David and Tom Gardner recently interviewed Kellogg (NYSE: K) CEO Carlos Gutierrez on The Motley Fool Radio Show  on NPR. Kellogg stock has outperformed the S&P 500 over the past three and five years. This is the first of three parts.

TMF: You reported better-than-expected earnings for the last quarter. Mr. Gutierrez, for your last quarter, U.S. retail cereal sales were up 11%. Your U.S. snack division posted a 4% decline over the last quarter. So tell us, why the increase in your cereal business? Why the slowdown with snacks and cookies?

Gutierrez: Well, on the cereal business, for about two or three years now we have been reinvesting in that business. We actually changed our business model to go from one that is very focused on volume and pushing volume out the door to one that is focused on value and really selling for dollars, as opposed to trying to make volume or tonnage an end game.

That has changed our whole business model, the way we think about the company; the way we think about our metrics, our margins. So we have been growing gross margins and investing more money back into brand building, advertising, and innovation, and we are doing that with products that we can sell at a higher price and where we make more money. That in turn enables us to improve our mix and hopefully what we have got going here is a virtuous cycle.

On the snack side, it has been a different story. We have a portfolio made up of three segments. One is wholesome snacks, the other one is crackers, and then there is cookies. Cookies have been a very soft category this year. That is a combination of factors, whether it be a lack of innovation by us and some of the major players, or a lot of negative publicity around trans fatty acids and obesity.

But the good thing for us is that the highest-margin segment in the snacks portfolio is wholesome snacks and crackers, not cookies. So at least we are growing where we have got the margins. Obviously, we have a plan in place to stop the erosion in cookies and to at least stabilize that business going into 2004.

TMF: What is your best-selling cereal?

Gutierrez: Worldwide, I think our biggest brand is Frosted Flakes, but right now our hottest brand, literally worldwide, is Special K. 

TMF: How does shelf space work within the industry, just so we as consumers understand? Are companies like Kellogg's paying substantial amounts of money to be at eye level when I walk up and down the aisles of my Albertson's(NYSE: ABS) or Kroger(NYSE: KR) store?

Gutierrez: Well, the key thing is when you come out with a new product, to get onto the shelf is the big challenge. So often you will pay to get on the shelf and whether you are up on the top or at eye level, depends on the size of the brand. So that placement has to be earned, whereas getting on the shelf very often is a payment.

TMF: As I look at Kellogg's and General Mills(NYSE: GIS), the values that Wall Street is placing on these companies are very similar. Both companies are right around being valued near $15 billion. If we look forward over the next 10 years, what is it you think favors your success over General Mills? What is the competitive advantage at Kellogg's?

Gutierrez: I will tell you what we have got going without necessarily talking about them because I am sure they know more about their business than I do. We are a very focused food company. This is the time when many people are talking about the impact of consolidation, and it was very true if you go back two or three years ago. Everybody was predicting that the whole world was going to consolidate. Customers will consolidate, and there is going to be one big, evil empire that will control all food manufacturing and marketing.

I think what is happening is that companies that are relatively focused like Kellogg's, where we have half of our business in the U.S. in the same aisle of the supermarket. In some countries around the world, it is 90% or 100%. We are able to focus to do a couple of things very intensely as opposed to having to service 30 different places in a supermarket or having a sales force get 15 different calls from 15 different brand managers. So I think focus is one advantage that we have.

TMF: I want to present what look like competitive threats to us, and ask you to rank them. The first is in-house generic brands. For example, Safeway(NYSE: SWY) corn flakes sitting next to Kellogg's corn flakes. The second, and is this a greater one, breakfast establishments like McDonalds(NYSE: MCD) and Starbucks(Nasdaq: SBUX) -- fast food?

Gutierrez: They are both pretty high. I will say private label, number one. You could make an argument for each of them, but obviously as some of our retailers begin to differentiate themselves from other retailers, and from very large consolidated retailers, they are using private label. It is private label corn flakes versus cornflakes, but it is not private label Special K with Red Berries.

The way we are taking our product development is toward food products that aren't easy to duplicate. So we are concerned about private label, but I will tell you, in the cereal category, unlike other categories, private label is relatively flat from a share standpoint. So, we have been able to combat private label through innovation, through consumer promotions, through toys in the box, through nutrition news -- and that is the way that we have found that we can compete against private label.

Tomorrow: Gutierrez assesses Wal-Mart's threat to grocery stores.