UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

(Mark One)

OR

Commission file number 1-4171

KELLOGG COMPANY

One Kellogg Square, P.O. Box 3599, Battle Creek, MI 49016-3599

Registrant’s telephone number: 269-961-2000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  [X]  No  [   ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes  [X]  No  [   ]

Common Stock outstanding July 23, 2004 – 413,411,591 shares

KELLOGG COMPANY

INDEX

Kellogg Company and Subsidiaries

* Condensed from audited financial statements.

Refer to Notes to Consolidated Financial Statements.

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Kellogg Company and Subsidiaries

Refer to Notes to Consolidated Financial Statements.

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Kellogg Company and Subsidiaries

Refer to Notes to Consolidated Financial Statements.

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Notes to Consolidated Financial Statements

Note 1 Accounting policies

The unaudited interim financial information included in this report reflects normal recurring adjustments that management believes are necessary for a fair presentation of the results of operations, financial position, and cash flows for the periods presented. This interim information should be read in conjunction with the financial statements and accompanying notes contained on pages 32 to 52 of the Company’s 2003 Annual Report. The accounting policies used in preparing these financial statements are the same as those summarized in the Company’s 2003 Annual Report, except as discussed below. Certain amounts for 2003 have been reclassified to conform to current-period classifications. The results of operations for the quarter and year-to-date periods ended June 26, 2004, are not necessarily indicative of the results to be expected for other interim periods or the full year.

Basis of presentation

The Company’s fiscal year normally ends on the last Saturday of December and as a result, a 53^rd week is added every fifth or sixth year. The Company’s 2004 fiscal year will end on January 1, 2005, and include a 53rd week. Quarters normally consist of 13-week periods, with the fourth quarter of fiscal 2004 including a 14^th week.

Medicare prescription benefits

In December 2003, the Medicare Prescription Drug Improvement and Modernization Act of 2003 (the Act) became law. The Act introduces a prescription drug benefit under Medicare Part D as well as a federal subsidy (beginning in 2006) to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. In January 2004, the Company elected, pursuant to FASB Staff Position (FSP) FAS 106-1, to defer accounting recognition of the effects of the Act until authoritative FASB guidance was issued.

In May 2004, the FASB issued FSP FAS 106-2, which applies to sponsors of single-employer defined benefit postretirement health care plans that are impacted by the Act. In general, the FSP concludes that plan sponsors should follow SFAS No. 106 “Employers’ Accounting for Postretirement Benefits Other Than Pensions,” in accounting for the effects of the Act, with benefits attributable to past service cost accounted for as an actuarial experience gain. The FSP is generally effective for the first interim period beginning after June 15, 2004, with earlier application encouraged. For employers such as Kellogg that elected deferral under FSP FAS 106-1, this guidance may be adopted retroactively to the date of Act enactment or prospectively from the date of adoption.

While detailed regulations necessary to implement the Act have not yet been issued, management believes that certain health care benefit plans covering a significant portion of the Company’s U.S. workforce will qualify for the Medicare Part D subsidy, resulting in a reduction in the Company’s share of prescription drug benefits available under these plans. Accordingly, the Company adopted FSP FAS 106-2 as of its second quarter 2004 reporting period beginning March 28, 2004, and has performed a remeasurement of its plan assets and obligations as of December 27, 2003. The reduction in the benefit obligation attributable to past service cost is approximately $73 million and the total reduction in benefit cost for full-year 2004 is approximately $10 million, of which $5 million has been recognized in results for the year-to-date period ended June 26, 2004.

Stock compensation

The Company uses various equity-based compensation programs to provide long-term performance incentives for its global workforce. Currently, these incentives consist of stock options, performance units, restricted stock grants, and stock purchase plans with various preferred terms. These awards are administered through several plans, as described in Note 8 to Consolidated Financial Statements on pages 41-43 of the Company’s 2003 Annual Report.

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The Company currently uses the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for its employee stock options and other stock-based compensation. Under this method, because the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of the grant, no compensation expense is recognized. The table below presents pro forma results for the current and prior-year periods, as if the Company had used the alternate fair value method of accounting for stock-based compensation, prescribed by SFAS No. 123 “Accounting for Stock-Based Compensation” (as amended by SFAS No. 148). Under this pro forma method, the fair value of each option grant was estimated at the date of grant using the Black-Scholes option-pricing model and was recognized over the vesting period, generally two years. Pricing model assumptions included expected terms of 3-4 years; and risk-free interest rates, dividend yields, and volatility assumptions consistent with the expected terms and particular grant dates.

Note 2 Cost-reduction initiatives

To position the Company for sustained reliable growth in earnings and cash flow for the long term, management is undertaking a series of cost-reduction initiatives. Continuing from 2003 are various manufacturing capacity rationalization and efficiency initiatives in the Company’s North American and European operating segments. Some of these initiatives are still in the planning stages and individual actions are being announced as plans are finalized.

During the first quarter of 2004, the Company commenced the global roll-out of its SAP information technology system, resulting in accelerated depreciation of legacy software assets to be abandoned during 2005, as well as related consulting and other implementation expenses. Total incremental costs for 2004 are expected to be approximately $30 million.

In close association with this SAP roll-out, management has undertaken a major initiative to improve the organizational design and effectiveness of pan-European operations. Specific benefits of this initiative are expected to include improved marketing and promotional coordination across Europe, supply chain network savings, and overhead cost reductions. To achieve these benefits, management intends to implement, by early 2005, a new European legal and operating structure with strengthened pan-European management authority and coordination. To complete this business transformation, the Company expects to incur various up-front costs, including relocation, severance, and consulting, of approximately $30 million during 2004.

To improve operations and provide for future growth, during the second quarter of 2004, management completed decision bargaining and initiated effects bargaining with the union regarding the Company’s proposal to close its veggie foods manufacturing facility in Worthington, Ohio. The proposal includes the out-sourcing of certain operations and consolidation of remaining production at the Zanesville, Ohio facility over the next year. The Worthington facility employs approximately 300 employees. If implemented as proposed, total asset write-offs and

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up-front costs of the project could amount to approximately $30 million, the majority of which is expected to be recognized during 2004.

Also during the second quarter of 2004, the Company commenced the relocation of its U.S. snacks business unit from Elmhurst, Illinois (the former headquarters of Keebler Foods Company) to Battle Creek, Michigan, as the next logical step in the integration process. Approximately one-third of the approximately 300 employees affected by this initiative have accepted relocation/reassignment offers. Management intends to fill the remaining open positions via internal and external recruiting efforts. To complete this initiative, management expects to incur approximately $20 million in relocation, recruiting, and severance costs during 2004. Subject to achieving certain employment levels and other regulatory requirements, management expects to defray a significant portion of these up-front costs through various multi-year tax incentives, beginning in 2005.

Taking into account the incremental costs of all of the above-described initiatives, the Company recorded total charges of approximately $20 million for the quarter and $29 million for the year-to-date period ended June 28, 2004. Approximately 70% of the year-to-date charges were comprised of asset write-offs, with the remainder consisting of severance, consulting, and other cash costs. Approximately 60% of the year-to-date charges were recorded in cost of goods sold, with the balance recorded in selling, general, and administrative (SGA) expense. The year-to-date charges impacted the Company’s operating segments as follows (in millions): North America-$15, Europe-$14. The exit cost reserve balance at December 27, 2003, of approximately $19 million was substantially paid out during the first quarter of 2004. Principally attributable to severance costs accrued during the second quarter of 2004, exit cost reserves at June 26, 2004, totaled approximately $4 million.

Cost of goods sold for the quarter ended June 28, 2003, included charges of approximately $15 million, attributable primarily to equipment disposals associated with manufacturing network optimization efforts in the Company’s U.S. snacks business.

Note 3 Other income (expense), net

Other income (expense), net includes non-operating items such as interest income, foreign exchange gains and losses, charitable donations, and gains on asset sales. Other income (expense), net for the quarter and year-to-date periods ended June 26, 2004, includes a charge of approximately $8 million for a contribution to the Kellogg’s Corporate Citizenship Fund, a private trust established for charitable giving.

Other income (expense), net for the year-to-date period ended June 28, 2003, includes a credit of approximately $13 million related to favorable legal settlements; a charge of $8 million for a contribution to the Kellogg’s Corporate Citizenship Fund; and a charge of $6.5 million to recognize the impairment of a cost-basis investment in an e-commerce business venture. These charges were recorded principally during the first quarter of 2003.

Note 4 Equity

Earnings per share

Basic net earnings per share is determined by dividing net earnings by the weighted average number of common shares outstanding during the period. Diluted net earnings per share is similarly determined, except that the denominator is increased to include the number of additional common shares that would have been outstanding if all dilutive potential common shares had been issued. Dilutive potential common shares are comprised principally of employee stock options issued by the Company. Basic net earnings per share is reconciled to diluted net earnings per share as follows:

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Comprehensive Income

Comprehensive income includes net earnings and all other changes in equity during a period except those resulting from investments by or distributions to shareholders. Accumulated other comprehensive income for the periods presented consists of foreign currency translation adjustments pursuant to SFAS No. 52 “Foreign Currency Translation,” unrealized gains and losses on cash flow hedges pursuant to SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities,” and minimum pension liability adjustments pursuant to SFAS No. 87 “Employers’ Accounting for Pensions.”

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Accumulated other comprehensive income (loss) as of June 26, 2004, and December 27, 2003, consisted of the following:

Note 5 Debt

In January 2004, the Company repaid $500 million of maturing seven-year Notes, replacing these Notes with short-term debt.

Note 6 Employee benefits

The Company sponsors a number of U.S. and foreign pension, other postretirement, and postemployment plans to provide various benefits for its employees. These plans are described on pages 43-46 of the Company’s 2003 Annual Report. Components of benefit expense for the periods presented were:

Pension

Other nonpension postretirement

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Postemployment

Note 7 Operating segments

Kellogg Company is the world’s leading producer of cereal and a leading producer of convenience foods, including cookies, crackers, toaster pastries, cereal bars, frozen waffles, and meat alternatives. Kellogg products are manufactured and marketed globally. In recent years, the Company was managed in two major divisions — United States and International. During late 2003, the Company reorganized its geographic management structure to North America, Europe, Latin America, and Asia Pacific. This new organizational structure is the basis of the operating segment data presented below. The prior periods have been restated to conform to the current-period presentation. This restatement includes: 1) the combination of U.S. and Canadian results into North America, 2) the reclassification of certain U.S. export operations from U.S. to Latin America, and 3) the reallocation of certain selling, general, and administrative (SGA) expenses between Corporate and North America.

(a)

Includes Australia and Asia.

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Note 8 Supplemental information on goodwill and other intangible assets

Intangible assets subject to amortization:

(a) The currently estimated aggregate amortization expense for each of the 5 succeeding fiscal years is approximately $3.0 million per year.

Intangible assets not subject to amortization:

Changes in the carrying amount of goodwill for the quarter-to-date period ended June 26, 2004:

(b) Includes Australia and Asia.

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KELLOGG COMPANY

PART I - FINANCIAL INFORMATION

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

Results of operations

Overview

Kellogg Company is the world’s leading producer of cereal and a leading producer of convenience foods, including cookies, crackers, toaster pastries, cereal bars, frozen waffles, and meat alternatives. Kellogg products are manufactured and marketed globally. In recent years, we managed our operations in two major divisions — United States and International. In late 2003, we reorganized our geographic management structure to North America, Europe, Latin America, and Asia Pacific. This new organizational structure is the basis of the operating segment data presented in this report.

For the quarter ended June 26, 2004, the Company reported net earnings per share of $.57, a 14% increase over the prior-period amount of $.50. Both consolidated net sales and operating profit increased 6%. The combination of strong business momentum, reduced interest expense, and lower tax rate resulted in a 16% increase in net earnings for the quarter, despite higher commodity costs, a double-digit increase in brand-building expenditures, and significant up-front charges related to cost-reduction initiatives.

Net sales and operating profit

The following tables provide an analysis of net sales and operating profit performance for the second quarter of 2004 versus 2003:

(a)		2003 results were restated to conform to 2004 operating segment presentation as follows: 1) U.S. and Canadian results combined into North America, 2) certain U.S. export operations reclassified from U.S. to Latin America, and 3) certain SGA expenditures reallocated between Corporate and North America.
(b)		Includes Australia and Asia.

During the second quarter of 2004, consolidated net sales increased 6%, on top of a similar increase in the year-ago period. Internal net sales (which excludes the impact of currency and, if applicable, acquisitions, dispositions, and

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shipping day differences) grew nearly 5%. During the quarter, successful innovation and brand-building investment continued to drive growth in most of our businesses.

North America reported net sales growth of approximately 5%, with internal growth across all major product groups. Internal net sales of our North America retail cereal business increased approximately 2%, on top of 3% growth in the prior-year period. Successful innovation and consumer promotion activities supported continued sales growth and category share gains by our U.S. cereal business, offsetting softness in Canada. Internal net sales of our North America retail snacks business (consisting primarily of wholesome snacks, cookies, crackers, and toaster pastries) increased 7%, due primarily to sales of fruit snacks and other new products, strong toaster pastry performance, and double-digit growth in our Canadian snacks business. Despite continued category weakness, cookie sales increased versus the prior period. Internal net sales of our North America frozen and specialty channel (which includes food service, vending, convenience, drug stores, and custom manufacturing) businesses collectively increased approximately 4%, on top of 5% growth in the second quarter of 2003.

Net sales in our European operating segment increased more than 11%, buoyed by favorable foreign exchange movements and internal net sales growth of 3%. This growth was attributable principally to strong pan-European sales of wholesome snacks and cereal sales within continental Europe. After a very strong first quarter performance, second quarter cereal sales by our UK business unit were relatively flat, bringing the year-to-date rate of internal net sales growth to 5%. The current-quarter results were affected by various category and competitive factors, which we are addressing with brand-building initiatives during the second half of the year.

Continued strong performance in Latin America resulted in net sales growth of 9%, with internal net sales growth of 16% more than offsetting unfavorable foreign currency movements. Most of this growth was due to very strong price/mix and tonnage improvements in both cereal and snack sales by our Mexican business unit, which benefited from continued expansion of its direct store door (DSD) delivery system.

Net sales in our Asia Pacific operating segment increased 2%, as favorable foreign currency movements more than offset an internal sales decline of nearly 6%. This decline was attributable principally to negative publicity on sugar-containing products in Korea and competitive conditions in Australia.

Consolidated operating profit increased 6% during the quarter, with internal growth exceeding 4%. This internal growth was achieved despite a double-digit increase in brand-building expenditures, as well as significantly higher commodity costs. Furthermore, as discussed in the “Cost-reduction initiatives” section below, we are absorbing a significant amount of up-front cash expenditures and asset write-offs during 2004.

The following tables provide an analysis of net sales and operating profit performance for the year-to-date period ended June 26, 2004, versus the comparable prior-year period:

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(a)		2003 results were restated to conform to 2004 operating segment presentation as follows: 1) U.S. and Canadian results combined into North America, 2) certain U.S. export operations reclassified from U.S. to Latin America, and 3) certain SGA expenditures reallocated between Corporate and North America.
(b)		Includes Australia and Asia.

Cost-reduction initiatives

To position our Company for sustained reliable growth in earnings and cash flow for the long term, we are undertaking a series of cost-reduction initiatives. Continuing from 2003 are various manufacturing capacity rationalization and efficiency initiatives in the Company’s North American and European operating segments. Through the second quarter of 2004, we have 1) commenced the global roll-out of our SAP information technology system, 2) undertaken a major initiative to improve the organizational design and effectiveness of pan-European operations, 3) completed decision bargaining and initiated effects bargaining with the union regarding the consolidation of U.S. veggie foods manufacturing operations, and 4) begun the relocation of our U.S. snacks business unit to Battle Creek, Michigan. Additional initiatives are still in the planning stages and individual actions are being announced as plans are finalized.

Related to commenced projects, we expect to incur approximately $130 million of up-front cash expenditures and asset write-offs to complete these initiatives, the majority of which is being recognized in earnings during 2004. These costs are included in our 2004 consolidated performance target of high single-digit growth in net earnings per share, as well as our projections for full-year cash flow. Additional information on individual projects is contained in Note 2 to Consolidated Financial Statements.

Taking into account the incremental costs of all in-process initiatives, we recorded total charges of approximately $20 million for the quarter and $29 million for the year-to-date period ended June 26, 2004. Approximately 70% of the year-to-date charges were comprised of asset write-offs, with the remainder consisting of severance, consulting, and other cash costs. Approximately 60% of the year-to-date charges were recorded in cost of goods sold, with the balance recorded in selling, general, and administrative (SGA) expense. The year-to-date charges impacted our operating segments as follows (in millions): North America-$15, Europe-$14.

Cost of goods sold for the quarter ended June 28, 2003, included charges of approximately $15 million, attributable primarily to equipment disposals associated with manufacturing network optimization efforts in our U.S. snacks business.

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Margin performance

Margin performance for the second quarter and year-to-date periods of 2004 versus 2003 was: