive income into net postretirement health care costs during 2007 are $67 million and $(26) million, respectively.
In December 2003, the United States enacted into law the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the "Act"). The Act establishes a prescription drug benefit under Medicare, known as "Medicare Part D," and a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D.
In May 2004, the FASB issued FASB Staff Position No. 106-2, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003" ("FSP 106-2"). FSP 106-2 requires companies to account for the effect of the subsidy on benefits attributable to past service as an actuarial experience gain and as a reduction of the service cost component of net postretirement health care costs for amounts attributable to current service, if the benefit provided is at least actuarially equivalent to Medicare Part D.
The Company adopted FSP 106-2 in the third quarter of 2004. The impact for 2006, 2005 and 2004 was a reduction of pre-tax net postretirement health care costs and an increase in net earnings. The amounts in the table above reflect the following benefits:
The following weighted-average assumptions were used to determine the Company's net postretirement cost for the years ended December 31:
In 2007, the discount rate used to determine the Company's net postretirement cost will be 5.90% for its U.S. plans and 5.00% for its Canadian plans, and the health care cost trend rate will be 8.00% for its U.S. plans and 8.50% for its Canadian plans.
The Company's postretirement health care plans are not funded. The changes in the accumulated benefit obligation and net amount accrued at December 31, 2006 and 2005, were as follows:
The current portion of the Company's accrued postretirement health care costs of $216 million and $208 million at December 31, 2006 and 2005, respectively, is included in other accrued liabilities on the consolidated balance sheets.
The following weighted-average assumptions were used to determine the Company's postretirement benefit obligations at December 31:
Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects as of December 31, 2006:
The Company's estimated future benefit payments for its postretirement health care plans at December 31, 2006, were as follows:
Postemployment Benefit Plans:
Kraft and certain of its affiliates sponsor postemployment benefit plans covering substantially all salaried and certain hourly employees. The cost of these plans is charged to expense over the working life of the covered employees. Net postemployment costs consisted of the following for the years ended December 31, 2006, 2005 and 2004:
As previously discussed in Note 3. Asset Impairment, Exit and Implementation Costs, the Company announced several workforce reduction programs during 2006, 2005 and 2004, as part of the overall restructuring program. The cost of these programs, $247 million, $139 million and $167 million in 2006, 2005 and 2004, respectively, is included in other expense, above.
The estimated net gain for the postemployment benefit plans that will be amortized from accumulated other comprehensive income into net postemployment costs during 2007 is $7 million.
The Company's postemployment plans are not funded. The changes in the benefit obligations of the plans at December 31, 2006 and 2005, were as follows:
The accumulated benefit obligation was determined using a discount rate of 6.3% in 2006, an assumed ultimate annual turnover rate of 0.3% in 2006 and 2005, assumed compensation cost increases of 4.0% in 2006 and 2005, and assumed benefits as defined in the respective plans. Postemployment costs arising from actions that offer employees benefits in excess of those specified in the respective plans are charged to expense when incurred.
Note 16. Additional Information:
The amounts shown below are for continuing operations.
Minimum rental commitments under non-cancelable operating leases in effect at December 31, 2006, were as follows (in millions):
Note 17. Financial Instruments:
Derivative financial instruments:
The Company operates globally, with manufacturing and sales facilities in various locations around the world, and utilizes certain financial instruments to manage its foreign currency and commodity exposures. Derivative financial instruments are used by the Company, principally to reduce exposures to market risks resulting from fluctuations in foreign exchange rates and commodity prices by creating offsetting exposures. The Company is not a party to leveraged derivatives and, by policy, does not use financial instruments for speculative purposes. Financial instruments qualifying for hedge accounting must maintain a specified level of effectiveness between the hedging instrument and the item being hedged, both at inception and throughout the hedged period. The Company formally documents the nature of and relationships between the hedging instruments and hedged items, as well as its risk-management objectives, strategies for undertaking the various hedge transactions and method of assessing hedge effectiveness. Additionally, for hedges of forecasted transactions, the significant characteristics and expected terms of the forecasted transaction must be specifically identified, and it must be probable that each forecasted transaction will occur. If it were deemed probable that the forecasted transaction will not occur, the gain or loss would be recognized in earnings currently.
The Company uses forward foreign exchange contracts and foreign currency options to mitigate its exposure to changes in exchange rates from third-party and intercompany actual and forecasted transactions. Substantially all of the Company's derivative financial instruments are effective as hedges. The primary currencies to which the Company is exposed, based on the size and location of its businesses, include the euro, Swiss franc, British pound and Canadian dollar. At December 31, 2006 and 2005, the Company had foreign exchange option and forward contracts with aggregate notional amounts of $2.6 billion and $2.2 billion, respectively. The effective portion of unrealized gains and losses associated with forward and option contracts is deferred as a component of accumulated other comprehensive earnings (losses) until the underlying hedged transactions are reported on the Company's consolidated statement of earnings.
The Company is exposed to price risk related to forecasted purchases of certain commodities used as raw materials by its businesses. Accordingly, the Company uses commodity forward contracts as cash flow hedges, primarily for coffee, milk, sugar and cocoa. In general, commodity forward contracts qualify for the normal purchase exception under SFAS No. 133 and are, therefore, not subject to the provisions of SFAS No. 133. In addition, commodity futures and options are also used to hedge the price of certain commodities, including milk, coffee, cocoa, wheat, corn, sugar, soybean oil, natural gas and heating oil. For qualifying contracts, the effective portion of unrealized gains and losses on commodity futures and option contracts is deferred as a component of accumulated other comprehensive earnings (losses) and is recognized as a component of cost of sales in the Company's consolidated statement of earnings when the related inventory is sold. Unrealized gains or losses on net commodity positions were
immaterial at December 31, 2006 and 2005. At December 31, 2006 and 2005, the Company had net long commodity positions of $533 million and $521 million, respectively.
Ineffectiveness related to cash flow hedges was not material for the years ended December 31, 2006, 2005 and 2004. At December 31, 2006, the Company was hedging forecasted transactions for periods not exceeding the next fifteen months, and expects substantially all amounts reported in accumulated other comprehensive earnings (losses) to be reclassified to the consolidated statement of earnings within the next twelve months.
Derivative gains or losses reported in accumulated other comprehensive earnings (losses) are a result of qualifying hedging activity. Transfers of gains or losses from accumulated other comprehensive earnings (losses) to earnings are offset by corresponding gains or losses on the underlying hedged item. Hedging activity affected accumulated other comprehensive earnings (losses), net of income taxes, during the years ended December 31, 2006, 2005 and 2004, as follows (in millions):
Credit exposure and credit risk:
The Company is exposed to credit loss in the event of nonperformance by counterparties. However, the Company does not anticipate nonperformance, and such exposure was not material at December 31, 2006.
Fair value:
The aggregate fair value, based on market quotes, of the Company's third-party debt at December 31, 2006, was $10,421 million as compared with its carrying value of $10,214 million. The aggregate fair value of the Company's third-party debt at December 31, 2005, was $10,750 million as compared with its carrying value of $10,548 million.
In September 2006, the FASB issued SFAS No. 157 "Fair Value Measurements," which will be effective for financial statements issued for fiscal years beginning after November 15, 2007. This statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. The adoption of this statement will not have a material impact on the Company's financial statements.
See Notes 4, 8 and 9 for additional disclosures of fair value for short-term borrowings and long-term debt.
Note 18. Contingencies:
Kraft and its subsidiaries are parties to a variety of legal proceedings arising out of the normal course of business, including a few cases in which substantial amounts of damages are sought. While the results of litigation cannot be predicted with certainty, management believes that the final outcome of these proceedings will not have a material adverse effect on the Company's consolidated financial position, results of operations or cash flows.
Third-Party Guarantees:
At December 31, 2006, the Company's third-party guarantees, which are primarily derived from acquisition and divestiture activities, approximated $21 million, of which $8 million have no specified expiration dates. Substantially all of the remainder expire through 2016, with no guarantees expiring during 2007. The Company is required to perform under these guarantees in the event that a third party fails to make contractual payments or achieve performance measures. The Company has a liability of $16 million on its consolidated balance sheet at December 31, 2006, relating to these guarantees.
Note 19. Quarterly Financial Data (Unaudited):
Basic and diluted EPS are computed independently for each of the periods presented. Accordingly, the sum of the quarterly EPS amounts may not agree to the total for the year.
During 2006 and 2005, the Company recorded the following pre-tax charges or (gains) in earnings from continuing operations:
As discussed in Note 13. Income Taxes, the Company has recognized income tax benefits in the consolidated statements of earnings during 2006 and 2005 as a result of various tax events, including a reimbursement from Altria Group, Inc. in cash for unrequired federal tax reserves and net state tax reversals due to the conclusion of an audit of Altria Group, Inc.'s consolidated federal income tax returns for the years 1996 through 1999, and benefits earned under the provisions of the American Jobs Creation Act.
Note 20. Subsequent Event:
On January 31, 2007, the Altria Group, Inc. Board of Directors announced that Altria Group, Inc. plans to spin off all of its remaining interest (89.0%) in the Company on a pro rata basis to Altria Group, Inc. stockholders in a tax-free transaction. The distribution of all the Kraft shares owned by Altria Group, Inc. will be made on March 30, 2007 ("Distribution Date"), to Altria Group, Inc. stockholders of record as of the close of business on March 16, 2007. Based on the number of shares of Altria Group, Inc. outstanding at December 31, 2006, the distribution ratio would be approximately 0.7 shares of Kraft Class A common stock for every share of Altria Group, Inc. common stock outstanding. Prior to the distribution, Altria Group, Inc. will convert its Class B shares of Kraft common stock, which carry ten votes per share, into Class A shares of Kraft, which carry one vote per share. Following the distribution, only Class A common shares of Kraft will be outstanding and Altria Group, Inc. will not own any shares of Kraft.
Stock Compensation:
Holders of Altria Group, Inc. stock options will be treated as stockholders and will, accordingly, have their stock awards split into two instruments. Holders of Altria Group, Inc. stock options will receive the following stock options, which, immediately after the spin-off, will have an aggregate intrinsic value equal to the intrinsic value of the pre-spin Altria Group, Inc. options:
•a new Kraft option to acquire the number of shares of Kraft Class A common stock equal to the product of (a) the number of Altria Group, Inc. options held by such person on the Distribution Date and (b) the approximate distribution ratio of 0.7 mentioned above; and
•an adjusted Altria Group, Inc. option for the same number of shares of Altria Group, Inc. common stock with a reduced exercise price.
Holders of Altria Group, Inc. restricted stock or stock rights awarded prior to January 31, 2007, will retain their existing award and will receive restricted stock or stock rights of Kraft Class A common stock. The amount of Kraft restricted stock or stock rights awarded to such holders will be calculated using the same formula set forth above with respect to new Kraft options. All of the restricted stock and stock rights will not vest until the completion of the original restriction period (typically, three years from the date of the original grant). Recipients of Altria Group, Inc. stock rights awarded on January 31, 2007, will not receive restricted stock or stock rights of Kraft. Rather, they will receive additional stock rights of Altria Group, Inc. to preserve the intrinsic value of the original award.
To the extent that employees of the remaining Altria Group, Inc. receive Kraft stock options, Altria Group, Inc. will reimburse the Company in cash for the Black-Scholes fair value of the stock options to be received. To the extent that Kraft employees hold Altria Group, Inc. stock options, the Company will reimburse Altria Group, Inc. in cash for the Black-Scholes fair value of the stock options. To the extent that holders of Altria Group, Inc. stock rights receive Kraft stock rights, Altria Group, Inc. will pay to the Company the fair value of the Kraft stock rights less the value of projected forfeitures. Based upon the number of Altria Group, Inc. stock awards outstanding at December 31, 2006, the net amount of these reimbursements would be a payment of approximately $133 million from the Company to Altria Group, Inc. Based upon the number of Altria Group, Inc. stock awards outstanding at December 31, 2006, the Company would have to issue 28 million stock options and 3 million shares of restricted stock and stock rights. The Company estimates that the issuance of these awards would result in an approximate $0.02 decrease in diluted earnings per share. However, these estimates are subject to change as stock awards vest (in the case of restricted stock) or are exercised (in the case of stock options) prior to the record date for the distribution.
Other Matters:
As previously mentioned in Note 2. Summary of Significant Accounting Policies, the Company is currently included in the Altria Group, Inc. consolidated federal income tax return, and federal income tax contingencies are recorded as liabilities on the balance sheet of Altria Group, Inc. Prior to the distribution of Kraft shares, Altria Group, Inc. will reimburse the Company in cash for these liabilities, which are approximately $300 million, plus interest.
As previously mentioned in Note 4. Related Party Transactions, a subsidiary of Altria Group, Inc. currently provides the Company with certain services at cost plus a 5% management fee. After the Distribution Date, the Company will undertake these activities, and services provided by a subsidiary of Altria Group, Inc. will cease in 2007. All intercompany accounts will be settled in cash.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A. Controls and Procedures.
a)Disclosure Controls and Procedures The Company carried out an evaluation, with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company's disclosure controls and procedures (pursuant to Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report. Based upon that
evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective.
b) Changes in Internal Control Over Financial Reporting.
The Company's management evaluated, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, any change in the Company's internal control over financial reporting and determined that there has been no change in the Company's internal control over financial reporting during the quarter ended December 31, 2006 that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.
However, as noted within Item 4 of the Company's quarterly report on Form 10-Q for the period ended September 30, 2006, the Company entered into a seven-year agreement in April 2006 to receive information technology services from Electronic Data Systems ("EDS"). Pursuant to this agreement, the Company began to transition certain of its processes and procedures into the EDS control environment during the quarter ended September 30, 2006. As the Company migrates to the EDS environment, management ensures that key controls are mapped to applicable EDS controls, tests transition controls prior to the migration date of those controls, and as appropriate, maintains and evaluates controls over the flow of information to and from EDS. The Company expects this transition period to continue for three years.
See also "Report of Management on Internal Control over Financial Reporting" in Item 8.
Item 9B.
Item 9B. Other Information.
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
Executive Officers of the Company
The following are the executive officers of the Company as of March 1, 2007:
All of the above-named officers have been employed by the Company in various capacities during the past five years, except for Ms. Rosenfeld, Mr. Firestone, Ms. May, and Mr. Khosla. Prior to being appointed Chief Executive Officer of the Company on June 26, 2006, Ms. Rosenfeld was Chairman and Chief Executive Officer of Frito-Lay, Inc., a division of PepsiCo, from September 2004 to June 2006. Prior to joining Frito-Lay, Inc. Ms. Rosenfeld worked for more than 20 years at the Company, holding a number of key management positions, including President of the Company's North American business. Prior to joining the Company in 2003, Mr. Firestone was Senior Vice President and General Counsel for Philip Morris International Inc. From 1998 until 2001, he was Chief Counsel for Philip Morris Europe. Each of Philip Morris International Inc. and Philip Morris Europe is an affiliate of the Company insomuch that each of the Company, Philip Morris International Inc. and Philip Morris Europe is under common control of Altria. Prior to joining the Company in 2005, Ms. May held various positions with Baxter International, Inc. From 2001 to 2005, she was Corporate Vice President of Human Resources. Prior to joining the Company in 2007, Mr. Khosla served as Managing Director of Fonterra Co-operative Group. Before joining Fonterra in 2004, Khosla spent 27 years with Unilever in India, London and Europe.
The Company has adopted a code of ethics as defined in Item 406 of Regulation S-K, which code applies to all of its employees, including its principal executive officer, principal financial officer, principal accounting officer or controller, and persons performing similar functions. This code of ethics, which is entitled The Kraft Foods Code of Conduct for Compliance and Integrity, is available free of charge on the Company's website at www.kraft.com and will be provided free of charge to any stockholder requesting a copy by writing to: Corporate Secretary, Kraft Foods Inc., Three Lakes Drive, Northfield, IL 60093. Any waiver granted by the Company to its principal executive officer, principal financial officer, principal accounting officer or controller under the code of ethics, or certain amendments to the code of ethics, will be disclosed on the Company's website at www.kraft.com.
In addition, the Company has adopted corporate governance guidelines and charters for its Audit Committee, Compensation Committee and Nominating and Governance Committee, as well as a code of business conduct and ethics that applies to the members of its Board of Directors. All of these materials are available on the Company's website at www.kraft.com and will be provided free of charge to any stockholder requesting a copy by writing to: Corporate Secretary, Kraft Foods Inc., Three Lakes Drive, Northfield, IL 60093. Certain of these materials may also be found in the proxy statement relating to the Company's 2007 Annual Meeting of Stockholders.
The information on the Company's website is not, and shall not be deemed to be, a part of this Report or incorporated into any other filings the Company makes with the SEC.
On May 8, 2006, the Company filed its Annual CEO Certification as required by Section 303A.12 of the New York Stock Exchange Listed Company Manual.
See also Item 11
Item 11. Executive Compensation.
Except for the information relating to the executive officers of, and certain documents adopted by, the Company set forth in Item 10 of this Report and the information regarding equity compensation plans set forth in Item 12
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The number of shares to be issued upon exercise or vesting of awards issued under, and the number of shares remaining available for future issuance under, the Company's equity compensation plans at December 31, 2006 were as follows:
Equity Compensation Plan Information
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
See Item 11.
Item 14.
Item 14. Principal Accounting Fees and Services.
See Item 11.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules.
(a) Index to Consolidated Financial Statements and Schedules
Schedules other than those listed above have been omitted either because such schedules are not required or are not applicable.
(b)The following exhibits are filed as part of this Report (Exhibit Nos. 10.4 through 10.13, 10.16, 10.17, 10.22, 10.23 and 10.24 are management contracts, compensatory plans or arrangements):
3.1
Articles of Incorporation of the Registrant(1)
3.2
Articles of Amendment to the Articles of Incorporation of the Registrant(1)
3.3
Registrant's Amended and Restated By-Laws(2)
4.1
Indenture between the Registrant and JPMorgan Chase Bank, Trustee, dated as of October 17, 2001(3)
4.2
The Registrant agrees to furnish copies of any instruments defining the rights of holders of long-term debt of the Registrant and its consolidated subsidiaries that does not exceed 10 percent of the total assets of the Registrant and its consolidated subsidiaries to the Commission upon request.
10.1
Corporate Agreement between Altria Group, Inc. and the Registrant(4)
10.2
Services Agreement between Altria Corporate Services, Inc. and the Registrant (including Exhibits)(5)
10.3
Tax-Sharing Agreement between Altria Group, Inc. and the Registrant(6)
10.4
2001 Kraft Foods Inc. Performance Incentive Plan(4)
10.5
Kraft Foods Inc. 2005 Performance Incentive Plan(19)
10.6
2001 Kraft Foods Inc. Compensation Plan for Non-Employee Directors, as amended(7)
10.7
Kraft Foods Inc. Supplemental Benefits Plan I (including First Amendment adding Supplement A)(6)
10.8
Kraft Foods Inc. Supplemental Benefits Plan II(6)
10.9
Form of Employee Grantor Trust Enrollment Agreement(8)(12)
10.10
The Altria Group, Inc. 1992 Incentive Compensation and Stock Option Plan(9)(12)
10.11
The Altria Group, Inc. 1997 Performance Incentive Plan(10)(12)
10.12
The Altria Group, Inc. 2000 Performance Incentive Plan(11)(12)
10.13
2001 Kraft Foods Inc. Compensation Plan for Non-Employee Directors (Deferred Compensation)(13)
10.14
Pre-Owned Aircraft Purchase and Sales Agreements, between Altria Corporate Services, Inc. and Kraft Foods Aviation, LLC(14)
10.15
Assignment and Consent, among Gulfstream Aerospace Corporation, Altria Corporate Services, Inc., and Kraft Foods Aviation, LLC(15)
10.16
Assignment and consent to assignment by and among Gulfstream Aerospace Corporation, Altria Corporate Services, Inc. and Kraft Foods Aviation, LLC(16)
10.17
Form of Restricted Stock Agreement(17)
10.18
$4.5 Billion 5-Year Revolving Credit Agreement dated as of April 15, 2005(20)
10.19
Purchase and Sale Agreement between Kraft Foods Global, Inc. and Altria Corporate Services, Inc.(21)
10.20
Environmental Agreement between Kraft Foods Global, Inc. and Altria Corporate Services, Inc.(21)
10.21
2006 Stock Compensation Plan for Non-Employee Directors(22)
10.22
Form of Restricted Stock Award Letter(23)
10.23
Master Professional Services Agreement between Kraft Foods Global, Inc. and Electronic Data Systems Services Corporation dated as of April 27, 2006(24)
10.24
Purchase and Sale Agreement between Altria Corporate Services, Inc. and Kraft Foods Global, Inc.(25)
10.25
Assignment and Assumption of Lease among Altria Corporate Services, Inc., Kraft Foods Global, Inc. and 410 Century Associates, L.P.(25)
10.26
Bill of Sale between Altria Corporate Services, Inc. and Kraft Foods Global, Inc.(25)
10.27
Offer of Employment letter between Kraft Foods Inc. and Irene B. Rosenfeld entered into as of June 24, 2006(24)
10.28
Agreement Relating to United Biscuits Southern Europe, dated as of July 8, 2006(26)
10.29
Separation Agreement and General Release between Kraft Foods Inc. and Roger K. Deromedi, dated as of August 31, 2006(27)
10.30
Credit Agreement relating to a EUR 440,000,000 364-Day Term Loan Facility, among Sheffield Investments S.L., UBS Limited and Citibank International Plc., dated as of August 25, 2006(28)
10.31
Guaranty between Kraft Foods Inc. and Citibank International Plc., dated as of August 25, 2006(28)
10.32
Separation Agreement and General Release between Kraft Foods Inc. and David S. Johnson, dated as of October 19, 2006(29)
10.33
Distribution Agreement by and between Altria Group, Inc. and Kraft Foods Inc. dated January 31, 2007(30)
10.34
Form of Restricted Stock Agreement(31)
Statements re: computation of ratios(18)
Subsidiaries of the Registrant
Consent of PricewaterhouseCoopers LLP, Independent Registered Public Accounting Firm
Powers of Attorney
31.1
Certification of the Registrant's Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certification of the Registrant's Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
Certification of the Registrant's Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
Certification of the Registrant's Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(1)Incorporated by reference to the Registrant's Form S-1 filed with the Securities and Exchange Commission on March 16, 2001.
(2)Incorporated by reference to the Registrant's Form 8-K filed with the Securities and Exchange Commission on December 8, 2004.
(3)Incorporated by reference to the Registrant's Form S-3 filed with the Securities and Exchange Commission on August 16, 2001.
(4)Incorporated by reference to the Registrant's Amendment No. 5 to Form S-1 filed with the Securities and Exchange Commission on June 8, 2001.
(5)Incorporated by reference to the Registrant's Amendment No. 2 to Form S-1 filed with the Securities and Exchange Commission on May 11, 2001.
(6)Incorporated by reference to the Registrant's Amendment No. 1 to Form S-1 filed with the Securities and Exchange Commission on May 2, 2001.
(7)Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 2003.
(8)Incorporated by reference to the Annual Report on Form 10-K of Altria Group, Inc. for the year ended December 31, 1995.
(9)Incorporated by reference to the Annual Report on Form 10-K of Altria Group, Inc. for the year ended December 31, 1997.
(10)Incorporated by reference to the Proxy Statement of Altria Group, Inc. dated March 10, 1997.
(11)Incorporated by reference to the Proxy Statement of Altria Group, Inc. dated March 10, 2000.
(12)Compensation plans maintained by Altria Group, Inc. and its subsidiaries in which officers of the Registrant have historically participated.
(13)Incorporated by reference to the Registrant's Annual Report on Form 10-K for the year ended December 31, 2001.
(14)Incorporated by reference to the Registrant's Form 8-K filed with the Securities and Exchange Commission on December 20, 2004.
(15)Incorporated by reference to the Registrant's Form 8-K filed with the Securities and Exchange Commission on December 22, 2004.
(16)Incorporated by reference to the Registrant's Form 8-K filed with the Securities and Exchange Commission on January 26, 2005.
(17)Incorporated by reference to the Registrant's Form 8-K filed with the Securities and Exchange Commission on January 28, 2005.
(18)Incorporated by reference to the Registrant's Current Report on Form 8-K filed with the Securities and Exchange Commission on February 7, 2006.
(19)Incorporated by reference to the Registrant's Definitive Proxy Statement for the 2005 Annual Meeting of Stockholders, filed with the Commission on March 4, 2005.
(20)Incorporated by reference to the Registrant's Current Report on Form 8-K filed with the Securities and Exchange Commission on April 21, 2005.
(21)Incorporated by reference to the Registrant's Current Report on Form 8-K filed with the Securities and Exchange Commission on December 19, 2005.
(22)Incorporated by reference to Exhibit E to the Registrant's Definitive Proxy Statement dated March 10, 2006.
(23)Incorporated by reference to the Registrant's Current Report on Form 8-K filed with the Securities and Exchange Commission on April 26, 2006.
(24)Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 2006.
(25)Incorporated by reference to the Registrant's Current Report on Form 8-K filed with the Securities and Exchange Commission on May 24, 2006.
(26)Incorporated by reference to the Registrant's Current Report on Form 8-K filed with the Securities and Exchange Commission on July 13, 2006.
(27)Incorporated by reference to the Registrant's Current Report on Form 8-K filed with the Securities and Exchange Commission on September 6, 2006.
(28)Incorporated by reference to the Registrant's Current Report on Form 8-K filed with the Securities and Exchange Commission on September 11, 2006.
(29)Incorporated by reference to the Registrant's Current Report on Form 8-K filed with the Securities and Exchange Commission on October 24, 2006.
(30)Incorporated by reference to the Registrant's Current Report on Form 8-K filed with the Securities and Exchange Commission on January 31, 2007.
(31)Incorporated by reference to the Registrant's Current Report on Form 8-K filed with the Securities and Exchange Commission on February 1, 2007.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
KRAFT FOODS INC.
By:
/s/ JAMES P. DOLLIVE (James P. Dollive,
Executive Vice President
and Chief Financial Officer)
Date: March 1, 2007
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated:
Signature
Title
Date
/s/ IRENE B. ROSENFELD (Irene B. Rosenfeld)
Director and Chief Executive Officer
March 1, 2007
/s/ JAMES P. DOLLIVE (James P. Dollive)
Executive Vice President and Chief Financial Officer
March 1, 2007
/s/ PAMELA E. KING (Pamela E. King)
Senior Vice President and Corporate Controller
March 1, 2007
*
AJAY BANGA,
JAN BENNINK,
LOUIS C. CAMILLERI,
DINYAR S. DEVITRE,
RICHARD LERNER, M.D.,
JOHN C. POPE,
MARY SCHAPIRO,
CHARLES R. WALL,
DEBORAH C. WRIGHT
Directors
*By:
/s/ JAMES P. DOLLIVE (James P. Dollive,
Attorney-in-fact)
March 1, 2007
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ON FINANCIAL STATEMENT SCHEDULE
To the Board of Directors and Shareholders of Kraft Foods Inc.:
Our audits of the consolidated financial statements, of management's assessment of the effectiveness of internal control over financial reporting and of the effectiveness of internal control over financial reporting referred to in our report dated February 5, 2007 appearing in this Annual Report on Form 10-K of Kraft Foods Inc. also included an audit of the financial statement schedule listed in Item 15(a) of this Form 10-K. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.
/s/ PRICEWATERHOUSECOOPERS LLP
Chicago, Illinois
February 5, 2007
S-1
KRAFT FOODS INC. and SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS
for the years ended December 31, 2006, 2005 and 2004
(in millions)
Notes:
(a)Primarily related to divestitures, acquisitions and currency translation.
(b)Represents charges for which allowances were created. S-2
PART I
Item 1. Business.
Distribution, Competition and Raw Materials
Regulation
Acquisitions and Divestitures
Other Matters
Item 1A. Risk Factors.
Item 1B. Unresolved Staff Comments.
Item 2. Properties.
Item 3. Legal Proceedings.
Item 4. Submission of Matters to a Vote of Security Holders.
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Comparison of Five-Year Cumulative Total Return
Item 6. Selected Financial Data.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
Item 8. Financial Statements and Supplementary Data.
REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
KRAFT FOODS INC. and SUBSIDIARIES CONSOLIDATED BALANCE SHEETS, at December 31, (in millions of dollars)
KRAFT FOODS INC. and SUBSIDIARIES CONSOLIDATED STATEMENTS of EARNINGS for the years ended December 31, (in millions of dollars, except per share data)
KRAFT FOODS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
Item 9A. Controls and Procedures.
Item 9B. Other Information.
PART III
Item 10. Directors, Executive Officers and Corporate Governance.
Item 11. Executive Compensation.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
Item 14. Principal Accounting Fees and Services.
PART IV
Item 15. Exhibits and Financial Statement Schedules.
SIGNATURES
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON FINANCIAL STATEMENT SCHEDULE
KRAFT FOODS INC. and SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS for the years ended December 31, 2006, 2005 and 2004 (in millions)