By: James M. Pethokoukis

May 15, 2006, U.S. News & World Report

BATTLE CREEK, MICH.--Chris Keller has an achy right knee that he desperately wants to keep healthy enough to permit a few rounds of springtime golf now that the weather has finally warmed up. So about the last thing Keller wants to be doing right now is walking quickly through a manufacturing plant, gingerly stepping over cables and tubing while avoiding all the slippery spots on the floor. But that's exactly what he's doing on this fine spring afternoon. Not that Keller has a choice. As operations manager at cereal-and-snack giant Kellogg's research institute, he's responsible for giving VIP tours of the company's 150,000-square-foot pilot-projects plant and the adjoining 9,000-square-foot process lab. Housed together, these facilities are where Kellogg food scientists cook up the latest prototypes of potential new products.

The lab, in Keller's words, is a "sort of super-industrial-strength kitchen." Very much Martha Stewart meets Madame Curie, it's crammed with ovens and burners, mixers and food processors galore. "If a scientist sitting at his desk has an idea and wants to try something," Keller explains, "he can just come in here to get an early read on if it will work." Researchers can also take advantage of some 3,000 to 4,000 ingredients stocked in the lab. There are the usual suspects--flour, sugar, chocolate chips--as well as more exotic ones that you probably wouldn't find in your home pantry, like freeze-dried asparagus and more than 50 types of vanilla and vanilla flavors. If the small batches of new cereals or snack bars from the lab seem tasty enough, the recipe is then attempted in the pilot plant, where food can be produced in far larger test batches. It contains scaled-down versions of equipment found in Kellogg's full-scale manufacturing plant.

But as much as it's Keller's job to help guests understand how Kellogg innovates, it's also his responsibility to make sure they don't see quite everything. He always keeps a few strides ahead of his visitors, and he always makes sure that he's first around every corner. On this day, Keller quickly hustles the tour past a row of tall metal racks in the lab. They're packed with small amounts of cereal and snack prototypes. Some have clandestine-sounding code names like "Project Moon" or "Project Parfait." Others are just labeled "chunky" or "mint."

Later on, as the tour enters the pilot plant, Keller stops abruptly in front of yet another vat of brown flakes. Like a factory traffic cop, he thrusts out his upraised palm as he inspects the cereal. "OK, we can walk by it," he finally shouts over the drone of conveyor belts, extruders, and other machinery. "But I am not going to tell you what it is!"

Flaky. You can't really blame the folks at Kellogg's for treating the W.K. Kellogg Institute as if it's a culinary Area 51. Transparency hasn't exactly been the company's friend throughout its history. Back in 1894, Will Keith Kellogg was working at the famed Battle Creek sanitarium founded by his brother, John Harvey Kellogg. Searching for a bread substitute by boiling wheat, the brothers accidentally discovered the process for making cereal flakes. In 1906, production of toasted cornflakes began at W.K. Kellogg's newly formed Battle Creek Toasted Corn Flake Co. But Kellogg failed to successfully patent the flake-toasting process or trademark the name "Toasted Corn Flakes." Battle Creek quickly become home to dozens of toasted-flake purveyors, and the original cereal company changed its name to Kellogg Co.

The company was also forced to innovate. Were Kellogg still offering only same-old, same-old cornflake or bran flake cereals, it's pretty unlikely the company would have generated $10.2 billion in revenue last year. "Innovation has been one of the key things underneath as to why the company has been so successful," says James Jenness, CEO of Kellogg, while sitting in the corporate boardroom at company headquarters. "In the world of marketing, you hear a lot about product life cycles, where you introduce a product or brand, it goes for a while, lives, and then dies off. But in our business, life cycles do not exist."

Or, more precisely, constant innovation helps ensure that life cycles don't exist. That's why in addition to classic Special K cereal, Kellogg offers Special K Vanilla Almond, Fruit & Yogurt, Red Berries, Purple Berries, and Bars among other iterations in over 180 countries. As another example, Jenness points to All-Bran, which was introduced in 1916 and was Kellogg's fastest-growing global brand last year. Sure, you have more and more baby boomers chowing down on the stuff as they search for what Jenness euphemistically terms "digestive health."(The original All-Bran box promoted itself as a "natural laxative.") But the boomers also demand great taste. So Kellogg now offers All-Bran Yogurt Bites, which mixes wheat bran with yogurt-coated toasted oats. "We've taken a brand that has been around for 90 years and made it sing for today's consumers," Jenness says. "That is the essence of what we are doing for all products."

And apparently doing a bang-up job of it. "I think what you are seeing here is a company that is really innovating very well," says Citigroup Investment Research analyst David Driscoll. He notes, for instance, an increase in product launches. In the first quarter, the company launched 18 new products, compared with 15 in 2005 and seven in 2003. (Also in the first quarter, the company earned a better-than-expected $274 million on sales of $2.7 billion.) And that constant stream of high-quality offerings has made an impact. In 2005, the company captured 50 percent of new cereal product sales in the United States versus its total market share of 34 percent. Even more telling, the new products sell at 15 percent more per pound than the base products.

Adding higher-margin offerings is a key element of the company's growth strategy. "If the economics [of a new product] aren't better, it doesn't go out the door," says Jeffrey Montie, president of Kellogg North America. That attitude is a necessity since extensions of an existing product tend to cannibalize a portion of the old product's sales.

Crackle and pop. Innovation's effects haven't gone unnoticed by investors. "Kellogg is an excellent innovator, and that is why they have been clearly outperforming the sector they compete in," says analyst Timothy Ramey of D.A. Davidson in Lake Oswego, Ore. During the past five years, shares of Kellogg are up 107 percent versus 39 percent for General Mills and 3 percent for Kraft.

Not so long ago, Kellogg seemed to be floundering. The stock--and seemingly company fortunes--were down in the late 1990s as Kellogg focused more on cutting prices than on creating new products. But innovation moved back to the forefront "when Carlos Gutierrez took the helm," says Tim O'Day, an adjunct marketing professor at the University of Michigan's Ross School of Business and a former Leo Burnett ad executive who worked the Kellogg account. Moving over from Kellogg Asia-Pacific in 1999, Gutierrez, who is now U.S. secretary of commerce, instituted a "volume to value" strategy. He shifted resources, such as increased R&D spending, to higher-margin products. The company also made big purchases: organic cereal company Kashi and snack giant Keebler.

Jenness, a former Kellogg-focused Burnett exec who took over from Gutierrez in February 2005, knows that when people hear the word innovation, they're likely to think of Google or Apple Computer before they think of Kellogg. Probably way, way before. Can you really compare search-engine technology or the iPod with Special K Red Berries? "You take some freeze-dried fruit and throw it in. How big of a deal can that be?" Jenness asks. "But it is a big deal because putting any kind of fruit with flakes is not easy because you have problems with moisture absorption and moisture transfer." Turns out that using the heartier, crunchier flakes found in the European version of Special K solved the soggy-flake problem. In charge of solving all manner of food science conundrums at Kellogg is Margaret Bath, vice president of research, quality, and technology. It's her job to balance the expenditure of resources for product innovation with the net new sales the product could generate. Special K Red Berries required a modest amount of innovation, and Bath thought it would be a typical "brand sustainer," helping keep Special K fresh, "like adding a different color loop to Froot Loops." Instead, it has been a high-growth product, racking up $84 million in non-Wal-Mart sales in the past year, because many consumers choosing Red Berries liked the weight-control--"shape management" in Kellogg-speak--aspect of regular Special K but found the cereal too bland.

A high-innovation, high-sales product would be something like Nutri-Grain bars (introduced in 1991). "I would like to have 40 or 50 percent [of products] in the breakthrough category, though I know that's not realistic," she says. Yet little tweaks, like different versions of All-Bran or Special K, add up. "Big $100 million hits are great, but you can also win with lots of singles and doubles," says Tim Calkins, associate professor of marketing at Northwestern University's Kellogg School of Management. "And Kellogg doesn't need to take big risks to get them." Of course, Bath wants to avoid high-innovation, low-sales products like Kellogg's new Drink 'n Crunch, a cup that allows consumers to suck down their cereal and milk while on the move. "It's just not doing that well," Bath says. "I don't think we have it quite right. Getting the right proportion of cereal with the right amount of milk without it being a choking hazard is difficult. And everyone does it differently at home." But, she quickly adds, there's no innovation without risk of failure. "I only ask my team to fail fast," she says. "It's better to fail in the consumer research phase than in the international launch phase."

"Science fair." Drink 'n Crunch may not be the best example of "failing fast," but it does demonstrate one unique way Kellogg generates ideas. The product was spawned by a yearly Kellogg event called Moonlighting. It allows researchers to work on projects in their spare time--while also tapping the insights of the consumer research team--and present the results to the company's business units in a trade-show-style environment. The first Moonlighting event was held in 1996 in a conference room, showcasing 20 to 25 ideas. "It looked like a glorified middle-school science fair with poster boards and everything," recalls Mark Holdridge, the program's founder and now Kellogg's lead scientist on its advanced innovation team. By 2000, there were more than 100 exhibits, and Kellogg staged Moonlighting at the Hilton Chicago ballroom. The hand-drawn poster board era was over. "It was getting a little bit out of hand," Holdridge says. "People were even going and getting custom-made graphics."

Kellogg may have scaled back the pomp a little since then, but not the size. This year, Moonlighting will take place at the Kellogg Arena and Convention Center in downtown Battle Creek, with more than 300 presenters displaying some 170 items. So far, Holdridge says, some 30 Moonlighting projects have made it to market. And Bath estimates that former Moonlighting projects have generated some $250 million in sales during the past five years.

"What Moonlighting did was take the relationship between marketing and product development and turn it on its head," says Laura Schmidt, who worked with Holdridge on the Moonlighting program back in the late 1990s. Now she's a consultant at Landis Strategy and Innovation in Palm Beach Gardens, Fla. "Usually, marketing rules the roost at companies. They take their consumer insights and tell developers what the program is. For Kellogg management, it was cultural change that would not have happened if not for Moonlighting."

Not to say that marketing and consumer research aren't driving forces behind product innovation at Kellogg. "They lay out the hunting grounds," says Alan Harris, Kellogg's chief marketing officer. "From there, we create the ideas and concepts that eventually become food." Indeed, the genesis of the idea for Special K Red Berries came out of focus groups in France where consumers expressed an interest in "indulgent" foods. But when divining "unarticulated needs," surveys and focus groups aren't enough. In recent years, Kellogg has started also employing up-close-and-personal techniques called ethnography--long popular in Japan--that are derived from anthropologist Margaret Mead's controversial work with indigenous Samoans in the 1920s. "We've put in a much more concerted effort the past two or three years to get closer to the consumer," says Mike Mickunas, a senior director of market research. "This comes partly from the desire to move more aggressively in innovation and also out of a recognition that the old methods weren't taking us far enough. ... You need to get into people's lives."

Now Kellogg market researchers often visit people in their homes to watch as they eat their breakfast and sit in the far back seats of minivans as soccer moms chuck Nutri-Grain bars toward their hungry kids. They'll even text-message subjects throughout the day to monitor their snack cravings. Among Kellogg's findings: Breakfast time is highly ritualistic, which may be what's hampering Drink 'n Crunch. (You can't peruse the back of a cereal box while you're driving.) Researchers also found that while kids love Pop-Tarts, the snacks get all crumbly when Mom tries to pack them in lunches. So now the company offers Go-Tarts!, snacks that are individually packed and possess a tougher outer shell. And Kellogg now offers easier-to-open packaging for Nutri-Grain bars since parents often want kids to help themselves to those. "Packaging doesn't come up much in focus groups," Mickunas says.

In the competitive cereal and snack markets, there are always plenty of innovation challenges. For one: creating a popular lemon-based cereal that consumers always seem to say they want but never seem to like. Or a real-chocolate version of Special K that doesn't turn, as Bath puts it, into a "flaming mess" in warm climates. So much to be done. "There is a cycle of change that is a great opportunity if you can keep bringing new and relevant ideas to consumers," Jenness says. "But it's also a threat if you are not innovating. You have some winners and some losers, but you've got to keep swinging."