10-K 1 d10k.htm FORM 10-K Form 10-K
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 


 

FORM 10-K

 

(Mark One)

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2005

 

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                      to                     

 

Commission file number 1-1183

 


 

LOGO

 

PepsiCo, Inc.

(Exact Name of Registrant as Specified in Its Charter)

 

North Carolina   13-1584302

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

 

700 Anderson Hill Road, Purchase, New York   10577
(Address of Principal Executive Offices)   (Zip Code)

 


 

Registrant’s telephone number, including area code 914-253-2000

 

Securities registered pursuant to Section 12(b) of the Securities Exchange Act of 1934:

 

        Title of Each Class        


 

Name of Each Exchange

            on Which Registered            


Common Stock, par value 1-2/3 cents per share   New York and Chicago Stock Exchanges

 

Securities registered pursuant to Section 12(g) of the Securities Exchange Act of 1934: None

 

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x  No ¨

 

Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes ¨  No x

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 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 ¨


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Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

 

Indicate by check mark whether the registrant is large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated filer x

  Accelerated filer ¨   Non-accelerated filer ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes ¨  No x

 

The aggregate market value of PepsiCo Common Stock held by nonaffiliates of PepsiCo as of June 11, 2005, the last day of business of our most recently completed second fiscal quarter, was $98,905,247,548.40. The number of shares of PepsiCo Common Stock outstanding as of February 17, 2006 was 1,656,763,169.

 

Documents of Which Portions

Are Incorporated by Reference


 

Parts of Form 10-K into Which Portion of

Documents Are Incorporated


Proxy Statement for PepsiCo’s May 3, 2006

Annual Meeting of Shareholders

  III

 

 



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PepsiCo, Inc.

 

Form 10-K Annual Report

For the Fiscal Year Ended December 31, 2005

 

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PART I

         

Item 1.

   Business    1

Item 1A.

   Risk Factors    6

Item 1B.

   Unresolved Staff Comments    10

Item 2.

   Properties    10

Item 3.

   Legal Proceedings    11

Item 4.

   Submission of Matters to a Vote of Security Holders    12

PART II

         

Item 5.

   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities    15

Item 6.

   Selected Financial Data    17

Item 7.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    18

Item 7A.

   Quantitative and Qualitative Disclosures About Market Risk    98

Item 8.

   Financial Statements and Supplementary Data    98

Item 9.

   Changes in and Disagreements With Accountants on Accounting and Financial Disclosure    98

Item 9A.

   Controls and Procedures    98

Item 9B.

   Other Information    98

PART III

         

Item 10.

   Directors and Executive Officers of the Registrant    99

Item 11.

   Executive Compensation    99

Item 12.

   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    100

Item 13.

   Certain Relationships and Related Transactions    102

Item 14.

   Principal Accountant Fees and Services    102

PART IV

         

Item 15.

   Exhibits and Financial Statement Schedules    103


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PART I

 

Item 1.        Business

 

PepsiCo, Inc. was incorporated in Delaware in 1919 and was reincorporated in North Carolina in 1986. When used in this report, the terms “we,” “us,” “our” and the “Company” mean PepsiCo and its divisions and subsidiaries.

 

Our Divisions

 

We are a leading, global snack and beverage company. We manufacture, market and sell a variety of salty, convenient, sweet and grain-based snacks, carbonated and non-carbonated beverages and foods. We are organized into four divisions:

 

    Frito-Lay North America,
    PepsiCo Beverages North America,
    PepsiCo International, and
    Quaker Foods North America.

 

Our North American divisions operate in the United States and Canada. Our international divisions operate in over 200 countries, with our largest operations in Mexico and the United Kingdom. Financial information concerning our divisions and geographic areas is presented in Note 1 to our consolidated financial statements and additional information concerning our division operations, customers and distribution network is presented under the heading “ Our Business” contained in “ Item 7. Management’s Discussion and Analysis.”

 

Frito-Lay North America

 

Frito-Lay North America (FLNA) manufactures or uses contract manufacturers, markets, sells and distributes branded snacks. These snacks include Lay’s potato chips, Doritos tortilla chips, Cheetos cheese flavored snacks, Tostitos tortilla chips, Fritos corn chips, branded dips, Ruffles potato chips, Quaker Chewy granola bars, Rold Gold pretzels, Sun Chips multigrain snacks, Munchies snack mix, Grandma’s cookies, Lay’s Stax potato crisps, Quaker Quakes corn and rice snacks, Quaker Fruit & Oatmeal bars, Cracker Jack candy coated popcorn and Go Snacks. FLNA branded products are sold to independent distributors and retailers. FLNA’s net revenue was $10.3 billion in 2005, $9.6 billion in 2004 and $9.1 billion in 2003 and approximated 32% of our total division net revenue in 2005, 33% of our total division net revenue in 2004 and 34% of our total division net revenue in 2003.

 

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PepsiCo Beverages North America

 

PepsiCo Beverages North America (PBNA) manufactures or uses contract manufacturers, markets and sells beverage concentrates, fountain syrups and finished goods, under various beverage brands, including Pepsi, Mountain Dew, Gatorade, Tropicana Pure Premium, Sierra Mist, Tropicana juice drinks, Mug, Propel, SoBe, Tropicana Twister, Dole and Slice. PBNA also manufactures, markets and sells ready-to-drink tea and coffee products through joint ventures with Lipton and Starbucks. In addition, PBNA licenses the Aquafina water brand to its bottlers and markets this brand. PBNA sells concentrate and finished goods for some of these brands to bottlers licensed by us, and some of these branded products are sold directly by us to independent distributors and retailers. The franchise bottlers sell our brands as finished goods to independent distributors and retailers. PBNA’s net revenue was $9.1 billion in 2005, $8.3 billion in 2004 and $7.7 billion in 2003 and approximated 28% of our total division net revenue in 2005, 28% of our total division net revenue in 2004 and 29% of our total division net revenue in 2003.

 

PepsiCo International

 

PepsiCo International (PI) manufactures through consolidated businesses as well as through noncontrolled affiliates, a number of leading salty and sweet snack brands including Gamesa and Sabritas in Mexico, Walkers in the United Kingdom, and Smith’s in Australia. Further, PI manufactures or uses contract manufacturers, markets and sells many Quaker brand snacks. PI also manufactures, markets and sells beverage concentrates, fountain syrups and finished goods under the brands Pepsi, 7UP, Mirinda, Gatorade, Mountain Dew and Tropicana. These brands are sold to franchise bottlers, independent distributors and retailers. However, in certain markets, PI operates its own bottling plants and distribution facilities. PI also licenses the Aquafina water brand to certain of its franchise bottlers. PI’s net revenue was $11.4 billion in 2005, $9.9 billion in 2004 and $8.7 billion in 2003 and approximated 35% of our total division net revenue in 2005, 34% of our total division net revenue in 2004 and 32% of our total division net revenue in 2003.

 

Quaker Foods North America

 

Quaker Foods North America (QFNA) manufactures or uses contract manufacturers, markets and sells cereals, rice, pasta and other branded products. QFNA’s products include Quaker oatmeal, Aunt Jemima mixes and syrups, Quaker grits, Cap’n Crunch and Life ready-to-eat cereals, Rice-A-Roni, Pasta Roni and Near East side dishes. These branded products are sold to independent distributors and retailers. QFNA’s net revenue was $1.7 billion in 2005 and $1.5 billion in each of 2004 and 2003 and approximated 5% of our total division net revenue in each of 2005, 2004 and 2003.

 

Our Distribution Network

 

Our products are brought to market through direct-store-delivery, broker-warehouse and foodservice and vending distribution networks. The distribution system used depends on

 

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customer needs, product characteristics and local trade practices. These distribution systems are described under the heading “ Our Business” contained in “ Item 7. Management’s Discussion and Analysis.”

 

Ingredients and Other Supplies

 

The principal ingredients we use in our food and beverage businesses are aspartame, cocoa, corn, corn sweeteners, flavorings, flour, juice and juice concentrates, oats, oranges, grapefruits and other fruits, potatoes, rice, seasonings, sucralose, sugar, vegetable and essential oils and wheat. Our key packaging materials include aluminum used for cans, P.E.T. resin used for plastic bottles, film packaging used for snack foods and cardboard. Fuel and natural gas are also important commodities due to their use in our plants and in the trucks delivering our products. These ingredients, raw materials and commodities are purchased mainly in the open market. We employ specialists to secure adequate supplies of many of these items and have not experienced any significant continuous shortages. The prices we pay for such items are subject to fluctuation. When prices increase, we may or may not pass on such increases to our customers. When we have decided to pass along price increases in the past, we have done so successfully. However, there is no assurance that we will be able to do so in the future.

 

Our Brands

 

We own numerous valuable trademarks which are essential to our worldwide businesses, including Alegro, AMP, Aquafina, Aquafina Sparkling, Aunt Jemima, Cap’n Crunch, Cheetos, Cracker Jack, Diet Pepsi, Doritos, Frito Lay, Fritos, Gamesa, Gatorade, Grandma’s, Lay’s, Life, Mirinda, Mountain Dew, Mountain Dew Code Red, Mountain Dew MDX, Mug, Near East, Pasta Roni, Pepsi, Pepsi Max, Pepsi Lime, Pepsi One, Pepsi Twist, Pepsi-Cola, Pepsi Wild Cherry, Propel, Quaker, Quaker Chewy, Quaker Quakes, Rice-A-Roni, Rold Gold, Ruffles, Sabritas, 7UP and Diet 7UP (outside the United States), Sierra Mist, Simba, Slice, Smith’s, Snack a Jacks, SoBe, Sonric’s, Sun Chips, Tostitos, Tropicana, Tropicana Pure Premium, Tropicana Twister, Walkers and Wotsits. Trademarks remain valid so long as they are used properly for identification purposes, and we emphasize correct use of our trademarks. We have authorized, through licensing arrangements, the use of many of our trademarks in such contexts as snack food joint ventures and beverage bottling appointments. In addition, we license the use of our trademarks on promotional items for the primary purpose of enhancing brand awareness.

 

We either own or have licenses to use a number of patents which relate to some of our products, their packaging, the processes for their production and the design and operation of various equipment used in our businesses. Some of these patents are licensed to others.

 

Seasonality

 

Our beverage and food divisions are subject to seasonal variations. Our beverage sales are higher during the warmer months and certain food sales are higher in the cooler months. Weekly sales are generally highest in the third quarter due to seasonal and

 

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holiday-related patterns. However, taken as a whole, seasonality does not have a material impact on our business.

 

Our Customers

 

Our customers include franchise bottlers and independent distributors and retailers. We normally grant our bottlers exclusive contracts to sell and manufacture certain beverage products bearing our trademarks within a specific geographic area. These arrangements specify the amount to be paid by our bottlers for concentrate and finished goods and for Aquafina royalties, as well as the manufacturing process required for product quality.

 

Retail consolidation has increased the importance of major customers and further consolidation is expected. Sales to Wal-Mart Stores, Inc. represent approximately 9% of our total worldwide net revenue; and our top five retail customers currently represent approximately 26% of our 2005 North American net revenue, with Wal-Mart representing approximately 11%. These percentages include concentrate sales to our bottlers which are used in finished goods sold by them to these retailers. In addition, sales to The Pepsi Bottling Group (PBG) represent approximately 10% of our total net revenue. See “ Our Customers”, “ Our Related Party Bottlers” and Note 8 to our consolidated financial statements for more information on our customers, including our anchor bottlers.

 

Our Competition

 

Our businesses operate in highly competitive markets. We compete against global, regional, local and private label manufacturers on the basis of price, quality, product variety and effective distribution. In measured channels, our chief beverage competitor, The Coca-Cola Company, has a slightly larger share of CSD consumption in the United States, while we have a larger share of chilled juices and isotonics. In addition, The Coca-Cola Company maintains a significant CSD share advantage in many markets outside North America. Further, our snack brands hold significant leadership positions in the snack industry worldwide. Our snack brands face local and regional competitors, as well as national and global snack competitors, and compete on issues related to price, quality, variety and distribution. Success in this competitive environment is dependent on effective promotion of existing products and the introduction of new products. We believe that the strength of our brands, innovation and marketing, coupled with the quality of our products and flexibility of our distribution network, allow us to compete effectively.

 

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LOGO

 

* The markets and market share information in the charts above are defined by the sources of the information: Information Resources, Inc. and A.C. Nielsen Corporation. The above charts exclude data from certain customers such as Wal-Mart that do not report data to these services.

 

Regulatory Environment and Environmental Compliance

 

The conduct of our businesses, and the production, distribution, sale, advertising, labeling, safety, transportation and use of many of our products, are subject to various laws and regulations administered by federal, state and local governmental agencies in the United States, as well as to foreign laws and regulations administered by government entities and agencies in markets where we operate. It is our policy to follow the laws and regulations around the world that apply to our businesses.

 

In the United States, we are required to comply with federal laws, such as the Food, Drug and Cosmetic Act, the Occupational Safety and Health Act, the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, the Federal Motor Carrier Safety Act, laws governing equal employment opportunity, customs and foreign trade laws and regulations, laws governing the sales of products in schools, and various other federal statutes and regulations. We are also subject to various state and local statutes and regulations, including California Proposition 65 which requires that a specific warning appear on any product that contains a component listed by the State of California as having been found to cause cancer or birth defects. Under Proposition 65, even trace amounts of listed components can expose affected products to the prospect of warning labels. As a result, many food and beverage producers who sell products in California, including PepsiCo, may be required to provide warning labels on their products.

 

In many jurisdictions, compliance with competition laws is of special importance to us due to our competitive position in those jurisdictions. We rely on legal and operational compliance programs, as well as local in-house and outside counsel, to guide our businesses in complying with applicable laws and regulations of the countries in which we do business.

 

The cost of compliance with U.S. and foreign laws does not have a material financial impact on our operations.

 

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We are subject to national and local environmental laws in the United States and in the foreign countries in which we do business. We have compliance programs in place designed to meet applicable environmental compliance requirements. Environmental compliance costs have not had, and are not expected to have, a material impact on our capital expenditures, earnings or competitive position.

 

Employees

 

As of December 31, 2005, we employed, subject to seasonal variations, approximately 157,000 people worldwide, including approximately 62,000 people employed within the United States. We believe that relations with our employees are generally good.

 

Available Information

 

The public may read and copy any materials that we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, D.C. 20549. Information on the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file with the SEC at http://www.sec.gov.

 

Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, proxy statements and amendments to those reports, are also available free of charge on our internet website at http://www.pepsico.com as soon as reasonably practicable after such reports are electronically filed with or furnished to the Securities and Exchange Commission.

 

Item 1A. Risk Factors

 

Forward-Looking and Cautionary Statements

 

We discuss expectations regarding our future performance, such as our business outlook, in our annual and quarterly reports, press releases, and other written and oral statements. These “forward-looking statements” are based on currently available competitive, financial and economic data and our operating plans. They are inherently uncertain, and investors must recognize that events could turn out to be significantly different from our expectations. We undertake no obligation to update any forward-looking statement. The following discussion of risks is by no means all inclusive but is designed to highlight what we believe are important factors to consider when evaluating our trends and future results.

 

Demand for our products may be adversely affected by changes in consumer preferences and tastes.

 

We are a consumer products company operating in highly competitive markets and rely on continued demand for our products. To generate revenues and profits, we must sell products that appeal to our customers and to consumers. Any significant changes in consumer preferences and our inability to anticipate and react to such changes could

 

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result in reduced demand for our products and erosion of our competitive and financial position. Our success depends on our ability to respond to consumer trends, such as consumer health concerns about obesity, product attributes and ingredients. In addition, changes in product category consumption and consumer demographics could result in reduced demand for our products. Consumer preferences may shift due to a variety of factors, including the aging of the general population, changes in social trends, changes in travel, vacation or leisure activity patterns or a downturn in economic conditions, which may reduce consumers’ willingness to purchase premium branded products. Our continued success is also dependent on our product innovation, including maintaining a robust pipeline of new products, and the effectiveness of our advertising campaigns and marketing programs. There can be no assurance as to our continued ability to develop and launch successful new products or variants of existing products, or to effectively execute advertising campaigns and marketing programs. In addition, both the launch and ongoing success of new products and advertising campaigns are inherently uncertain, especially as to their appeal to consumers.

 

Any damage to our reputation could have an adverse effect on our business, financial condition and results of operations.

 

Maintaining a good reputation globally is critical to selling our branded products. If we fail to maintain high standards for product quality, safety and integrity, our reputation could be jeopardized. Adverse publicity about these types of concerns, whether or not valid, may reduce demand for our products or cause production and delivery disruptions. If any of our products becomes unfit for consumption, misbranded or causes injury, we may have to engage in a product recall and/or be subject to liability. A widespread product recall or a significant product liability judgment could cause our products to be unavailable for a period of time, which could further reduce consumer demand and brand equity. Failure to maintain high ethical, social and environmental standards for all of our operations and activities could also jeopardize our reputation. Damage to our reputation or loss of consumer confidence in our products for any of these reasons could have a material adverse effect on our business, financial condition and results of operations, as well as require additional resources to rebuild our reputation.

 

If we are not able to build and sustain proper information technology infrastructure, our business could suffer.

 

We depend on information technology as an enabler to operating efficiently and interfacing with customers, as well as maintaining financial accuracy and efficiency. If we do not allocate, and effectively manage, the resources necessary to build and sustain the proper technology infrastructure, we could be subject to transaction errors, processing inefficiencies, the loss of customers, business disruptions, or the loss of or damage to intellectual property through security breach.

 

We have embarked on a multiyear Business Process Transformation (BPT) initiative that includes the delivery of an SAP enterprise resource planning application, as well as the migration to common business processes across our North American operations. There can be no certainty that these programs will deliver the expected benefits. The failure to

 

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deliver our goals may impact our ability to (1) process transactions accurately and efficiently and (2) remain in step with the changing needs of the trade, which could result in the loss of customers. In addition, the failure to either deliver the application on time, or anticipate the necessary readiness and training needs, could lead to business disruption.

 

As with all large systems, our information systems could be penetrated by outside parties intent on extracting information, corrupting information or disrupting business processes. Such unauthorized access could disrupt our business and could result in the loss of assets.

 

Disruption of our supply chain could have an adverse effect on our business, financial condition and results of operations.

 

Our ability to make, move and sell products is critical to our success. Damage or disruption to our manufacturing or distribution capabilities due to weather, natural disaster, fire or explosion, terrorism, pandemic, strikes or other reasons could impair our ability to manufacture or sell our products. Failure to take adequate steps to mitigate the likelihood or potential impact of such events, or to effectively manage such events if they occur, could adversely affect our business, financial condition and results of operations, as well as require additional resources to restore our supply chain.

 

Trade consolidation or the loss of any key customer could adversely affect our financial performance.

 

There is a greater concentration of our customer base around the world generally due to the continued consolidation of retail trade. As retail ownership becomes more concentrated, retailers demand lower pricing and increased promotional programs. Further, as larger retailers increase utilization of their own distribution networks and private label brands, the competitive advantages we derive from our go-to-market systems and brand equity may be eroded. Failure to appropriately respond to these trends or to offer effective sales incentives and marketing programs to our customers could reduce our ability to secure adequate shelf space at our retailers and adversely affect our financial performance.

 

In addition, retail consolidation has increased the importance of major customers and further consolidation is expected. Sales to Wal-Mart Stores, Inc. represent approximately 9% of our total worldwide net revenue; and our top five retail customers currently represent approximately 26% of our 2005 North American net revenue, with Wal-Mart representing approximately 11%. These percentages include concentrate sales to our bottlers which are used in finished goods sold by them to these retailers. We must maintain mutually beneficial relationships with our key customers, including our retailers and anchor bottlers, to effectively compete. Loss of any of our key customers could have an adverse effect on our business, financial condition and results of operations. See “ Our Customers,” “ Our Related Party Bottlers” and Note 8 to our consolidated financial statements for more information on our customers, including our anchor bottlers.

 

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Our business may be adversely impacted by unfavorable economic or environmental conditions or political or other developments and risks in the countries in which we operate.

 

Unfavorable global economic or environmental changes, political conditions or other developments may result in business disruption, supply constraints, foreign currency devaluation, inflation, deflation or decreased demand. Economic conditions in North America could also adversely impact growth. For example, rising fuel costs may impact the sales of our products in convenience stores where our products are generally sold in higher margin single serve packages. Our international operations accounted for over a third of our revenue for the period ended December 31, 2005. Unstable economic and political conditions or civil unrest in the countries in which we operate could have adverse impacts on our business results or financial condition.

 

Regulatory decisions and changes in the legal and regulatory environment could increase our costs and liabilities or limit our business activities.

 

The conduct of our businesses, and the production, distribution, sale, advertising, labeling, safety, transportation and use of many of our products, are subject to various laws and regulations administered by federal, state and local governmental agencies in the United States, as well as to foreign laws and regulations administered by government entities and agencies in markets in which we operate. In many jurisdictions, compliance with competition laws is of special importance to us due to our competitive position in those jurisdictions. These laws and regulations may change, sometimes dramatically, as a result of political, economic or social events. Changes in laws, regulations or governmental policy and the related interpretations may alter the environment in which we do business and, therefore, may impact our results or increase our costs or liabilities. Such regulatory environment changes include changes in food and drug laws, laws related to advertising and deceptive marketing practices, accounting standards, taxation requirements, competition laws and environmental laws, including California Proposition 65 and the regulation of water consumption and treatment. In particular, governmental bodies in countries where we operate may impose new labeling, product or production requirements, or other restrictions. Regulatory authorities under whose laws we operate may also have enforcement powers that can subject us to actions such as product recall, seizure of products or other sanctions, which could have an adverse effect on our sales or damage our reputation. See also “Regulatory Environment and Environmental Compliance.”

 

If we are unable to hire or retain key employees, it could have a negative impact on our business.

 

Our continued growth requires us to develop our leadership bench and to implement programs, such as our long-term incentive program, designed to retain talent. However, there is no assurance that we will continue to be able to hire or retain key employees. We compete to hire new employees, and then must train them and develop their skills and competencies. Our operating results could be adversely affected by increased costs due to increased competition for employees, higher employee turnover or increased employee

 

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benefit costs. Any unplanned turnover could deplete our institutional knowledge base and erode our competitive advantage.

 

Our operating results may be adversely affected by increased costs or shortages of raw materials.

 

We are exposed to the market risks arising from adverse changes in commodity prices, affecting the cost of our raw materials and energy. The raw materials and energy which we use for the production of our products are largely commodities that are subject to price volatility and fluctuations in availability caused by changes in global supply and demand, weather conditions, agricultural uncertainty or governmental controls. We purchase these materials and energy mainly in the open market. If commodity price changes result in unexpected increases in raw materials and energy costs, we may not be able to increase our prices to offset these increased costs without suffering reduced volume, revenue and operating income.

 

Our business could suffer if we are unable to compete effectively.

 

Our businesses operate in highly competitive markets. We compete against global, regional and private label manufacturers on the basis of price, quality, product variety and effective distribution. Increased competition and anticipated actions by our competitors could lead to downward pressure on prices and/or a decline in our market share, either of which could adversely affect our results. See “Our Competition” for more information about our competitors.

 

Item 1B. Unresolved Staff Comments

 

Not applicable.

 

Item 2. Properties

 

We own our corporate headquarters building in Purchase, New York and our data center in Plano, Texas. Leases of plants in North America generally are on a long-term basis, expiring at various times, with options to renew for additional periods. Most international plants are leased for varying and usually shorter periods, with or without renewal options. We believe that our properties are in good operating condition and are suitable for the purposes for which they are being used.

 

Frito-Lay North America

 

Frito-Lay North America (FLNA) owns or leases approximately 40 food manufacturing and processing plants and approximately 1,950 warehouses, distribution centers and offices, including its headquarters building and a research facility in Plano, Texas.

 

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PepsiCo Beverages North America

 

PepsiCo Beverages North America (PBNA) utilizes approximately 45 plants and production processing facilities and approximately 25 warehouses, distribution centers and offices. We lease PBNA’s headquarters building in downtown Chicago, Illinois, and own its Tropicana facility in Bradenton, Florida and its concentrate plants in Puerto Rico and Ireland. The other properties utilized by PBNA are owned or leased by us or our co-packers. In addition, licensed bottlers in which we have an ownership interest own or lease approximately 70 bottling plants.

 

PepsiCo International

 

PepsiCo International (PI) owns or leases approximately 200 plants and approximately 1,700 warehouses, distribution centers and offices. We own PI’s concentrate plant in Ireland and have a long-term lease on PI’s snack plant in the United Kingdom. PI is headquartered in the corporate facility in Purchase, NY.

 

Quaker Foods North America

 

Quaker Foods North America (QFNA) utilizes approximately 28 manufacturing plants in North America. QFNA owns its plant in Cedar Rapids, Iowa. The other properties utilized by QFNA are owned or leased by us or our co-packers. QFNA is headquartered in the same facility with PBNA in downtown Chicago, Illinois.

 

Shared Properties

 

QFNA shares approximately 6 plants with FLNA, 1 plant with PBNA, 17 distribution centers with FLNA and PBNA, 8 warehouses and 9 offices with PBNA and FLNA, including a research and development laboratory in Barrington, Illinois. In addition, FLNA and PI share 1 plant.

 

Item 3. Legal Proceedings

 

We are party to a variety of legal proceedings arising in the normal course of business, including the matters discussed below. While the results of proceedings cannot be predicted with certainty, management believes that the final outcome of these proceedings will not have a material adverse effect on our consolidated financial statements, results of operations or cash flows.

 

On April 30, 2004, we announced that Frito-Lay and Pepsi-Cola Company received notification from the Securities and Exchange Commission (the “SEC”) indicating that the SEC staff was proposing to recommend that the SEC bring a civil action alleging that a non-executive employee at Pepsi-Cola and another at Frito-Lay signed documents in early 2001 prepared by Kmart acknowledging payments in the amount of $3 million from Pepsi-Cola and $2.8 million from Frito-Lay. Kmart allegedly used these documents to prematurely recognize the $3 million and $2.8 million in revenue. Frito-Lay and Pepsi-Cola have cooperated fully with this investigation and provided written responses to the

 

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SEC staff notices setting forth the factual and legal bases for their belief that no enforcement actions should be brought against Frito-Lay or Pepsi-Cola.

 

Based on an internal review of the Kmart matters, no officers of PepsiCo, Pepsi-Cola or Frito-Lay are involved. Neither of these matters involves any allegations regarding PepsiCo’s accounting for its transactions with Kmart or PepsiCo’s financial statements.

 

Item 4. Submission of Matters to a Vote of Security Holders

 

Not applicable.

 

Our Executive Officers

 

The following is a list of names, ages and background of our current executive officers:

 

Steven S Reinemund, 57, has been PepsiCo’s Chairman and Chief Executive Officer since May 2001. He was elected a director of PepsiCo in 1996 and before assuming his current position, served as President and Chief Operating Officer from September 1999 until May 2001. Mr. Reinemund began his career with PepsiCo in 1984 as a senior operating officer of Pizza Hut, Inc. He became President and Chief Executive Officer of Pizza Hut in 1986, and President and Chief Executive Officer of Pizza Hut Worldwide in 1991. In 1992, Mr. Reinemund became President and Chief Executive Officer of Frito-Lay, Inc., and Chairman and Chief Executive Officer of the Frito-Lay Company in 1996. Mr. Reinemund is also a director of Johnson & Johnson.

 

Peter A. Bridgman, 53, has been our Senior Vice President and Controller since August 2000. Mr. Bridgman began his career with PepsiCo at Pepsi-Cola International in 1985 and became Chief Financial Officer for Central Europe in 1990. He became Senior Vice President and Controller for Pepsi-Cola North America in 1992 and Senior Vice President and Controller for The Pepsi Bottling Group, Inc. (PBG) in 1999.

 

John C. Compton, 44, was appointed President and CEO of Quaker, Tropicana, Gatorade in March 2005 and also serves on PepsiCo’s liquid refreshment beverage oversight council. Mr. Compton began his career at PepsiCo in 1983 as a Frito-Lay Production Supervisor in the Pulaski, Tennessee manufacturing plant. He has spent 22 years at PepsiCo in various Sales, Marketing, Operations and General Management assignments. Mr. Compton served as Vice Chairman and President of the North American Salty Snacks Division of Frito-Lay from March 2003 until March 2005. Prior to that, he served as Chief Marketing Officer of Frito-Lay’s North American Salty Snacks Division from August 2001 until March 2003.

 

Dawn E. Hudson, 48, is President and Chief Executive Officer of Pepsi-Cola North America (PCNA) and also serves on PepsiCo’s liquid refreshment beverage oversight council. Ms. Hudson was promoted to CEO of PCNA in March 2005 and has been president since 2002. Previously, as Senior Vice President, Strategy and Marketing, she led PCNA’s brand strategy and marketing efforts, as well as channel strategy and marketing, product innovation, research and development, joint ventures and marketplace initiative development. She also oversaw corporate marketing synergies as a result of the

 

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merger with Quaker. Ms. Hudson began her PepsiCo career at Frito-Lay North America in 1996 as Executive Vice President, Marketing and New Business and joined PCNA a year later as Senior Vice President, responsible for flavors, new business, packaging and joint ventures.

 

Matthew M. McKenna, 55, has been our Senior Vice President of Finance since August 2001. Mr. McKenna began his career at PepsiCo as Vice President, Taxes in 1993. In 1998, he became Senior Vice President, Taxes and served as Senior Vice President and Treasurer from 1998 until 2001. Prior to joining PepsiCo, he was a partner with the law firm of Winthrop, Stimson, Putnam & Roberts in New York. Mr. McKenna is also a director of PepsiAmericas, Inc. and a member of the Management Committee of Pepsi Bottling Ventures LLC.

 

Margaret D. Moore, 58, is our Senior Vice President, Human Resources, a position she assumed at the end of 1999. From November 1998 to December 1999, she was Senior Vice President and Treasurer of PBG. Prior to joining PBG, Ms. Moore spent 25 years with PepsiCo in a number of senior financial and human resources positions. Ms. Moore is also a director of PBG.

 

Indra K. Nooyi, 50, was elected to PepsiCo’s Board and became President and Chief Financial Officer in May 2001, after serving as Senior Vice President and Chief Financial Officer since February 2000. Ms. Nooyi also served as Senior Vice President, Strategic Planning and Senior Vice President, Corporate Strategy and Development from 1994 until 2000. Prior to joining PepsiCo, Ms. Nooyi spent four years as Senior Vice President of Strategy, Planning and Strategic Marketing for Asea Brown Boveri, Inc. She was also Vice President and Director of Corporate Strategy and Planning at Motorola, Inc. Ms. Nooyi is also a director of Motorola, Inc.

 

Lionel L. Nowell III, 51, has been our Senior Vice President and Treasurer since August 2001. Mr. Nowell joined PepsiCo as Senior Vice President and Controller in 1999 and then became Senior Vice President and Chief Financial Officer of PBG. Prior to joining PepsiCo, he was Senior Vice President, Strategy and Business Development for RJR Nabisco, Inc. From 1991 to 1998, he served as Chief Financial Officer of Pillsbury North America, and its Pillsbury Foodservice and Haagen Dazs units, serving as Vice President and Controller of the Pillsbury Company, Vice President of Food and International Retailing Audit, and Director of Internal Audit.

 

Irene B. Rosenfeld, 52, was appointed Chairman and Chief Executive Officer of Frito-Lay, Inc. in September 2004. Prior to joining PepsiCo, Ms. Rosenfeld served as President of Kraft Foods North American Businesses. During her career at Kraft, she also served as Group Vice President responsible for Kraft’s North American manufacturing, distribution, procurement, R&D and information systems and also served as President of Kraft Canada and Kraft Mexico. Prior to that, Ms. Rosenfeld served in various senior management positions with Kraft after joining Kraft in 1981.

 

Larry D. Thompson, 60, became PepsiCo’s Senior Vice President, Government Affairs, General Counsel and Secretary in November 2004. Prior to joining PepsiCo, Mr. Thompson served as a Senior Fellow with the Brookings Institution in Washington, D.C.

 

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and served as Deputy Attorney General in the U.S. Department of Justice. In 2002, he was named to lead the National Security Coordination Council and was also named by President Bush to head the Corporate Fraud Task Force. In April 2000, Mr. Thompson was selected by Congress to chair the bipartisan Judicial Review Commission on Foreign Asset Control. Prior to his government career, he was a partner in the law firm of King & Spalding, a position he held from 1986 to 2001.

 

Michael D. White, 54, was appointed Chairman and Chief Executive Officer of PepsiCo International in February 2003, after serving as President and Chief Executive Officer of Frito-Lay’s Europe/Africa/Middle East division since 2000. From 1998 to 2000, Mr. White was Senior Vice President and Chief Financial Officer of PepsiCo. Mr. White has also served as Executive Vice President and Chief Financial Officer of PepsiCo Foods International and Chief Financial Officer of Frito-Lay North America. He joined Frito-Lay in 1990 as Vice President of Planning.

 

Executive officers are elected by our Board of Directors, and their terms of office continue until the next annual meeting of the Board or until their successors are elected and have qualified. There are no family relationships among our executive officers.

 

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PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Stock Trading Symbol – PEP

 

Stock Exchange Listings – The New York Stock Exchange is the principal market for our Common Stock, which is also listed on the Amsterdam, Chicago and Swiss Stock Exchanges.

 

Stock Prices – The composite quarterly high, low and closing prices for PepsiCo Common Stock for each fiscal quarter of 2005 and 2004 are contained in our Selected Financial Data.

 

Shareholders – At December 31, 2005, there were approximately 197,500 shareholders of record of our common stock.

 

Dividends – We target an annual dividend payout of approximately 45% of prior year’s net income from continuing operations. Dividends are usually declared in late January or early February, May, July and November and paid at the end of March, June and September and the beginning of January. The dividend record dates for these payments are, subject to approval of the Board of Directors, expected to be March 10, June 9, September 8, and December 8, 2006. We have paid quarterly cash dividends since 1965. The quarterly dividends declared in 2005 and 2004 are contained in our Selected Financial Data.

 

For information on securities authorized for issuance under our equity compensation plans see Item 12.

 

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A summary of our common stock repurchases (in millions, except average price per share) during the fourth quarter under the $7 billion repurchase program authorized by our Board of Directors and publicly announced on March 29, 2004, and expiring on March 31, 2007, is set forth in the following table. All such shares of common stock were repurchased pursuant to open market transactions.

 

Issuer Purchases of Common Stock

 

Period


   (a) Total
Number of
Shares
Repurchased


   (b) Average
Price Paid Per
Share


   (c) Total
Number of
Shares
Purchased as
Part of Publicly
Announced
Plans or
Programs


   (d) Maximum
Number of
Shares that may
Yet Be
Purchased
Under the Plans
or Programs


 

9/3/05

                    $ 2,771  

9/4/05 – 10/1/05

   4.4    $ 55.29    4.4      (245 )
                     


                        2,526  

10/2/05 – 10/29/05

   3.4      57.83    3.4      (195 )
                     


                        2,331  

10/30/05 – 11/26/05

   3.6      58.76    3.6      (213 )
                     


                        2,118  

11/27/05 – 12/31/05

   4.1      59.53    4.1      (243 )
    
         
  


     15.5    $ 57.77    15.5    $ 1,875  
    
  

  
  


 

In addition, PepsiCo repurchases shares of its convertible preferred stock from an employee stock ownership plan (ESOP) fund established by Quaker in connection with share redemptions by ESOP participants. The following table summarizes our convertible preferred share repurchases during the fourth quarter.

 

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Issuer Purchases of Convertible Preferred Stock

 

Period


   (a) Total
Number of
Shares
Repurchased


   (b) Average
Price Paid Per
Share


   (c) Total
Number of
Shares
Purchased as
Part of Publicly
Announced
Plans or
Programs


   (d) Maximum
Number of
Shares that may
Yet Be
Purchased
Under the Plans
or Programs


9/3/05

                     

9/4/05 – 10/1/05

   4,300    $ 279.52    N/A    N/A

10/2/05 – 10/29/05

   7,700      287.57    N/A    N/A

10/30/05 – 11/26/05

   3,200      291.27    N/A    N/A

11/27/05 – 12/31/05

   3,200      294.01    N/A    N/A
    
         
  
     18,400    $ 287.45    N/A    N/A
    
  

  
  

 

Item 6. Selected Financial Data

 

Selected Financial Data is included on page 94.

 

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Item 7. Management’s Discussion and Analysis     

 

OUR BUSINESS

    

Our Operations

   20

Our Chairman and CEO Perspective

   22

Our Customers

   27

Our Distribution Network

   28

Our Competition

   28

Other Relationships

   29

Our Business Risks

   29

OUR CRITICAL ACCOUNTING POLICIES

    

Revenue Recognition

   33

Brand and Goodwill Valuations

   34

Income Tax Expense and Accruals

   35

Stock-Based Compensation Expense

   36

Pension and Retiree Medical Plans

   39

OUR FINANCIAL RESULTS

    

Items Affecting Comparability

   43

Results of Continuing Operations – Consolidated Review

   44

Results of Continuing Operations – Division Review

   49

Frito-Lay North America

   50

PepsiCo Beverages North America

   51

PepsiCo International

   52

Quaker Foods North America

   54

Our Liquidity, Capital Resources and Financial Position

   55

 

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Consolidated Statement of Income

   58

Consolidated Statement of Cash Flows

   59

Consolidated Balance Sheet

   61

Consolidated Statement of Common Shareholders’ Equity

   62

Notes to Consolidated Financial Statements

    

Note 1 – Basis of Presentation and Our Divisions

   63

Note 2 – Our Significant Accounting Policies

   67

Note 3 – Restructuring and Impairment Charges and Merger-Related Costs

   69

Note 4 – Property, Plant and Equipment and Intangible Assets

   70

Note 5 – Income Taxes

   72

Note 6 – Stock-Based Compensation

   74

Note 7 – Pension, Retiree Medical and Savings Plans

   77

Note 8 – Noncontrolled Bottling Affiliates

   80

Note 9 – Debt Obligations and Commitments

   83

Note 10 – Risk Management

   85

Note 11 – Net Income per Common Share from Continuing Operations

   87

Note 12 – Preferred and Common Stock

   88

Note 13 – Accumulated Other Comprehensive Loss

   89

Note 14 – Supplemental Financial Information

   90

MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL REPORTING

   91

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

   93

SELECTED FINANCIAL DATA

   94

FIVE-YEAR SUMMARY

   95

GLOSSARY

   96

 

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Our discussion and analysis is an integral part of understanding our financial results. Definitions of key terms can be found in the glossary on page 96. Tabular dollars are presented in millions, except per share amounts. All per share amounts reflect common per share amounts, assume dilution unless noted, and are based on unrounded amounts. Percentage changes are based on unrounded amounts.

 

OUR BUSINESS

 

Our Operations

 

We are a leading, global snack and beverage company. We manufacture, market and sell a variety of salty, convenient, sweet and grain-based snacks, carbonated and non-carbonated beverages and foods. We are organized into four divisions:

 

    Frito-Lay North America,

 

    PepsiCo Beverages North America,

 

    PepsiCo International, and

 

    Quaker Foods North America.

 

Net revenue and operating profit contributions to growth from each of our divisions in 2005 are as follows:

 

LOGO

 

Our North American divisions operate in the United States and Canada. Our international divisions operate in over 200 countries, with our largest operations in Mexico and the United Kingdom. Additional information concerning our divisions and geographic areas is presented in Note 1.

 

Frito-Lay North America

 

Frito-Lay North America (FLNA) manufactures or uses contract manufacturers, markets, sells and distributes branded snacks. These snacks include Lay’s potato chips, Doritos tortilla chips, Cheetos cheese flavored snacks, Tostitos tortilla chips, Fritos corn chips, branded dips, Ruffles potato chips, Quaker Chewy granola bars, Rold Gold pretzels, Sun Chips multigrain snacks, Munchies snack mix, Grandma’s cookies, Lay’s Stax potato crisps, Quaker Quakes corn and rice snacks, Quaker Fruit & Oatmeal bars, Cracker Jack candy coated popcorn and Go Snacks. FLNA branded products are sold to independent distributors and retailers.

 

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PepsiCo Beverages North America

 

PepsiCo Beverages North America (PBNA) manufactures or uses contract manufacturers, markets and sells beverage concentrates, fountain syrups and finished goods, under various beverage brands including Pepsi, Mountain Dew, Gatorade, Tropicana Pure Premium, Sierra Mist, Tropicana juice drinks, Mug, Propel, SoBe, Tropicana Twister, Dole and Slice. PBNA also manufactures, markets and sells ready-to-drink tea and coffee products through joint ventures with Lipton and Starbucks. In addition, PBNA licenses the Aquafina water brand to its bottlers and markets this brand. PBNA sells concentrate and finished goods for some of these brands to bottlers licensed by us, and some of these branded products are sold directly by us to independent distributors and retailers. The franchise bottlers sell our brands as finished goods to independent distributors and retailers. PBNA’s volume reflects sales to its independent distributors and retailers, and the sales of beverages bearing our trademarks that franchise bottlers have reported as sold to independent distributors and retailers.

 

PepsiCo International

 

PepsiCo International (PI) manufactures through consolidated businesses as well as through noncontrolled affiliates, a number of leading salty and sweet snack brands including Gamesa and Sabritas in Mexico, Walkers in the United Kingdom, and Smith’s in Australia. Further, PI manufactures or uses contract manufacturers, markets and sells many Quaker brand snacks. PI also manufactures, markets and sells beverage concentrates, fountain syrups and finished goods under the brands Pepsi, 7UP, Mirinda, Gatorade, Mountain Dew and Tropicana. These brands are sold to franchise bottlers, independent distributors and retailers. However, in certain markets, PI operates its own bottling plants and distribution facilities. PI also licenses the Aquafina water brand to certain of its franchise bottlers. PI reports two measures of volume. Snack volume is reported on a system-wide basis, which includes our own volume and the volume sold by our noncontrolled affiliates. Beverage volume reflects company-owned and franchise bottler sales of beverages bearing our trademarks to independent distributors and retailers.

 

Quaker Foods North America

 

Quaker Foods North America (QFNA) manufactures or uses contract manufacturers, markets and sells cereals, rice, pasta and other branded products. QFNA’s products include Quaker oatmeal, Aunt Jemima mixes and syrups, Quaker grits, Cap’n Crunch and Life ready-to-eat cereals, Rice-A-Roni, Pasta Roni and Near East side dishes. These branded products are sold to independent distributors and retailers.

 

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Our Chairman and CEO Perspective

 

The questions below reflect key questions shareholders most often ask about our businesses, and are followed by answers from our Chairman and CEO, Steve Reinemund.

 

There is a lot in the press about the “obesity epidemic.” How urgent is the obesity issue, and does it pose a risk to PepsiCo’s business?

 

There is no question that obesity is a significant issue gaining increased attention and importance in many nations. Public health is a complex issue that requires partnerships across public and private sectors to find solutions that help consumers.

 

That’s why, while we view this issue as a challenge, we also see the growing interest in health and wellness as a growth opportunity. Given that North America revenues from our Smart Spot eligible products – more than 250 products that contribute to healthier lifestyles – grew at more than two-and-one-half times the rate of the rest of our portfolio in 2005, it’s clear that our strategy is aligned with the interests of our consumers and retail partners. And it’s the right thing to do for our business. As a result, our commitment to health and wellness has never been stronger.

 

We believe the solution to consumers’ health and wellness needs – and the obesity epidemic in particular – lies in the concept of energy balance; that is, finding balance between the calories consumed and the calories burned. It requires companies like PepsiCo to be part of the solution – a priority on which we will continue to take action.

 

Whether it’s reformulating our products with lower sugar, fat or sodium, adding new or additional ingredients that deliver health benefits, or developing entirely new products, we’ve committed considerable resources to doing what we do best – giving consumers what they want. We’ve also committed to supporting active lifestyles and marketing responsibly.

 

Your commitment to the International business seems to be paying off. What are the drivers of growth in your International business, and do you expect the growth to continue at the same pace?

 

The outstanding growth achieved by our International business in 2005 is the result of years of investment and the implementation of a deliberate strategy to create scale in key international markets that will deliver profitable growth. As the fastest growing division at PepsiCo – and now the largest revenue generator – PepsiCo International’s strategy clearly is delivering results.

 

To give more perspective on why we’re encouraged about our international growth prospects, the portfolio of international markets is both broadening and strengthening, as we deliver exciting new products, tailored to local tastes, to consumers in more than 200 countries and territories. We’re particularly pleased with our growing presence in key emerging markets such as Brazil, China, India and Russia.

 

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We’re very proud of the growth generated through our brands. Our performance is directly attributable to the passionate people who run our businesses in our international markets, each and every day of the year, adapting our products, packaging and distribution systems to a wide variety of tastes and market conditions.

 

We continue to expect our International business to grow at about twice the rate of our North American businesses, though favorable global macroeconomics clearly contributed to our 2005 performance which exceeded that expectation.

 

What is the role of acquisitions in PepsiCo’s future growth?

 

We continue to believe that small, strategic, or “tuck in” acquisitions, will help propel our future growth. Our recent acquisitions of Sakata in Australia, Star Foods in Poland, Punica in Germany, P.J. Smoothies in the United Kingdom and Stacy’s Pita Chips in the United States, are clear examples of how smaller acquisitions that offer considerable synergies with our existing businesses can help us grow in new geographies and new categories.

 

In each case, we exercise a disciplined approach to assessing any opportunity, carefully reviewing both strategic and financial criteria to ensure a fit with PepsiCo.

 

It’s important to understand that while acquisitions have a role to play in our growth plans, we believe we’ll continue to experience strong “organic” growth in our existing portfolio of businesses. They’re equipped with big, muscular brands, they have room to grow, and they receive constant investment and attention.

 

The carbonated soft drink category in North America has slowed in recent years. What does this trend mean for PepsiCo’s growth prospects?

 

While our carbonated soft drink business was down in North America in 2005, we’re convinced that, over time, growth can be restored as we continue to invest in innovation for our carbonated beverages. Our diet carbonated soft drinks continue to grow in North America, an indication that consumers will remain engaged with the category if we offer carbonated soft drinks they desire.

 

Importantly, if you look at the total liquid refreshment beverage (LRB) category in North America – meaning all beverage occasions except for coffee, alcohol, tap and bulk water – you’ll see it’s growing at about 2.5% annually. This is consistent with historical growth rates for LRB, and PepsiCo is very well positioned to capture this growth.

 

That’s because we have an advantaged portfolio of non-carbonated beverages, which is exactly where the growth in LRB is, and where we believe it continues to head. PepsiCo’s line-up of waters, sports drinks, teas and energy drinks includes leading brands, and they illustrate how an advantaged portfolio of non-carbonated beverages can deliver great products for consumers, and solid returns for retailers and shareholders.

 

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How are you preparing to grow PepsiCo’s top line?

 

In a word, innovation – the lifeblood of any consumer products company. PepsiCo views this capability as a critical and sustainable competitive advantage. It is the reason we spend considerable time and dollars filling our pipeline with an array of consumer propositions to address needs for convenient foods and beverages.

 

We use a thoughtful and balanced approach to funding innovation and putting resources in place to support it. Some examples of that balance include balancing good-for-you and better-for-you product innovation with resources earmarked for our fun-for-you portfolio. In 2005, for example, our investment in new Aquafina FlavorSplash and new Gatorade Lemonade drove growth with our Smart Spot portfolio, while Lay’s Cheddar and Sour Cream flavored potato chips contributed to solid growth with our Lay’s brand.

 

But it also means balancing investment between carbonated and non-carbonated beverages, and balancing between “close-in” ideas like line extensions, and entirely new product platforms that don’t exist today. We’ve implemented new ways of coordinating the collection of insights from consumers and retail partners so we can better share those insights across our businesses, and generate ideas that have a greater chance of success in the marketplace.

 

I think it’s important to understand that innovation isn’t limited to products. Across PepsiCo, we’re constantly innovating to strengthen our go-to-market systems and to find structures that drive faster, more efficient and more cost-effective decision making. A current example is our Business Process Transformation, or BPT, a comprehensive, multi-year initiative that centers on moving all of PepsiCo to a common set of processes for key business activities, with current efforts focused on North America.

 

More than a year ago, you announced PepsiCo’s Business Process Transformation (BPT) initiative. What are the objectives of this program, and what is its status?

 

Through larger acquisitions and mergers over the years, such as Tropicana and Quaker, we’ve recognized the need to seamlessly integrate formerly independent information systems. We are also committed to harmonizing key business processes such as Finance, Consumer Insights, Purchasing and Supply Chain and continuously improving our customer service.

 

We’re supporting these processes with common Information Technology applications, linking our systems so that key pieces of data supporting all our businesses flow seemlessly from system to system. 2005 was a big year of preparation for the first deployment of our new, integrated system, which started its phased roll out in early 2006.

 

In fact, on January 16, the very first of these new capabilities began its roll out. Several of our North American plants, along with our Global Procurement team, now have streamlined tools and processes used for purchasing materials other than commodities, packaging and ingredients. Additional capabilities will be rolled out over the next several years.

 

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When complete, we expect to have an infrastructure that will support better, faster decisions, allowing us to capture more growth opportunities, and better serve our customers. Importantly, it will also leverage PepsiCo’s scale for efficiency and effectiveness.

 

On the cost side, a number of key commodities have seen high rates of inflation. How is PepsiCo managing in an environment of increasing costs?

 

There is no doubt that 2005 was a challenging year for input costs – especially energy and plastics resin. Between several major hurricanes hitting the United States and inflation, we saw some expected and some unexpected pressure on our margins, but we managed those cost pressures and met our financial targets.

 

And we expect 2006 to be challenging as well, largely reflecting increased energy and commodity costs. However, we have solid plans in place to offset these rising costs through productivity programs and hedging strategies, and expect to carefully manage pricing to help offset some of the inflation.

 

PepsiCo’s businesses generate a great deal of cash, and the Company’s balance sheet is very conservative. Why don’t you put more debt on the balance sheet and use the proceeds to increase the dividend or increase share repurchases?

 

PepsiCo does generate considerable cash, and we are disciplined about how cash is reinvested in the business. Over the past three years, $5.7 billion has been reinvested in the businesses through capital expenditures and acquisitions, and $12.0 billion has been returned to shareholders through a combination of dividends and share repurchases. In essence, any cash we have not reinvested in the business has been returned to our shareholders. And, we are pleased with our current capital structure and debt ratings, which give us ready access to capital markets and keep our cost of borrowing down.

 

PepsiCo’s focus on people – specifically diversity and inclusion – has been a priority in previous reports. What results have you delivered through this focus and what changes have you made?

 

In terms of the diversity of our workforce, we’ve seen a significant increase in the number of women and people of color who’ve joined PepsiCo in various functions and at various levels. Since 2000, the percentage of women in management positions in the United States, has risen from 20% to 25%. The number of people of color in management positions has climbed from 15% to almost 22% – we made a gain of about 2 points of growth in 2005 alone. This change in the workforce has contributed to our growth through product ideas, greater insights about consumers and connections into growing urban and ethnic communities.

 

While a diverse workforce is important, we must also create an inclusive environment where everyone – regardless of race, gender, physical ability or sexual orientation – feels valued, engaged, and wants to be part of our growth. It is only through inclusion that we will fully unleash innovation and growth for our business.

 

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To capture this potential, we made some changes in 2005. For example, to put accountability for diversity and inclusion squarely in the hands of our people, and into our divisions, we formed the PepsiCo Diversity & Inclusion Governance Council. Representatives from each division and various functions comprise the council, and its chair reports directly to me.

 

I also asked each of my direct reports to take ownership for the development of specific employee groups. Whether it is African Americans, Latinos, white males, women, or other groups of PepsiCo employees, each has a voice at the most senior decision-making entity at your company.

 

In the context of people issues, corporate responsibility is a hot topic. How are you ensuring PepsiCo associates are acting in accordance with the law, and – beyond the law – doing the right thing?

 

The need for trust between corporations and the general public is as big as ever, and investors rightly should ask this question of every company. PepsiCo’s focus on values remains honed on a commitment to every shareholder – to deliver sustained growth, through empowered people, operating with responsibility and building trust.

 

This commitment, along with other guiding principles, is what we aspire to each and every day. It complements our approach to corporate governance, the strength of our financial controls, and the company’s Worldwide Code of Conduct.

 

Our Values and our Worldwide Code of Conduct are known to every PepsiCo associate and are presented in 38 languages on our website (www.pepsico.com). But the strength of any such commitment is not in the words themselves, but in how they are lived every day.

 

We continuously remind our associates of the rewards that come with running the company in a legal, ethical and responsible way, along with the consequences of failing to do so. We want, and intend to be, a sustainable enterprise, and that demands our people act in responsible ways, and think about our businesses for the long term.

 

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Our Customers

 

Our customers include franchise bottlers and independent distributors and retailers. We normally grant our bottlers exclusive contracts to sell and manufacture certain beverage products bearing our trademarks within a specific geographic area. These arrangements specify the amount to be paid by our bottlers for concentrate and full goods and for Aquafina royalties, as well as the manufacturing process required for product quality.

 

Since we do not sell directly to the consumer, we rely on and provide financial incentives to our customers to assist in the distribution and promotion of our products. For our independent distributors and retailers, these incentives include volume-based rebates, product placement fees, promotions and displays. For our bottlers, these incentives are referred to as bottler funding and are negotiated annually with each bottler to support a variety of trade and consumer programs, such as consumer incentives, advertising support, new product support, and vending and cooler equipment placement. Consumer incentives include coupons, pricing discounts and promotions, such as sweepstakes and other promotional offers. Advertising support is directed at advertising programs and supporting bottler media. New product support includes targeted consumer and retailer incentives and direct marketplace support, such as point-of-purchase materials, product placement fees, media and advertising. Vending and cooler equipment placement programs support the acquisition and placement of vending machines and cooler equipment. The nature and type of programs vary annually. The level of bottler funding is at our discretion because these incentives are not required by the terms of our bottling contracts.

 

Retail consolidation has increased the importance of major customers and further consolidation is expected. Sales to Wal-Mart Stores, Inc. represent approximately 9% of our total worldwide net revenue; and our top five retail customers currently represent approximately 26% of our 2005 North American net revenue, with Wal-Mart representing approximately 11%. These percentages include concentrate sales to our bottlers which are used in finished goods sold by them to these retailers. In addition, sales to The Pepsi Bottling Group (PBG) represent approximately 10% of our total net revenue. See “ Our Related Party Bottlers” and Note 8 for more information on our anchor bottlers.

 

Our Related Party Bottlers

 

We have ownership interests in certain of our bottlers. Our ownership is less than 50% and since we do not control these bottlers, we do not consolidate their results. We include our share of their net income based on our percentage of economic ownership in our income statement as bottling equity income. We have designated three related party bottlers, PBG, PepsiAmericas, Inc. (PAS) and Pepsi Bottling Ventures LLC (PBV), as our anchor bottlers. Our anchor bottlers distribute approximately 62% of our North American beverage volume and approximately 19% of our international beverage volume. Our anchor bottlers participate in the bottler funding programs described above. Approximately 8% of our total 2005 sales incentives are related to these bottlers. See Note 8

 

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for additional information on these related parties and related party commitments and guarantees.

 

Our Distribution Network

 

Our products are brought to market through direct-store-delivery, broker-warehouse and foodservice and vending distribution networks. The distribution system used depends on customer needs, product characteristics and local trade practices.

 

Direct-Store-Delivery

 

We and our bottlers operate direct-store-delivery systems that deliver snacks and beverages directly to retail stores where the products are merchandised by our employees or our bottlers. Direct-store-delivery enables us to merchandise with maximum visibility and appeal. Direct-store-delivery is especially well-suited to products that are restocked often and respond to in-store promotion and merchandising.

 

Broker-Warehouse

 

Some of our products are delivered from our manufacturing plants and warehouses to customer warehouses and retail stores. These less costly systems generally work best for products that are less fragile and perishable, have lower turnover, and are less likely to be impulse purchases.

 

Foodservice and Vending

 

Our foodservice and vending sales force distributes snacks, foods and beverages to third-party foodservice and vending distributors and operators, and for certain beverages, distributes through our bottlers. This distribution system supplies our products to schools, businesses, stadiums, restaurants and similar locations.

 

Our Competition

 

Our businesses operate in highly competitive markets. We compete against global, regional, local and private label manufacturers on the basis of price, quality, product variety and effective distribution. In measured channels, our chief beverage competitor, The Coca-Cola Company, has a slightly larger share of carbonated soft drink (CSD) consumption in the U.S., while we have a larger share of chilled juices and isotonics. In addition, The Coca-Cola Company maintains a significant CSD share advantage in many markets outside North America. Further, our snack brands hold significant leadership positions in the snack industry worldwide. Our snack brands face local and regional competitors, as well as national and global snack competitors, and compete on issues related to price, quality, variety and distribution. Success in this competitive environment is dependent on effective promotion of existing products and the introduction of new products. We believe that the strength of our brands, innovation and marketing, coupled with the quality of our products and flexibility of our distribution network, allow us to compete effectively.

 

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Other Relationships

 

Certain members of our Board of Directors also serve on the boards of certain vendors and customers. Those Board members do not participate in our vendor selection and negotiations nor in our customer negotiations. Our transactions with these vendors and customers are in the normal course of business and are consistent with terms negotiated with other vendors and customers. In addition, certain of our employees serve on the boards of our anchor bottlers and other affiliated companies and do not receive incremental compensation for their Board services.

 

Our Business Risks

 

Our Approach to Managing Risks

 

We are subject to risks in the normal course of business due to adverse developments with respect to:

 

    product demand,

 

    our reputation,

 

    information technology,

 

    supply chain,

 

    retail consolidation and the loss of major customers,

 

    global economic and environmental conditions,

 

    the regulatory environment,

 

    workforce retention,

 

    raw materials and energy,

 

    competition, and

 

    market risks.

 

Please see “ Risk Factors” in Item 1A. and “ Market Risks” below for more information about these risks.

 

The achievement of our strategic and operating objectives will necessarily involve taking risks. Our risk management process is intended to ensure that risks are taken knowingly and purposefully. As such, we leverage an integrated risk management framework to identify, assess, prioritize, manage, monitor, and communicate risks across the company. This framework includes:

 

   

the PepsiCo Executive Risk Council (PERC), comprised of a cross-functional, geographically diverse, senior management group which identifies, assesses, prioritizes and addresses primarily strategic and reputational risks;

 

   

Division Risk Committees (DRCs), comprised of cross-functional senior management teams which meet regularly each year to identify, assess, prioritize and address division-specific operating risks;

 

   

PepsiCo’s Risk Management Office, which manages the overall process, provides ongoing guidance, tools and analytical support to the PERC and the DRCs, identifies and assesses potential risks, and facilitates ongoing communication between the parties, as well as to PepsiCo’s Audit Committee; and

 

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PepsiCo Corporate Audit, which confirms the ongoing effectiveness of the risk management framework through periodic audit and review procedures.

 

In 2005, we continued our effort to drive risk mitigation focus to where risks can be most efficiently and effectively managed and reinforced ownership and accountability for risk management within the business. Some highlights include:

 

   

With respect to product demand, we continued to focus on the development of products that respond to consumer trends, such as consumer health concerns about obesity, product attributes and ingredients, including reformulating products to lower sugar, fats, and sodium; adding ingredients that deliver health benefits; and expanding our offering of portion-controlled packages. Smart Spot eligible products continued to be the fastest growing part of our North American product portfolio. We continued to focus on marketing our products in ways that promote healthier lifestyles. We helped create and endorsed the American Beverage Association’s new schools policy, which defines the types of products that may be sold in schools. We actively promoted healthy energy balance through our national sponsorship of America On the Move, a program designed to help families take simple steps to maintain a healthy energy balance.

 

   

We enhanced the coordination of our Division-led product integrity efforts through the creation of the PepsiCo Product Integrity Council (PPIC), a cross-functional forum to share leading practices and confer about areas of potential risk.

 

   

We continued to enhance our internal IT infrastructure, by consolidating and updating technology and retiring older technology, as well as improving our information security capabilities.

 

   

We continued implementation of our BPT initiative, which we believe will enable us to remain in step with the changing needs of our customers. Overall BPT project governance is provided through steering committees headed by senior executives and a team is in place to drive effective risk management and quality processes and to build an internal control environment compliant with the Sarbanes-Oxley Act.

 

   

We continue to assess our capability to mitigate potential business disruptions and evaluate an integrated approach to business disruption management, including disaster recovery, crisis management, and business continuity.

 

   

We established a compliance and ethics leadership structure, appointing an SVP, Deputy General Counsel who is focusing on business practices and compliance, prioritizing projects to enhance the effectiveness of our compliance and ethics program, including developing a multilingual Code of Conduct training program that will be rolled out in 2006.

 

   

We have implemented human resource programs which focus on diversity and inclusion, leadership development, succession planning, and employee work-life flexibility, and are aimed at hiring, developing, and retaining our talented and motivated workforce.

 

Market Risks

 

We are exposed to the market risks arising from adverse changes in:

 

    commodity prices, affecting the cost of our raw materials and energy,

 

    foreign exchange rates,

 

    interest rates,

 

    stock prices, and

 

    discount rates affecting the measurement of our pension and retiree medical liabilities.

 

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In the normal course of business, we manage these risks through a variety of strategies, including productivity initiatives, global purchasing programs and hedging strategies. Ongoing productivity initiatives involve the identification and effective implementation of meaningful cost saving opportunities or efficiencies. Our global purchasing programs include fixed-price purchase orders and pricing agreements. Our hedging strategies involve the use of derivatives. Certain derivatives are designated as either cash flow or fair value hedges and qualify for hedge accounting treatment, while others do not qualify and are marked to market through earnings. We do not use derivative instruments for trading or speculative purposes and we limit our exposure to individual counterparties to manage credit risk. The fair value of our derivatives fluctuates based on market rates and prices. The sensitivity of our derivatives to these market fluctuations is discussed below. See Note 10 for further discussion of these derivatives and our hedging policies. See “ Our Critical Accounting Policies” for a discussion of the exposure of our pension plan assets and pension and retiree medical liabilities to risks related to stock prices and discount rates.

 

Inflationary, deflationary and recessionary conditions impacting these market risks also impact the demand for and pricing of our products. See “ Risk Factors” in Item 1A. for further discussion.

 

Commodity Prices

 

Our open commodity derivative contracts had a face value of $89 million at December 31, 2005 and $155 million at December 25, 2004. The open derivative contracts designated as accounting hedges resulted in net unrecognized gains of $39 million at December 31, 2005 and an unrecognized loss of $1 million at December 25, 2004. We estimate that a 10% decline in commodity prices would have reduced our unrecognized gains on open contracts to $35 million in 2005 and increased our unrecognized losses to $9 million in 2004. The open derivative contracts that were not designated as accounting hedges resulted in net recognized losses of $3 million in 2005 and $2 million in 2004. We estimate that a 10% decline in commodity prices would have increased our recognized losses on open contracts to $4 million in 2005 and to $5 million in 2004.

 

In 2006, we expect continued pricing pressures on our raw materials and energy costs. We expect to be able to mitigate the impact of these increased costs through our hedging strategies and ongoing productivity initiatives.

 

Foreign Exchange

 

Financial statements of foreign subsidiaries are translated into U.S. dollars using period-end exchange rates for assets and liabilities and weighted-average exchange rates for revenues and expenses. Adjustments resulting from translating net assets are reported as a separate component of accumulated other comprehensive loss within shareholders’ equity under the caption currency translation adjustment.

 

Our operations outside of the U.S. generate over a third of our net revenue of which Mexico, the United Kingdom and Canada comprise nearly 20%. As a result, we are

 

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exposed to foreign currency risks, including unforeseen economic changes and political unrest. During 2005, net favorable foreign currency, primarily increases in the Mexican peso, Brazilian real, and Canadian dollar, contributed over 1 percentage point to net revenue growth. Currency declines which are not offset could adversely impact our future results.

 

Exchange rate gains or losses related to foreign currency transactions are recognized as transaction gains or losses in the income statement as incurred. We may enter into derivatives to manage our exposure to foreign currency transaction risk. Our foreign currency derivatives had a total face value of $1.1 billion at December 31, 2005 and $908 million at December 25, 2004. The contracts designated as accounting hedges resulted in net unrecognized losses of $9 million at December 31, 2005 and $27 million at December 25, 2004. We estimate that an unfavorable 10% change in the exchange rates would have resulted in unrecognized losses of $81 million in 2005 and $110 million in 2004. The contracts not designated as accounting hedges resulted in net recognized gains of $14 million and less than $1 million at December 31, 2005 and December 25, 2004, respectively. These gains were almost entirely offset by changes in the underlying hedged items, resulting in no net impact on earnings.

 

Interest Rates

 

We centrally manage our debt and investment portfolios considering investment opportunities and risks, tax consequences and overall financing strategies. We may use interest rate and cross currency interest rate swaps to manage our overall interest expense and foreign exchange risk. These instruments effectively change the interest rate and currency of specific debt issuances. These swaps are entered into concurrently with the issuance of the debt that they are intended to modify. The notional amount, interest payment and maturity date of the swaps match the principal, interest payment and maturity date of the related debt. Our counterparty credit risk is considered low because these swaps are entered into only with strong creditworthy counterparties, are generally settled on a net basis and are of relatively short duration.

 

Assuming year-end 2005 and 2004 variable rate debt and investment levels, a one point increase in interest rates would have decreased net interest expense by $8 million in 2005 and $11 million in 2004.

 

Stock Prices

 

A portion of our deferred compensation liability is tied to certain market indices and our stock price. We manage these market risks with mutual fund investments and prepaid forward contracts for the purchase of our stock. The combined gains or losses on these investments are substantially offset by changes in our deferred compensation liability.

 

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OUR CRITICAL ACCOUNTING POLICIES

 

An appreciation of our critical accounting policies is necessary to understand our financial results. These policies may require management to make difficult and subjective judgments regarding uncertainties, and as a result, such estimates may significantly impact our financial results. The precision of these estimates and the likelihood of future changes depend on a number of underlying variables and a range of possible outcomes. Other than our accounting for stock-based compensation and pension plans, our critical accounting policies do not involve the choice between alternative methods of accounting. We applied our critical accounting policies and estimation methods consistently in all material respects, and for all periods presented, and have discussed these policies with our Audit Committee.

 

In connection with our ongoing BPT initiative, we aligned certain accounting policies across our divisions in 2005. We conformed our methodology for calculating our bad debt reserves and modified our policy for recognizing revenue for products shipped to customers by third-party carriers. Additionally, we conformed our method of accounting for certain costs, primarily warehouse and freight. These changes reduced our net revenue by $36 million and our operating profit by $60 million in 2005. We also made certain reclassifications on our Consolidated Statement of Income in the fourth quarter of 2005 from cost of sales to selling, general and administrative expenses in connection with our BPT initiative. These reclassifications resulted in reductions to cost of sales of $556 million through the third quarter of 2005, $732 million in the full year 2004 and $688 million in the full year 2003, with corresponding increases to selling, general and administrative expenses in those periods. These reclassifications had no net impact on operating profit and have been made to all periods presented for comparability.

 

Our critical accounting policies arise in conjunction with the following:

 

    revenue recognition,

 

    brand and goodwill valuations,

 

    income tax expense and accruals,

 

    stock-based compensation expense, and

 

    pension and retiree medical plans.

 

Revenue Recognition

 

Our products are sold for cash or on credit terms. Our credit terms, which are established in accordance with local and industry practices, typically require payment within 30 days of delivery in the U.S. and may allow discounts for early payment. We recognize revenue upon shipment or delivery to our customers based on written sales terms that do not allow for a right of return. However, our policy for DSD and chilled products is to remove and replace damaged and out-of-date products from store shelves to ensure that consumers receive the product quality and freshness they expect. Similarly, our policy for warehouse distributed products is to replace damaged and out-of-date products. Based on our historical experience with this practice, we have reserved for anticipated damaged and out-of-date products. Our bottlers have a similar replacement policy and are responsible for the products they distribute.

 

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Our policy is to provide customers with product when needed. In fact, our commitment to freshness and product dating serves to regulate the quantity of product shipped or delivered. In addition, DSD products are placed on the shelf by our employees with customer shelf space limiting the quantity of product. For product delivered through our other distribution networks, customer inventory levels are monitored.

 

As discussed in “ Our Customers,” we offer sales incentives and discounts through various programs to customers and consumers. Sales incentives and discounts are accounted for as a reduction of sales and totaled $8.9 billion in 2005, $7.8 billion in 2004 and $7.1 billion in 2003. Sales incentives include payments to customers for performing merchandising activities on our behalf, such as payments for in-store displays, payments to gain distribution of new products, payments for shelf space and discounts to promote lower retail prices. A number of our sales incentives, such as bottler funding and customer volume rebates, are based on annual targets, and accruals are established during the year for the expected payout. These accruals are based on contract terms and our historical experience with similar programs and require management judgment with respect to estimating customer participation and performance levels. Differences between estimated expense and actual incentive costs are normally insignificant and are recognized in earnings in the period such differences are determined. The terms of most of our incentive arrangements do not exceed a year, and therefore do not require highly uncertain long-term estimates. For interim reporting, we estimate total annual sales incentives for most of our programs and record a pro rata share in proportion to revenue. Certain arrangements extend beyond one year. For example, fountain pouring rights may extend up to 15 years. The costs incurred to obtain these arrangements are recognized over the contract period as a reduction of revenue, and the remaining balances of $321 million at year-end 2005 and $337 million at year-end 2004 are included in current assets and other assets in our Consolidated Balance Sheet.

 

We estimate and reserve for our bad debt exposure based on our experience with past due accounts. In 2005, our method of determining the reserves was conformed across our divisions in connection with our BPT initiative, as discussed above. Bad debt expense is classified within selling, general and administrative expenses in our Consolidated Statement of Income.

 

Brand and Goodwill Valuations

 

We sell products under a number of brand names, many of which were developed by us. The brand development costs are expensed as incurred. We also purchase brands and goodwill in acquisitions. Upon acquisition, the purchase price is first allocated to identifiable assets and liabilities, including brands, based on estimated fair value, with any remaining purchase price recorded as goodwill.

 

We believe that a brand has an indefinite life if it has significant market share in a stable macroeconomic environment and a history of strong revenue and cash flow performance that we expect to continue for the foreseeable future. If these perpetual brand criteria are not met, brands are amortized over their expected useful lives, which generally range from five to 40 years. Determining the expected life of a brand requires considerable management judgment and is based on an evaluation of a number of factors, including

 

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the competitive environment, market share, brand history and the macroeconomic environment of the countries in which the brand is sold.

 

Goodwill, including the goodwill that is part of our noncontrolled bottling investment balances, and perpetual brands are not amortized. Perpetual brands and goodwill are assessed for impairment at least annually to ensure that discounted future cash flows continue to exceed the related book value. A perpetual brand is impaired if its book value exceeds its fair value. Goodwill is evaluated for impairment if the book value of its reporting unit exceeds its fair value. A reporting unit can be a division or business within a division. If the fair value of an evaluated asset is less than its book value, the asset is written down to fair value based on its discounted future cash flows.

 

Amortizable brands are only evaluated for impairment upon a significant change in the operating or macroeconomic environment. If an evaluation of the undiscounted cash flows indicates impairment, the asset is written down to its estimated fair value, which is based on its discounted future cash flows.

 

Considerable management judgment is necessary to evaluate the impact of operating and macroeconomic changes and to estimate future cash flows. Assumptions used in our impairment evaluations, such as forecasted growth rates and our cost of capital, are consistent with our internal forecasts and operating plans. These assumptions could be adversely impacted by certain of the risks discussed in “ Risk Factors” in Item 1A.

 

We did not recognize any impairment charges for perpetual brands or goodwill in the years presented. As of December 31, 2005, we had $5.2 billion of perpetual brands and goodwill, of which 70% related to Tropicana and Walkers.

 

Income Tax Expense and Accruals

 

Our annual tax rate is based on our income, statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we operate. Significant judgment is required in determining our annual tax rate and in evaluating our tax positions. We establish reserves when, despite our belief that our tax return positions are fully supportable, we believe that certain positions are subject to challenge and that we may not succeed. We adjust these reserves, as well as the related interest, in light of changing facts and circumstances, such as the progress of a tax audit. See Note 5 for additional information regarding our tax reserves.

 

An estimated effective tax rate for a year is applied to our quarterly operating results. In the event there is a significant or unusual item recognized in our quarterly operating results, the tax attributable to that item is separately calculated and recorded at the same time as that item. We consider the tax benefits from the resolution of prior year tax matters to be such items.

 

Tax law requires items to be included in our tax returns at different times than the items are reflected in our financial statements. As a result, our annual tax rate reflected in our financial statements is different than that reported in our tax returns (our cash tax rate).

 

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Some of these differences are permanent, such as expenses that are not deductible in our tax return, and some differences reverse over time, such as depreciation expense. These temporary differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in our tax returns in future years for which we have already recorded the tax benefit in our income statement. We establish valuation allowances for our deferred tax assets when we believe expected future taxable income is not likely to support the use of a deduction or credit in that tax jurisdiction. Deferred tax liabilities generally represent tax expense recognized in our financial statements for which payment has been deferred, or expense for which we have already taken a deduction in our tax return but we have not yet recognized as expense in our financial statements.

 

The American Jobs Creation Act of 2004 (AJCA) created a one-time incentive for U.S. corporations to repatriate undistributed international earnings by providing an 85% dividends received deduction. As approved by our Board of Directors in July 2005, we repatriated approximately $7.5 billion in earnings previously considered indefinitely reinvested outside the U.S. in the fourth quarter of 2005. In 2005, we recorded income tax expense of $460 million associated with this repatriation. Other than the earnings repatriated, we intend to continue to reinvest earnings outside the U.S. for the foreseeable future and therefore have not recognized any U.S. tax expense on these earnings. At December 31, 2005, we had approximately $7.5 billion of undistributed international earnings.

 

In 2005, our annual tax rate for continuing operations was 36.1% compared to 24.7% in 2004 as discussed in “ Other Consolidated Results.” The tax rate in 2005 increased 11.4 percentage points primarily as a result of the AJCA tax charge and the absence of the 2004 tax benefits related to the favorable resolution of certain open tax items. For 2006, our annual tax rate is expected to be 28.0%, primarily reflecting the absence of the AJCA tax charge and changes in our concentrate sourcing around the world.

 

Stock-Based Compensation Expense

 

We believe that we will achieve our best results if our employees act and are rewarded as business owners. Therefore, we believe stock ownership and stock-based incentive awards are the best way to align the interests of employees with those of our shareholders. Historically, following competitive market practices, we have used stock option grants as our primary form of long-term incentive compensation. These grants are made at the current stock price, meaning each employee’s exercise price is equivalent to our stock price on the date of grant. Employees must generally provide three additional years of service to earn the grant, referred to as the vesting period. Our options generally have a 10-year term, which means our employees would have up to seven years after the vesting period to elect to pay the exercise price to purchase one share of our stock for each option exercised. Employees benefit from stock options to the extent our stock price appreciates above the exercise price after vesting and during the term of the grant. There have been no reductions to the exercise price of previously issued awards, and any repricing of awards would require approval of our shareholders.

 

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Our new executive compensation program, which became effective in 2004, strengthens the relationship between pay and individual performance through greater differentiation in the amount of base pay, bonus and stock-based compensation based on an employee’s job level and performance. The new program results in a shift of both cash and stock-based compensation to our top performing executives. In addition, our new program provides executives, who are awarded long-term incentives based on their performance, with a choice of stock options or restricted stock units (RSUs). RSU expense is based on the fair value of PepsiCo stock on the date of grant and is amortized over the vesting period, generally three years. Each restricted stock unit can be settled in a share of our stock after the vesting period. Executives who elect RSUs receive one RSU for every four stock options that would have otherwise been granted. Senior officers do not have a choice and are granted 50% stock options and 50% RSUs. Vesting of RSU awards for senior officers is contingent upon the achievement of pre-established performance targets.

 

We also continued, as we have since 1989, to grant an annual award of stock options to all eligible employees, based on job level or classification under our broad-based stock option program, SharePower. As part of the new compensation program which began in 2004, the SharePower program grant was reduced by approximately 50% for employees in the U.S. and replaced with matching contributions of PepsiCo stock to our 401(k) savings plans. We did not reduce the SharePower award for international employees and continued using tenure, in addition to job level and classification, as a basis for the award. For additional information on our 401(k) savings plans, see Note 7.

 

Method of Accounting

 

We account for our employee stock options under the fair value method of accounting using a Black-Scholes valuation model to measure stock-based compensation expense at the date of grant. We adopted Statement of Financial Accounting Standards (SFAS) 123R, Share-Based Payment, under the modified prospective method in the first quarter of 2006. We do not expect our adoption of SFAS 123R to materially impact our financial statements.

 

Our divisions are held accountable for stock-based compensation expense and, therefore, this expense is allocated to our divisions as an incremental employee compensation cost. The allocation of stock-based compensation expense is approximately 29% to FLNA, 22% to PBNA, 31% to PI, 4% to QFNA and 14% to corporate unallocated expenses. The expense allocated to our divisions excludes any impact of changes in our Black-Scholes assumptions during the year which reflect market conditions over which division management has no control. Therefore, any variances between allocated expense and our actual expense are recognized in corporate unallocated expenses.

 

Our Assumptions

 

Our Black-Scholes model estimates the expected value our employees will receive from the options based on a number of assumptions, such as interest rates, employee exercises,

 

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our stock price and dividend yield. Our weighted-average fair value assumptions include:

 

    

Estimated

2006


  2005

  2004

  2003

Expected life

   6 yrs.   6 yrs.   6 yrs.   6 yrs.

Risk free interest rate

   3.8%   3.8%   3.3%   3.1%

Expected volatility

   21%   23%   26%   27%

Expected dividend yield

   1.9%   1.8%   1.8%   1.15%

 

The expected life is a significant assumption as it determines the period for which the risk free interest rate, volatility and dividend yield must be applied. The expected life is the period over which our employee groups are expected to hold their options. It is based on our historical experience with similar grants. The risk free interest rate is based on the expected U.S. Treasury rate over the expected life. Volatility reflects movements in our stock price over the most recent historical period equivalent to the expected life. Dividend yield is estimated over the expected life based on our stated dividend policy and forecasts of net income, share repurchases and stock price.

 

2006 Estimated Expense and Sensitivity of Assumptions

 

Our stock-based compensation expense, including RSUs, is as follows:

 

     Estimated
2006


   2005

   2004

Stock-based compensation expense

   $296    $311    $368

 

If we assumed a 100 basis point change in the following assumptions, our estimated 2006 stock-based compensation expense would increase/(decrease) as follows:

 

    

100 Basis Point

Increase


  100 Basis Point
Decrease


Risk free interest rate

   $6   $(6)

Expected volatility

   $2   $(2)

Expected dividend yield

   $(9)   $10

 

If the expected life were assumed to be one year longer, our estimated 2006 stock-based compensation expense would increase by $12 million. If the expected life were assumed to be one year shorter, our estimated 2006 stock-based compensation expense would decrease by $7 million. As noted, changing the assumed expected life impacts all of the Black-Scholes valuation assumptions as the risk free interest rate, expected volatility and expected dividend yield are estimated over the expected life.

 

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Pension and Retiree Medical Plans

 

Our pension plans cover full-time employees in the U.S. and certain international employees. Benefits are determined based on either years of service or a combination of years of service and earnings. U.S. retirees are also eligible for medical and life insurance benefits (retiree medical) if they meet age and service requirements. Generally, our share of retiree medical costs is capped at specified dollar amounts that vary based upon years of service, with retirees contributing the remainder of the cost.

 

Our Assumptions

 

The determination of pension and retiree medical plan obligations and associated expenses requires the use of assumptions to estimate the amount of the benefits that employees earn while working, as well as the present value of those benefits. Annual pension and retiree medical expense amounts are principally based on four components: (1) the value of benefits earned by employees for working during the year (service cost), (2) increase in the liability due to the passage of time (interest cost), and (3) other gains and losses as discussed below, reduced by (4) expected return on plan assets for our funded plans.

 

Significant assumptions used to measure our annual pension and retiree medical expense include:

 

   

the interest rate used to determine the present value of liabilities (discount rate);

 

   

certain employee-related factors, such as turnover, retirement age and mortality;

 

   

for pension expense, the expected return on assets in our funded plans and the rate of salary increases for plans where benefits are based on earnings; and

 

   

for retiree medical expense, health care cost trend rates.

 

Our assumptions reflect our historical experience and management’s best judgment regarding future expectations. Some of these assumptions require significant management judgment and could have a material impact on the measurement of our pension and retiree medical benefit expenses and obligations. The assumptions used to measure our annual pension and retiree medical expenses are determined as of September 30 (measurement date) and all plan assets and liabilities are generally reported as of that date.

 

At each measurement date, the discount rate is based on interest rates for high-quality, long-term corporate debt securities with maturities comparable to our liabilities. In the U.S., we utilize the Moody’s AA Corporate Index yield and adjust for the differences between the average duration of the bonds in this Index and the average duration of our benefits liabilities based upon a published index.

 

The expected return on pension plan assets is based on our historical experience, our pension plan investment strategy and our expectations for long-term rates of return. Our pension plan investment strategy is reviewed annually and is based upon plan liabilities, an evaluation of market conditions, tolerance for risk, and cash requirements for benefit payments. We use a third-party advisor to assist us in determining our investment allocation and modeling our long-term rate of return assumptions. Our current investment allocation target for our U.S. plans is 60% in equity securities, with the balance in fixed income securities and cash. Our expected long-term rate of return assumptions on U.S. plan assets is 7.8%, reflecting an estimated long-term return of 9.3%

 

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from equity securities and an estimated 5.8% from fixed income securities. Approximately 80% of our pension plan assets relate to our U.S. plans. We use a market-related value method that recognizes each year’s asset gain or loss over a five-year period. Therefore, it takes five years for the gain or loss from any one year to be fully included in the other gains and losses calculation described below.

 

Other gains and losses resulting from actual experience differing from our assumptions and from changes in our assumptions are also determined at each measurement date. If this net accumulated gain or loss exceeds 10% of the greater of plan assets or liabilities, a portion of the net gain or loss is included in expense for the following year. The cost or benefit of plan changes which increase or decrease benefits for prior employee service (prior service cost) is included in expense on a straight-line basis over the average remaining service period of those expected to benefit, which is approximately 11 years for pension expense and approximately 13 years for retiree medical.

 

Weighted-average assumptions for pension and retiree medical expense are the following:

 

     2006

   2005

   2004

Pension

              

Expense discount rate

   5.6%    6.1%    6.1%

Expected rate of return on plan assets

   7.7%    7.8%    7.8%

Expected rate of compensation increases

   4.4%    4.3%    4.4%

Retiree medical

              

Expense discount rate

   5.7%    6.1%    6.1%

Current health care cost trend rate

   10.0%    11.0%    12.0%

 

Future Expense

 

An analysis of the estimated change in pension and retiree medical expense follows:

 

     Pension

   

Retiree

Medical


 

2005 expense

   $ 329     $ 135  

Decrease in discount rate

     84       6  

Increase in experience loss/(gain) amortization

     69       (3 )

Impact of contributions

     (63 )     —    

Other, including impact of 2003 Medicare Act

     (14 )     (12 )
    


 


2006 estimated expense

   $ 405     $ 126  
    


 


 

Our 2006 pension expense is estimated to be approximately $405 million and retiree medical expense is estimated to be approximately $126 million. These estimates incorporate the 2006 assumptions, as well as the impact of the increased pension plan assets resulting from our discretionary contributions of $729 million in 2005 and the impact of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (Medicare Act) as discussed in Note 7. Changes in our 2006 assumptions include updates to the lump sum discount rate for the U.S. plans and to the mortality tables for

 

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certain international plans. The estimated increase of $69 million in net experience loss amortization included in estimated 2006 pension expense primarily reflects the recognition of lower than expected returns and past asset losses, which account for approximately $36 million of the increase, as well as assumption changes and demographic experience, which account for approximately $20 million of the increase.

 

Pension service costs, measured at a fixed discount rate but including the effect of demographic assumption changes, as well as the effects of gains and losses due to demographics, are reflected in division results. The effect of changes in discount and asset return rates, gains and losses other than those due to demographics, and the impact of funding are reflected in corporate unallocated expenses. Approximately $26 million of the increased pension and retiree medical expense in 2006 will be reflected in corporate unallocated expenses.

 

Based on our current assumptions which reflect our prior experience, current plan provisions, and expectations for future experience, and assuming the Board approves annual discretionary contributions of approximately $200 million, we expect our pension expense to remain relatively flat in 2007. In 2008, we expect our pension expense to begin to decline, with the expense dropping to approximately $305 million by 2011 as unrecognized experience losses are amortized. If our assumptions and our plan provisions for retiree medical remain unchanged and our experience mirrors these assumptions, we expect our annual retiree medical expense beyond 2006 to approximate $130 million.

 

Sensitivity of Assumptions

 

A decrease in the discount rate or in the expected rate of return assumptions would increase pension expense. The estimated impact of a 25 basis point decrease in the discount rate on 2006 pension expense is an increase of approximately $39 million. The estimated impact on 2006 pension expense of a 25 basis point decrease in the expected rate of return assumption is an increase of approximately $16 million. See Note 7 regarding the sensitivity of our retiree medical cost assumptions.

 

Future Funding

 

We make contributions to pension trusts maintained to provide plan benefits for certain pension plans. These contributions are made in accordance with applicable tax regulations that provide for current tax deductions for our contributions, and taxation to the employee only upon receipt of plan benefits. Generally, we do not fund our pension plans when our contributions would not be currently deductible.

 

Our pension contributions for 2005 were $803 million, of which $729 million was discretionary. In 2006, we expect contributions to be about $250 million with approximately $200 million expected to be discretionary. Our cash payments for retiree medical are estimated to be $85 million in 2006. As our retiree medical plans are not subject to regulatory funding requirements, we fund these plans on a pay-as-you-go basis.

 

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For estimated future benefit payments, including our pay-as-you-go payments as well as those from trusts, see Note 7.

 

Recent Accounting Pronouncements

 

There have been no new accounting pronouncements issued or effective during 2005 that have had, or are expected to have, a material impact on our consolidated financial statements.

 

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OUR FINANCIAL RESULTS

 

Items Affecting Comparability

 

The year-over-year comparisons of our financial results are affected by the following items:

 

     2005

    2004

 

Net revenue

                

53rd week

   $ 418       —    

Operating profit

                

53rd week

   $ 75       —    

2005 restructuring charges

   $ (83 )     —    

2004 restructuring and impairment charges

     —       $ (150 )

Net income

                

AJCA tax charge

   $ (460 )     —    

53rd week

   $ 57       —    

2005 restructuring charges

   $ (55 )     —    

2004 restructuring and impairment charges

     —       $ (96 )

Net tax benefits – continuing operations

     —       $ 266  

Tax benefit from discontinued operations

     —       $ 38  

Net income per common share diluted

                

AJCA tax charge

   $ (0.27 )     —    

53rd week

   $ 0.03       —    

2005 restructuring charges

   $ (0.03 )     —    

2004 restructuring and impairment charges

     —       $ (0.06 )

Net tax benefits – continuing operations

     —       $ 0.15  

Tax benefit from discontinued operations

     —       $ 0.02  

 

For the items and accounting changes affecting our 2003 results, see Note 1 and our 2003 Annual Report.

 

53rd week

 

In 2005, we had an additional week of results (53rd week). Our fiscal year ends on the last Saturday of each December, resulting in an additional week of results every five or six years.

 

2005 Restructuring Charges

 

In the fourth quarter of 2005, we incurred restructuring charges of $83 million to reduce costs in our operations, principally through headcount reductions.

 

2004 Restructuring and Impairment Charges

 

In the fourth quarter of 2004, we incurred restructuring and impairment charges of $150 million in conjunction with the consolidation of FLNA’s manufacturing network in

 

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connection with its ongoing productivity program. Savings from this productivity program have been used to offset increased marketplace spending.

 

AJCA Tax Charge

 

As approved by our Board of Directors in July 2005, in the fourth quarter of 2005 we repatriated approximately $7.5 billion in earnings previously considered indefinitely reinvested outside the U.S. in connection with the AJCA. In 2005, we recorded income tax expense of $460 million associated with this repatriation.

 

Net Tax Benefits – Continuing Operations

 

In the fourth quarter of 2004, we recognized $45 million of tax benefits related to the completion of the U.S. Internal Revenue Service (IRS) audit for pre-merger Quaker open tax years. In the third quarter of 2004, we recognized $221 million of tax benefits related to a reduction in foreign tax accruals following the resolution of certain open tax issues with foreign tax authorities, and a refund claim related to prior U.S. tax settlements.

 

Tax Benefit from Discontinued Operations

 

In the fourth quarter of 2004, we reached agreement with the IRS for an open issue related to our discontinued restaurant operations which resulted in a tax benefit of $38 million.

 

Results of Continuing Operations – Consolidated Review

 

In the discussions of net revenue and operating profit below, effective net pricing reflects the year-over-year impact of discrete pricing actions, sales incentive activities and mix resulting from selling varying products in different package sizes and in different countries.

 

Servings

 

Since our divisions each use different measures of physical unit volume (i.e., kilos, pounds and case sales), a common servings metric is necessary to reflect our consolidated physical unit volume. Our divisions’ physical volume measures are converted into servings based on U.S. Food and Drug Administration guidelines for single-serving sizes of our products.

 

Total servings increased 7% in 2005 compared to 2004 as servings for beverages worldwide grew over 7% and servings for snacks worldwide grew 6%. All of our divisions positively contributed to the total servings growth. Total servings increased 6% in 2004 compared to 2003 as servings for beverages worldwide grew 7% and servings for snacks worldwide grew over 5%.

 

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Net Revenue and Operating Profit

 

                       Change

 
     2005

    2004

    2003

    2005

    2004

 

Division net revenues

   $ 32,562     $ 29,261     $ 26,969     11 %   8 %

Divested businesses

     —         —         2              
    


 


 


           

Total net revenue

   $ 32,562     $ 29,261     $ 26,971     11 %   8 %
    


 


 


           

Division operating profit

   $ 6,710     $ 6,098     $ 5,463     10 %   12 %

Corporate unallocated

     (788 )     (689 )     (502 )   14 %   38 %

Merger-related costs

     —         —         (59 )            

Impairment and restructuring charges

     —         (150 )     (147 )            

Divested businesses

     —         —         26              
    


 


 


           

Total operating profit

   $ 5,922     $ 5,259     $ 4,781     13 %   10 %
    


 


 


           

Division operating profit margin

     20.6 %     20.8 %     20.3 %   (0.2 )   0.5  

Total operating profit margin

     18.2 %     18.0 %     17.7 %   0.2     0.3  

 

2005

 

Net revenue increased 11% reflecting, across all divisions, increased volume, favorable effective net pricing, and net favorable foreign currency movements. The volume gains contributed 6 percentage points, the effective net pricing contributed 3 percentage points and the net favorable foreign currency movements contributed over 1 percentage point. The 53rd week contributed over 1 percentage point to revenue growth and almost 1 percentage point to volume growth.

 

Total operating profit increased 13% and margin increased 0.2 percentage points. Division operating profit increased 10% and margin decreased 0.2 percentage points. The operating profit gains primarily reflect leverage from the revenue growth, partially offset by higher selling and distribution (S&D) expenses and increased cost of sales, largely due to higher raw materials, energy, and S&D labor costs, as well as higher advertising and marketing expenses. In 2005, division operating profit margin reflects our current year restructuring actions, while total operating profit margin benefited from a favorable comparison to prior year restructuring and impairment charges. The additional week in 2005 contributed over 1 percentage point to both total and division operating profit growth.

 

2004

 

Division net revenue increased 8%, primarily due to strong volume gains across all divisions, favorable product mix, primarily at PBNA and PI, and net favorable foreign currency movements. The volume gains contributed over 4 percentage points, the

 

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favorable mix contributed almost 2 percentage points, and the net favorable foreign currency contributed almost 2 percentage points to division net revenue growth.

 

Total operating profit increased 10% and margin increased 0.3 percentage points. Division operating profit increased 12% and division margin increased 0.5 percentage points. These gains reflect leverage from the revenue growth, partially offset by increased selling, general and administrative expenses, primarily corporate unallocated expenses. In addition, total operating profit growth reflects the absence of merger-related costs in 2004.

 

Corporate Unallocated Expenses

 

Corporate unallocated expenses include the costs of our corporate headquarters, centrally managed initiatives such as our BPT initiative, unallocated insurance and benefit programs, foreign exchange transaction and certain commodity derivative gains and losses, as well as profit-in-inventory elimination adjustments for our noncontrolled bottling affiliates and certain other items.

 

In 2005, corporate unallocated expenses increased 14%. This increase primarily reflects higher costs associated with our BPT initiative which contributed 7 percentage points, increased support behind health and wellness and innovation initiatives which contributed 5 percentage points, and Corporate departmental expenses and restructuring charges which each contributed 2 percentage points to the increase. In 2005, items of a non-recurring nature included charges of $55 million to conform our method of accounting across all divisions, primarily for warehouse and freight costs, and a gain of $25 million in connection with the settlement of a class action lawsuit related to our purchases of high fructose corn syrup from 1991 to 1995. In 2004, we recorded a charge of $50 million for the settlement of a contractual dispute with a former business partner.

 

In 2004, corporate unallocated expenses increased 38%. Higher employee-related costs contributed 18 percentage points of the increase, an accrual recognized in the fourth quarter for the settlement of a contractual dispute with a former business partner represented 10 percentage points of the increase and higher costs related to our BPT initiative contributed 4 percentage points of the increase. Corporate departmental expenses increased 2% compared to prior year.

 

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Other Consolidated Results

 

                 Change

 
     2005

    2004

    2003

    2005

    2004

 

Bottling equity income

   $ 557     $ 380     $ 323     46 %   18 %

Interest expense, net

   $ (97 )   $ (93 )   $ (112 )   4 %   (17 )%

Annual tax rate

     36.1 %     24.7 %     28.5 %            

Net income – continuing operations

   $ 4,078     $ 4,174     $ 3,568     (2 )%   17 %

Net income per common share – continuing operations – diluted

   $ 2.39     $ 2.41     $ 2.05     (1 )%   18 %

 

Bottling equity income includes our share of the net income or loss of our noncontrolled bottling affiliates as described in “ Our Customers.” Our interest in these bottling investments may change from time to time. Any gains or losses from these changes, as well as other transactions related to our bottling investments, are also included on a pre-tax basis. We continue to sell shares of PBG stock to trim our ownership to the level at the time of PBG’s initial public offering, since our ownership has increased as a result of PBG’s share repurchase program. During 2005, we sold 7.5 million shares of PBG stock. The resulting lower ownership percentage reduces the equity income from PBG that we recognize.

 

2005

 

Bottling equity income increased 46% reflecting $126 million of pre-tax gains on our sales of PBG stock, as well as stronger bottler results. In the first quarter of 2006, PBG and PAS adopted SFAS 123R which will negatively impact our bottling equity income.

 

Net interest expense increased 4% reflecting the impact of higher debt levels, substantially offset by higher investment rates and cash balances.

 

The tax rate increased 11.4 percentage points reflecting the $460 million tax charge related to our repatriation of undistributed international earnings, as well as the absence of income tax benefits of $266 million recorded in the prior year related to a reduction in foreign tax accruals following the resolution of certain open tax items with foreign tax authorities and a refund claim related to prior U.S. tax settlements. This increase was partially offset by increased international profit which is taxed at a lower rate.

 

Net income from continuing operations decreased 2% and the related net income per common share from continuing operations decreased 1%. These decreases reflect the impact of the tax items discussed above, partially offset by our operating profit growth, increased bottling equity income, which includes the gain on our PBG stock sale, the

 

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impact of the 53rd week, a favorable comparison to prior year restructuring and impairment charges, and for net income per share, the impact of our share repurchases.

 

2004

 

Bottling equity income increased 18%, primarily reflecting increased earnings from our anchor bottlers and favorable comparisons from international bottling investments, primarily as a result of the nationwide strike in Venezuela in early 2003.

 

Net interest expense declined 17% primarily due to favorable interest rates and higher average cash balances, partially offset by higher average debt balances and lower gains in the market value of investments used to economically hedge a portion of our deferred compensation liability. The offsetting increase in deferred compensation costs is reported in corporate unallocated expenses.

 

The annual tax rate decreased 3.8 percentage points compared to the prior year, primarily as a result of tax benefits from the resolution of open items with tax authorities in both years, as discussed in “Items Affecting Comparability.” The tax benefits reduced our tax rate by 2.6 percentage points. Increased benefit from concentrate operations and favorable changes arising from agreements with the IRS in the fourth quarter of 2003 also contributed to the decline in rate.

 

Net income from continuing operations increased 17% and the related net income per common share from continuing operations increased 18%. These increases primarily reflect the solid operating profit growth and our lower annual tax rate. The absence of merger-related costs in 2004 and increased bottling equity income also contributed to the growth.

 

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Results of Continuing Operations – Division Review

 

The results and discussions below are based on how our Chief Executive Officer monitors the performance of our divisions. Prior year amounts exclude the results of divested businesses. For additional information on these items and our divisions, see Note 1.

 

     FLNA

    PBNA

    PI

    QFNA

    Total

 

Net Revenue, 2005

   $ 10,322     $ 9,146     $ 11,376     $ 1,718     $ 32,562  

Net Revenue, 2004

   $ 9,560     $ 8,313     $ 9,862     $ 1,526     $ 29,261  

% Impact of:

                                        

Volume

     4.5 %     4 %(a)     8 %(a)     9 %     6 %

Effective net pricing

     3       5       2.5       3       3  

Foreign exchange

     0.5       —         3       1       1  

Acquisition/divestitures

     —         —         2       —         0.5  

% Change(b)

     8 %     10 %     15 %     13 %     11 %

 

     FLNA

    PBNA

    PI

    QFNA

    Divested
Businesses


   Total

 

Net Revenue, 2004

   $ 9,560     $ 8,313     $ 9,862     $ 1,526       —      $ 29,261  

Net Revenue, 2003

   $ 9,091     $ 7,733     $ 8,678     $ 1,467     $ 2    $ 26,971  

% Impact of:

                                               

Volume

     3 %     3 %(a)     7 %(a)     3 %     —        4 %

Effective net pricing

     2       4       2       —         —        2  

Foreign exchange

     —         —         4       1       —        2  

Acquisition/divestitures

     —         —         1       —         —        —    

% Change(b)

     5 %     7 %     14 %     4 %     N/A      8 %

 

(a)

For beverages sold to our bottlers, net revenue volume growth is based on our concentrate shipments and equivalents.

(b)

Amounts may not sum due to rounding.

 

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Frito-Lay North America

 

                    % Change

     2005

   2004

   2003

   2005

   2004

Net revenue

   $ 10,322    $ 9,560    $ 9,091    8    5

Operating profit

   $ 2,529    $ 2,389    $ 2,242    6    7

 

2005

 

Net revenue grew 8% reflecting volume growth of 4.5% and positive effective net pricing driven by salty snack pricing actions and favorable mix on both salty and convenience foods products. Pound volume grew primarily due to mid single-digit growth in trademark Lay’s potato chips, high single-digit growth in salty trademark Tostitos, double-digit growth in Santitas, mid single-digit growth in trademark Cheetos, high single-digit growth in Dips and Fritos, and double-digit growth in Sun Chips. These gains were partially offset by the discontinuance of Toastables and Doritos Rollitos. Overall, salty snacks revenue grew 8% with volume growth of 5%, and convenience foods products revenue grew 13% with volume growth of 1%. Convenience foods products revenue benefited from favorable mix. The additional week contributed 2 percentage points to volume and net revenue growth.

 

Operating profit grew 6% reflecting positive effective net pricing actions and volume growth. This growth was offset by higher S&D costs resulting from increased labor and benefit charges and fuel costs; higher cost of sales, driven by raw materials, natural gas and freight; and increased advertising and marketing costs. Operating profit was also negatively impacted by more than 1 percentage point as a result of fourth quarter charges to reduce costs in our operations, principally through headcount reductions. The additional week contributed 2 percentage points to operating profit growth.

 

Products qualifying for our new Smart Spot program represented approximately 13% of net revenue. These products experienced double-digit revenue growth, while the balance of the portfolio had high single-digit revenue growth. See our website at www.smartspot.com for additional information on our Smart Spot program.

 

2004

 

Net revenue grew 5% reflecting volume growth of 3% and positive effective net pricing due to salty snack pricing actions and favorable mix. Pound volume grew primarily due to new products, single-digit growth in Lay’s Classic potato chips, strong double-digit growth in Variety Pack and mid single-digit growth in Tostitos and Fried Cheetos. Lay’s Stax and Doritos Rollitos led the new product growth. These gains were partially offset by single-digit declines in Doritos and Fritos and double-digit declines in Rold Gold and Quaker Toastables.

 

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Operating profit grew nearly 7% reflecting the positive pricing actions and volume growth. Higher commodity costs, driven by corn oil and energy costs were largely offset by cost leverage generated from ongoing productivity initiatives.

 

Smart Spot eligible products represented approximately 10% of 2004 FLNA net revenue. These products experienced high single-digit revenue growth and the balance of the portfolio had mid single-digit revenue growth.

 

PepsiCo Beverages North America

 

                    % Change

     2005

   2004

   2003

   2005

   2004

Net revenue

   $ 9,146    $ 8,313    $ 7,733    10    7

Operating profit

   $ 2,037    $ 1,911    $ 1,690    7    13

 

2005

 

Net revenue grew 10% and volume grew 4%. The volume increase was driven by a 16% increase in non-carbonated beverages, partially offset by a 1% decline in CSDs. Within non-carbonated beverages, Gatorade, Trademark Aquafina, Tropicana juice drinks, Propel and SoBe all experienced double-digit growth. Above average summer temperatures across the country, as well as the launch of new products such as Aquafina FlavorSplash and Gatorade Lemonade earlier in the year, drove Gatorade and Trademark Aquafina growth. Tropicana Pure Premium experienced a low single-digit decline resulting from price increases taken in the first quarter. The decline in CSDs reflects low single-digit declines in Trademark Pepsi and Trademark Mountain Dew, slightly offset by low single-digit growth in Sierra Mist. Across the brands, a low single-digit decline in regular CSDs was partially offset by low single-digit growth in diet CSDs. The additional week in 2005 had no significant impact on volume growth as bottler volume is reported based on a calendar month.

 

Net revenue also benefited from 5 percentage points of favorable effective net pricing, reflecting the continued migration from CSDs to non-carbonated beverages and price increases taken in the first quarter, primarily on concentrate and Tropicana Pure Premium, partially offset by increased trade spending in the current year. The additional week in 2005 contributed 1 percentage point to net revenue growth.

 

Operating profit increased nearly 7%, primarily reflecting net revenue growth. This increase was partially offset by higher raw material, energy, and transportation costs, as well as increased advertising and marketing expenses. The additional week in 2005 contributed 1 percentage point to operating profit growth and was fully offset by a 1 percentage point decline related to charges taken in the fourth quarter of 2005 to reduce costs in our operations, principally through headcount reductions.

 

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Smart Spot eligible products represented almost 70% of net revenue. These products experienced double-digit revenue growth, while the balance of the portfolio grew in the low single-digit range.

 

2004

 

Net revenue increased 7% and volume increased 3%. The volume increase reflects non-carbonated beverage growth of 10% and a slight increase in CSDs. The non-carbonated beverage growth was fueled by double-digit growth in Gatorade, Aquafina and Propel, as well as the introduction of bottler-distributed Tropicana juice drinks. Tropicana Pure Premium increased slightly for the year. The carbonated soft drink performance reflects a low single-digit increase in Trademark Mountain Dew and a slight increase in Trademark Sierra Mist, offset by a slight decline in Trademark Pepsi. Across the trademarks, high single-digit diet CSD growth was substantially offset by a low single-digit decline in regular CSDs. The increase in Trademark Mountain Dew reflects growth in both Diet and regular Mountain Dew and the limited time only offering of Mountain Dew Pitch Black, substantially offset by declines in both Mountain Dew Code Red and LiveWire. The performance of Trademark Pepsi reflects declines in regular Pepsi, Pepsi Twist and Pepsi Blue, mostly offset by increases in Diet Pepsi and the introduction of Pepsi Edge. Favorable product mix contributed 3 percentage points to net revenue growth, primarily reflecting a migration to non-carbonated beverages. Additionally, concentrate and fountain price increases taken in the first quarter contributed 1 percentage point to net revenue growth.

 

Operating profit increased 13% reflecting the net revenue growth, partially offset by higher selling, general and administrative costs, as well as costs related to marketplace initiatives.

 

Smart Spot eligible products represented over 60% of net revenue. These products experienced high single-digit revenue growth, and the balance of the portfolio had mid single-digit revenue growth.

 

PepsiCo International

 

                    % Change

     2005

   2004

   2003

   2005

   2004

Net revenue

   $ 11,376    $ 9,862    $ 8,678    15    14

Operating profit

   $ 1,607    $ 1,323    $ 1,061    21    25

 

2005

 

International snacks volume grew 7%, reflecting growth of 11% in the Europe, Middle East & Africa region, 5% in the Latin America region and 6% in the Asia Pacific region. Acquisition and divestiture activity, principally the divestiture last year of our interest in a South Korea joint venture, reduced Asia region volume by 11 percentage points. The

 

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acquisition of a business in Romania late in 2004 increased the Europe, Middle East & Africa region volume growth by 3 percentage points. Cumulatively, our divestiture and acquisition activities did not impact the reported total PepsiCo International snack volume growth rate. The overall gains reflected mid single-digit growth at Sabritas in Mexico, double-digit growth in India, Turkey, Russia, Australia and China, partially offset by a low single-digit decline at Walkers in the United Kingdom. The decline at Walkers is due principally to marketplace pressures. The additional week contributed 1 percentage point to international snack volume growth.

 

Beverage volume grew 11%, reflecting growth of 14% in the Europe, Middle East & Africa region, 11% in the Asia Pacific region and 6% in the Latin America region. Acquisitions had no significant impact on the reported total PepsiCo International beverage volume growth rate. Broad-based increases were led by double-digit growth in the Middle East, China, Argentina, Venezuela and Russia. Carbonated soft drinks and non-carbonated beverages both grew at a double-digit rate. The additional week had no impact on beverage volume growth as volume is reported based on a calendar month.

 

Net revenue grew 15%, primarily as a result of the broad-based volume growth and favorable effective net pricing. Foreign currency contributed almost 3 percentage points of growth reflecting the favorable Mexican peso and Brazilian real, partially offset by the unfavorable British pound. Acquisitions and divestitures contributed almost 2 percentage points of growth. The additional week contributed 1 percentage point to revenue growth. Cumulatively, the impact of foreign currency, acquisitions and divestitures, and the additional week on net revenue was 5 percentage points.

 

Operating profit grew 21% driven largely by the broad-based volume growth and favorable effective net pricing, partially offset by increased energy and raw material costs. Foreign currency contributed 4 percentage points of growth based on the favorable Mexican peso and Brazilian real. The net favorable impact from acquisition and divestiture activity, primarily the acquisition of General Mills’ minority interest in Snack Ventures Europe in Q1 2005, contributed 2 percentage points of growth. The additional week contributed 1 percentage point to operating profit growth which was fully offset by a 1 percentage point decline in operating profit growth related to fourth quarter charges to reduce costs in our operations and rationalize capacity.

 

2004

 

International snacks volume grew 8%, comprised of 7% in our Latin America region, 8% in our Europe, Middle East & Africa region and 14% in our Asia Pacific region. These gains were driven by high single-digit growth at Sabritas in Mexico, strong double-digit growth in India, low single-digit growth at Gamesa in Mexico coupled with double-digit growth in Egypt, Venezuela, Turkey and Brazil.

 

Beverage volume grew 12%, comprised of 14% in our Europe, Middle East & Africa region, 15% in our Asia Pacific region and 8% in our Latin America region. Broad-based increases were led by double-digit growth in the Middle East and China, high single-digit growth in Mexico and double-digit growth in India, Germany, Russia and Venezuela.

 

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Favorable comparisons as a result of the 2003 national strike in Venezuela and the German deposit law impact contributed to the growth in Venezuela and Germany. Both carbonated soft drinks and non-carbonated beverages grew at double-digit rates.

 

Net revenue grew 14% driven by the broad-based volume growth and favorable mix. Foreign currency impact contributed 4 percentage points of growth driven by the favorable British pound and euro, partially offset by the unfavorable Mexican peso. Acquisitions contributed less than 1 percentage point.

 

Operating profit grew 25% driven largely by the volume and favorable mix. The favorable comparison of certain reserve actions taken in 2003 on potentially unrecoverable beverage assets contributed 2 percentage points of growth. Foreign currency impact contributed almost 3 percentage points of growth driven by the favorable British pound and euro, partially offset by the unfavorable Mexican peso.

 

Quaker Foods North America

 

                    % Change

     2005

   2004

   2003

   2005

   2004

Net revenue

   $ 1,718    $ 1,526    $ 1,467    13    4

Operating profit

   $ 537    $ 475    $ 470    13    1

 

2005

 

Net revenue increased 13% and volume increased 9%. The volume increase reflects double-digit growth in Oatmeal, Aunt Jemima syrup and mix, Rice-A-Roni and Pasta Roni, as well as high single-digit growth in Cap’n Crunch cereal and mid single-digit growth in Life cereal. Higher effective net pricing contributed nearly 3 percentage points of growth reflecting favorable product mix, the settlement of prior year trade spending accruals and price increases on ready-to-eat cereals taken in the third quarter of 2004. Favorable Canadian exchange rates contributed nearly 1 percentage point to net revenue growth. The additional week in 2005 contributed approximately 2 percentage points to both net revenue and volume growth.

 

Operating profit increased 13% reflecting the net revenue growth. This growth was partially offset by higher advertising and marketing costs behind programs for core brands and innovation, as well as an unfavorable cost of sales comparison primarily due to higher energy and raw materials costs in the latter part of 2005. The additional week in 2005 contributed approximately 2 percentage points to operating profit growth.

 

Smart Spot eligible products represented approximately half of net revenue and had double-digit revenue growth. The balance of the portfolio also experienced double-digit revenue growth.

 

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2004

 

Net revenue increased 4% and volume increased 3%. The volume increase reflects high single-digit growth in Oatmeal and double-digit growth in Life cereal, partially offset by a mid single-digit decline in Cap’n Crunch cereal. The Life cereal growth was led by the introduction of Honey Graham Life. Favorable product mix, reflecting growth in higher revenue per pound brands, was offset by promotional spending behind new products. Favorable Canadian exchange rates contributed 1 percentage point to net revenue growth.

 

Operating profit increased 1% reflecting the net revenue growth, substantially offset by an unfavorable cost of sales comparison and higher advertising and marketing costs.

 

Smart Spot eligible products represented approximately half of net revenue and had high single-digit revenue growth. The balance of the portfolio was flat.

 

Our Liquidity, Capital Resources and Financial Position

 

Our strong cash-generating capability and financial condition give us ready access to capital markets throughout the world. Our principal source of liquidity is our operating cash flow. This cash-generating capability is one of our fundamental strengths and provides us with substantial financial flexibility in meeting operating, investing and financing needs. In addition, we have revolving credit facilities that are further discussed in Note 9. Our cash provided from operating activities is somewhat impacted by seasonality. Working capital needs are impacted by weekly sales, which are generally highest in the third quarter due to seasonal and holiday-related sales patterns, and generally lowest in the first quarter.

 

Operating Activities

 

In 2005, our operations provided $5.9 billion of cash compared to $5.1 billion in the prior year. The increase reflects our solid business results, as well as lower taxes paid in the current year as 2004 tax payments included a $760 million tax payment related to our 2003 settlement with the IRS. This increase was partially offset by $803 million of pension plan contributions in the current year, of which $729 million was discretionary, compared to pension payments of $458 million in the prior year, of which $400 million was discretionary.

 

Investing Activities

 

In 2005, we used $3.5 billion, primarily reflecting capital spending of $1.7 billion, acquisitions of $1.1 billion, primarily the $750 million acquisition of General Mills’ minority interest in Snack Ventures Europe, and net purchases of short-term investments of $1.0 billion. These amounts were partially offset by the proceeds from our sale of PBG stock of $214 million. In 2004, we used $2.3 billion for investing, primarily reflecting capital spending of $1.4 billion and short-term investments of almost $1.0 billion.

 

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In the first quarter of 2006, we completed our acquisition of Stacy’s Pita Chip Company which was funded with existing domestic cash. This acquisition will be included in the first quarter of 2006 as an investing activity in our Condensed Consolidated Statement of Cash Flows.

 

We anticipate net capital spending of approximately $2.2 billion in 2006, which is above our long-term target of approximately 5% of net revenue. Planned capital spending in 2006 includes increased investments in manufacturing capacity to support growth in our China snack and beverage operations and our North American Gatorade business, as well as increased investment in support of our ongoing BPT initiative. We expect capital spending to return to our long-term targeted rate following 2006.

 

Financing Activities

 

In 2005, we used $1.9 billion, primarily reflecting common share repurchases of $3.0 billion and dividend payments of $1.6 billion, partially offset by net proceeds from short-term borrowings of $1.8 billion and stock option proceeds of $1.1 billion. This compares to $2.3 billion used for financing in 2004, primarily reflecting share repurchases at a cost of $3.0 billion and dividend payments of $1.3 billion, partially offset by net issuances of short-term borrowings of $1.1 billion and proceeds from exercises of stock options of nearly $1.0 billion.

 

In 2004, our Board of Directors authorized a new $7.0 billion share repurchase program. Since inception of the new program, we have repurchased $5.1 billion of shares, leaving $1.9 billion of remaining authorization. We target an annual dividend payout of approximately 45% of prior year’s net income from continuing operations. Each spring we review our capital structure with our Board, including our dividend policy and share repurchase activity.

 

Management Operating Cash Flow

 

We focus on management operating cash flow as a key element in achieving maximum shareholder value, and it is the primary measure we use to monitor cash flow performance. However, it is not a measure provided by accounting principles generally accepted in the U.S. Since net capital spending is essential to our product innovation initiatives and maintaining our operational capabilities, we believe that it is a recurring and necessary use of cash. As such, we believe investors should also consider net capital spending when evaluating our cash from operating activities. The table below reconciles the net cash provided by operating activities as reflected in our Consolidated Statement of Cash Flows to our management operating cash flow.

 

     2005

    2004

    2003

 

Net cash provided by operating activities

   $ 5,852     $ 5,054     $ 4,328  

Capital spending

     (1,736 )     (1,387 )     (1,345 )

Sales of property, plant and equipment

     88       38       49  
    


 


 


Management operating cash flow

   $ 4,204     $ 3,705     $ 3,032  
    


 


 


 

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Management operating cash flow was used primarily to repurchase shares and pay dividends. We expect to continue to return approximately all of our management operating cash flow to our shareholders through dividends and share repurchases. However, see “ Risk Factors” in Item 1A. and “ Our Business Risks” for certain factors that may impact our operating cash flows.

 

Credit Ratings

 

Our debt ratings of Aa3 from Moody’s and A+ from Standard & Poor’s contribute to our ability to access global capital markets. We have maintained strong investment grade ratings for over a decade. Our Moody’s rating reflects an upgrade from A1 to Aa3 in 2004 due to the strength of our balance sheet and cash flows. Each rating is considered strong investment grade and is in the first quartile of their respective ranking systems. These ratings also reflect the impact of our anchor bottlers’ cash flows and debt.

 

Credit Facilities and Long-Term Contractual Commitments

 

See Note 9 for a description of our credit facilities and long-term contractual commitments.

 

Off-Balance Sheet Arrangements

 

It is not our business practice to enter into off-balance sheet arrangements, other than in the normal course of business, nor is it our policy to issue guarantees to our bottlers, noncontrolled affiliates or third parties. However, certain guarantees were necessary to facilitate the separation of our bottling and restaurant operations from us. As of year-end 2005, we believe it is remote that these guarantees would require any cash payment. See Note 9 for a description of our off-balance sheet arrangements.

 

Financial Position

 

Significant changes in our Consolidated Balance Sheet from December 25, 2004 to December 31, 2005 not discussed above were as follows:

 

   

Other assets increased primarily reflecting our increased pension contributions in the current year.

 

   

Income taxes payable increased primarily reflecting $460 million of taxes accrued related to our repatriation of international earnings in connection with the AJCA to be paid in the first quarter of 2006.

 

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OUR FINANCIAL RESULTS

 

Consolidated Statement of Income

 

PepsiCo, Inc. and Subsidiaries

Fiscal years ended December 31, 2005, December 25, 2004 and December 27, 2003

 

(in millions except per share amounts)                                    


   2005

    2004

    2003

 

Net Revenue

   $ 32,562     $ 29,261     $ 26,971  

Cost of sales

     14,176       12,674       11,691  

Selling, general and administrative expenses

     12,314       11,031       10,148  

Amortization of intangible assets

     150       147       145  

Restructuring and impairment charges

     —         150       147  

Merger-related costs

     —         —         59  
    


 


 


Operating Profit

     5,922       5,259       4,781  

Bottling equity income

     557       380       323  

Interest expense

     (256 )     (167 )     (163 )

Interest income

     159       74       51  
    


 


 


Income from Continuing Operations before Income Taxes

     6,382       5,546       4,992  

Provision for Income Taxes

     2,304       1,372       1,424  
    


 


 


Income from Continuing Operations

     4,078       4,174       3,568  

Tax Benefit from Discontinued Operations

     —         38       —    
    


 


 


Net Income

   $ 4,078     $ 4,212     $ 3,568  
    


 


 


Net Income per Common Share – Basic

                        

Continuing operations

   $ 2.43     $ 2.45     $ 2.07  

Discontinued operations

     —         0.02       —    
    


 


 


Total

   $ 2.43     $ 2.47     $ 2.07  
    


 


 


Net Income per Common Share – Diluted

                        

Continuing operations

   $ 2.39     $ 2.41     $ 2.05  

Discontinued operations

     —         0.02       —    
    


 


 


Total

   $ 2.39     $ 2.44 *   $ 2.05  
    


 


 


 

* Based on unrounded amounts.

 

See accompanying notes to consolidated financial statements.

 

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Consolidated Statement of Cash Flows

 

PepsiCo, Inc. and Subsidiaries

Fiscal years ended December 31, 2005, December 25, 2004 and December 27, 2003

 

(in millions)


   2005

    2004

    2003

 

Operating Activities

                        

Net income

   $ 4,078     $ 4,212     $ 3,568  

Adjustments to reconcile net income to net cash provided by operating activities

                        

Depreciation and amortization

     1,308       1,264       1,221  

Stock-based compensation expense

     311       368       407  

Restructuring and impairment charges

     —         150       147  

Cash payments for merger-related costs and restructuring charges

     (22 )     (92 )     (109 )

Tax benefit from discontinued operations

     —         (38 )     —    

Pension and retiree medical plan contributions

     (877 )     (534 )     (605 )

Pension and retiree medical plan expenses

     464       395       277  

Bottling equity income, net of dividends

     (411 )     (297 )     (276 )

Deferred income taxes and other tax charges and credits

     440       (203 )     (286 )

Merger-related costs

     —         —         59  

Other non-cash charges and credits, net

     145       166       101  

Changes in operating working capital, excluding effects of acquisitions and divestitures

                        

Accounts and notes receivable

     (272 )     (130 )     (220 )

Inventories

     (132 )     (100 )     (49 )

Prepaid expenses and other current assets

     (56 )     (31 )     23  

Accounts payable and other current liabilities

     188       216       (11 )

Income taxes payable

     609       (268 )     182  
    


 


 


Net change in operating working capital

     337       (313 )     (75 )

Other

     79       (24 )     (101 )
    


 


 


Net Cash Provided by Operating Activities

     5,852       5,054       4,328  
    


 


 


Investing Activities

                        

Snack Ventures Europe (SVE) minority interest acquisition

     (750 )     —         —    

Capital spending

     (1,736 )     (1,387 )     (1,345 )

Sales of property, plant and equipment

     88       38       49  

Other acquisitions and investments in noncontrolled affiliates

     (345 )     (64 )     (71 )

Cash proceeds from sale of PBG stock

     214       —         —    

Divestitures

     3       52       46  

Short-term investments, by original maturity

                        

More than three months – purchases

     (83 )     (44 )     (38 )

More than three months – maturities

     84       38       28  

Three months or less, net

     (992 )     (963 )     (940 )
    


 


 


Net Cash Used for Investing Activities

     (3,517 )     (2,330 )     (2,271 )
    


 


 


 

(Continued on following page)

 

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Consolidated Statement of Cash Flows (continued)

 

PepsiCo, Inc. and Subsidiaries

Fiscal years ended December 31, 2005, December 25, 2004 and December 27, 2003

 

(in millions)


   2005

    2004

    2003

 

Financing Activities

                        

Proceeds from issuances of long-term debt

   $ 25     $ 504     $ 52  

Payments of long-term debt

     (177 )     (512 )     (641 )

Short-term borrowings, by original maturity

                        

More than three months – proceeds

     332       153       88  

More than three months – payments

     (85 )     (160 )     (115 )

Three months or less, net

     1,601       1,119       40  

Cash dividends paid

     (1,642 )     (1,329 )     (1,070 )

Share repurchases – common

     (3,012 )     (3,028 )     (1,929 )

Share repurchases – preferred

     (19 )     (27 )     (16 )

Proceeds from exercises of stock options

     1,099       965       689  
    


 


 


Net Cash Used for Financing Activities

     (1,878 )     (2,315 )     (2,902 )
    


 


 


Effect of exchange rate changes on cash and cash equivalents

     (21 )     51       27  
    


 


 


Net Increase/(Decrease) in Cash and Cash Equivalents

     436       460       (818 )

Cash and Cash Equivalents, Beginning of Year

     1,280       820       1,638  
    


 


 


Cash and Cash Equivalents, End of Year

   $ 1,716     $ 1,280     $ 820  
    


 


 


 

See accompanying notes to consolidated financial statements.

 

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Consolidated Balance Sheet

 

PepsiCo, Inc. and Subsidiaries

December 31, 2005 and December 25, 2004

 

(in millions except per share amounts)


   2005

    2004

 

ASSETS

                

Current Assets

                

Cash and cash equivalents

   $ 1,716     $ 1,280  

Short-term investments

     3,166       2,165  
    


 


       4,882       3,445  

Accounts and notes receivable, net

     3,261       2,999  

Inventories

     1,693       1,541  

Prepaid expenses and other current assets

     618       654  
    


 


Total Current Assets

     10,454       8,639  
                  

Property, Plant and Equipment, net

     8,681       8,149  

Amortizable Intangible Assets, net

     530       598  
                  

Goodwill

     4,088       3,909  

Other nonamortizable intangible assets

     1,086       933  
    


 


Nonamortizable Intangible Assets

     5,174       4,842  

Investments in Noncontrolled Affiliates

     3,485       3,284  

Other Assets

     3,403       2,475  
    


 


Total Assets

   $ 31,727     $ 27,987  
    


 


LIABILITIES AND SHAREHOLDERS’ EQUITY

                

Current Liabilities

                

Short-term obligations

   $ 2,889     $ 1,054  

Accounts payable and other current liabilities

     5,971       5,599  

Income taxes payable

     546       99  
    


 


Total Current Liabilities

     9,406       6,752  
                  

Long-Term Debt Obligations

     2,313       2,397  

Other Liabilities

     4,323       4,099  

Deferred Income Taxes

     1,434       1,216  
    


 


Total Liabilities

     17,476       14,464  

Commitments and Contingencies

                

Preferred Stock, no par value

     41       41  

Repurchased Preferred Stock

     (110 )     (90 )

Common Shareholders’ Equity

                

Common stock, par value 1 2/3¢ per share (issued 1,782 shares)

     30       30  

Capital in excess of par value

     614       618  

Retained earnings

     21,116       18,730  

Accumulated other comprehensive loss

     (1,053 )     (886 )
    


 


       20,707       18,492  

Less: repurchased common stock, at cost (126 and 103 shares, respectively)

     (6,387 )     (4,920 )
    


 


Total Common Shareholders’ Equity

     14,320       13,572  
    


 


Total Liabilities and Shareholders’ Equity

   $ 31,727     $ 27,987  
    


 


 

See accompanying notes to consolidated financial statements.

 

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Consolidated Statement of Common Shareholders’ Equity

 

PepsiCo, Inc. and Subsidiaries

Fiscal years ended December 31, 2005, December 25, 2004 and December 27, 2003

 

(in millions)


   2005

    2004

    2003

 
   Shares

    Amount

    Shares

    Amount

    Shares

    Amount

 

Common Stock

   1,782     $ 30     1,782     $ 30     1,782     $ 30  
    

 


 

 


 

 


Capital in Excess of Par Value

                                          

Balance, beginning of year

           618             548             207  

Stock-based compensation expense

           311             368             407  

Stock option exercises (a)

           (315 )           (298 )           (66 )
          


       


       


Balance, end of year

           614             618             548  
          


       


       


Retained Earnings

                                          

Balance, beginning of year

           18,730             15,961             13,489  

Net income

           4,078             4,212             3,568  

Cash dividends declared – common

           (1,684 )           (1,438 )           (1,082 )

Cash dividends declared – preferred

           (3 )           (3 )           (3 )

Cash dividends declared – RSUs

           (5 )           (2 )           —    

Other

           —               —               (11 )
          


       


       


Balance, end of year

           21,116             18,730             15,961  
          


       


       


Accumulated Other Comprehensive Loss

                                          

Balance, beginning of year

           (886 )           (1,267 )           (1,672 )

Currency translation adjustment

           (251 )           401             410  

Cash flow hedges, net of tax:

                                          

Net derivative gains/(losses)

           54             (16 )           (11 )

Reclassification of (gains)/losses to net income

           (8 )           9             (1 )

Minimum pension liability adjustment, net of tax

           16             (19 )           7  

Unrealized gain on securities, net of tax

           24             6             1  

Other

           (2 )           —               (1 )
          


       


       


Balance, end of year

           (1,053 )           (886 )           (1,267 )
          


       


       


Repurchased Common Stock

                                          

Balance, beginning of year

   (103 )     (4,920 )   (77 )     (3,376 )   (60 )     (2,524 )

Share repurchases

   (54 )     (2,995 )   (58 )     (2,994 )   (43 )     (1,946 )

Stock option exercises

   31       1,523     32       1,434     26       1,096  

Other

   —         5     —         16     —         (2 )
    

 


 

 


 

 


Balance, end of year

   (126 )     (6,387 )   (103 )     (4,920 )   (77 )     (3,376 )
    

 


 

 


 

 


Total Common Shareholders’ Equity

         $ 14,320           $ 13,572           $ 11,896  
          


       


       


           2005

          2004

          2003

 

Comprehensive Income

                                          

Net Income

         $ 4,078           $ 4,212           $ 3,568  

Currency translation adjustment

           (251 )           401             410  

Cash flow hedges, net of tax

           46             (7 )           (12 )

Minimum pension liability adjustment, net of tax

           16             (19 )           7  

Unrealized gain on securities, net of tax

           24             6             1  

Other

           (2 )           —               (1 )
          


       


       


Total Comprehensive Income

         $ 3,911           $ 4,593           $ 3,973  
          


       


       


 

(a)

Includes total tax benefit of $125 million in 2005, $183 million in 2004 and $340 million in 2003.

 

See accompanying notes to consolidated financial statements.

 

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Notes to Consolidated Financial Statements

 

Note 1 — Basis of Presentation and Our Divisions

 

Basis of Presentation

 

Our financial statements include the consolidated accounts of PepsiCo, Inc. and the affiliates that we control. In addition, we include our share of the results of certain other affiliates based on our economic ownership interest. We do not control these other affiliates, as our ownership in these other affiliates is generally less than 50%. Our share of the net income of noncontrolled bottling affiliates is reported in our income statement as bottling equity income. Bottling equity income also includes any changes in our ownership interests of these affiliates. In 2005, bottling equity income includes $126 million of pre-tax gains on our sales of PBG stock. See Note 8 for additional information on our noncontrolled bottling affiliates. Our share of other noncontrolled affiliates is included in division operating profit. Intercompany balances and transactions are eliminated. In 2005, we had an additional week of results (53rd week). Our fiscal year ends on the last Saturday of each December, resulting in an additional week of results every five or six years.

 

In connection with our ongoing BPT initiative, we aligned certain accounting policies across our divisions in 2005. We conformed our methodology for calculating our bad debt reserves and modified our policy for recognizing revenue for products shipped to customers by third-party carriers. Additionally, we conformed our method of accounting for certain costs, primarily warehouse and freight. These changes reduced our net revenue by $36 million and our operating profit by $60 million in 2005. We also made certain reclassifications on our Consolidated Statement of Income in the fourth quarter of 2005 from cost of sales to selling, general and administrative expenses in connection with our BPT initiative. These reclassifications resulted in reductions to cost of sales of $556 million through the third quarter of 2005, $732 million in the full year 2004 and $688 million in the full year 2003, with corresponding increases to selling, general and administrative expenses in those periods. These reclassifications had no net impact on operating profit and have been made to all periods presented for comparability.

 

The preparation of our consolidated financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that affect reported amounts of assets, liabilities, revenues, expenses and disclosure of contingent assets and liabilities. Estimates are used in determining, among other items, sales incentives accruals, future cash flows associated with impairment testing for perpetual brands and goodwill, useful lives for intangible assets, tax reserves, stock-based compensation and pension and retiree medical accruals. Actual results could differ from these estimates.

 

See “ Our Divisions” below and for additional unaudited information on items affecting the comparability of our consolidated results, see “ Items Affecting Comparability” in Management’s Discussion and Analysis.

 

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Tabular dollars are in millions, except per share amounts. All per share amounts reflect common per share amounts, assume dilution unless noted, and are based on unrounded amounts. Certain reclassifications were made to prior years’ amounts to conform to the 2005 presentation.

 

Our Divisions

 

We manufacture or use contract manufacturers, market and sell a variety of salty, sweet and grain-based snacks, carbonated and non-carbonated beverages, and foods through our North American and international business divisions. Our North American divisions include the United States and Canada. The accounting policies for the divisions are the same as those described in Note 2, except for certain allocation methodologies for stock-based compensation expense and pension and retiree medical expense, as described in the unaudited information in “Our Critical Accounting Policies.” Additionally, beginning in the fourth quarter of 2005, we began centrally managing commodity derivatives on behalf of our divisions. Certain of the commodity derivatives, primarily those related to the purchase of energy for use by our divisions, do not qualify for hedge accounting treatment. These derivatives hedge underlying commodity price risk and were not entered into for speculative purposes. Such derivatives are marked to market with the resulting gains and losses recognized as a component of corporate unallocated expense. These gains and losses are reflected in division results when the divisions take delivery of the underlying commodity. Therefore, division results reflect the contract purchase price of the energy or other commodities.

 

Division results are based on how our Chairman and Chief Executive Officer evaluates our divisions. Division results exclude certain Corporate-initiated restructuring and impairment charges, merger-related costs and divested businesses. For additional unaudited information on our divisions, see “ Our Operations” in Management’s Discussion and Analysis.

 

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LOGO

 

     2005

   2004

   2003

   2005

    2004

    2003

 
     Net Revenue

   Operating Profit

 

FLNA

   $ 10,322    $ 9,560    $ 9,091    $ 2,529     $ 2,389     $ 2,242  

PBNA

     9,146      8,313      7,733      2,037       1,911       1,690  

PI

     11,376      9,862      8,678      1,607       1,323       1,061  

QFNA

     1,718      1,526      1,467      537       475       470  
    

  

  

  


 


 


Total division

     32,562      29,261      26,969      6,710       6,098       5,463  

Divested businesses

     —        —        2      —         —         26  

Corporate

     —        —        —        (788 )     (689 )     (502 )
    

  

  

  


 


 


       32,562      29,261      26,971      5,922       5,409       4,987  

Restructuring and impairment charges

     —        —        —        —         (150 )     (147 )

Merger-related costs

     —        —        —        —         —         (59 )
    

  

  

  


 


 


Total

   $ 32,562    $ 29,261    $ 26,971    $ 5,922     $ 5,259     $ 4,781  
    

  

  

  


 


 


 

LOGO

 

Divested Businesses

 

During 2003, we sold our Quaker Foods North America Mission pasta business. The results of this business are reported as divested businesses.

 

Corporate

 

Corporate includes costs of our corporate headquarters, centrally managed initiatives, such as our BPT initiative, unallocated insurance and benefit programs, foreign exchange transaction gains and losses, and certain commodity derivative gains and losses, as well as profit-in-inventory elimination adjustments for our noncontrolled bottling affiliates and certain other items.

 

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Restructuring and Impairment Charges and Merger-Related CostsSee Note 3.

 

Other Division Information

 

     2005

   2004

   2003

   2005

   2004

   2003

     Total Assets

   Capital Spending

FLNA

   $ 5,948    $ 5,476    $ 5,332    $ 512    $ 469    $ 426

PBNA

     6,316      6,048      5,856      320      265      332

PI

     9,983      8,921      8,109      667      537      521

QFNA

     989      978      995      31      33      32
    

  

  

  

  

  

Total division

     23,236      21,423      20,292      1,530      1,304      1,311

Corporate (a)

     5,331      3,569      2,384      206      83      34

Investments in bottling affiliates

     3,160      2,995      2,651      —        —        —  
    

  

  

  

  

  

     $ 31,727    $ 27,987    $ 25,327    $ 1,736    $ 1,387    $ 1,345
    

  

  

  

  

  

(a)    Corporate assets consist principally of cash and cash equivalents, short-term investments, and property, plant and equipment.

LOGO
     2005

   2004

   2003

   2005

   2004

   2003

    

Amortization of

Intangible

Assets


  

Depreciation and

Other

Amortization


FLNA

   $ 3    $ 3    $ 3    $ 419    $ 420    $ 416

PBNA

     76      75      75      264      258      245

PI

     71      68      66      420      382      350

QFNA

     —        1      1      34      36      36
    

  

  

  

  

  

Total division

     150      147      145      1,137      1,096      1,047

Corporate

     —        —        —        21      21      29
    

  

  

  

  

  

     $ 150    $ 147    $ 145    $ 1,158    $ 1,117    $ 1,076
    

  

  

  

  

  

 

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     2005

   2004

   2003

   2005

   2004

   2003

     Net Revenue(a)

   Long-Lived Assets(b)

U.S.

   $ 19,937    $ 18,329    $ 17,377    $ 10,723    $ 10,212    $ 9,907

Mexico

     3,095      2,724      2,642      902      878      869

United Kingdom

     1,821      1,692      1,510      1,715      1,896      1,724

Canada

     1,509      1,309      1,147      582      548      508

All other countries

     6,200      5,207      4,295      3,948      3,339      3,123
    

  

  

  

  

  

     $ 32,562    $ 29,261    $ 26,971    $ 17,870    $ 16,873    $ 16,131
    

  

  

  

  

  

 

 

LOGO

 

(a)

Represents net revenue from businesses operating in these countries.

 

(b)

Long-lived assets represent net property, plant and equipment, nonamortizable and net amortizable intangible assets and investments in noncontrolled affiliates. These assets are reported in the country where they are primarily used.

 

Note 2 — Our Significant Accounting Policies

 

Revenue Recognition

 

We recognize revenue upon shipment or delivery to our customers based on written sales terms that do not allow for a right of return. However, our policy for direct-store-delivery (DSD) and chilled products is to remove and replace damaged and out-of-date products from store shelves to ensure that our consumers receive the product quality and freshness that they expect. Similarly, our policy for warehouse distributed products is to replace damaged and out-of-date products. Based on our historical experience with this practice, we have reserved for anticipated damaged and out-of-date products. For additional unaudited information on our revenue recognition and related policies, including our policy on bad debts, see “ Our Critical Accounting Policies” in Management’s Discussion and Analysis. We are exposed to concentration of credit risk by our customers, Wal-Mart and PBG. Wal-Mart represents approximately 9% of our net revenue, including concentrate sales to our bottlers which are used in finished goods sold by them to Wal-Mart; and PBG represents approximately 10%. We have not experienced credit issues with these customers.

 

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Sales Incentives and Other Marketplace Spending

 

We offer sales incentives and discounts through various programs to our customers and consumers. Sales incentives and discounts are accounted for as a reduction of revenue and totaled $8.9 billion in 2005, $7.8 billion in 2004 and $7.1 billion in 2003. While most of these incentive arrangements have terms of no more than one year, certain arrangements extend beyond one year. For example, fountain pouring rights may extend up to 15 years. Costs incurred to obtain these arrangements are recognized over the contract period and the remaining balances of $321 million at December 31, 2005 and $337 million at December 25, 2004 are included in current assets and other assets in our Consolidated Balance Sheet. For additional unaudited information on our sales incentives, see “ Our Critical Accounting Policies” in Management’s Discussion and Analysis.

 

Other marketplace spending includes the costs of advertising and other marketing activities and is reported as selling, general and administrative expenses. Advertising expenses were $1.8 billion in 2005, $1.7 billion in 2004 and $1.6 billion in 2003. Deferred advertising costs are not expensed until the year first used and consist of:

 

   

media and personal service prepayments,

 

   

promotional materials in inventory, and

 

   

production costs of future media advertising.

 

Deferred advertising costs of $202 million and $137 million at year-end 2005 and 2004, respectively, are classified as prepaid expenses in our Consolidated Balance Sheet.

 

Distribution Costs

 

Distribution costs, including the costs of shipping and handling activities, are reported as selling, general and administrative expenses. Shipping and handling expenses were $4.1 billion in 2005, $3.9 billion in 2004 and $3.6 billion in 2003.

 

Cash Equivalents

 

Cash equivalents are investments with original maturities of three months or less which we do not intend to rollover beyond three months.

 

Software Costs

 

We capitalize certain computer software and software development costs incurred in connection with developing or obtaining computer software for internal use. Capitalized software costs are included in property, plant and equipment on our Consolidated Balance Sheet and amortized on a straight-line basis over the estimated useful lives of the software, which generally do not exceed 5 years. Net capitalized software and development costs were $327 million at December 31, 2005 and $181 million at December 25, 2004.

 

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Commitments and Contingencies

 

We are subject to various claims and contingencies related to lawsuits, taxes and environmental matters, as well as commitments under contractual and other commercial obligations. We recognize liabilities for contingencies and commitments when a loss is probable and estimable. For additional information on our commitments, see Note 9.

 

Other Significant Accounting Policies

 

Our other significant accounting policies are disclosed as follows:

 

   

Property, Plant and Equipment and Intangible Assets Note 4 and, for additional unaudited information on brands and goodwill, see “ Our Critical Accounting Policies” in Management’s Discussion and Analysis.

 

   

Income TaxesNote 5 and, for additional unaudited information, see “ Our Critical Accounting Policies” in Management’s Discussion and Analysis.

 

   

Stock-Based Compensation ExpenseNote 6 and, for additional unaudited information, see “ Our Critical Accounting Policies” in Management’s Discussion and Analysis.

 

   

Pension, Retiree Medical and Savings PlansNote 7 and, for additional unaudited information, see “ Our Critical Accounting Policies” in Management’s Discussion and Analysis.

 

   

Risk ManagementNote 10 and, for additional unaudited information, see “ Our Business Risks” in Management’s Discussion and Analysis.

 

There have been no new accounting pronouncements issued or effective during 2005 that have had, or are expected to have, a material impact on our consolidated financial statements.

 

Note 3 — Restructuring and Impairment Charges and Merger-Related Costs

 

2005 Restructuring Charges

 

In the fourth quarter of 2005, we incurred a charge of $83 million ($55 million after-tax or $0.03 per share) in conjunction with actions taken to reduce costs in our operations, principally through headcount reductions. Of this charge, $34 million related to FLNA, $21 million to PBNA, $16 million to PI and $12 million to Corporate (recorded in corporate unallocated expenses). Most of this charge related to the termination of approximately 700 employees. We expect the substantial portion of the cash payments related to this charge to be paid in 2006.

 

2004 and 2003 Restructuring and Impairment Charges

 

In the fourth quarter of 2004, we incurred a charge of $150 million ($96 million after-tax or $0.06 per share) in conjunction with the consolidation of FLNA’s manufacturing network as part of its ongoing productivity program. Of this charge, $93 million related to asset impairment, primarily reflecting the closure of four U.S. plants. Production from

 

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these plants was redeployed to other FLNA facilities in the U.S. The remaining $57 million included employee-related costs of $29 million, contract termination costs of $8 million and other exit costs of $20 million. Employee-related costs primarily reflect the termination costs for approximately 700 employees. Through December 31, 2005, we have paid $47 million and incurred non-cash charges of $10 million, leaving substantially no accrual.

 

In the fourth quarter of 2003, we incurred a charge of $147 million ($100 million after-tax or $0.06 per share) in conjunction with actions taken to streamline our North American divisions and PepsiCo International. These actions were taken to increase focus and eliminate redundancies at PBNA and PI and to improve the efficiency of the supply chain at FLNA. Of this charge, $81 million related to asset impairment, reflecting $57 million for the closure of a snack plant in Kentucky, the retirement of snack manufacturing lines in Maryland and Arkansas and $24 million for the closure of a PBNA office building in Florida. The remaining $66 million included employee-related costs of $54 million and facility and other exit costs of $12 million. Employee-related costs primarily reflect the termination costs for approximately 850 sales, distribution, manufacturing, research and marketing employees. As of December 31, 2005, all terminations had occurred and substantially no accrual remains.

 

Merger-Related Costs

 

In connection with the Quaker merger in 2001, we recognized merger-related costs of $59 million ($42 million after-tax or $0.02 per share) in 2003.

 

Note 4 — Property, Plant and Equipment and Intangible Assets

 

     Average
Useful Life


   2005

    2004

    2003

Property, plant and equipment, net

                           

Land and improvements

           10 –30 yrs.    $ 685     $ 646        

Buildings and improvements

   20 – 44      3,736       3,605        

Machinery and equipment, including fleet and software

   5 – 15      11,658       10,950        

Construction in progress

          1,066       729        
         


 


     
            17,145       15,930        

Accumulated depreciation

          (8,464 )     (7,781 )      
         


 


     
          $ 8,681     $ 8,149        
         


 


     

Depreciation expense

        $ 1,103     $ 1,062     $ 1,020
         


 


 

Amortizable intangible assets, net

                           

Brands

   5 – 40    $ 1,054     $ 1,008        

Other identifiable intangibles

   3 – 15      257       225        
         


 


     
            1,311       1,233        
                             

Accumulated amortization

          (781 )     (635 )      
         


 


     
          $ 530     $ 598        
         


 


     

Amortization expense

        $ 150     $ 147     $ 145
         


 


 

 

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Depreciation and amortization are recognized on a straight-line basis over an asset’s estimated useful life. Land is not depreciated and construction in progress is not depreciated until ready for service. Amortization of intangible assets for each of the next five years, based on average 2005 foreign exchange rates, is expected to be $152 million in 2006, $35 million in 2007, $35 million in 2008, $34 million in 2009 and $33 million in 2010.

 

Depreciable and amortizable assets are only evaluated for impairment upon a significant change in the operating or macroeconomic environment. In these circumstances, if an evaluation of the undiscounted cash flows indicates impairment, the asset is written down to its estimated fair value, which is based on discounted future cash flows. Useful lives are periodically evaluated to determine whether events or circumstances have occurred which indicate the need for revision. For additional unaudited information on our amortizable brand policies, see “ Our Critical Accounting Policies” in Management’s Discussion and Analysis.

 

Nonamortizable Intangible Assets

 

Perpetual brands and goodwill are assessed for impairment at least annually to ensure that discounted future cash flows continue to exceed the related book value. A perpetual brand is impaired if its book value exceeds its fair value. Goodwill is evaluated for impairment if the book value of its reporting unit exceeds its fair value. A reporting unit can be a division or business within a division. If the fair value of an evaluated asset is less than its book value, the asset is written down based on its discounted future cash flows to fair value. No impairment charges resulted from the required impairment evaluations. The change in the book value of nonamortizable intangible assets is as follows:

 

    Balance,
Beginning
2004


  Acquisition

  Translation
and Other


  Balance,
End of
2004


  Acquisition

  Translation
and Other


    Balance,
End of
2005


Frito-Lay North America

                                           

Goodwill

  $ 130   $ —     $ 8   $ 138   $ —     $ 7     $ 145
   

 

 

 

 

 


 

PepsiCo Beverages North America

                                           

Goodwill

    2,157     —       4     2,161     —       3       2,164

Brands

    59     —       —       59     —       —         59
   

 

 

 

 

 


 

      2,216     —       4     2,220     —       3       2,223
   

 

 

 

 

 


 

PepsiCo International

                                           

Goodwill

    1,334     29     72     1,435     278     (109 )     1,604

Brands

    808     —       61     869     263     (106 )     1,026
   

 

 

 

 

 


 

      2,142     29     133     2,304     541     (215 )     2,630
   

 

 

 

 

 


 

Quaker Foods North America

                                           

Goodwill

    175     —       —       175     —       —         175
   

 

 

 

 

 


 

Corporate

                                           

Pension intangible

    2     —       3     5     —       (4 )     1
   

 

 

 

 

 


 

Total goodwill

    3,796     29     84     3,909     278     (99 )     4,088

Total brands

    867     —       61     928     263     (106 )     1,085

Total pension intangible

    2     —       3     5     —       (4 ))     1
   

 

 

 

 

 


 

    $ 4,665   $ 29   $ 148   $ 4,842   $ 541   $ (209 )   $ 5,174
   

 

 

 

 

 


 

 

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Note 5 — Income Taxes

 

     2005

    2004

    2003

 
Income before income taxes – continuing operations                         

U.S.

   $ 3,175     $ 2,946     $ 3,267  

Foreign

     3,207       2,600       1,725  
    


 


 


     $ 6,382     $ 5,546     $ 4,992  
    


 


 


Provision for income taxes – continuing operations

                        

Current: U.S. Federal

   $ 1,638     $ 1,030     $ 1,326  

   Foreign

     426       256       341  

   State

     118       69       80  
    


 


 


       2,182       1,355       1,747  
    


 


 


Deferred: U.S. Federal

     137       11       (274 )

     Foreign

     (26 )     5       (47 )

     State

     11       1       (2 )
    


 


 


       122       17       (323 )
    


 


 


     $ 2,304     $ 1,372     $ 1,424  
    


 


 


Tax rate reconciliation – continuing operations

                        

U.S. Federal statutory tax rate

     35.0 %     35.0 %     35.0 %

State income tax, net of U.S. Federal tax benefit

     1.4       0.8       1.0  

Taxes on AJCA repatriation

     7.0       —         —    

Lower taxes on foreign results

     (6.5 )     (5.4 )     (5.5 )

Settlement of prior years’ audit

     —         (4.8 )     (2.2 )

Other, net

     (0.8 )     (0.9 )     0.2  
    


 


 


Annual tax rate

     36.1 %     24.7 %     28.5 %
    


 


 


Deferred tax liabilities

                        

Investments in noncontrolled affiliates

   $ 993     $ 850          

Property, plant and equipment

     772       857          

Pension benefits

     863       669          

Intangible assets other than nondeductible goodwill

     135       153          

Zero coupon notes

     35       46          

Other

     169       157          
    


 


       

Gross deferred tax liabilities

     2,967       2,732          
    


 


       

Deferred tax assets

                        

Net carryforwards

     608       666          

Stock-based compensation

     426       402          

Retiree medical benefits

     400       402          

Other employee-related benefits

     342       379          

Other

     520       460          
    


 


       

Gross deferred tax assets

     2,296       2,309          

Valuation allowances

     (532 )     (564 )        
    


 


       

Deferred tax assets, net

     1,764       1,745          
    


 


       

Net deferred tax liabilities

   $ 1,203     $ 987          
    


 


       

 

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     2005

    2004

   2003

 

Deferred taxes included within:

                       

Prepaid expenses and other current assets

   $ 231     $ 229         

Deferred income taxes

   $ 1,434     $ 1,216         

Analysis of valuation allowances

                       

Balance, beginning of year

   $ 564     $ 438    $ 487  

(Benefit)/provision

     (28 )     118      (52 )

Other (deductions)/additions

     (4 )     8      3  
    


 

  


Balance, end of year

   $ 532     $ 564    $ 438  
    


 

  


 

For additional unaudited information on our income tax policies, including our reserves for income taxes, see “ Our Critical Accounting Policies” in Management’s Discussion and Analysis.

 

Carryforwards, Credits and Allowances

 

Operating loss carryforwards totaling $5.1 billion at year-end 2005 are being carried forward in a number of foreign and state jurisdictions where we are permitted to use tax operating losses from prior periods to reduce future taxable income. These operating losses will expire as follows: $0.1 billion in 2006, $4.1 billion between 2007 and 2025 and $0.9 billion may be carried forward indefinitely. In addition, certain tax credits generated in prior periods of approximately $39.4 million are available to reduce certain foreign tax liabilities through 2011. We establish valuation allowances for our deferred tax assets when the amount of expected future taxable income is not likely to support the use of the deduction or credit.

 

Undistributed International Earnings

 

The AJCA created a one-time incentive for U.S. corporations to repatriate undistributed international earnings by providing an 85% dividends received deduction. As approved by our Board of Directors in July 2005, we repatriated approximately $7.5 billion in earnings previously considered indefinitely reinvested outside the U.S. in the fourth quarter of 2005. In 2005, we recorded income tax expense of $460 million associated with this repatriation. Other than the earnings repatriated, we intend to continue to reinvest earnings outside the U.S. for the foreseeable future and, therefore, have not recognized any U.S. tax expense on these earnings. At December 31, 2005, we had approximately $7.5 billion of undistributed international earnings.

 

Reserves

 

A number of years may elapse before a particular matter, for which we have established a reserve, is audited and finally resolved. The number of years with open tax audits varies depending on the tax jurisdiction. During 2004, we recognized $266 million of tax benefits related to the favorable resolution of certain open tax issues. In addition, in 2004, we recognized a tax benefit of $38 million upon agreement with the IRS on an open issue related to our discontinued restaurant operations. At the end of 2003, we entered into agreements with the IRS for open years through

 

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1997. These agreements resulted in a tax benefit of $109 million in the fourth quarter of 2003. As part of these agreements, we also resolved the treatment of certain other issues related to future tax years.

 

The IRS has initiated their audits of our tax returns for the years 1998 through 2002. Our tax returns subsequent to 2002 have not yet been examined. While it is often difficult to predict the final outcome or the timing of resolution of any particular tax matter, we believe that our reserves reflect the probable outcome of known tax contingencies. Settlement of any particular issue would usually require the use of cash. Favorable resolution would be recognized as a reduction to our annual tax rate in the year of resolution. Our tax reserves, covering all federal, state and foreign jurisdictions, are presented in the balance sheet within other liabilities (see Note 14), except for any amounts relating to items we expect to pay in the coming year which are included in current income taxes payable. For further unaudited information on the impact of the resolution of open tax issues, see “Other Consolidated Results.”

 

Note 6 — Stock-Based Compensation

 

Our stock-based compensation program is a broad-based program designed to attract and retain employees while also aligning employees’ interests with the interests of our shareholders. Employees at all levels participate in our stock-based compensation program. In addition, members of our Board of Directors participate in our stock-based compensation program in connection with their service on our Board. Stock options and RSUs are granted to employees under the shareholder-approved 2003 Long-Term Incentive Plan (LTIP), our only active stock-based plan. Stock-based compensation expense was $311 million in 2005, $368 million in 2004 and $407 million in 2003. Related income tax benefits recognized in earnings were $87 million in 2005, $103 million in 2004 and $114 million in 2003. At year-end 2005, 51 million shares were available for future executive and SharePower grants. For additional unaudited information on our stock-based compensation program, see “ Our Critical Accounting Policies” in Management’s Discussion and Analysis.

 

SharePower Grants

 

SharePower options are awarded under our LTIP to all eligible employees, based on job level or classification, and in the case of international employees, tenure as well. All stock option grants have an exercise price equal to the fair market value of our common stock on the day of grant and generally have a 10-year term with vesting after three years.

 

Executive Grants

 

All senior management and certain middle management are eligible for executive grants under our LTIP. All stock option grants have an exercise price equal to the fair market value of our common stock on the day of grant and generally have a 10-year term with vesting after three years. There have been no reductions to the exercise price of previously issued awards, and any repricing of awards would require approval of our shareholders.

 

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Beginning in 2004, executives who are awarded long-term incentives based on their performance are offered the choice of stock options or RSUs. RSU expense is based on the fair value of PepsiCo stock on the date of grant and is amortized over the vesting period, generally three years. Each restricted stock unit can be settled in a share of our stock after the vesting period. Executives who elect RSUs receive one RSU for every four stock options that would have otherwise been granted. Senior officers do not have a choice and are granted 50% stock options and 50% RSUs. Vesting of RSU awards for senior officers is contingent upon the achievement of pre-established performance targets. We granted 3 million RSUs in both 2005 and 2004 with weighted-average intrinsic values of $53.83 and $47.28, respectively.

 

Method of Accounting and Our Assumptions

 

We account for our employee stock options under the fair value method of accounting using a Black-Scholes valuation model to measure stock-based compensation expense at the date of grant. We adopted SFAS 123R, Share-Based Payment, under the modified prospective method in the first quarter of 2006. We do not expect our adoption of SFAS 123R to materially impact our financial statements.

 

Our weighted-average Black-Scholes fair value assumptions include:

 

     2005

   2004

   2003

Expected life

   6 yrs.    6 yrs.    6 yrs.

Risk free interest rate

   3.8%    3.3%    3.1%

Expected volatility

   23%    26%    27%

Expected dividend yield

   1.8%    1.8%    1.15%

 

Our Stock Option Activity(a)

 

     2005

   2004

   2003

     Options

    Average
Price(b)


   Options

    Average
Price
(b)

   Options

    Average
Price
(b)

Outstanding at beginning of year

   174,261     $ 40.05    198,173     $ 38.12    190,432     $ 36.45

Granted

   12,328       53.82    14,137       47.47    41,630       39.89

Exercised

   (30,945 )     35.40    (31,614 )     30.57    (25,833 )     26.74

Forfeited/expired

   (5,495 )     43.31    (6,435 )     43.82    (8,056 )     43.56
    

        

        

     

Outstanding at end of year

   150,149       42.03    174,261       40.05    198,173       38.12
    

        

        

     

Exercisable at end of year

   89,652       40.52    94,643       36.41    97,663       32.56
    

        

        

     

 

(a)

Options are in thousands and include options previously granted under Quaker plans. No additional options or shares may be granted under the Quaker plans.

 

(b)

Weighted-average exercise price.

 

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Stock options outstanding and exercisable at December 31, 2005(a)

 

     Options Outstanding

   

Options

Exercisable


 

Range of Exercise Price


   Options

   Average
Price
(b)

   Average
Life
(c)

    Options

   Average
Price
(b)

   Average
Life
(c)

 

$14.40 to $21.54

   905    $ 20.01    3.56  yrs.   905    $ 20.01    3.56  yrs.

$23.00 to $33.75

   14,559      30.46    3.07     14,398      30.50    3.05  

$34.00 to $43.50

   82,410      39.44    5.34     48,921      39.19    4.10  

$43.75 to $56.75

   52,275      49.77    7.17     25,428      49.48    6.09  
    
               
             
     150,149      42.03    5.67     89,652      40.52    4.45  
    
               
             

 

(a)

Options are in thousands and include options previously granted under Quaker plans. No additional options or shares may be granted under the Quaker plans.

 

(b)

Weighted-average exercise price.

 

(c)

Weighted-average contractual life remaining.

 

Our RSU Activity(a)

 

     2005

   2004

     RSUs

   

Average

Intrinsic
Value(b)


   Average
Life (c)


   RSUs

   

Average

Intrinsic
Value
(b)


  

Average

Life (c)


Outstanding at beginning of year

   2,922     $ 47.30         —       $ —       

Granted

   3,097       53.83         3,077       47.28     

Converted

   (91 )     48.73         (18 )     47.25     

Forfeited/expired

   (259 )     50.51         (137 )     47.25     
    

             

          

Outstanding at end of year

   5,669       50.70    1.8 yrs.    2,922       47.30    2.2 yrs.
    

             

          

 

(a)

RSUs are in thousands.

 

(b)

Weighted-average intrinsic value.

 

(c)

Weighted-average contractual life remaining.

 

Other stock-based compensation data

 

     Stock Options

   RSUs

     2005

   2004

   2003

   2005

   2004

Weighted-average fair value of options granted

   $ 13.45    $ 12.04    $ 11.21              

Total intrinsic value of options/RSUs exercised/converted(a)

   $ 632,603    $ 667,001    $ 466,719    $ 4,974    $ 914

Total intrinsic value of options/RSUs outstanding(a)

   $ 2,553,594    $ 2,062,153    $ 1,641,505    $ 334,931    $ 151,760

Total intrinsic value of options exercisable(a)

   $ 1,662,198    $ 1,464,926    $ 1,348,658              

 

(a)

In thousands.

 

At December 31, 2005, there was $315 million of total unrecognized compensation cost related to nonvested share-based compensation grants. This unrecognized compensation is expected to be recognized over a weighted-average period of 1.6 years.

 

76


Table of Contents

Note 7 — Pension, Retiree Medical and Savings Plans

 

Our pension plans cover full-time employees in the U.S. and certain international employees. Benefits are determined based on either years of service or a combination of years of service and earnings. U.S. retirees are also eligible for medical and life insurance benefits (retiree medical) if they meet age and service requirements. Generally, our share of retiree medical costs is capped at specified dollar amounts, which vary based upon years of service, with retirees contributing the remainder of the costs. We use a September 30 measurement date and all plan assets and liabilities are generally reported as of that date. The cost or benefit of plan changes that increase or decrease benefits for prior employee service (prior service cost) is included in expense on a straight-line basis over the average remaining service period of employees expected to receive benefits.

 

The Medicare Act was signed into law in December 2003 and we applied the provisions of the Medicare Act to our plans in 2005 and 2004. The Medicare Act provides a subsidy for sponsors of retiree medical plans who offer drug benefits equivalent to those provided under Medicare. As a result of the Medicare Act, our 2005 and 2004 retiree medical costs were $11 million and $7 million lower, respectively, and our 2005 and 2004 liabilities were reduced by $136 million and $80 million, respectively. We expect our 2006 retiree medical costs to be approximately $18 million lower than they otherwise would have been as a result of the Medicare Act.

 

For additional unaudited information on our pension and retiree medical plans and related accounting policies and assumptions, see “ Our Critical Accounting Policies” in Management’s Discussion and Analysis.

 

     Pension

    Retiree Medical

 
     2005

    2004

    2003

    2005

    2004

    2003

    2005

    2004

    2003

 
     U.S.

    International

       

Weighted-average assumptions

                

Liability discount rate

     5.7 %     6.1 %     6.1 %     5.1 %     6.1 %     6.1 %     5.7 %     6.1 %     6.1 %

Expense discount rate

     6.1 %     6.1 %     6.7 %     6.1 %     6.1 %     6.4 %     6.1 %     6.1 %     6.7 %

Expected return on plan assets

     7.8 %     7.8 %     8.3 %     8.0 %     8.0 %     8.0 %     —         —         —    

Rate of compensation increases

     4.4 %     4.5 %     4.5 %     4.1 %     3.9 %     3.8 %     —         —         —    

Components of benefit expense

                                                                        

Service cost

   $ 213     $ 193     $ 153     $ 32     $ 27     $ 24     $ 40     $ 38     $ 33  

Interest cost

     296       271       245       55       47       39       78       72       73  

Expected return on plan assets

     (344 )     (325 )     (305 )     (69 )     (65 )     (54 )     —         —         —    

Amortization of prior service cost/(benefit)

     3       6       6       1       1       —         (11 )     (8 )     (3 )

Amortization of experience loss

     106       81       44       15       9       5       26       19       13  
    


 


 


 


 


 


 


 


 


Benefit expense

     274       226       143       34       19       14       133       121       116  

Settlement/curtailment loss

     —         4