Kellogg Co

NYSE:K

Earnings Call Transcript 2020-Q2

[Operator]

Good morning. Welcome to the Kellogg Company's Second Quarter 2020 Earnings Call. [Operator Instructions]. Thank you. Please note, this event is being recorded. At this time, I will turn the call over to John Renwick, Vice President of Investor Relations and Corporate Lending for Kellogg Company. Mr. Renwick, you may begin your conference call.

[John Renwick, VP, IR & Corporate Planning]

Thank you, Gary. Good morning, and thank you for joining us today for a review of our second quarter results as well as updates regarding our outlook for 2020. I'm joined this morning by Steve Cahillane, our Chairman, and CEO; and Amit Banati, our Chief Financial Officer.

Slide 3 shows our forward-looking statements disclaimer. As you are aware, certain statements made today such as projections for Kellogg Company's future performance, are forward-looking statements. Actual results could be materially different from those projected. For further information concerning factors that could cause these results to differ, please refer to this third slide of the presentation as well as to our public SEC filings.

This is a particular note during the current COVID-19 pandemic when the length and severity of the crisis and resultant economic and business impacts are so difficult to predict.

A replay of today's conference call will be available by phone through Thursday, August 6. The call will also be available via webcast, which will be archived for at least 90 days on the Investor page of kelloggcompany.com.

As always, when referring to our results and outlook, unless otherwise noted, we will be referring to them on a currency-neutral basis for net sales. And on a currency-neutral adjusted basis for operating profit and earnings per share. And now I'll turn it over to Steve.

[Steven Cahillane, Chairman, CEO & President]

Thanks, John, and good morning, everyone. These are certainly unusual and troubling times. The pandemic drags on with cases rising again in many states and countries that had just begun to reopen. And recent events around racial injustices have only added to an environment that is both uncertain and worrisome. It goes without saying that these crises have touched us all in some way, and our hearts go out to individuals and families that have been directly affected, and we certainly hope you and your families and friends are staying safe.

As a company with heart and soul, it has been very important for us to maintain ongoing communication with our stakeholders about what we are doing to keep each other safe.

How we continue to supply our markets with food and how we are giving back to our communities. We've also worked to increase our open dialogue about diversity and inclusion, which we deem to be inherent in our company's values. This is included stepped-up actions like incremental donations to the NAACP, town halls, and testimonials by employees, professors, and authors, and we will continue to do so.

So we are certainly operating in unprecedented times. And from our employees on the front lines, in our plants and distribution centers and now back in stores, to our employees working from their homes, this organization has come together and rallied to the occasion like nothing I've ever seen before.

From a business perspective, turning to Slide 5, we're managing well through the crisis. Our 1 priority, of course, has been keeping our employees and their families safe as best as we can. We've talked previously about the investments and process changes we have made, and we will remain vigilant to protect our people.

We've told you that we feel we have an incredible responsibility in supplying food during this time. I'm happy to report that we've experienced no major supply disruptions and managed to increase our production and keep up our service levels in spite of higher-than-expected demand in many markets.

We continue to aid our communities through volunteer hours and through what is now nearly $15 million in cash and food donations that we've made since this crisis began. These are our priorities during the crisis, and we are executing well against them.

Turning to Slide 6. It was in the usual quarter, to say the least. In addition to executing against our crisis priorities, we again delivered exceptional results in the second quarter, even amidst a very uncertain environment and new unusual ways of working.

Our net sales came in much higher than expected. We'd assume that at-home consumption growth would decelerate meaningfully during the second quarter, but with prolonged prices, it held up higher and for longer than we had forecast. And in some of our categories, retailers were able to catch up to demand and rebuild inventory. Meanwhile, declines in away-from-home channels persisted, and our emerging markets did not slow down as much as we had expected given COVID disruptions and recessionary conditions.

We also generated higher-than-expected operating profit. The higher-than-projected volume ran through our well-utilized plants, driving strong operating leverage. This more than offset significant incremental COVID-related costs in the quarter, mainly around safety, employee benefits, temporary labor, and logistics. The net of this was an unusually large increase in gross profit.

Our operating profit also received a temporary boost from the deferral of various investments. We again shifted brand building investments in the second half, particularly investment in activities that we tied to canceled or delayed sporting events, movie releases, and innovation launches. We also shifted some overhead and capital investment to the second half. As a result, we have seen an even larger shift of the year's operating profit into the first half. It's important to recognize that we also executed well, and there are clear signs that our underlying business is in good shape.

For instance, we continue to increase household penetration aided by our ability to get food into the market and to adjust our brand communication. There is trial, repeat, and reappraisal that can benefit us long after the crisis finally passes.

All other signs of execution include our improved category share performance, including some brands that we've been revitalizing through fresh brand messaging. And our supply chain is operating well, gradually improving our service levels amidst unusually challenging circumstances. All of these contributed to an outsized financial delivery in Q2.

So let's discuss what this means for our full year, turning to Slide 7. We recognize that many companies have refrained from giving guidance in this uncertain environment, and we can understand why. There are a number of variables that are extremely uncertain right now. So today, we're going to offer you our planning stance for the second half and how we are approaching some of these variables, and we are raising our full year guidance to reflect our over-delivery in the first half.

From a net sales standpoint, our increased full year outlook reflects the strong growth we delivered in the first half as well as a slightly improved top-line outlook for the second half. We won't get more aggressive than that because too many variables are simply too uncertain. From a profit and earnings standpoint, we do know that our second half profit will be weighted down by investment. Most of this increased second half investment is simply shifted from the first and second quarters, the result of focusing on supply and postponing promotional activity tied to canceled events. Specifically, in the second half, we plan to return to full commercial programming and to completely invest our full year brand building budget.

Again, there are many unique assumptions that we have to make in formulating an outlook right now. The length and severity of the COVID crisis and related economic recession is not knowable. But Amit will walk you through our key planning assumptions in a moment.

Suffice it to say, we feel very good about having a front-weighted profit delivery this year and a strengthened commercial plan for the second half. So with that, let me turn it over to Amit, who will take you through our financial results and outlook in more detail.

[Amit Banati, SVP & CFO]

Thank you, Steve, and good morning, everyone. Let me start with Slide 9 and a reminder of our financial approach during the crisis. Employee safety is the top priority, and we will continue to invest in this area in safety supplies, temperature checks, and incremental cleaning protocols as well as information technology to facilitate working remotely.

To supply the market with food, we've continued to focus production on priority SKUs, utilize temporary labor where necessary, and reward our frontline workers with bonuses and benefits. We've also invested in logistics to get food to our customers as quickly as possible. We've continued to ensure financial flexibility which is particularly important in this environment of economic recession and volatile financial markets.

Our cash flow has been very strong, enabling us to carry higher-than-usual cash balances and shows strong liquidity and reduce debt leverage. And we've remained committed to investing in the future. As Steve mentioned, the crisis led us to defer some commercial activity and investments to the second half, and we plan to execute not only those shifted investments but also incremental investments that can be funded by our strong first half earnings and cash flow. So this is the context in which we view our financial results and outlook.

Slide 10 summarizes our results for the second quarter and first half. As Steve mentioned, these strong results reflect good execution in an unprecedented environment. There really were 2 big factors that exceeded our expectations for the quarter. First, at-home consumption in developed markets did decelerate through the quarter, but not nearly as quickly as we had anticipated back in April, particularly as we improved our share performance in key markets and categories.

And second, our emerging markets did slow amidst lockdowns and economic slowdowns, but we managed through them well and they did not slow by as much as we had expected. From a margin perspective, the better-than-expected volume and very strong supply chain execution resulted in greater operating leverage than expected, more than offsetting higher incremental COVID costs, which amounted to more than $20 million in quarter two, a sizable increase from quarter 1.

We also found ourselves having to delay more brand investment into the second half than previously anticipated, acting with agility to shift plans due to postponed events and supply constraints. These were the key underlying drivers in the quarter. On top of that, of course, was the mechanical impact of last year's divestiture. The absence of those businesses' results negatively impacted organic net sales by approximately 6% in quarter two and about 8% year-to-date. Its negative impact on adjusted basis operating profit was more than 8% in quarter two and 10% year-to-date. We lapped the divestiture this week. So we'll have only 1 month impact in quarter three.

Below operating profit, we continue to prioritize debt reduction, making no share buybacks in the quarter and reducing our interest expense on lower net debt. Other income benefited from changes to certain pension funds in the quarter, though this was offset by a higher-than-projected effective tax rate. The result of all of these is in earnings per share and cash flow that again came in ahead of pace. Taking into a little more detail, let's look at net sales growth on Slide 11. Our organic basis net sales growth was 9% year-on-year in the quarter, slightly higher than our first quarter growth. This organic growth was again driven by volume, reflecting the pandemic-related demand, which end up higher and for longer than expected.

Our price/mix was modestly negative in the quarter, owing to category and country mix. Once again, our organic net sales growth was across all 4 regions and across all 4 global category groups: snacks, cereals, frozen foods and noodles, and other.

The divestiture impact in quarter two reflects the absence of those businesses. In quarter three, we'll have only 1 month of impact translating into approximately negative 2% of net sales. Currency was adverse in quarter two, owing to the dollar strengthening against key currencies back in March.

Now let's turn to profit margins on Slide 12. As we've discussed previously, our goal this year was to finish 2020 at a stable level year-on-year on gross profit margin. Obviously, the surge in at-home demand and the resultant operating leverage has moved this plan from being a gradual improvement across the year to being a front-weighted plan. During quarter two, we saw a substantial year-on-year increase in gross margin, reflecting not only operating leverage from higher volume but also a moderation of what had been a meaningfully negative margin mix trend towards emerging markets.

In the pandemic-affected second quarter, emerging markets actually grew less than developed markets. In a moment, I'll discuss why we view this large quarter two gain as temporary. But this front-weighted performance does offer increased confidence in our full year outlook for gross profit margin. At the operating profit margin, the improvement was also substantial in quarter two and also mostly timing related. As we've discussed previously, a good portion of our brand-building investment had to be shifted to the second half, particularly investment that was tied to external events or innovation launches that have been postponed. We are repurposing that investment into brand activities in the second half.

Let's discuss cash flow and capital structure on Slide 13. Our cash flow continued to be strong in quarter two, up significantly year-on-year. This brings our year-to-date cash flow to more than $750 million, our strongest first half performance in years, even despite the absence of businesses we divested last July. Some of this is timing. Our earnings are front half-weighted this year with significant investment delayed to the second half. And as we did not want to disrupt our supply chain during the first half, our capital expenditure is weighted to the second half as well.

However, this strong year-on-year performance also reflects continued strong working capital management and reduced cash outlays related to restructurings. The next chart on the slide shows our net debt position. A combination of last year's divestiture proceeds and strong year-to-date cash flow have enabled us to pay down debt year-on-year and carry higher-than-usual cash balances around the world. In fact, at quarter end, our cash position was again over $1 billion.

Our bond offering in May was very successful, indicating confidence in our balance sheet and cash flow and resulting in low interest rates. Our liquidity is excellent. In addition to our high cash balances, we retain access to commercial paper, and we have $2.5 billion of unused backup facilities. We're taking a proactive approach to financial flexibility in an uncertain operating environment, and we feel good about our liquidity and balance sheet going into the second half.

Let's now discuss our rest of year outlook, starting with Slide 14. Obviously, this is a time of tremendous uncertainty and myriad variables can yield a wide range of outcomes. We want to give you visibility into the assumptions around which we are planning for the second half, specifically related to the pandemic and our investment plans. First, we plan for net sales growth to slow in the second half. We assume that at-home demand in developed markets continue to decelerate week-to-week through quarter three. Our outlook still considers the likelihood of prolonged softness in our away-from-home channels, including channels like travel and lodging that may take longer to stabilize and recover. And we assume that our emerging markets businesses will continue to feel the impact of COVID disruption and economic recession in the second half.

Next, we view much of our outsized Q2 improvement in gross profit margin to be temporary. As we enter the second half, we lap the divestiture. So that particular year-on-year benefit obviously goes away. We also assume that we'll have less operating leverage in the second half as volume slows. And we'll have some plant-related changeovers as we resume production of paused SKUs. We'll sustain much of the direct COVID costs, particularly around safety and cleaning, and we will have less productivity savings this year due to delays in capital investments during the crisis. The result is year-on-year pressure on gross margin in the second half.

And finally, we will execute a substantial year-on-year increase in investment in brands and capabilities. There is principally the advertising and promotion investment that shifted out of the first half and into the second half. And on top of that, there is also some incremental investment. In addition, there is incremental overhead and capital that reflects our desire to invest behind capabilities. Simply put, we are taking the profit upside we realized in the first half and putting it to good use: investment for future growth in categories that just got more exciting.

So this is how we are viewing the crisis from a financial perspective in the second half. Again, as I'm sure you can appreciate, it's hard to say how the crisis will play out. But these are the assumptions we are planning around at this time. Now let's put it all together and look at our full year guidance shown on Slide 15. As Steve mentioned, we are raising our guidance for the year. Based on our second half planning assumptions, we now expect to finish 2020 with organic net sales growth of around 5%. This implies a modest improvement to our previous growth forecast for the second half and a substantial increase to our full year guidance.

We now expect currency-neutral adjusted operating profit to decline by only about 1%, which is about 3 percentage points better than our previous guidance and still includes roughly 6 percentage points of negative impact from our divestiture. This improved profit picture reflects a sizable growth in the first half, partially offset by shifted and incremental investments coming into the second half.

This increase in investment will weigh down operating profit in quarter three, in particular. Our outlook for currency-neutral adjusted earnings per share also improves meaningfully to a year-on-year decline of only about 1%, despite a negative impact of about 5% from the divestiture. This raised EPS guidance is driven by the increased outlook for operating profit.

Below operating profit, our other income line benefits from quarter 2's favorable pension changes, but this should be roughly offset by an increased tax rate, owing to some unfavorable tax items recognized in quarter two, which will put us closer to a 22.5% rate for the year. Cash flow is now forecast to be about $1 billion, the high end of our previous guidance range. This improvement reflects our raised earnings outlook, partially offset by increased capital expenditure as we invest for the future. As I said, this is our planning stance. Yes, there could be upside if at-home consumption remains more elevated than we have assumed. However, there could also be downside if emerging markets feel greater pressure from recessionary impacts or if we suffer unanticipated supply chain disruptions related to the pandemic.

We think this is an appropriate planning stance, and we are pleased to be able to raise guidance while also investing more for the future. And with that, let me turn it back to Steve for a review of each of our major businesses.

[Steven Cahillane, Chairman, CEO & President]

Thanks, Amit. I'll now do our normal walk through the regions. Even keeping in mind the uniqueness of the current environment, and therefore, the timing related benefits to sales and operating profit, we saw good underlying execution and performance in all of our regions and all 4 of the global category groups.

Let's begin with North America in Slide 17. We've had a strong quarter in first half of 2020 as the pandemic has lifted demand for at-home consumption. The result was organic net sales growth of 11% in quarter two, which turned out to be even higher than our 6% growth in quarter 1. This elevated consumption was most pronounced in meal-oriented categories, which for us is cereal, frozen breakfast, and frozen veggie foods.

Reversing what happened in quarter 1, shipment growth in quarter two to retail channels exceeded consumption growth, mainly in cereal, suggesting replenishment of retailers' inventory. We were also rebuilding our own inventory during quarter two, helping us to improve our service levels and adding to an unusually large margin benefit from operating leverage in the quarter. This, too, has a timing element to it.

Not surprisingly, our away-from-home business declined sharply in quarter two, though we managed it well. We've mitigated sales declines in the schools channel by shifting toward emergency feeding programs and our declines in convenience stores have begun to moderate. That said, our sales in the restaurants remain down sharply, and we are seeing our sharpest declines in vending and travel and lodging, with the latter likely to remain soft for some time.

In Canada, we recorded double-digit organic net sales growth, led by elevated consumption growth in cereal and frozen breakfast and veggie foods as well as our expansion of Cheez-It. Importantly, we gained share in 4 of our 6 main categories there. North America's profit growth was notably strong in quarter two, and this reflects the unusually high operating leverage and a shift of investment to the second half.

Let's take a look at each of our 3 major category groupings in North America, starting with our largest, snacks, on Slide 18. This is the business affected by the divestiture. But on an organic basis, it had another good quarter with net sales increasing 6% year-on-year. Our crackers consumption in the U.S. increased by almost 9% in quarter two, gaining share of the category.

Cheez-It continue to grow at a double-digit rate, and we also saw share gains by our Club and Cars brands reflecting their orientation toward at-home occasions as a company man crackers. In salty snacks, Pringles grew consumption by almost 12%, modestly trailing the category because of declines in immediate consumption pack formats. The brand's core four flavors collectively grew in line with the category.

In portable wholesome snacks, we've gained share behind double-digit growth in Pop-Tarts and continued growth in Rice Krispies Treats. These brands are more than offsetting softness in the overall category, which has been declining because of the on-the-go nature of so many of its products. For us, this has included RXBAR.

As we move to the second half, we expect to see moderating at-home consumption growth against tougher year-ago comparisons, but with the resumption of commercial programming and investment. Now let's turn to North America cereal and Slide 19. The U.S. and Canadian cereal categories continued to see elevated levels of consumption during quarter two. And in both markets, our quarter two net sales got further lift from replenishing retailer inventories.

In the United States, our cereal consumption was up almost 16% year-on-year, outpacing the category. Importantly, we are gaining share not only behind taste/fun brands like Froot Loops but also behind health and wellness-oriented brands that we set out to revitalize this year through refreshed messaging and media.

Special K gained share in quarter two as is Mini-Wheats and Raisin Bran. We are also excited about the consumer trial and rediscovery we are seeing from new and lapsed users in cereal. Household penetration continued to rise sequentially and year-over-year in quarter two, and we are tailoring our messaging and media to reaching out to these consumers. We're not only growing consumption faster than the category but we're also increasing household penetration faster than the category.

As we enter the second half, we've returned to normal merchandising activity. Not only versus the first half when investment was delayed but also against last year when we were only just coming out of the pack-sized harmonization during the year ago third quarter. We're certainly encouraged by the momentum we're building in our cereal business.

Now let's turn to our North America frozen foods Business and Slide 20. These categories saw very elevated at-home demand continue in quarter two, driving very strong net sales growth. In what we call the frozen from the griddle category, our Eggo brand posted consumption growth of about 26% during the quarter, gaining substantial share, while our Kashi brand grew about 19%. We outpaced each of the category's 3 product segments: waffles, pancakes, and french toast, aided by strong innovation and renovation we have done over the past year.

In frozen veggie foods, our Morningstar Farms brand grew consumption by more than 31% in the quarter, failing to keep up with the category only because we ran up against our capacity in the quarter. Both of these categories are seeing increased household penetration.

So even as at-home demand inevitably decelerates, we see an opportunity to increase our communication to take advantage of the increased household penetration.

Indeed, in the second half, we will be investing in this communication as well as in the launch of Incogmeato. You'll recall that this is the refrigerated sub-line of our Morningstar Farms brand, whose launch was deferred to the second half because of retailer resets getting delayed because of the crisis.

So another big quarter for Kellogg North America. And even though much of its first half profit growth will reverse in quarter three and quarter 4 when we see growth rates moderate and our investments get executed, there's no doubt that our business in North America will emerge from 2020 much stronger.

Now let's discuss our international businesses, starting with Europe on Slide 21. Europe had another solid quarter. Specifically, we realized elevated cereal consumption growth across all of our key markets in Europe as shown on the slide. And equally importantly, we've gained share in each of our top 5 cereal markets namely the U.K., France, Germany, Italy, and Spain. Our Krave brand, known as Tresor in some markets, is up 25% year-to-date and has become the 1 cereal brand in Europe.

Special K, the 3 cereal brand in Europe, has kept up with the category so far this year, attributed to our packaging and messaging overhauls. Coco Pops, another brand in Europe's top 5 also outpaced the category. So between at-home demand rising during the pandemic and strong execution and share gains by our team, our cereal net sales grew at a double-digit rate in quarter two. Our net sales in snacks, however, declined in the quarter as expected. You'll recall that with the cancellation of the Euro Cup soccer tournament, we had to cancel a 360-degree marketing program that was a strong plan to grow Pringles on top of 2 years of exceptional summer programs.

Due to the agility and creativity of our brand team, we were able to move to a combination of smaller programs, which successfully held Europe's Pringles sales flat year-on-year. Our only soft spot in the quarter was portable wholesome snacks, whose on-the-go orientation has pulled down the entire category and our share remained relatively stable. As we focused on supplying the market with food, we did defer more of Kellogg Europe's overall brand investment to the second half, which effectively shifted profit into the first half and out of the second half. We're very pleased with how we are executing in Europe.

Let's turn to Latin America and Slide 22. Amidst a growing COVID crisis and an uncertain economic environment, our Latin American business is performing well. Net sales in the quarter grew 14% on an organic basis during quarter two, which was much more than we expected for two reasons. First, at home demand growth actually accelerated in this region as the COVID outbreak worsened.

This was especially the case for meal-oriented categories in the modern trade channels. For us, this had a major effect on cereal, and we saw double-digit consumption growth in key cereal markets across the region during quarter two.

And second, retailers proceeded with their summer promotions as normal in June, whereas we had anticipated some execution delays given COVID limitations. The result was higher-than-expected cereal net sales which more than offset impacts of recessionary economic environment and general softness in snacking categories, particularly in high-frequency stores or mom-and-pop's and on-the-go channels.

Our snacking categories have not seen a lift in demand, particularly in on-the-go-oriented categories like wholesome snacks, and particularly in markets like Brazil where high-frequency stores predominate. The good news is that Pringles continued to grow consumption and gain share in key markets like Mexico and Brazil.

With COVID cases on the rise and an economy that is clearly soft, we remain cautious in our outlook for Latin America's second half, particularly with new labeling restrictions in Mexico. But there is no question that our team is managing well through a difficult environment.

And finally, we'll discuss EMEA, shown on Slide 23. EMEA also exceeded expectations in the second quarter. Cereal sales remained strong, sustaining a mid-single-digit growth rate as at-home consumption remained elevated in the more developed markets of the region. We also performed well within these cereal markets. In Australia and South Africa, for instance, our strong double-digit consumption growth rates were enough to gain multiple points of share in those growing cereal categories. The biggest positive surprise in the quarter was Multipro, the distributor portion of our rapidly growing business in West Africa.

COVID lockdowns and a softening economy did indeed slow growth from Multipro, but certainly not as much as we anticipated. Where we did see softness, as expected, was in snacks in the Middle East and other emerging markets like India, related to COVID disruption and slowing economies. Nevertheless, despite challenging macro environment, we still managed to deliver good top-line growth in this region in quarter two, and our profit growth was augmented further by delays in brand investment to the second half.

We see quarter 2's top-line growth remaining at a decelerated pace in the second half, given the macro environment, but we like how we are managing through the crisis overall in EMEA. So allow me to summarize with Slide 25. The company continues to execute well amidst the crisis. It hasn't been easy. It has required courage and flexibility in the part of our employees, and it has required considerable incremental costs in the form of safety and cleaning, temporary labor, additional freight, and bonuses for our deserving frontline employees, and its working. We're keeping our employees safe. We're supplying food to customers and consumers. We're giving back to the community. And we're enhancing our financial flexibility. Meanwhile, we're very grateful for our partnerships with our suppliers, and our retail customers during these challenging times. It is this execution that has enabled us to deliver even better results than we had anticipated in both quarter 1 and quarter two and both in market and our financial results.

This has important implications. We are able to raise our financial forecast for the year, delivering more net sales, more operating profit, more earnings per share, and more cash flow than we had planned. And yet, at the same time, we are also able to reinvest back in the business during the second half. This means investing to revitalize more of the brands in our portfolio and reaching out to new and lapsed users who have rediscovered our foods during the crisis. It means we can invest more in capabilities that will give us a leg up in the marketplace, such as data and analytics, digital and e-commerce, and packaging.

And in the end, it means we can finish 2020 with both better-than-expected financial performance and come out a stronger company. It means we can improve our financial flexibility in a time of great uncertainty, and it only solidifies our path towards balanced and consistent growth in sales, profit, and cash flow over time.

Before we close, I want to extend a heartfelt thank you to our employees, their bravery, dedication, and hard work are exemplary. And their engagement during this time of crisis has been inspiring. It just reaffirms that Kellogg has a truly special culture.

And with that, we'll open it up for your questions.

[Operator]

[Operator Instructions]. Our first question comes from Chris Growe with Stifel.

[Christopher Growe, Stifel, Nicolaus & Company]

I had two questions for you. The first one just be -- would be there's some -- a lot of shifts and movement occurring this quarter, especially behind marketing. As we're trying to get a sense of the fixed cost leverage, no doubt that's a benefit to margins and help drive profit growth. Can you give a better sense of how that leverage took hold? Maybe how much marketing shift into the second half of the year?

I don't know if there's a way you can give kind of a gross margin discussion in terms of the various costs that occurred in the quarter as well. So I'm just trying to look at the leverage and the profit growth that occurred kind of absent the unique items.

[Steven Cahillane, Chairman, CEO & President]

Yes. Thanks, Chris. I'll start, and then I think Amit will build on it. First, obviously, we had monumental changes in the first half. If you think about, at the very beginning, the March Madness, obviously being canceled, NBA on and on, everything just got canceled. So that led us to making big shifts in marketing and investment, which we plan on, as we said in the prepared remarks, to fully invest in the second half.

Order of magnitude, we're talking about being as much as $60 million, 6-0 in shift from the first half into the second half, much of that advertising and promotion. And a lot of it will be weighted towards quarter three, which we're obviously in right now. You want to talk about maybe, look at the operating leverage, Amit?

[Amit Banati, SVP & CFO]

Sure. So Chris, just on gross margin, obviously, we had a very strong gross margin performance in the quarter. I think if I were to kind of break down the drivers of that, the divestiture was about 60 basis points, which was just mechanical as it flowed through. We did have incremental costs related to COVID of around $22 million, so that was about a 50 basis points headwind during the quarter.

Input costs were roughly neutral. So largely, the balance of the gross margin was driven really by two things: one, the operating leverage coming through, and also a positive margin mix. So as the growth was more pronounced and moved away from snacks towards RTEC and noodles that that created a positive margin mix for us in the quarter.

I think as we look to the second half, we'd expect the margin mix to be neutral, and then obviously, with lower volume growth, the operating leverage would be lower in the second half. And overall, we remain confident of our guidance on a stable gross profit margin for the year.

[Christopher Growe, Stifel, Nicolaus & Company]

And just in relation to that leverage point you made, did the increase in inventories that occurred, both your own and at retail, did that -- how much does that contribute to the gross margin then?

[Amit Banati, SVP & CFO]

Well, I think it was -- I think in terms of the inventories specifically, we did see a replenishment of inventory.

[Steven Cahillane, Chairman, CEO & President]

Trade inventory.

[Amit Banati, SVP & CFO]

Of trade inventory. But from an overall standpoint, right, I think the leverage was driven by the increased production in the quarter.

[Operator]

Next question is from Jason English with Goldman Sachs.

[Jason English, Goldman Sachs Group]

Impressive results this quarter, congratulations to you and your organization. The North American cereal business was especially impressive. But as we look at consumption, it looks like the demand is waning despite the breakfast occasion being one of the slowest to recover in the away-from-home market. I was hoping you could sort of opine on why you think we're seeing the cereal business fade? Or at least consumption levels fade faster than most other at-home categories?

[Steven Cahillane, Chairman, CEO & President]

Yes. Thanks for the question, Jason. What I'd say about cereal consumption, it's moved around. It's been pretty choppy. And if you look at the latest syndicated data, it actually looks like it's coming back now. And so it's been choppier, and I think some of that might be stocking up. We do see trips down and baskets up, so people load up their pantry, but they are going through it.

And so I think we're just going to have to continue to take a wait-and-see approach because all of our panel research also suggests that consumption remains very strong and very robust. And we like our performance in that. And we're investing quite substantially in the back half of the year in a back-to-school program. You can see the Mission Tiger, which has been on air, which has been very successful in really gaining steam. So it's one to watch, obviously, but we're pretty confident that the at-home consumption is going to remain elevated. And we're assuming a deceleration, obviously, from the height of it as people become more mobile and things do return back to normal, but we're still seeing good overall consumption, although choppy.

[Jason English, Goldman Sachs Group]

That's helpful. Good context. In light of that, why do you expect margin mix to not be a tailwind in the back half of the year? What's going to change to make that go net neutral or see the benefits fade?

[Amit Banati, SVP & CFO]

Yes. So I think, Jason, in the second, mix was favorable in the quarter, like I said, as we saw growth move from snacks towards RTEC and noodles. I think as we look at the second half, we expect that to moderate as we get back to more normal consumption levels. So that's the assumption. That's the planning assumption, underlying gross margin for the second half.

[Operator]

The next question is from Bryan Spillane with Bank of America.

[Bryan Spillane, Bank of America Merrill Lynch]

Just two questions related to the second half. First, I guess as you're thinking about or you're planning for an increase in marketing expenses in the back half and especially in the third quarter. Can you just talk about how back-to-school is shaping up? And what changes you may be making to your sort of back-to-school promotions and merchandising? And then maybe just related -- or second, would be just on Pringles in Europe. I know that there's a change in merchandising there because you've done a lot relative to soccer in recent years. So can you just update us there in terms of what your changed plans are, I guess, for Pringles in Europe in the third quarter?

[Steven Cahillane, Chairman, CEO & President]

Sure. Thanks for the question, Bryan. First, with respect to the back-to-school program and how we're thinking about the second half, I'd start by actually giving you some -- we didn't say it, but our actual advertising spend in the first half was still up year-over-year.

But obviously, in-store merchandising and promotions and consumer promotions affected by COVID in the first half.

As we think about the back half, we were very purposeful in back-to-school, for example, in thinking about what the environment might be. Will kids be actually going back to brick-and-mortar? Will they be doing a hybrid? Will they be staying at home? So we believe our program works in any environment, and it's tied to literature and books and getting books into kids' hands tied to the purchase of our cereals. And so we think it's very good. We think it's very strong. And we think it's very versatile depending on what the environment may end up being. And so the team has worked very hard on it, and I think we've got a solid, solid program.

With respect to Pringles, Pringles, obviously, in the first half, we had to lap the cancellation of the Euro Cup, which was huge. And we put a lot of effort into building that program to lap what it had been 2 years of exceptional performance in Pringles over the course of the summertime.

And now as we think about Q3 and Q4, we're taking the same type of approach. How do we put together programs around gaming, how do we put together programs that drive more in-store execution. We have our sales force back in store. So we have a lot more merchandising happening. And the fact that we were able to get to flat on Pringles in the first half of the year, lapping exceptional 2-year performances without the Euro Cup, I think, is a testament to the versatility and the agility of the team, and we expect that to continue in the second half. But it will be -- it will continue to be a challenge.

[Operator]

The next question is from Rob Dickerson with Jefferies.

[Robert Dickerson, Jefferies]

Just had a quick question on your comment that you think maybe kind of consumption, let's say, demand, food-at-home, however, we want to define it in Q4 starts to normalize. Obviously, you have a lot of scenarios, right, I'm sure you put in place. But maybe if you could just provide a little bit more color as to what, in this case, what normalized means exactly? And then, I guess, number two, just kind of how you think broadly about food-at-home consumption versus what you were seeing in kind of on-the-go, just given you do have part of your portfolio in on-the-go and then foodservice, right?

And I just asked because if food-at-home consumption comes down a bit, maybe on-the-go improves a little bit, maybe foodservice recovery is slow but still improves. So just kind of holistically, what does normalization mean? And how are the moving parts impact that?

[Steven Cahillane, Chairman, CEO & President]

Yes. Thanks, Rob. It's obviously an important question, and it's an unknowable, right? And we all have our hunches about what might happen, but it's an unknowable what happens with this virus. We expect that right now, we're still seeing at-home consumption obviously elevated. But as we think about planning and giving guidance for the rest of the year, the best that we felt we could do is take a planning stance that says it will decelerate. And in quarter 4, it will get back to a more normalized world. So that you can understand and you can make your own judgments about, do you think that's conservative? Do you think that's straight down the middle of the fairway? It's an unknowable, but it is our planning stance.

Same thing for travel and lodging and away-from-home, we expect that that will continue to face pressure. Travel and lodging, probably more so than convenience, which we're seeing come back. We are seeing mobility grow but it's choppy. Obviously, then you have the virus wreaking havoc in many states in the southern part of the United States and that goes backwards. And so from a planning stance, that's why we tried to be as transparent as possible and tell you exactly what we're thinking. And then you can draw your conclusions as to exactly how you think that may change, particularly in quarter 4 and beyond.

[Robert Dickerson, Jefferies]

Okay. Fair enough. And then just quickly, just in terms of the back half investments, let's say, you're not the only food company that's speaking to back half investments. Again, kind of broadly speaking is your feel that as a lot of companies have kind of experienced this increased tussled penetration lift that as we get through the back half generally, right, the kind of the brand investment will be up across all channels within food. And then maybe as we even think to 2021, those levels can remain high because everybody is essentially trying to keep that penetration as sticky as possible. That's it.

[Steven Cahillane, Chairman, CEO & President]

Yes, Rob, I think that's right. If you think about just the environment that we're in, this elevated demand has made these categories more attractive than they've been in many, many years. Obviously, that a lot of that is driven by COVID. But it does drive reappraisal. It does drive increased penetration. Our penetration is up and our usage is up. And so these are big opportunities for us to continue to connect our brands with consumers in an environment of elevated demand, making as much of that stick as possible.

And so our whole goal with this investment in the second half is again, to fully spend what we plan to spend, but to come out of this a much stronger company, and we are very confident that we're going to be able to do that. Because we've got good brand plans. We're investing in organic growth opportunities that are more attractive than they have been in many, many years.

And so it's a crisis, obviously, but it's an opportunity for us to strengthen our brands, to make better connections with consumers, to build retailer programs that work for the retailers, that work for us, that work for consumers and drive stickiness and drive brand loyalty and, therefore, come out of this crisis and into next year in a much stronger position than when we entered it.

[Operator]

Next question is from David Driscoll with DD Research.

[David Driscoll, DD Research]

I wanted to ask a little bit about this advertising and brand-building shift into the second half. Steve, what do you say to the question or concern from investors that moving a sizable amount of brand building will be less efficient in just 6 months versus had it been able to spend -- been able to be spent over a full 12 months?

Do you worry about the effectiveness of all of the spending that you're moving into the second half? And if not, why? Maybe give us a little bit of inside color here on why this spending is going to be highly effective and maybe on which brands? Is there some things that we all should be looking for to understand the good work that your team is doing?

[Steven Cahillane, Chairman, CEO & President]

Great. Thanks, Dave. Good question. And we are very confident that we're going to have terrific ROIs on our brand spend. And the return on investment calculations will be very important as we plan out, and we'll guide exactly where we're spending. But it's also for the long-term, to build the long-term equities and continue to improve awareness, trial, and overall brand health of our brands.

The other thing I would tell you is, and this is continuing, with people far less mobile and staying at home, our ability to connect with them continues to be very strong, maybe not as strong as April and May when the lockdowns were very severe, but people are less mobile, they're at home, and we know how to connect with them.

And that's what it's going to be about. So it's digital, it's social, it's traditional, all guided by ROIs and with very attractive categories. Look across our portfolio, cereal doing very well, frozen, breakfast, frozen veggie doing very well. Incogmeato, we've consolidated that launch into the back half of the year. That will be fully supported.

And so there's a lot of really exciting things that we're spending our money against and that we're very excited about. But we'll be guided by the right ROIs and the long-term nature of building equities for our brands.

[David Driscoll, DD Research]

One follow-up for me is, you mentioned that you have this expectation that everything moderates, and that's your planning expectation. Is there any concern that if you're wrong, if there's upside to this, will you have the capacity? Will you have the inventories to service elevated demand? So if you can see what I'm getting at, I'm just worried that if you tell the manufacturing team to only plan for a certain scenario of moderation, if it comes out better, maybe you don't actually have the inventories to meet retailer demand.

[Steven Cahillane, Chairman, CEO & President]

Yes. So I'd start by saying what our supply chain has done in the first half of this year has been extraordinary. And it starts with a commitment to keeping people safe to making sure that we've got the right procedures and processes in place. And none of that has changed. Our plans continue to run at a very high level even now.

So we will do our best to stay agile to forecast as best as we possibly can and to make sure that we can execute against any potential upside, and so that's our planning stance. Certainly, we're working on how can we make it better. We're working on rebuilding inventories. Our service levels are still not where they were pre-COVID. They're certainly much better and continue to improve.

But the supply chain continues to really show exemplary performance and their ability to be agile and meet unexpected demand has proven itself. And if necessary, I think we've got a lot of confidence that they'll be able to meet whatever unforeseen future is in front of us.

[Amit Banati, SVP & CFO]

Operator, I think we have time for one more question.

[Operator]

And that question comes from Alexia Howard with Bernstein.

[Alexia Howard, Sanford C. Bernstein & Co.]

Just a couple of questions from me. As you think about the uses of cash, given the big surge in free cash flow that you've got, where are you likely to channel that? And is it possible that you might target acquisitions? Or will you return to shareholders? That's my first question. And then second one actually relates to pricing. As I look in your press release, the pricing in North America and in Europe, particularly was down a price/mix. So down marginally, I think, 1 and a bit percent in North America, but down actually more profoundly, I think, minus 4.5% [Technical Difficulty]. And yet, when we look at the Nielsen data, the pricing is upon shelf, and I was just wondering if you can just speak to what the dynamics are there.

[Amit Banati, SVP & CFO]

All right. So I think just from a cash standpoint, I think we're looking to invest the cash, as Steve talked in brand building, increased CapEx. I think debt reduction continues to be a priority, so we're very focused on that as we've said throughout the course of this year.

So that will continue to remain the priority in the second half as well. And we're making good progress on that, as you saw in the prepared remarks. I think from a price/mix standpoint, pricing was actually positive in the quarter. I think what you're seeing is the mix, and it goes back to the category mix. We've seen growth move away from snacks towards RTEC and noodles. And on the price/mix line, that's negative. But on the gross margin line, that's actually a positive. So really, that's what's driving the price mix.

[Operator]

This concludes our question-and-answer session. I would like to turn the conference back over to John Renwick for any closing remarks.

[John Renwick, VP, IR & Corporate Planning]

Well, thank you. We are at the 10:30 point here. If you did not get to ask a question, I apologize, but I'm around all day. And hope you all have a good day.

[Operator]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.