UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 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 30, 2006
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
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) |
Registrants 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 ¨
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 registrants 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 a 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 (assuming for these purposes, but without conceding, that all executive officers and directors of PepsiCo are affiliates of PepsiCo) as of June 17, 2006, the last day of business of our most recently completed second fiscal quarter, was $98,446,600,086.90 (based on the closing sale price of PepsiCos Common Stock on that date as reported on the New York Stock Exchange). The number of shares of PepsiCo Common Stock outstanding as of February 9, 2007 was 1,637,764,939.
Documents of Which Portions Are Incorporated by Reference |
Parts of Form 10-K into Which Portion of Documents Are Incorporated | |||
Proxy Statement for PepsiCos May 2, 2007 Annual Meeting of Shareholders |
III |
PepsiCo, Inc.
Form 10-K Annual Report
For the Fiscal Year Ended December 30, 2006
Item 1. |
1 | |||
Item 1A. |
7 | |||
Item 1B. |
12 | |||
Item 2. |
12 | |||
Item 3. |
13 | |||
Item 4. |
13 | |||
Item 5. |
17 | |||
Item 6. |
19 | |||
Item 7. |
Managements Discussion and Analysis of Financial Condition and Results of Operations |
20 | ||
Item 7A. |
105 | |||
Item 8. |
105 | |||
Item 9. |
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure |
105 | ||
Item 9A. |
105 | |||
Item 9B. |
106 | |||
Item 10. |
107 | |||
Item 11. |
108 | |||
Item 12. |
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters |
108 | ||
Item 13. |
Certain Relationships and Related Transactions, and Director Independence |
108 | ||
Item 14. |
109 | |||
Item 15. |
110 |
i
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, PepsiCo and the Company mean PepsiCo, Inc. 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 division operates in approximately 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 Lays potato chips, Doritos tortilla chips, Tostitos tortilla chips, Cheetos cheese flavored snacks, Fritos corn chips, branded dips, Ruffles potato chips, Quaker Chewy granola bars, SunChips multigrain snacks, Rold Gold pretzels, Santitas tortilla chips, Frito-Lay nuts, Grandma's cookies, Munchies snack mix, Gamesa cookies, Lays Stax potato crisps, Funyuns onion flavored rings, Quaker Quakes corn and rice snacks, Miss Vickies potato chips, branded crackers, Quaker snack mix, Smartfood popcorn, Chesters fries, Stacys pita chips and Quaker Fruit & Oatmeal bars. FLNA branded products are sold to independent distributors and retailers. FLNA's net revenue was $10.8 billion in 2006, $10.3 billion in 2005 and $9.6 billion in 2004 and approximated 31% of our total net revenue in 2006, 32% of our total net revenue in 2005 and 33% of our total net revenue in 2004.
1
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, Lipton, Sierra Mist, Tropicana juice drinks, Propel, Dole and SoBe. PBNA also manufactures or uses contract manufacturers, markets and sells ready-to-drink tea, coffee and water products through joint ventures with Unilever (under the Lipton brand name) 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 authorized bottlers, and some of these branded products are sold directly by us to independent distributors and retailers. The bottlers sell our brands as finished goods to independent distributors and retailers. PBNA's net revenue was $9.6 billion in 2006, $9.1 billion in 2005 and $8.3 billion in 2004 and approximated 27% of our total net revenue in 2006 and 28% of our total net revenue in 2005 and 2004.
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 Lays, Walkers, Cheetos, Doritos, Ruffles, Gamesa and Sabritas. 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, Tropicana and Mountain Dew. These brands are sold to authorized 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 authorized bottlers. PI's net revenue was $13.0 billion in 2006, $11.4 billion in 2005 and $9.9 billion in 2004 and approximated 37% of our total net revenue in 2006, 35% of our total net revenue in 2005 and 34% of our total net revenue in 2004.
Quaker Foods North America
Quaker Foods North America (QFNA) manufactures or uses contract manufacturers, markets and sells cereals, rice, pasta and other branded products. QFNAs products include Quaker oatmeal, Aunt Jemima mixes and syrups, Cap'n Crunch cereal, Quaker grits, Life cereal, 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 $1.8 billion in 2006, $1.7 billion in 2005 and $1.5 billion in 2004 and approximated 5% of our total net revenue in each of 2006, 2005 and 2004.
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. These distribution
2
systems are described under the heading Our Business contained in Item 7. Managements 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, grapefruits and other fruits, juice and juice concentrates, oats, oranges, potatoes, rice, seasonings, sucralose, sugar, vegetable and essential oils, and wheat. Our key packaging materials include aluminum used for cans, polyethylene terepthalate (PET) 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. See Note 10 to our consolidated financial statements for additional information on how we manage our commodity costs.
Our Brands
We own numerous valuable trademarks which are essential to our worldwide businesses, including Alegro, AMP, Aquafina, Aunt Jemima, Cap'n Crunch, Cheetos, Cracker Jack, Diet Pepsi, Doritos, Frito-Lay, Fritos, Gamesa, Gatorade, Grandma's, Izze, Lay's, Life, Mirinda, Mountain Dew, Mug, Near East, Pasta Roni, Pepsi, Pepsi Max, Pepsi One, Propel, Quaker, Quaker Chewy, Quaker Quakes, Rice-A-Roni, Rold Gold, Ruffles, Sabritas, Sakata, 7UP and Diet 7UP (outside the United States), Sierra Mist, Simba, Smiths, Snack a Jacks, SoBe, Sonrics, Stacys, SunChips, Tostitos, Tropicana, Tropicana Pure Premium, Tropicana Twister, Walkers and Wotsits. We also hold long-term licenses to use valuable trademarks in connection with our products, including Lipton, Starbucks, Dole and Ocean Spray. 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.
3
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 beverage and snack sales are generally highest in the third quarter due to seasonal and holiday-related patterns. However, taken as a whole, seasonality does not have a material impact on our business.
Our Customers
Our customers include authorized bottlers and independent distributors, including foodservice 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, finished goods and Aquafina royalties, as well as the manufacturing process required for product quality.
Retail consolidation continues to increase the importance of major customers. Sales to Wal-Mart represent approximately 9% of our total net revenue; and our top five retail customers currently represent approximately 26% of our 2006 North American net revenue, with Wal-Mart representing approximately 13%. 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 contained in Item 7. Managements Discussion and Analysis 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 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, product 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.
4
* |
The categories and category 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. |
Research and Development
We engage in a variety of research and development activities. These activities principally involve the development of new products, improvement in the quality of existing products, improvement and modernization of production processes, and the development and implementation of new technologies to enhance the quality and value of both current and proposed product lines. Research and development costs were $344 million in 2006 and $340 million in 2005 and are reported as selling, general and administrative expenses.
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 regulating 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
5
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. See also Risk Factors Regulatory decisions and changes in the legal and regulatory environment could increase our costs and liabilities or limit our business activities.
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.
We are subject to national and local environmental laws in the United States and in the foreign countries in which we do business, including laws relating to water consumption and treatment. We are committed to meeting all 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 30, 2006, we employed approximately 168,000 people worldwide, including approximately 63,000 people employed within the United States. Our employment levels are subject to seasonal variations. 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 U.S. Securities and Exchange Commission (SEC) at the SECs Public Reference Room at 100 F Street, NE, 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 SEC.
6
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 or if we are unable to innovate or market our products effectively.
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 any inability on our part to anticipate and react to such changes could 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 or 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, weather, negative publicity resulting from regulatory action or litigation against companies in the industry, or a downturn in economic conditions. Any of these changes may reduce consumers willingness to purchase our 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 either 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. Our failure to successfully launch new products could decrease demand for our existing products by negatively affecting consumer perception of existing brands, as well as result in inventory write-offs and other costs.
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
7
could be jeopardized. Adverse publicity about these types of concerns or the incidence of product contamination or tampering, 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 or adverse publicity regarding our responses to health concerns, our environmental impacts, including agricultural materials, packaging, energy and water use and waste management, or other sustainability issues, could also jeopardize our reputation. Failure to comply with local laws and regulations, to maintain an effective system of internal controls or to provide accurate and timely financial statement information could also hurt 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 improve the effectiveness of our operations and to interface with our customers, as well as to maintain 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 multi-year 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 operations. There can be no certainty that these programs will deliver the expected benefits. The failure to 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 and loss of customers and revenue.
Our information systems could also 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 and that of our suppliers, business partners, including bottlers, contract manufacturers, independent distributors and retailers, to make, move and sell products is critical to our success. Damage or disruption to our or their manufacturing or distribution
8
capabilities due to weather, natural disaster, fire or explosion, terrorism, pandemics such as avian flu, 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, the loss of any key customer, or failure to maintain good relationships with our bottling partners could adversely affect our financial performance.
We must maintain mutually beneficial relationships with our key customers, including our retailers and bottling partners, to effectively compete. 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.
Retail consolidation continues to increase the importance of major customers. Sales to Wal-Mart represent approximately 9% of our total net revenue; and our top five retail customers currently represent approximately 26% of our 2006 North American net revenue, with Wal-Mart representing approximately 13%. These percentages include concentrate sales to our bottlers which are used in finished goods sold by them to these retailers. Loss of any of our key customers, including Wal-Mart, could have an adverse effect on our business, financial condition and results of operations.
Furthermore, if we are unable to provide an appropriate mix of incentives to our bottlers through a combination of advertising and marketing support, they may take actions that, while maximizing their own short-term profit, may be detrimental to us or our brands. Such actions could have an adverse effect on our profitability. See Our Customers and Our Related Party Bottlers contained in Item 7. Managements Discussion and Analysis and Note 8 to our consolidated financial statements for more information on our customers, including our anchor bottlers.
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. 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. Our operations outside of the U.S. accounted for 41% and 36% of our net revenue and operating profit, respectively, for the year ended December 30, 2006. Our continued success depends on our ability to
9
broaden and strengthen our presence in emerging markets, such as Brazil, Russia, India and China, and to create scale in key international markets.
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. These laws and regulations may change, sometimes dramatically, as a result of political, economic or social events. 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 laws relating to the regulation of water rights and treatment. 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.
In particular, governmental bodies in jurisdictions where we operate may impose new labeling, product or production requirements, or other restrictions. For example, Proposition 65 in California requires that a warning be given for any product that exposes consumers to a substance listed by the state as having been found to cause cancer or birth defects. If we were required to label any of our products or place warnings in locations where our products are sold in California under Proposition 65, sales of those products could suffer not only in California but elsewhere as a result of the adverse publicity.
In many jurisdictions, compliance with competition laws is of special importance to us due to our competitive position in those jurisdictions. 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 or outsource certain functions effectively, 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
10
benefit costs. Any unplanned turnover could deplete our institutional knowledge base and erode our competitive advantage.
In addition, we have outsourced certain information technology support services and administrative functions, such as payroll processing and benefit plan administration, to third-party service providers and may outsource other functions in the future to achieve cost savings and efficiencies. If the service providers that we outsource these functions to do not perform effectively we may not be able to achieve the expected cost savings and may have to incur additional costs to correct errors made by such service providers. Depending on the function involved, such errors may also lead to business disruption, processing inefficiencies or the loss of or damage to intellectual property through security breach, or harm employee morale.
Our operating results may be adversely affected by increased costs, disruption of supply or shortages of raw materials and other supplies.
We and our business partners use various raw materials and other supplies in our business, including aspartame, cocoa, corn, corn sweeteners, flavorings, flour, grapefruits and other fruits, juice and juice concentrates, oats, oranges, potatoes, rice, seasonings, sucralose, sugar, vegetable and essential oils, and wheat. Our key packaging materials include aluminum used for cans, PET 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. Some of these raw materials and supplies are available from a limited number of suppliers. 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 profitability may also be adversely impacted due to water scarcity and regulation. Water is a limited resource in many parts of the world. As demand for water continues to increase, we and our business partners may face disruption of supply or increased costs to obtain the water needed to produce our products.
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.
11
Item 1B. Unresolved Staff Comments
Not applicable.
Our most significant corporate properties include our corporate headquarters building in Purchase, New York and our data center in Plano, Texas, both of which are owned. 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 owned or leased on a long-term basis. 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
FLNAs most significant properties include its headquarters building and a research facility in Plano, Texas, both of which are owned. FLNA also owns or leases approximately 40 food manufacturing and processing plants and approximately 1,980 warehouses, distribution centers and offices.
PepsiCo Beverages North America
PBNA utilizes approximately 60 plants and production processing facilities and 37 warehouses, distribution centers and offices. PBNAs most significant properties include its headquarters building in downtown Chicago, Illinois, which is leased, and its Tropicana facility in Bradenton, Florida, its concentrate plant in Ireland and its research and development facility in Valhalla, New York, all of which are owned. The other properties utilized by PBNA are owned or leased by us or our co-packers. In addition, authorized bottlers in which we have an ownership interest own or lease approximately 70 bottling plants.
PepsiCo International
PI owns or leases approximately 150 plants and approximately 1,500 warehouses, distribution centers and offices. In addition, authorized bottlers in which we have an ownership interest own or lease approximately 350 plants and distribution centers. PIs most significant property, a concentrate plant in Ireland, is owned. PI is headquartered in the corporate facility in Purchase, New York.
Quaker Foods North America
QFNA utilizes approximately 35 manufacturing plants and production processing facilities in North America. QFNA owns a plant in Cedar Rapids, Iowa, which is its most significant property. 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.
12
Shared Properties
QFNA shares approximately 10 production facilities with FLNA, 4 production facilities with PBNA, 16 warehouses and distribution centers with FLNA and PBNA, and 10 offices with PBNA and FLNA, including a research and development laboratory in Barrington, Illinois.
We are party to a variety of legal proceedings arising in the normal course of business. 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 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. Neither of these matters involved any allegations regarding PepsiCos accounting for its transactions with Kmart or PepsiCos financial statements. On December 6, 2006, the SEC informed us that the investigation with respect to these matters has been terminated and that no enforcement action has been recommended against PepsiCo.
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
Executive Officers of the Registrant
The following is a list of names, ages and background of our current executive officers:
Peter A. Bridgman, 54, 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. in 1999.
Albert P. Carey, 55, was appointed President and Chief Executive Officer of Frito-Lay North America in June 2006. Mr. Carey began his career with Frito-Lay in 1981 where he spent 20 years in a variety of roles. He served as President, PepsiCo Sales from February 2003 until June 2006. Prior to that, he served as Chief Operating Officer, PepsiCo Beverages & Foods North America from June 2002 to February 2003 and as PepsiCo's Senior Vice President, Sales and Retailer Strategies from August 1998 to June 2002.
13
John C. Compton, 45, has been Chief Executive Officer of PepsiCo North America since September 2006 and also serves on PepsiCos 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 23 years at PepsiCo in various Sales, Marketing, Operations and General Management assignments. From March 2005 until September 2006, he was President and Chief Executive Officer of Quaker, Tropicana, Gatorade. 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-Lays North American Salty Snacks Division from August 2001 until March 2003.
Richard Goodman, 58, has been PepsiCos Chief Financial Officer since October 2006. From 2003 until October 2006, Mr. Goodman was Senior Vice President and Chief Financial Officer of PepsiCo International. Prior to that, he served as Senior Vice President and Chief Financial Officer of PepsiCo Beverages International from 2001 to 2003 and as Vice President and General Auditor of PepsiCo from 2000 to 2001. Mr. Goodman joined PepsiCo in 1992 as Vice President of Corporate Strategic Planning, International and held a number of senior financial positions with PepsiCo and its affiliates until 1997 when he left PepsiCo to pursue other opportunities. Before joining PepsiCo in 1992, Mr. Goodman was with W.R. Grace & Co. in a variety of global chief financial officer positions.
Dawn E. Hudson, 49, is President and Chief Executive Officer of Pepsi-Cola North America and PepsiCo Foodservice and also serves on PepsiCos liquid refreshment beverage oversight council. Ms. Hudson was promoted to Chief Executive Officer of Pepsi-Cola North America and PepsiCo Foodservice in March 2005, and has been President of Pepsi-Cola North America since 2002. Previously, as Senior Vice President, Strategy and Marketing, she led Pepsi-Cola North Americas 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 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 Pepsi-Cola North America a year later as Senior Vice President, responsible for flavors, new business, packaging and joint ventures.
Hugh F. Johnston, 45, has been PepsiCo's Executive Vice President, Operations since October 2006. From April 2005 until October 2006, Mr. Johnston was PepsiCo's Senior Vice President, Transformation. Prior to that, he served as Senior Vice President and Chief Financial Officer of PepsiCo Beverages and Foods from November 2002 through March 2005, and as PepsiCo's Senior Vice President of Mergers and Acquisitions from March 2002 until November 2002. Mr. Johnston joined PepsiCo in 1987 as a Business Planner and held various finance positions until 1999 when he left to join Merck & Co., Inc. as Vice President, Retail, a position which he held until he rejoined PepsiCo in 2002. Prior to joining PepsiCo in 1987, Mr. Johnston was with General Electric Company in a variety of finance positions.
14
Charles I. Maniscalco, 53, has been President and Chief Executive Officer of Quaker, Tropicana, Gatorade since September 2006. Mr. Maniscalco also serves on PepsiCo's liquid refreshment beverage oversight council. From 2002 until September 2006, he was President Gatorade/Propel, and from August 2001 until 2002 he was Senior Vice President and General Manager, Convenience Foods for Frito-Lay North America. Mr. Maniscalco started his career at Quaker Oats in 1980 as a market research analyst. Over the years he held a wide variety of roles at Quaker Oats, including marketing and general management positions encompassing Quakers food, beverages and pet food divisions.
Matthew M. McKenna, 56, has been Senior Vice President of Finance since August 2001. From 1998 until 2001, Mr. McKenna was Senior Vice President and Treasurer. Mr. McKenna began his career at PepsiCo as Vice President, Taxes in 1993, and he became Senior Vice President, Taxes in 1998. Mr. McKenna is a director of PepsiAmericas, Inc. and a member of the Management Committee of Pepsi Bottling Ventures. Mr. McKenna is also a director of Foot Locker, Inc.
Margaret D. Moore, 59, is 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. She is scheduled to retire from PepsiCo in June 2007.
Indra K. Nooyi, 51, has been PepsiCos President and Chief Executive Officer since October 2006 and has been named Chairman of PepsiCos Board of Directors effective May 2, 2007. She was elected to PepsiCos Board of Directors 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 PepsiCo's Senior Vice President, Corporate Strategy and Development from 1996 until February 2000 and as PepsiCos Senior Vice President, Strategic Planning from 1994 until 1996. 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, 52, has been 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 The Pepsi Bottling Group, Inc. 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.
Steven S Reinemund, 58, has been Executive Chairman of PepsiCo since October 2006 and has been Chairman of PepsiCos Board of Directors since May 2001. From May 2001 until October 2006, Mr. Reinemund was PepsiCos Chief Executive Officer. He was elected a director of PepsiCo in 1996 and served as President and Chief Operating
15
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, Inc. 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. He will be retiring from PepsiCo effective May 2, 2007.
Larry D. Thompson, 61, 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. 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.
Cynthia M. Trudell, 53, is Senior Vice President, Chief Personnel Officer, a position which she assumed in February 2007. Ms. Trudell served as a director of PepsiCo from January 2000 until her appointment to her current position. She was formerly Vice President of Brunswick Corporation and President of Sea Ray Group from 2001 until 2006. From 1999 until 2001, Ms. Trudell served as General Motors Vice President, and Chairman and President of Saturn Corporation, a wholly owned subsidiary of GM. Ms. Trudell began her career with the Ford Motor Co. as a chemical process engineer. In 1981, she joined GM and held various engineering and manufacturing supervisory positions. In 1995, she became plant manager at GM's Wilmington Assembly Center in Delaware. In 1996, she became President of IBC Vehicles in Luton, England, a joint venture between General Motors and Isuzu.
Michael D. White, 55, has been Vice Chairman of PepsiCo and a member of PepsiCos Board of Directors since March 2006 and Chairman and Chief Executive Officer of PepsiCo International since February 2003. Prior to that, he served as President and Chief Executive Officer of Frito-Lays Europe/Africa/Middle East division from 2000 until February 2003. 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. Mr. White is also a director of Whirlpool Corporation.
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.
16
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 Chicago and Swiss Stock Exchanges.
Stock Prices The composite quarterly high, low and closing prices for PepsiCo common stock for each fiscal quarter of 2006 and 2005 are contained in our Selected Financial Data.
Shareholders At February 1, 2007, there were approximately 192,000 shareholders of record of our common stock.
Dividends We target an annual dividend payout of approximately 45% of prior years 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 9, June 8, September 7, and December 7, 2007. We have paid consecutive quarterly cash dividends since 1965. Information with respect to the quarterly dividends declared in 2006 and 2005 is contained in our Selected Financial Data.
For information on securities authorized for issuance under our equity compensation plans, see Item 12 Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
17
A summary of our common stock repurchases (in millions, except average price per share) during the fourth quarter under the $8.5 billion repurchase program authorized by our Board of Directors and publicly announced on May 3, 2006, and expiring on June 30, 2009, is set forth in the following table. All such shares of common stock were repurchased pursuant to open market transactions, other than 640,000 shares of common stock which were repurchased pursuant to a privately negotiated block trade transaction.
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 (or Approximate Dollar Value) of Shares that may Yet Be Purchased Under the Plans or Programs |
|||||||
9/9/06 |
$ | 8,165 | |||||||||
9/10/06 10/7/06 |
5.8 | $ | 64.86 | 5.8 | (377 | ) | |||||
7,788 | |||||||||||
10/8/06 11/4/06 |
2.2 | 63.19 | 2.2 | (140 | ) | ||||||
7,648 | |||||||||||
11/5/06 12/2/06 |
3.4 | 62.19 | 3.4 | (212 | ) | ||||||
7,436 | |||||||||||
12/3/06 12/30/06 |
1.0 | 63.40 | 1.0 | (61 | ) | ||||||
Total |
12.4 | $ | 63.71 | 12.4 | $ | 7,375 | |||||
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.
18
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 (or Approximate Dollar Value) of Shares that may Yet Be Purchased Under the Plans or Programs | |||||
9/9/06 |
|||||||||
9/10/06 10/7/06 |
2,900 | $ | 323.33 | N/A | N/A | ||||
10/8/06 11/4/06 |
| | N/A | N/A | |||||
11/5/06 12/2/06 |
2,600 | 315.63 | N/A | N/A | |||||
12/3/06 12/30/06 |
1,900 | 313.95 | N/A | N/A | |||||
Total |
7,400 | $ | 318.22 | N/A | N/A | ||||
Item 6. Selected Financial Data
Selected Financial Data is included on page 101.
19
Item 7. Managements Discussion and Analysis
22 | ||
Our Chairman and President and Chief Executive Officer Perspective |
23 | |
28 | ||
29 | ||
30 | ||
30 | ||
31 | ||
36 | ||
37 | ||
38 | ||
39 | ||
42 | ||
46 | ||
47 | ||
51 | ||
52 | ||
53 | ||
55 | ||
57 | ||
58 |
20
61 | ||
62 | ||
64 | ||
65 | ||
66 | ||
70 | ||
73 | ||
Note 4 Property, Plant and Equipment and Intangible Assets |
74 | |
76 | ||
78 | ||
80 | ||
85 | ||
88 | ||
91 | ||
Note 11 Net Income per Common Share from Continuing Operations |
93 | |
94 | ||
95 | ||
96 | ||
98 | ||
100 | ||
101 | ||
102 | ||
103 |
21
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 103. 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.
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 division operates in approximately 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 Lays potato chips, Doritos tortilla chips, Tostitos tortilla chips, Cheetos cheese flavored snacks, Fritos corn chips, branded dips, Ruffles potato chips, Quaker Chewy granola bars, SunChips multigrain snacks, Rold Gold pretzels, Santitas tortilla chips, Frito-Lay nuts, Grandma's cookies, Munchies snack mix, Gamesa cookies, Lays Stax potato crisps, Funyuns onion flavored rings, Quaker Quakes corn and rice snacks, Miss Vickies potato chips, branded crackers, Quaker snack mix, Smartfood popcorn, Chesters fries, Stacys pita chips and Quaker Fruit & Oatmeal bars. FLNA branded products are sold to independent distributors and retailers.
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, Lipton, Sierra Mist, Tropicana juice drinks, Propel, Dole and SoBe. PBNA also manufactures or uses contract manufacturers, markets and sells ready-to-drink tea, coffee and water products through joint ventures with Unilever (under the Lipton brand name) 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 authorized bottlers, and some of these branded products are sold directly by us
22
to independent distributors and retailers. The bottlers sell our brands as finished goods to independent distributors and retailers. PBNAs volume reflects sales to its independent distributors and retailers, as well as the sales of beverages bearing our trademarks that 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 Lays, Walkers, Cheetos, Doritos, Ruffles, Gamesa and Sabritas. 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, Tropicana and Mountain Dew. These brands are sold to authorized 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 authorized 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 authorized 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. QFNAs products include Quaker oatmeal, Aunt Jemima mixes and syrups, Cap'n Crunch cereal, Quaker grits, Life cereal, Rice-A-Roni, Pasta Roni and Near East side dishes. These branded products are sold to independent distributors and retailers.
Our Chairman and President and Chief Executive Officer Perspective
The questions below reflect key questions shareholders often ask about our businesses, and are followed by joint responses from our Chairman, Steve Reinemund, and our President and Chief Executive Officer, Indra Nooyi.
PepsiCos product categories and their impact on health continues to capture media, consumer and regulatory focus. How is PepsiCos portfolio faring in this environment?
As the transformation of PepsiCos portfolio continues, were able to add more choices for consumers to meet their needs for products that can contribute to healthier lifestyles, and were proud of each and every choice we offer.
Our efforts are galvanized by three imperatives: continue making our fun-for-you products more nutritious, develop new products that address the needs of the entire food pyramid, and try to ensure consumers never have to trade off nutrition and taste.
23
The range of product choices we offer grows each year, as we develop or acquire new products or platforms that range from indulgent to good-for-you. At the same time, were improving the nutritional profiles of our larger, core brands. For example, changing cooking oils to sunflower oil for both Lays and Ruffles potato chips at FLNA and Walkers crisps in the United Kingdom reduces the saturated fat in these products without sacrificing taste. And were working on developing new sweeteners and adding more nutritious ingredients to our products such as fiber to foods and beverages and omega-3 fatty acids to juices.
Our portfolio of more nutritious choices is working well in this environment, evidenced by over two-thirds of our North America top line growth in 2006 being driven by products that are PepsiCo Smart Spot eligible meaning they meet authoritative nutritional statements developed by the National Academy of Sciences or the U.S. Food and Drug Administration.
What, specifically, is PepsiCo doing to address regulatory pressures relating to health concerns across the globe?
On the regulatory and policy side, were firm believers in engaging a range of public and private experts to come to workable solutions on such things as how and where our products are sold and marketed. Were actively engaged with policy and thought leaders, as well as food and beverage industry leaders, to reach decisions on steps we can take to support consumers in their quest for healthier lifestyles. This includes insights from PepsiCos Blue Ribbon Advisory Board, a group of leading health and wellness experts and third-party advisors from across the globe, as well as our Ethnic Advisory Boards who have provided insights relating to multicultural consumers.
Most recently, PepsiCos work in the United States with the Clinton Foundation, the American Heart Association and the beverage industry, are examples of working proactively to set policies that put the right kinds of products in the right locations in this case, schools. Were working in our international markets in much the same way.
An advantaged portfolio of good- and better-for-you products products that are Smart Spot eligible has provided, and will continue to provide, growth opportunities at what we call the intersection of business and public interests.
How are you approaching innovation as a means to growth?
Innovation demands that we constantly look around the next corner to ensure were providing products that our consumers and retail customers want. We have a relentless focus on innovation, as new products consistently deliver 15% to 20% of our total growth. In 2006 alone, our North American businesses introduced new products that totaled greater than $1 billion in retail sales.
More strategically said, were focused on game-changing innovation. Clearly, we need to keep our existing big brands fresh while developing products and venturing into new categories.
24
Through a disciplined approach to innovation, weve developed a very strong pipeline for 2007 and beyond, including new products like Flat Earth vegetable and fruit crisps from Frito-Lay, and new beverage entries such as Izze, a sparkling beverage made with 70% fruit juice, and Naked Juice, a line of all natural juices and juice smoothies, acquired in January 2007. And well expand on our successes, such as introducing Baked Walkers crisps in the United Kingdom.
As the lifeblood of any successful consumer products company, we expect innovation will continue to be a key tool for growth at PepsiCo going forward.
How are you addressing rising input costs in your businesses?
Structural inflation is a reality we believe will persist over the next few years. Agricultural commodities, energy and certain metals are in a period of protracted inflation that's unlikely to moderate until supply catches up.
Fortunately, over the years we've demonstrated the resilience of the PepsiCo portfolio to navigate through these headwinds successfully. And we are confident we will find innovative solutions to cover rising input costs. It will mean pulling all available levers to address inflation, as we've always done, such as finding new productivity, strategically hedging our input costs, and executing prudent and judicious pricing.
How are you addressing the carbonated soft drink (CSD) category decline in North America?
Rejuvenating the CSD category requires us to deliver new products, new packaging and new benefits to re-engage consumers. 2007 has one of the strongest line-ups of CSD innovation weve had in many years. In essence, we plan to build a new category for us of "sparkling" beverages.
Whether its through Izze sparkling beverages, our new Jazz line, increased distribution of Pepsi Max throughout our system, new choreography packaging for Pepsi, or other new product and packaging news for Diet Pepsi, Mountain Dew and Sierra Mist, we believe weve got an impressive lineup ready for the marketplace. And were supporting our new products as we continue to support our established core brands.
Looking ahead, we have increased our investment in truly breakthrough innovations to come, like new sweeteners that we believe hold the power to restoring CSD category growth.
You have had good success promoting senior executives from within the Company. What are you doing to ensure you maintain a strong bench and good succession planning?
We announced a number of senior executive changes this year, ranging from CEO to senior executive talent of our operating divisions. Because of the deep bench strength, we were able to provide opportunities to current PepsiCo executives ensuring smooth
25
transitions and tapping into literally hundreds of years worth of experience within the Company.
If anything, this series of moves underscores the importance of continuously building bench strength in our management group. We continue to place a high priority on sustaining our pool of executive talent, and we clearly understand that in the global competition for talent our people planning processes must be world class.
How will Indra Nooyis appointment to CEO change PepsiCos strategic focus or priorities?
Our transition of the CEO role is as seamless a transition as any PepsiCo has ever done, largely reflecting the fact that we have co-authored the strategies the Company is pursuing.
There are no major new strategies that have been put into place since the transition took effect in October of 2006, and we continue to aggressively pursue those strategies that have been driving the Companys growth.
How will PepsiCos work with diversity and inclusion, and its work with corporate social responsibility and corporate governance evolve under new leadership?
Our commitment to diversity and inclusion as a means to drive our growth remains steadfast. We continue to see the impact of our efforts in our business results, as consumer product offerings, promotions and customer programming benefit from the diverse and inclusive workforce and environment were building.
Our focus on corporate responsibility has always been strong and will even be stronger as we contribute to societal growth and help address societal problems. Some would say we have a moral and social obligation. Others would say its simply good business. Either way, we have a major role to play.
Similarly for corporate governance, we continue to find ways to strengthen our approach, our tools and our reporting in the name of transparency for our shareholders and the range of constituents who track our business. For example, in 2006, PepsiCo participated in a pilot program at the SEC to test a new electronic filing system.
These kinds of priorities, which tie directly to our commitment to responsible corporate citizenship, will remain front and center.
Where is PepsiCo in its investment in business process transformation, and specifically its SAP implementation?
Business Process Transformation (BPT) is a multi-year transformation effort to simplify and synchronize our business processes and tools into one common platform.
In 2006, we began implementing SAP. We streamlined our indirect procurement system across our U.S. divisions, and for Quaker, Tropicana and Gatorade, we also streamlined customer orders, implemented a more efficient system for assessing and tracking capital expenditures and advertising and marketing spending, and provided common demand forecasting capability.
The project has an attractive business case including both IT cost savings and operating productivity. Additionally, we expect benefits from increased business information.
26
International has been a big contributor to PepsiCos growth over the past few years. How do you plan to sustain this growth?
PepsiCo International continues to be the growth engine for the Company delivering on our expectations to grow at about twice the rate of our North American businesses. Growth internationally across a wide range of markets is strong.
We believe the strong growth achieved by our PepsiCo International business in 2006 reflects the work of a world-class management team, years of investment, and the implementation of a deliberate strategy to create scale in key international markets that will deliver profitable growth.
The portfolio of international markets continues to broaden and strengthen as we deliver exciting new products, tailored to local tastes, to consumers in approximately 200 countries. And in developing and emerging markets in particular, growth in per capita GDP levels continues to generate increased demand for our products.
PepsiCo made a number of acquisitions in 2006 both in North America and internationally. How is the integration of these businesses going? And what kinds of mergers and acquisitions activity can we expect to see going forward?
Our North American acquisitions within the last year included Stacys bagel and pita chips, Izze carbonated beverages and Naked Juice fruit beverages (acquired January 2, 2007). Each acquisition gives us a new opportunity for growth, whether through new product categories or greater reach into emerging retail channels.
Internationally, we completed the acquisitions of Duyvis nuts in the Netherlands and Star Foods snacks in Poland, as well as Bluebird snacks in New Zealand in early 2007. Here again, each provides opportunity for growth through new geographies and new product lines internationally.
Before any acquisition is made, we apply a disciplined approach to evaluating returns on the investment within a reasonable period and focus on ensuring these businesses add profitable growth to PepsiCo. We feel very good about these acquisitions, and their integration is proceeding well.
Going forward, you can expect us to continue acting on our stated strategy of smaller, tuck-in acquisitions as a means to help us grow.
27
Whats the next big Power of One frontier?
Our Power of One initiatives those directed at accelerating growth for PepsiCo and our retailers through the power of the entire PepsiCo portfolio are most definitely moving to a new level.
In 2006, we conducted "Innovation Summits" with our customers to share a holistic view of how shopping and eating habits are fragmenting. Using the insights from these summits, weve worked with our retail partners and tailored our product offerings by account to maximize the potential of our categories and boost performance and results.
But our partnerships with customers go beyond top-line driving initiatives. Weve expanded it to include end-to-end supply chain efficiencies. We are refreshing our selling and merchandising activities and critically reviewing all touch points with our customers to eliminate inefficiencies like out-of-stocks and reduce "pain points," if any. This initiative extends beyond PepsiCo to include our bottling partners members of the extended PepsiCo family who work hand in hand with us on all of our initiatives.
Our customers include authorized bottlers and independent distributors, including foodservice 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, finished goods and 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
28
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 continues to increase the importance of major customers. In 2006, sales to Wal-Mart represented approximately 9% of our total net revenue; and our top five retail customers represented approximately 26% of our 2006 North American net revenue, with Wal-Mart representing approximately 13%. These percentages include concentrate sales to our bottlers which are used in finished goods sold by them to these retailers. In addition, sales to PBG represented approximately 10% of our total net revenue. See Our Related Party Bottlers and Note 8 for more information on our anchor 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 60% of our North American beverage volume and approximately 18% of our international beverage volume. Our anchor bottlers participate in the bottler funding programs described above. Approximately 8% of our total 2006 sales incentives are related to these bottlers. See Note 8 for additional information on these related parties and related party commitments and guarantees.
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, our bottlers and our distributors 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.
29
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. Our foodservice and vending sales force also distributes certain beverages through our bottlers. This distribution system supplies our products to schools, businesses, stadiums, restaurants and similar locations.
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 distribution. In measured channels, our chief beverage competitor, The Coca-Cola Company, has a slightly larger share of 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, product 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.
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.
30
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, the loss of major customers and failure to maintain good relationships with our bottling partners, |
|
global, economic, environmental and political conditions, |
|
the regulatory environment, |
|
workforce retention and outsourcing, |
|
raw materials and other supplies, |
|
competition, and |
|
market risks. |
Please see Risk Factors in Item 1A. above 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 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; |
|
PepsiCos Risk Management Office, which manages the overall risk management 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 PepsiCos Audit Committee and Board of Directors; and |
|
PepsiCo Corporate Audit, which confirms the ongoing effectiveness of the risk management framework through periodic audit and review procedures. |
In 2006, we continued to focus our mitigation efforts where it was determined that actions were necessary and appropriate to further reduce PepsiCos exposure to risks,
31
integrating those efforts in our businesses operating plans and budgets, where accountability is assigned and performance measured. Some highlights include:
|
To address certain risks related to the demand for our products, such as consumer health concerns about product attributes and ingredients, we continued to focus on the development of products that respond to consumer trends, including formulating products to lower sugar, fats, and sodium and adding ingredients and new products that can deliver nutritional benefits. For example, at FLNA we introduced a new portion control line of 100-calorie offerings, and we also switched to NuSun sunflower oil, an oil containing 90% mono- and polyunsaturated fats and less saturated fat than most other cooking oils, for our Lays and Ruffles potato chips. Internationally, we reduced the amount of saturated fats in our Walkers crisps in the United Kingdom by 70% and the amount of salt by 25%. Beyond providing more nutritious product choices, and in an effort to help address the growing concerns regarding childhood obesity trends in the U.S., we joined with the Alliance for a Healthier Generation a joint initiative of the William J. Clinton Foundation and the American Heart Association to set voluntary beverage guidelines for U.S. schools that limit portion sizes and establish voluntary guidelines for snacks and side items in U.S. schools. |
|
To help ensure that we maintain our reputation for providing safe convenient foods and beverages, we enhanced the coordination of our division-led product integrity efforts through the PepsiCo Product Integrity Council (PPIC), a cross-functional forum to share leading practices and confer about areas of potential risk. Through the PPIC, we completed a third-party review of our food safety and food security programs which helped identify opportunities to better leverage internal best practices across all of our businesses. Furthermore, we enhanced our product sampling and testing protocols. |
|
We continued to enhance our information technology infrastructure and application systems by upgrading our networks and updating or retiring older infrastructure and systems. We signed a multi-year managed services contract to consolidate PIs technology infrastructure into three data centers and another multi-year services contract to provide and manage PIs data network. The data center services will provide full system and data protection and backup and recovery capabilities, and the data network services will enhance security and provide 24x7x365 monitoring and response capabilities. We expect to fully implement both of these service contracts over the next three years. |
|
With respect to our BPT initiative, we continue to build on our learnings and incorporate these into the metrics used to monitor the project. Specific actions taken this year include revising the overall project structure, project resources and timelines. We also continue to invest in process and control resources to build a more automated control environment that remains compliant with the Sarbanes-Oxley Act. |
|
To address supply chain risks, we continued to assess our capability to mitigate potential business disruptions and increased the coordination of our efforts across IT disaster recovery, crisis management and business continuity. Having recognized the potentially significant impact of a pandemic such as avian |
32
influenza on our employees and our business, we formed a cross-functional, cross-divisional Pandemic Planning Team that worked to develop strategies and tactics to mitigate that impact. |
|
Against a challenging trade environment, we continued to work to ensure consistent and equitable trade practices across our customers, to deliver value-added product innovation and differentiation, to achieve the most effective trade spend across customers and channels through productivity programs, and to more effectively communicate to our customers the economic advantages of our direct-store-delivery (DSD) system. |
|
To address risks relating to legal and regulatory issues, we have launched an enhanced PepsiCo Code of Conduct training program in multiple languages. We also improved the functionality of our employee hotline to better enable reporting of compliance and ethics concerns and enhanced our process for handling reported incidents and ensuring appropriate corrective action. Furthermore, we completed environmental and health & safety audits that will help focus our mitigation efforts in these areas going forward. |
|
As part of our ongoing efforts to maintain a talented workforce, we continued to focus on leveraging diversity and inclusion, designing the right organizational model to meet our business needs and ensuring we have the talent base necessary to lead our growing businesses. Tactically, we worked to expand the breadth and depth of our succession plans and reinforced our focus on managing our people through an increased emphasis on people development as part of our performance management process. |
|
To manage our risks related to raw materials, we continued to reduce our input cost volatility across our total portfolio by employing various hedging strategies where appropriate and as market opportunities arose. We also continued to utilize our scale to achieve maximum value across our commodity portfolio and to ensure adequate supply. In addition, we have developed strategic global supplier solutions to help minimize volatility. |
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. |
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 include the use of derivatives. Certain derivatives are designated as either cash flow or
33
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 that qualify for hedge accounting had a face value of $55 million at December 30, 2006 and $89 million at December 31, 2005. The open derivative contracts that qualify for hedge accounting resulted in net unrealized gains of less than $1 million at December 30, 2006 and $39 million at December 31, 2005. We estimate that a 10% decline in commodity prices would have reduced our unrealized gains on open contracts to $2 million of unrealized losses in 2006 and $35 million of unrealized gains in 2005.
Our open commodity derivative contracts that do not qualify for hedge accounting had a face value of $196 million at December 30, 2006 and $129 million at December 31, 2005. The open derivative contracts that do not qualify for hedge accounting resulted in net losses of $28 million in 2006 and $3 million in 2005. We estimate that a 10% decline in commodity prices would have increased our net losses on open contracts to $31 million in 2006 and $4 million in 2005.
We expect to be able to continue to reduce the impact of increases in our raw material and energy 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 approximately 40% of our net revenue, with Mexico, the United Kingdom and Canada comprising approximately 20% of our net revenue. As a result, we are exposed to foreign currency risks, including unforeseen economic changes and political unrest. During 2006, net favorable foreign currency, primarily due to appreciation in the Canadian dollar and Brazilian real, contributed almost 1 percentage
34
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 our 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 $1.0 billion at December 30, 2006 and $1.1 billion at December 31, 2005. The contracts that qualify for hedge accounting resulted in net unrealized losses of $6 million at December 30, 2006 and $9 million at December 31, 2005. We estimate that an unfavorable 10% change in the exchange rates would have resulted in unrealized losses of $86 million in 2006 and $81 million in 2005. The contracts not meeting the criteria for hedge accounting resulted in net losses of $10 million in 2006 and net gains of $14 million in 2005. All losses and gains were 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 2006 and 2005 variable rate debt and investment levels, a 1-percentage-point increase in interest rates would have decreased net interest expense by $10 million in 2006 and $8 million in 2005.
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.
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
35
possible outcomes. Other than our accounting for 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.
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. |
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 generally within 30 to 90 days internationally, 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.
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 revenue and totaled $10.1 billion in 2006, $8.9 billion in 2005 and $7.8 billion in 2004. Sales incentives include payments to customers for performing merchandising activities on our behalf, such as payments for in-store
36
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, such as fountain pouring rights, may extend beyond one year. The costs incurred to obtain incentive arrangements are recognized over no longer than the contract period as a reduction of revenue, and the remaining balances of $297 million at year-end 2006 and $321 million at year-end 2005 are included in current assets and other assets on our 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 income statement.
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 the competitive environment, market share, brand history and the macroeconomic environment of the countries in which the brand is sold.
Perpetual brands and goodwill, including the goodwill that is part of our noncontrolled bottling investment balances, are not amortized. Perpetual brands and goodwill are assessed for impairment at least annually. If the carrying amount of a perpetual brand exceeds its fair value, as determined by its discounted cash flows, an impairment loss is recognized in an amount equal to that excess. Goodwill is evaluated using a two-step impairment test at the reporting unit level. A reporting unit can be a division or business within a division. The first step compares the book value of a reporting unit, including
37
goodwill, with its fair value, as determined by its discounted cash flows. If the book value of a reporting unit exceeds its fair value, we complete the second step to determine the amount of goodwill impairment loss that we should record. In the second step, we determine an implied fair value of the reporting units goodwill by allocating the fair value of the reporting unit to all of the assets and liabilities other than goodwill (including any unrecognized intangible assets). The amount of impairment loss is equal to the excess of the book value of the goodwill over the implied fair value of that goodwill.
Amortizable brands are only evaluated for impairment upon a significant change in the operating or macroeconomic environment. If an evaluation of the undiscounted future 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 based on the best available market information and 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 30, 2006, we had $5.8 billion of perpetual brands and goodwill, of which approximately 65% 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.
In 2006, we recognized non-cash tax benefits of $602 million (the 2006 Tax Adjustments), substantially all of which related to the Internal Revenue Services (IRS) examination of our consolidated income tax returns for the years 1998 through 2002. The IRS issued a Revenue Agents Report (RAR), and we are in agreement with their conclusion, except for one matter which we continue to dispute. The agreed adjustments relate to transfer pricing and various other transactions, including certain
38
acquisitions, the public offering of PBG, as well as the restructuring of our international snack foods operations during that audit period.
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). 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 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. In 2005, we repatriated approximately $7.5 billion in earnings previously considered indefinitely reinvested outside the U.S. and recorded income tax expense of $460 million related to 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 30, 2006, we had approximately $10.8 billion of undistributed international earnings.
In 2006, our annual tax rate was 19.3% compared to 36.1% in 2005 as discussed in Other Consolidated Results. The tax rate in 2006 decreased 16.8 percentage points primarily reflecting the 2006 Tax Adjustments, the absence of the 2005 AJCA tax charge and the resolution of certain state income tax audits in the current year. In 2007, our annual tax rate is expected to be 27.7%, primarily reflecting the absence of the 2006 Tax Adjustments.
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. A majority of our employees participate in our stock-based compensation programs. Stock option 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.
39
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.
Executives who are awarded long-term incentives based on their performance are offered the choice of stock options or restricted stock units (RSUs). 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. 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 RSU is settled in a share of our stock after the vesting period. 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. SharePower awards generally have a 10-year term and vest over three years.
Method of Accounting
We account for our employee stock options, which include grants under our executive program and broad-based SharePower program, under the fair value method of accounting using a Black-Scholes valuation model to measure stock option expense at the date of grant. All stock grants have an exercise price equal to the fair market value of our common stock on the date of grant. The fair value of stock option grants is amortized to expense over the vesting period.
On January 1, 2006, we adopted Statement of Financial Accounting Standards (SFAS) 123R, Share-Based Payment, under the modified prospective method. Since we had previously accounted for our stock-based compensation plans under the fair value provisions of SFAS 123, our adoption did not significantly impact our financial position or our results of operations. Under SFAS 123R, actual tax benefits recognized in excess of tax benefits previously established upon grant are reported as a financing cash inflow. Prior to adoption, such excess tax benefits were reported as an operating cash inflow.
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 in 2006 was approximately 28% to FLNA, 19% to PBNA, 32% to PI, 4% to QFNA and 17% 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.
40
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, our stock price and dividend yield. Our weighted-average fair value assumptions include:
Estimated 2007 |
2006 | 2005 | 2004 | |||||
Expected life |
6 yrs. | 6 yrs. | 6 yrs. | 6 yrs. | ||||
Risk free interest rate |
5.7% | 4.5% | 3.8% | 3.3% | ||||
Expected volatility |
18% | 18% | 23% | 26% | ||||
Expected dividend yield |
1.9% | 1.9% | 1.8% | 1.8% |
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.
2007 Estimated Expense and Sensitivity of Assumptions
Our stock-based compensation expense, including RSUs, is as follows:
Estimated 2007 |
2006 | 2005 | ||||
Stock-based compensation expense |
$271 | $270 | $311 |
If we assumed a 100-basis-point change in the following assumptions, our estimated 2007 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 |
$1 | $(1) | ||
Expected dividend yield |
$(9) | $10 |
If the expected life were assumed to be one year longer, our estimated 2007 stock-based compensation expense would increase by $7 million. If the expected life were assumed to be one year shorter, our estimated 2007 stock-based compensation expense would decrease by $8 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.
41
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. and Canada 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.
On December 30, 2006, we adopted SFAS 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans an amendment of FASB Statements No. 87, 88, 106, and 132(R) (SFAS 158). SFAS 158 requires that we recognize the overfunded or underfunded status of our pension and retiree medical plans (our Plans) as an asset or liability on our December 30, 2006 balance sheet. Subsequent changes in the funded status will be recognized in comprehensive income in the year in which they occur. SFAS 158 also requires that, beginning in 2008, our assumptions used to measure our annual pension and retiree medical expenses be determined as of the balance sheet date, and all plan assets and liabilities be reported as of that date. Currently, 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. In accordance with SFAS 158, prior year amounts have not been adjusted. For further information regarding the impact of our adoption of SFAS 158, see Note 7.
Our Assumptions
The determination of pension and retiree medical plan obligations and related 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 expenses 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 managements best judgment regarding future expectations. Due to the significant management judgment involved, our assumptions could have a material impact on the measurement of our pension and retiree medical benefit expenses and obligations.
42
At each measurement date, the discount rate is based on interest rates for high-quality, long-term corporate debt securities with maturities comparable to those of our liabilities. In the U.S., we use the Moodys Aa Corporate Index yield and adjust for differences between the average duration of the bonds in this Index and the average duration of our benefit 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 established 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. Our expected long-term rate of return on U.S. plan assets is 7.8%, reflecting estimated long-term rates of return of 9.3% from equity securities and 5.8% from fixed income securities. We use a market-related value method that recognizes each years 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 that increase or decrease benefits for prior employee service (prior service cost/(credit)) is included in earnings on a straight-line basis over the average remaining service period of those employees 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 expenses are as follows:
2007 | 2006 | 2005 | ||||
Pension |
||||||
Expense discount rate |
5.7% | 5.6% | 6.1% | |||
Expected rate of return on plan assets |
7.7% | 7.7% | 7.8% | |||
Expected rate of salary increases |
4.5% | 4.4% | 4.3% | |||
Retiree medical |
||||||
Expense discount rate |
5.8% | 5.7% | 6.1% | |||
Current health care cost trend rate |
9.0% | 10.0% | 11.0% |
43
Future Expense
The estimated changes in pension and retiree medical expense are as follows:
Pension | Retiree Medical |
|||||||
2006 expense |
$ | 417 | $ | 127 | ||||
Increase in discount rate |
(15 | ) | (2 | ) | ||||
(Decrease)/Increase in experience loss amortization |
(1 | ) | 1 | |||||
Impact of contributions |
(2 | ) | | |||||
Other |
(3 | ) | 4 | |||||
2007 estimated expense |
$ | 396 | $ | 130 | ||||
Pension and retiree medical 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 for North American employees. Division results also include interest costs, measured at a fixed discount rate, for retiree medical plans. Interest costs for the pension plans, measured at a fixed discount rate, and the effect of changes in discount rates, gains and losses other than those due to demographics, pension asset returns and the impact of pension funding are all reflected in corporate unallocated expenses.
Based on our current assumptions, which reflect our prior experience, current plan provisions and expectations for future experience, we expect our pension expense to decrease slightly in 2008, declining to approximately $360 million by 2012 as unrealized losses are amortized. If our assumptions and our plan provisions for retiree medical costs remain unchanged and our experience mirrors these assumptions, we expect our annual retiree medical expense beyond 2007 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 2007 pension expense is an increase of approximately $37 million. The estimated impact on 2007 pension expense of a 25-basis-point decrease in the expected rate of return 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.
44
Our pension contributions for 2006 were $59 million, all of which were non-discretionary. In 2007, we expect to make contributions of up to $150 million with up to $75 million expected to be discretionary. Our cash payments for retiree medical are estimated to be approximately $85 million in 2007. As our retiree medical plans are not subject to regulatory funding requirements, we fund these plans on a pay-as-you-go basis. For estimated future benefit payments, including our pay-as-you-go payments as well as those from trusts, see Note 7.
Recent Accounting Pronouncements
In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108), to address diversity in practice in quantifying financial statement misstatements. SAB 108 requires that we quantify misstatements based on their impact on each of our financial statements and related disclosures. On December 30, 2006, we adopted SAB 108. Our adoption of SAB 108 did not impact our financial statements.
In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxesan interpretation of FASB Statement No. 109 (FIN 48), which clarifies the accounting for uncertainty in tax positions. FIN 48 requires that we recognize in our financial statements, the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective as of the beginning of our 2007 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. We do not expect our adoption of FIN 48 to materially impact our financial statements.
In September 2006, the FASB issued SFAS 157, Fair Value Measurements (SFAS 157), which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The provisions of SFAS 157 are effective as of the beginning of our 2008 fiscal year. We are currently evaluating the impact of adopting SFAS 157 on our financial statements.
45
The year-over-year comparisons of our financial results are affected by the following items:
2006 | 2005 | |||||||
Net revenue |
||||||||
53rd week |
| $ | 418 | |||||
Operating profit |
||||||||
2006 restructuring and impairment charges |
$ | (67 | ) | | ||||
53rd week |
| $ | 75 | |||||
2005 restructuring charges |
| $ | (83 | ) | ||||
Net income |
||||||||
2006 restructuring and impairment charges |
$ | (43 | ) | | ||||
2006 Tax Adjustments |
$ | 602 | | |||||
PepsiCo share of PBG tax settlement |
$ | 18 | | |||||
AJCA tax charge |
| $ | (460 | ) | ||||
53rd week |
| $ | 57 | |||||
2005 restructuring charges |
| $ | (55 | ) | ||||
Net income per common share diluted |
||||||||
2006 restructuring and impairment charges |
$ | (0.03 | ) | | ||||
2006 Tax Adjustments |
$ | 0.36 | | |||||
PepsiCo share of PBG tax settlement |
$ | 0.01 | | |||||
AJCA tax charge |
| $ | (0.27 | ) | ||||
53rd week |
| $ | 0.03 | |||||
2005 restructuring charges |
| $ | (0.03 | ) |
For the items affecting our 2004 results, see Notes 3 and 5, as well as our 2005 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.
2006 Restructuring and Impairment Charges
In 2006, we incurred a charge of $67 million in conjunction with consolidating the manufacturing network at FLNA by closing two plants in the U.S., and rationalizing other assets, to increase manufacturing productivity and supply chain efficiencies.
2005 Restructuring Charges
In 2005, we incurred restructuring charges of $83 million to reduce costs in our operations, principally through headcount reductions.
46
2006 Tax Adjustments
In 2006, we recognized non-cash tax benefits of $602 million, substantially all of which related to the IRSs examination of our consolidated tax returns for the years 1998 through 2002.
PepsiCo Share of PBG Tax Settlement
In 2006, the IRS concluded its examination of PBGs consolidated income tax returns for the years 1999 through 2000 (PBGs Tax Settlement). Consequently, a non-cash benefit of $21 million was included in bottling equity income as part of recording our share of PBGs financial results.
AJCA Tax Charge
In 2005, we repatriated approximately $7.5 billion in earnings previously considered indefinitely reinvested outside the U.S. in connection with the AJCA and recorded income tax expense of $460 million related to this repatriation.
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, gallons, 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.
In 2006, total servings increased 5.5% over the prior year, as servings for beverages worldwide grew over 6% and servings for snacks worldwide grew 5%. All of our divisions positively contributed to the total servings growth. In 2005, total servings increased 7% compared to 2004, as servings for beverages worldwide grew over 7% and servings for snacks worldwide grew 6%.
47
Net Revenue and Operating Profit
Change | ||||||||||||||||||
2006 | 2005 | 2004 | 2006 | 2005 | ||||||||||||||
Total net revenue |
$ | 35,137 | $ | 32,562 | $ | 29,261 | 8 | % | 11 | % | ||||||||
Operating profit |
||||||||||||||||||
FLNA |
$ | 2,615 | $ | 2,529 | $ | 2,389 | 3 | % | 6 | % | ||||||||
PBNA |
2,055 | 2,037 | 1,911 | 1 | % | 7 | % | |||||||||||
PI |
1,948 | 1,607 | 1,323 | 21 | % | 21 | % | |||||||||||
QFNA |
554 | 537 | 475 | 3 | % | 13 | % | |||||||||||
Corporate unallocated |
(733 | ) | (788 | ) | (689 | ) | (7 | )% | 14 | % | ||||||||
Restructuring and impairment charges |
| | (150 | ) | ||||||||||||||
Total operating profit |
$ | 6,439 | $ | 5,922 | $ | 5,259 | 9 | % | 13 | % | ||||||||
Total operating profit margin |
18.3 | % | 18.2 | % | 18.0 | % | 0.1 | 0.2 |
2006
Net revenue increased 8% primarily reflecting higher volume and positive effective net pricing across all divisions. The volume gains and the effective net pricing each contributed 3 percentage points to net revenue growth. Acquisitions contributed 1 percentage point and foreign exchange contributed almost 1 percentage point to net revenue growth. The absence of the prior years additional week reduced net revenue by over 1 percentage point and reduced volume growth by almost 1 percentage point.
Total operating profit increased 9% and margin increased 0.1 percentage points. The operating profit gains reflect the net revenue growth, partially offset by the impact of higher raw material and energy costs across all divisions. The absence of the prior years additional week reduced operating profit growth by over 1 percentage point.
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. 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
48
marketing expenses. Total operating profit margin also benefited from a favorable comparison to prior year restructuring and impairment charges. The additional week in 2005 contributed over 1 percentage point to total operating profit growth.
Corporate Unallocated Expenses
Corporate unallocated expenses include the costs of our corporate headquarters, centrally-managed initiatives, such as our BPT initiative in North America, 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.
In 2006, corporate unallocated expenses decreased $55 million primarily reflecting the absence of a non-recurring charge of $55 million in the prior year to conform our method of accounting across all divisions, primarily for warehouse and freight costs. Higher costs associated with our BPT initiative of $35 million, as well as the unfavorable comparison to the prior years $25 million gain in connection with the settlement of a class action lawsuit related to our purchases of high fructose corn syrup from 1991 to 1995, were offset by the favorable impact of certain other corporate 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.
Change | ||||||||||||||||||
2006 | 2005 | 2004 | 2006 | 2005 | ||||||||||||||
Bottling equity income |
$ | 616 | $ | 557 | $ | 380 | 11 | % | 46 | % | ||||||||
Interest expense, net |
$ | (66 | ) | $ | (97 | ) | $ | (93 | ) | (33 | )% | 4 | % | |||||
Annual tax rate |
19.3 | % | 36.1 | % | 24.7 | % | ||||||||||||
Net income continuing operations |
$ | 5,642 | $ | 4,078 | $ | 4,174 | 38 | % | (2 | )% | ||||||||
Net income per common share continuing operations diluted |
$ | 3.34 | $ | 2.39 | $ | 2.41 | 40 | % | (1 | )% |
49
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 reduce our ownership to the level at the time of PBGs initial public offering, since our ownership has increased as a result of PBGs share repurchase program. We sold 10.0 million and 7.5 million shares of PBG stock in 2006 and 2005, respectively. The resulting lower ownership percentage reduces the equity income from PBG that we recognize.
2006
Bottling equity income increased 11% primarily reflecting a $186 million pre-tax gain on our sale of PBG stock, which compared favorably to a $126 million pre-tax gain in the prior year. The non-cash gain of $21 million from our share of PBGs Tax Settlement was fully offset by lower equity income from our anchor bottlers in the current year, primarily resulting from the impact of their respective adoptions of SFAS 123R in 2006.
Net interest expense decreased 33% primarily reflecting higher average rates on our investments and lower debt balances, partially offset by lower investment balances and the impact of higher average rates on our borrowings.
The tax rate decreased 16.8 percentage points compared to prior year primarily reflecting the 2006 Tax Adjustments, the absence of the 2005 AJCA tax charge and the resolution of certain state income tax audits in the current year.
Net income increased 38% and the related net income per share increased 40%. These increases primarily reflect the 2006 Tax Settlement, the absence of the AJCA tax charge and our solid operating profit growth.
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.
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 AJCA tax charge, as well as the absence of income tax benefits of $266 million recorded in 2004 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
50
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 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.
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. For additional information on these items and our divisions, see Note 1.
FLNA | PBNA | PI | QFNA | Total | ||||||||||||||||
Net Revenue, 2006 |
$ | 10,844 | $ | 9,565 | $ | 12,959 | $ | 1,769 | $ | 35,137 | ||||||||||
Net Revenue, 2005 |
$ | 10,322 | $ | 9,146 | $ | 11,376 | $ | 1,718 | $ | 32,562 | ||||||||||
% Impact of: |
||||||||||||||||||||
Volume |
1 | % | 3 | %(a) | 6 | %(a) | 1 | % | 3 | % | ||||||||||
Effective net pricing |
3 | 1 | 4 | 2 | 3 | |||||||||||||||
Foreign exchange |
0.5 | | 1 | 1 | 1 | |||||||||||||||
Acquisitions/divestitures |
0.5 | | 3 | | 1 | |||||||||||||||
% Change(b) |
5 | % | 5 | % | 14 | % | 3 | % | 8 | % | ||||||||||
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 | |||||||||||||||
Acquisitions/divestitures |
| | 2 | | 0.5 | |||||||||||||||
% Change(b) |
8 | % | 10 | % | 15 | % | 13 | % | 11 | % | ||||||||||
(a) |
For beverages sold to our bottlers, volume growth is based on our concentrate shipments and equivalents. |
(b) |
Amounts may not sum due to rounding. |
51
% Change | |||||||||||||
2006 | 2005 | 2004 | 2006 | 2005 | |||||||||
Net revenue |
$ | 10,844 | $ | 10,322 | $ | 9,560 | 5 | 8 | |||||
Operating profit |
$ | 2,615 | $ | 2,529 | $ | 2,389 | 3 | 6 |
2006
Net revenue grew 5% reflecting volume growth of 1% and positive effective net pricing due to salty snack pricing actions and favorable mix. Pound volume grew primarily due to double-digit growth in SunChips, Multipack and Quaker Rice Cakes. These volume gains were partially offset by low-single-digit declines in trademark Lays and Doritos. Overall, salty snacks revenue grew 5% with volume growth of 1%, and other macro snacks revenue grew 9% with volume growth of 6%. The Stacys Pita Chip Company acquisition contributed approximately 0.5 percentage points to both revenue and volume growth. The absence of the prior years additional week reduced volume and net revenue growth by 2 percentage points.
Operating profit grew 3% reflecting the net revenue growth. This growth was partially offset by higher commodity costs, primarily cooking oil and energy. Operating profit was also negatively impacted by almost 3 percentage points as a result of a fourth quarter charge for the consolidation of the manufacturing network, including the closure of two plants and rationalization of other manufacturing assets. The absence of the prior years additional week, which reduced operating profit growth by 2 percentage points, was largely offset by the impact of restructuring charges in the prior year to reduce costs in our operations, principally through headcount reductions.
Smart Spot eligible products represented approximately 15% of net revenue. These products experienced double-digit revenue growth, while the balance of the portfolio had low-single-digit revenue growth.
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 Lays 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 SunChips. 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 other macro snacks revenue grew 13% with volume growth of 1%. Other macro snacks products revenue benefited from favorable mix. The additional week contributed 2 percentage points to volume and net revenue growth.
52
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.
Smart Spot eligible products 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.
PepsiCo Beverages North America
% Change | |||||||||||||
2006 | 2005 | 2004 | 2006 | 2005 | |||||||||
Net revenue |
$ | 9,565 | $ | 9,146 | $ | 8,313 | 5 | 10 | |||||
Operating profit |
$ | 2,055 | $ | 2,037 | $ | 1,911 | 1 | 7 |
2006
Bottler case sales (BCS) volume grew 4%. The volume increase was driven by a 14% increase in non-carbonated beverages, partially offset by a 2% decline in CSDs. The non-carbonated portfolio performance was driven by double-digit growth in trademark Aquafina, Gatorade, Lipton ready-to-drink teas, Tropicana juice drinks and Propel. Tropicana Pure Premium experienced a low-single-digit decline in volume. The decline in CSDs reflects a low-single-digit decline in trademark Pepsi, partially offset by a mid-single-digit increase in trademark Sierra Mist and a low-single-digit increase in trademark Mountain Dew. Across the brands, regular CSDs experienced a low-single-digit decline and diet CSDs declined slightly. The additional week in 2005 had no significant impact on volume growth as bottler volume is reported based on a calendar month.
Net revenue grew 5%. Positive mix contributed to the revenue growth, reflecting the strength of non-carbonated beverages. Price increases taken in 2006, primarily on concentrate, Tropicana Pure Premium and fountain, were offset by overall higher trade spending. The absence of the prior years additional week reduced net revenue growth by 1 percentage point.
Operating profit increased 1% primarily reflecting the net revenue growth and lower advertising and marketing expenses. Higher raw material costs, primarily oranges, increased supply chain costs in Gatorade and higher energy costs substantially offset the operating profit increase. Total marketplace spending for the year increased, reflecting a shift from advertising and marketing spending to trade spending. Additionally, the impact of more-favorable settlements of trade spending accruals in 2005 was mostly offset by a favorable insurance settlement of $29 million in 2006. The absence of the
53
prior years additional week, which reduced operating profit growth by 1 percentage point, was fully offset by the impact of charges taken in the fourth quarter of 2005 to reduce costs in our operations, principally through headcount reductions.
Smart Spot eligible products represented over 70% of net revenue. These products experienced high-single-digit revenue growth, while the balance of the portfolio declined in the low-single-digit range.
2005
Net revenue grew 10% and BCS 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 2005. 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 2005 to reduce costs in our operations, principally through headcount reductions.
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.
54
% Change | |||||||||||||
2006 | 2005 | 2004 | 2006 | 2005 | |||||||||
Net revenue |
$ | 12,959 | $ | 11,376 | $ | 9,862 | 14 | 15 | |||||
Operating profit |
$ | 1,948 | $ | 1,607 | $ | 1,323 | 21 | 21 |
2006
International snacks volume grew 9%, reflecting double-digit growth in Russia, Turkey, Egypt and India, and single-digit growth at Sabritas in Mexico. Overall, the Europe, Middle East & Africa region grew 17%, the Latin America region grew 2.5% and the Asia Pacific region grew 12%. Acquisitions of two businesses in Europe in 2006 increased the Europe, Middle East & Africa region volume growth by nearly 6 percentage points. The acquisition of a business in Australia increased the Asia Pacific region volume growth by 1 percentage point. In aggregate, acquisitions contributed 2 percentage points to the reported total PepsiCo International snack volume growth rate. The absence of the prior years additional week reduced the growth rate by 1 percentage point.
Beverage volume grew 9%, reflecting broad-based increases led by double-digit growth in the Middle East, China, Argentina, Russia and Venezuela. The Europe, Middle East & Africa region grew 11%, the Asia Pacific region grew 9% and the Latin America region grew 7%. Acquisitions contributed 1 percentage point to the Europe, Middle East & Africa region volume growth rate and contributed slightly to the reported total PepsiCo International beverage volume growth rate. CSDs grew at a high-single-digit rate while non-carbonated beverages grew at a double-digit rate.
Net revenue grew 14%, primarily as a result of the broad-based volume growth and favorable effective net pricing. The net impact of acquisitions and divestitures contributed nearly 3 percentage points to net revenue growth. Foreign currency contributed 1 percentage point of growth. The absence of the prior years additional week reduced net revenue growth by 1 percentage point.
Operating profit grew 21%, driven primarily by the net revenue growth, partially offset by increased raw material and energy costs. The net impact of acquisitions and divestitures had no impact on the growth rate. Foreign currency contributed 1 percentage point of growth. The absence of the prior years additional week, which reduced the operating profit growth rate by 1 percentage point, was fully offset by the impact of charges taken in 2005 to reduce costs in our operations and rationalize capacity.
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 in 2004 of our interest in a
55
South Korea joint venture, reduced Asia Pacific region volume by 11 percentage points. The 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 the first quarter of 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.
56
% Change | |||||||||||||
2006 | 2005 | 2004 | 2006 | 2005 | |||||||||
Net revenue |
$ | 1,769 | $ | 1,718 | $ | 1,526 | 3 | 13 | |||||
Operating profit |
$ | 554 | $ | 537 | $ | 475 | 3 | 13 |
2006
Net revenue grew 3% and volume increased 1%. The volume increase reflects mid-single-digit growth in Oatmeal, high-single-digit growth in Life cereal and low-single-digit growth in Capn Crunch cereal. These increases were partially offset by a low-single-digit decline in Aunt Jemima syrup and mix and a mid-single-digit decline in Rice-A-Roni. Net revenue growth was also driven by favorable effective net pricing, which contributed almost 2 percentage points to net revenue growth, and favorable Canadian foreign exchange rates which contributed almost 1 percentage point. The absence of the prior years additional week reduced both net revenue and volume growth by approximately 2 percentage points.
Operating profit increased 3% primarily reflecting the net revenue growth. Increased cost of sales, primarily driven by higher raw material and energy costs, were largely offset by lower advertising and marketing expenses. The absence of the prior years additional week reduced operating profit growth by approximately 2 points.
Smart Spot eligible products represented approximately 55% of net revenue and had mid-single-digit net revenue growth. The balance of the portfolio experienced a low-single-digit decline. The absence of the prior years additional week negatively impacted these results.
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 Capn 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 material costs in the latter part of 2005. The additional week in 2005 contributed approximately 2 percentage points to operating profit growth.
57
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.
Our Liquidity and Capital Resources
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 2006, our operations provided $6.1 billion of cash compared to $5.9 billion in the prior year. The increase primarily reflects our solid business results. Our operating cash flow in 2006 also reflects increased net tax payments over the prior year of $897 million, which included $420 million related to our repatriation of international cash in 2005 in connection with the AJCA, substantially offset by reductions in pension plan contributions over the prior year of $744 million.
Investing Activities
In 2006, we used $194 million for our investing activities. Capital spending of $2.1 billion and acquisitions of $522 million were mostly offset by net sales of short-term investments of $2.0 billion and proceeds from our sale of PBG stock of $318 million. The increase in capital spending over the prior year primarily reflects increased investments at PI and in our North American Gatorade business, as well as increased support behind our ongoing BPT initiative. 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 the first quarter of 2007, we completed our acquisition of Naked Juice Company which was funded with existing domestic cash. This acquisition will be included in the first quarter of 2007 as an investing activity in our Condensed Consolidated Statement of Cash Flows.
We anticipate net capital spending of approximately $2.6 billion in 2007, which is expected to be within our net capital spending target of approximately 5% to 7% of net revenue in each of the next few years. Planned capital spending in 2007 includes increased investments at PI, particularly in the developing and emerging markets, and
58
additional investments in manufacturing capacity to support our North American Gatorade business as well as other non-carbonated beverage businesses. New capital projects are evaluated on a case-by-case basis and must meet certain payback and internal rate of return targets.
Financing Activities
In 2006, we used $6.0 billion for our financing activities, primarily reflecting the return of operating cash flow to our shareholders through common share repurchases of $3.0 billion and dividend payments of $1.9 billion. Net repayments of short-term borrowings of $2.3 billion were partially offset by stock option proceeds of $1.2 billion. In 2005, we used $1.9 billion for our financing activities, primarily reflecting 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.
On May 3, 2006, our Board of Directors authorized and publicly announced our new $8.5 billion repurchase program, which expires on June 30, 2009. Since inception of the new program, we have repurchased $1.1 billion of shares, leaving $7.4 billion of remaining authorization. We have historically repurchased significantly more shares each year than we have issued under our stock-based compensation plans, with average net annual repurchases of 1.4% of outstanding shares for the last five years. We target an annual dividend payout of approximately 45% of prior years net income from continuing operations. Annually, 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.
2006 | 2005 | 2004 | ||||||||||
Net cash provided by operating activities |
$ | 6,084 | $ | 5,852 | $ | 5,054 | ||||||
Capital spending |
(2,068 | ) | (1,736 | ) | (1,387 | ) | ||||||
Sales of property, plant and equipment |
49 | 88 | 38 | |||||||||
Management operating cash flow |
$ | 4,065 | $ | 4,204 | $ | 3,705 | ||||||
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.
59
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 Moodys and A+ from Standard & Poors contribute to our ability to access global capital markets. We have maintained strong investment grade ratings for over a decade. 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. At year-end 2006, we believe it is remote that these guarantees would require any cash payment. We do not enter into off-balance-sheet transactions specifically structured to provide income or tax benefits or to avoid recognizing or disclosing assets or liabilities. See Note 9 for a description of our off-balance-sheet arrangements.
60
OUR FINANCIAL RESULTS
Consolidated Statement of Income
PepsiCo, Inc. and Subsidiaries
Fiscal years ended December 30, 2006, December 31, 2005 and December 25, 2004
(in millions except per share amounts) |
2006 | 2005 | 2004 | |||||||||
Net Revenue |
$ | 35,137 | $ | 32,562 | $ | 29,261 | ||||||
Cost of sales |
15,762 | 14,176 | 12,674 | |||||||||
Selling, general and administrative expenses |
12,774 | 12,314 | 11,031 | |||||||||
Amortization of intangible assets |
162 | 150 | 147 | |||||||||
Restructuring and impairment charges sts |
| | 150 | |||||||||
Operating Profit |
6,439 | 5,922 | 5,259 | |||||||||
Bottling equity income |
616 | 557 | 380 | |||||||||
Interest expense |
(239 | ) | (256 | ) | (167 | ) | ||||||
Interest income |
173 | 159 | 74 | |||||||||
Income from Continuing Operations before Income Taxes |
6,989 | 6,382 | 5,546 | |||||||||
Provision for Income Taxes |
1,347 | 2,304 | 1,372 | |||||||||
Income from Continuing Operations |
5,642 | 4,078 | 4,174 | |||||||||
Tax Benefit from Discontinued Operations |
| | 38 | |||||||||
Net Income |
$ | 5,642 | $ | 4,078 | $ | 4,212 | ||||||
Net Income per Common Share Basic |
||||||||||||
Continuing operations |
$ | 3.42 | $ | 2.43 | $ | 2.45 | ||||||
Discontinued operations |
| | 0.02 | |||||||||
Total |
$ | 3.42 | $ | 2.43 | $ | 2.47 | ||||||
Net Income per Common Share Diluted |
||||||||||||
Continuing operations |
$ | 3.34 | $ | 2.39 | $ | 2.41 | ||||||
Discontinued operations |
| | 0.02 | |||||||||
Total |
$ | 3.34 | $ | 2.39 | $ | 2.44 | * | |||||
* |
Based on unrounded amounts. |
See accompanying notes to consolidated financial statements.
61
Consolidated Statement of Cash Flows
PepsiCo, Inc. and Subsidiaries
Fiscal years ended December 30, 2006, December 31, 2005 and December 25, 2004
(in millions) |
2006 | 2005 | 2004 | |||||||||
Operating Activities |
||||||||||||
Net income |
$ | 5,642 | $ | 4,078 | $ | 4,212 | ||||||
Depreciation and amortization |
1,406 | 1,308 | 1,264 | |||||||||
Stock-based compensation expense |
270 | 311 | 368 | |||||||||
Excess tax benefits from share-based payment arrangements |
(134 | ) | | | ||||||||
Restructuring and impairment charges |
| | 150 | |||||||||
Cash payments for merger-related costs and restructuring charges |
| (22 | ) | (92 | ) | |||||||
Tax benefit from discontinued operations |
| | (38 | ) | ||||||||
Pension and retiree medical plan contributions |
(131 | ) | (877 | ) | (534 | ) | ||||||
Pension and retiree medical plan expenses |
544 | 464 | 395 | |||||||||
Bottling equity income, net of dividends |
(479 | ) | (411 | ) | (297 | ) | ||||||
Deferred income taxes and other tax charges and credits |
(510 | ) | 440 | (203 | ) | |||||||
Other non-cash charges and credits, net |
32 | 145 | 166 | |||||||||
Change in accounts and notes receivable |
(330 | ) | (272 | ) | (130 | ) | ||||||
Change in inventories |
(186 | ) | (132 | ) | (100 | ) | ||||||
Change in prepaid expenses and other current assets |
(37 | ) | (56 | ) | (31 | ) | ||||||
Change in accounts payable and other current liabilities |
223 | 188 | 216 | |||||||||
Change in income taxes payable |
(295 | ) | 609 | (268 | ) | |||||||
Other, net |
69 | 79 | (24 | ) | ||||||||
Net Cash Provided by Operating Activities |
6,084 | 5,852 | 5,054 | |||||||||
Investing Activities |
||||||||||||
Snack Ventures Europe (SVE) minority interest acquisition |
| (750 | ) | | ||||||||
Capital spending |
(2,068 | ) | (1,736 | ) | (1,387 | ) | ||||||
Sales of property, plant and equipment |
49 | 88 | 38 | |||||||||
Investment in finance assets |
(25 | ) | | | ||||||||
Other acquisitions and investments in noncontrolled affiliates |
(522 | ) | (345 | ) | (64 | ) | ||||||
Cash proceeds from sale of PBG stock |
318 | 214 | | |||||||||
Divestitures |
37 | 3 | 52 | |||||||||
Short-term investments, by original maturity |
||||||||||||
More than three months purchases |
(29 | ) | (83 | ) | (44 | ) | ||||||
More than three months maturities |
25 | 84 | 38 | |||||||||
Three months or less, net |
2,021 | (992 | ) | (963 | ) | |||||||
Net Cash Used for Investing Activities |
(194 | ) | (3,517 | ) | (2,330 | ) | ||||||
(Continued on following page)
62
Consolidated Statement of Cash Flows (continued)
PepsiCo, Inc. and Subsidiaries
Fiscal years ended December 30, 2006, December 31, 2005 and December 25, 2004
(in millions) |
2006 | 2005 | 2004 | |||||||||
Financing Activities |
||||||||||||
Proceeds from issuances of long-term debt |
$ | 51 | $ | 25 | $ | 504 | ||||||
Payments of long-term debt |
(157 | ) | (177 | ) | (512 | ) | ||||||
Short-term borrowings, by original maturity |
||||||||||||
More than three months proceeds |
185 | 332 | 153 | |||||||||
More than three months payments |
(358 | ) | (85 | ) | (160 | ) | ||||||
Three months or less, net |
(2,168 | ) | 1,601 | 1,119 | ||||||||
Cash dividends paid |
(1,854 | ) | (1,642 | ) | (1,329 | ) | ||||||
Share repurchases common |
(3,000 | ) | (3,012 | ) | (3,028 | ) | ||||||
Share repurchases preferred |
(10 | ) | (19 | ) | (27 | ) | ||||||
Proceeds from exercises of stock options |
1,194 | 1,099 | 965 | |||||||||
Excess tax benefits from share-based payment arrangements |
134 | | | |||||||||
Net Cash Used for Financing Activities |
(5,983 | ) | (1,878 | ) | (2,315 | ) | ||||||
Effect of exchange rate changes on cash and cash equivalents |
28 | (21 | ) | 51 | ||||||||
Net (Decrease)/Increase in Cash and Cash Equivalents |
(65 | ) | 436 | 460 | ||||||||
Cash and Cash Equivalents, Beginning of Year |
1,716 | 1,280 | 820 | |||||||||
Cash and Cash Equivalents, End of Year |
$ | 1,651 | $ | 1,716 | $ | 1,280 | ||||||
See accompanying notes to consolidated financial statements.
63
PepsiCo, Inc. and Subsidiaries
December 30, 2006 and December 31, 2005
(in millions except per share amounts) |
2006 | 2005 | ||||||
ASSETS |
||||||||
Current Assets |
||||||||
Cash and cash equivalents |
$ | 1,651 | $ | 1,716 | ||||
Short-term investments |
1,171 | 3,166 | ||||||
Accounts and notes receivable, net |
3,725 | 3,261 | ||||||
Inventories |
1,926 | 1,693 | ||||||
Prepaid expenses and other current assets |
657 | 618 | ||||||
Total Current Assets |
9,130 | 10,454 | ||||||
Property, Plant and Equipment, net |
9,687 | 8,681 | ||||||
Amortizable Intangible Assets, net |
637 | 530 | ||||||
Goodwill |
4,594 | 4,088 | ||||||
Other nonamortizable intangible assets |
1,212 | 1,086 | ||||||
Nonamortizable Intangible Assets |
5,806 | 5,174 | ||||||
Investments in Noncontrolled Affiliates |
3,690 | 3,485 | ||||||
Other Assets |
980 | 3,403 | ||||||
Total Assets |
$ | 29,930 | $ | 31,727 | ||||
LIABILITIES AND SHAREHOLDERS EQUITY |
||||||||
Current Liabilities |
||||||||
Short-term obligations |
$ | 274 | $ | 2,889 | ||||
Accounts payable and other current liabilities |
6,496 | 5,971 | ||||||
Income taxes payable |
90 | 546 | ||||||
Total Current Liabilities |
6,860 | 9,406 | ||||||
Long-Term Debt Obligations |
2,550 | 2,313 | ||||||
Other Liabilities |
4,624 | 4,323 | ||||||
Deferred Income Taxes |
528 | 1,434 | ||||||
Total Liabilities |
14,562 | 17,476 | ||||||
Commitments and Contingencies |
||||||||
Preferred Stock, no par value |
41 | 41 | ||||||
Repurchased Preferred Stock |
(120 | ) | (110 | ) | ||||
Common Shareholders Equity |
||||||||
Common stock, par value 12/3¢ per share (issued 1,782 shares) |
30 | 30 | ||||||
Capital in excess of par value |
584 | 614 | ||||||
Retained earnings |
24,837 | 21,116 | ||||||
Accumulated other comprehensive loss |
(2,246 | ) | (1,053 | ) | ||||
23,205 | 20,707 | |||||||
Less: repurchased common stock, at cost (144 and 126 shares, respectively) |
(7,758 | ) | (6,387 | ) | ||||
Total Common Shareholders Equity |
15,447 | 14,320 | ||||||
Total Liabilities and Shareholders Equity |
$ | 29,930 | $ | 31,727 | ||||
See accompanying notes to consolidated financial statements.
64
Consolidated Statement of Common Shareholders Equity
PepsiCo, Inc. and Subsidiaries
Fiscal years ended December 30, 2006, December 31, 2005 and December 25, 2004
2006 | 2005 | 2004 | |||||||||||||||||||
(in millions) |
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 |
614 | 618 | 548 | ||||||||||||||||||
Stock-based compensation expense |
270 | 311 | 368 | ||||||||||||||||||
Stock option exercises(a) |
(300 | ) | (315 | ) | (298 | ) | |||||||||||||||
Balance, end of year |
584 | 614 | 618 | ||||||||||||||||||
Retained Earnings |
|||||||||||||||||||||
Balance, beginning of year |
21,116 | 18,730 | 15,961 | ||||||||||||||||||
Net income |
5,642 | 4,078 | 4,212 | ||||||||||||||||||
Cash dividends declared common |
(1,912 | ) | (1,684 | ) | (1,438 | ) | |||||||||||||||
Cash dividends declared preferred |
(1 | ) | (3 | ) | (3 | ) | |||||||||||||||
Cash dividends declared RSUs |
(8 | ) | (5 | ) | (2 | ) | |||||||||||||||
Balance, end of year |
24,837 | 21,116 | 18,730 | ||||||||||||||||||
Accumulated Other Comprehensive Loss |
|||||||||||||||||||||
Balance, beginning of year |
(1,053 | ) | (886 | ) | (1,267 | ) | |||||||||||||||
Currency translation adjustment |
465 | (251 | ) | 401 | |||||||||||||||||
Cash flow hedges, net of tax: |
|||||||||||||||||||||
Net derivative (losses)/gains |
(18 | ) | 54 | (16 | ) | ||||||||||||||||
Reclassification of (gains)/losses to net income |
(5 | ) | (8 | ) | 9 | ||||||||||||||||
Unamortized pension and retiree medical, net of tax |
(1,782 | ) | | | |||||||||||||||||
Minimum pension liability adjustment, net of tax |
138 | 16 | (19 | ) | |||||||||||||||||
Unrealized gain on securities, net of tax |
9 | 24 | 6 | ||||||||||||||||||
Other |
| (2 | ) | | |||||||||||||||||
Balance, end of year |
(2,246 | ) | (1,053 | ) | (886 | ) | |||||||||||||||
Repurchased Common Stock |
|||||||||||||||||||||
Balance, beginning of year |
(126 | ) | (6,387 | ) | (103 | ) | (4,920 | ) | (77 | ) | (3,376 | ) | |||||||||
Share repurchases |
(49 | ) | (3,000 | ) | (54 | ) | (2,995 | ) | (58 | ) | (2,994 | ) | |||||||||
Stock option exercises |
31 | 1,619 | 31 | 1,523 | 32 | 1,434 | |||||||||||||||
Other |
| 10 | | 5 | | 16 | |||||||||||||||
Balance, end of year |
(144 | ) | (7,758 | ) | (126 | ) | (6,387 | ) | (103 | ) | (4,920 | ) | |||||||||
Total Common Shareholders Equity |
$ | 15,447 | $ | 14,320 | $ | 13,572 | |||||||||||||||
2006 | 2005 | 2004 | |||||||||||||||||||
Comprehensive Income |
|||||||||||||||||||||
Net income |
$ | 5,642 | $ | 4,078 | $ | 4,212 | |||||||||||||||
Currency translation adjustment |
465 | (251 | ) | 401 | |||||||||||||||||
Cash flow hedges, net of tax |
(23 | ) | 46 | (7 | ) | ||||||||||||||||
Minimum pension liability adjustment, net of tax |
5 | 16 | (19 | ) | |||||||||||||||||
Unrealized gain on securities, net of tax |
9 | 24 | 6 | ||||||||||||||||||
Other |
| (2 | ) | | |||||||||||||||||
Total Comprehensive Income |
$ | 6,098 | $ | 3,911 | $ | 4,593 | |||||||||||||||
(a) Includes total tax benefits of $130 million in 2006, $125 million in 2005 and $183 million in 2004.
See accompanying notes to consolidated financial statements.
65
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. Bottling equity income includes $186 million and $126 million of pre-tax gains on our sales of PBG stock in 2006 and 2005, respectively. See Note 8 for additional information on our significant noncontrolled bottling affiliates. 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.
Raw materials, direct labor and plant overhead, as well as purchasing and receiving costs, costs directly related to production planning, inspection costs and raw material handling facilities, are included in cost of sales. The costs of moving, storing and delivering finished product are included in selling, general and administrative expenses.
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, tax reserves, stock-based compensation, pension and retiree medical accruals, useful lives for intangible assets, and future cash flows associated with impairment testing for perpetual brands, goodwill and other long-lived assets. 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 Managements Discussion and Analysis.
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
66
amounts. Certain reclassifications were made to prior years amounts to conform to the 2006 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 expenses, 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 in corporate unallocated expenses. These gains and losses are subsequently 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 President and Chief Executive Officer assesses the performance of and reallocates resources to our divisions. Division results exclude certain Corporate-initiated restructuring and impairment charges. For additional unaudited information on our divisions, see Our Operations in Managements Discussion and Analysis.
67
2006 | 2005 | 2004 | 2006 | 2005 | 2004 | ||||||||||||||||
Net Revenue | Operating Profit | ||||||||||||||||||||
FLNA |
$ | 10,844 | $ | 10,322 | $ | 9,560 | $ | 2,615 | $ | 2,529 | $ | 2,389 | |||||||||
PBNA |
9,565 | 9,146 | 8,313 | 2,055 | 2,037 | 1,911 | |||||||||||||||
PI |
12,959 | 11,376 | 9,862 | 1,948 | 1,607 | 1,323 | |||||||||||||||
QFNA |
1,769 | 1,718 | 1,526 | 554 | 537 | 475 | |||||||||||||||
Total division |
35,137 | 32,562 | 29,261 | 7,172 | 6,710 | 6,098 | |||||||||||||||
Corporate |
| | | (733 | ) | (788 | ) | (689 | ) | ||||||||||||
35,137 | 32,562 | 29,261 | 6,439 | 5,922 | 5,409 | ||||||||||||||||
Restructuring and impairment charges |
| | | | | (150 | ) | ||||||||||||||
Total |
$ | 35,137 | $ | 32,562 | $ | 29,261 | $ | 6,439 | $ | 5,922 | $ | 5,259 | |||||||||
Corporate
Corporate includes costs of our corporate headquarters, centrally-managed initiatives, such as our BPT initiative in North America, 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.
Restructuring and Impairment Charges See Note 3.
68
Other Division Information
2006 | 2005 | 2004 | 2006 | 2005 | 2004 | |||||||||||||
Total Assets | Capital Spending | |||||||||||||||||
FLNA |
$ | 5,969 | $ | 5,948 | $ | 5,476 | $ | 499 | $ | 512 | $ | 469 | ||||||
PBNA |
6,567 | 6,316 | 6,048 | 492 | 320 | 265 | ||||||||||||
PI |
11,274 | 9,983 | 8,921 | 835 | 667 | 537 | ||||||||||||
QFNA |
1,003 | 989 | 978 | 31 | 31 | 33 | ||||||||||||
Total division |
24,813 | 23,236 | 21,423 | 1,857 | 1,530 | 1,304 | ||||||||||||
Corporate (a) |
1,739 | 5,331 | 3,569 | 211 | 206 | 83 | ||||||||||||
Investments in bottling affiliates |
3,378 | 3,160 | 2,995 | | | | ||||||||||||
$ | 29,930 | $ | 31,727 | $ | 27,987 | $ | 2,068 | $ | 1,736 | $ | 1,387 | |||||||
(a) |
Corporate assets consist principally of cash and cash equivalents, short-term investments, and property, plant and equipment. |
2006 | 2005 | 2004 | 2006 | 2005 | 2004 | |||||||||||||
Amortization of Intangible Assets |
Depreciation and Other Amortization | |||||||||||||||||
FLNA |
$ | 9 | $ | 3 | $ | 3 | $ | 432 | $ | 419 | $ | 420 | ||||||
PBNA |
77 | 76 | 75 | 282 | 264 | 258 | ||||||||||||
PI |
76 | 71 | 68 | 478 | 420 | 382 | ||||||||||||
QFNA |
| | 1 | 33 | 34 | 36 | ||||||||||||
Total division |
162 | 150 | 147 | 1,225 | 1,137 | 1,096 | ||||||||||||
Corporate |
| | | 19 | 21 | 21 | ||||||||||||
$ | 162 | $ | 150 | $ | 147 | $ | 1,244 | $ | 1,158 | $ | 1,117 | |||||||
69
2006 | 2005 | 2004 | 2006 | 2005 | 2004 | |||||||||||||
Net Revenue(a) | Long-Lived Assets(b) | |||||||||||||||||
U.S. |
$ | 20,788 | $ | 19,937 | $ | 18,329 | $ | 11,515 | $ | 10,723 | $ | 10,212 | ||||||
Mexico |
3,228 | 3,095 | 2,724 | 996 | 902 | 878 | ||||||||||||
United Kingdom |
1,839 | 1,821 | 1,692 | 1,995 | 1,715 | 1,896 | ||||||||||||
Canada |
1,702 | 1,509 | 1,309 | 589 | 582 | 548 | ||||||||||||
All other countries |
7,580 | 6,200 | 5,207 | 4,725 | 3,948 | 3,339 | ||||||||||||
$ | 35,137 | $ | 32,562 | $ | 29,261 | $ | 19,820 | $ | 17,870 | $ | 16,873 | |||||||
(a) |
Represents net revenue from businesses operating in these countries. |
(b) |
Long-lived assets represent property, plant and equipment, nonamortizable intangible assets, 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 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 Managements Discussion and Analysis. We are exposed to concentration of credit risk by our customers, Wal-Mart and PBG. In 2006, Wal-Mart represented approximately 9% of our total net revenue, including concentrate sales to our bottlers which are used in finished goods sold by them to Wal-Mart; and PBG represented approximately 10%. We have not experienced credit issues with these customers.
70
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 $10.1 billion in 2006, $8.9 billion in 2005 and $7.8 billion in 2004. While most of these incentive arrangements have terms of no more than one year, certain arrangements, such as fountain pouring rights, extend beyond one year. Costs incurred to obtain these arrangements are recognized over no longer than the contract period and the remaining balances of $297 million at December 30, 2006 and $321 million at December 31, 2005 are included in current assets and other assets on our balance sheet. For additional unaudited information on our sales incentives, see Our Critical Accounting Policies in Managements 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 $1.7 billion in 2006, $1.8 billion in 2005 and $1.7 billion in 2004. 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 $171 million and $202 million at year-end 2006 and 2005, respectively, are classified as prepaid expenses on our 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 $4.6 billion in 2006, $4.1 billion in 2005 and $3.9 billion in 2004.
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 balance sheet and amortized on a straight-line basis when placed into service over the estimated useful lives of the software, which approximate five to seven years. Net capitalized software and development costs were $537 million at December 30, 2006 and $327 million at December 31, 2005.
71
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.
Research and Development
We engage in a variety of research and development activities. These activities principally involve the development of new products, improvement in the quality of existing products, improvement and modernization of production processes, and the development and implementation of new technologies to enhance the quality and value of both current and proposed product lines. Research and development costs were $344 million in 2006 and $340 million in 2005 and are reported as selling, general and administrative expenses.
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 Managements Discussion and Analysis. |
|
Income Taxes Note 5 and, for additional unaudited information, see Our Critical Accounting Policies in Managements Discussion and Analysis. |
|
Stock-Based Compensation Expense Note 6 and, for additional unaudited information, see Our Critical Accounting Policies in Managements Discussion and Analysis. |
|
Pension, Retiree Medical and Savings Plans Note 7 and, for additional unaudited information, see Our Critical Accounting Policies in Managements Discussion and Analysis. |
|
Risk Management Note 10 and, for additional unaudited information, see Our Business Risks in Managements Discussion and Analysis. |
Recent Accounting Pronouncements
As further discussed in Note 6, we adopted SFAS 123R on January 1, 2006.
As further discussed in Note 7, we adopted SFAS 158 on December 30, 2006.
In September 2006, the SEC issued SAB 108 to address diversity in practice in quantifying financial statement misstatements. SAB 108 requires that we quantify misstatements based on their impact on each of our financial statements and related disclosures. On December 30, 2006, we adopted SAB 108. Our adoption of SAB 108 did not impact our financial statements.
72
In July 2006, the FASB issued FIN 48 which clarifies the accounting for uncertainty in tax positions. FIN 48 requires that we recognize in our financial statements, the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective as of the beginning of our 2007 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. We do not expect our adoption of FIN 48 to materially impact our financial statements.
In September 2006, the FASB issued SFAS 157 which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The provisions of SFAS 157 are effective as of the beginning of our 2008 fiscal year. We are currently evaluating the impact of adopting SFAS 157 on our financial statements.
Note 3 Restructuring and Impairment Charges
2006 Restructuring and Impairment Charges
In 2006, we incurred a charge of $67 million ($43 million after-tax or $0.03 per share) in conjunction with consolidating the manufacturing network at FLNA by closing two plants in the U.S., and rationalizing other assets, to increase manufacturing productivity and supply chain efficiencies. The charge was comprised of $43 million of asset impairments, $14 million of severance and other employee costs and $10 million of other costs. Employee-related costs primarily reflect the termination costs for approximately 380 employees. We expect all of the cash payments related to this charge to be paid by the end of 2007.
2005 Restructuring Charges
In 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. Most of this charge related to the termination of approximately 700 employees. As of December 30, 2006, all terminations had occurred and substantially no accrual remains.
2004 Restructuring and Impairment Charges
In 2004, we incurred a charge of $150 million ($96 million after-tax or $0.06 per share) in conjunction with the consolidation of FLNAs manufacturing network as part of its ongoing productivity program. Of this charge, $93 million related to asset impairments, primarily reflecting the closure of four U.S. plants. Production from 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. As of December 30, 2006, all terminations had occurred and substantially no accrual remains.
73
Note 4 Property, Plant and Equipment and Intangible Assets
Average Useful Life |
2006 | 2005 | 2004 | ||||||||||||
Property, plant and equipment, net |
|||||||||||||||
Land and improvements |
10 30 | yrs. |
$ | 756 | $ | 685 | |||||||||
Buildings and improvements |
20 44 | 4,095 | 3,736 | ||||||||||||
Machinery and equipment, including fleet and software |
5 15 | 12,768 | 11,658 | ||||||||||||
Construction in progress |
1,439 | 1,066 | |||||||||||||
19,058 | 17,145 | ||||||||||||||
Accumulated depreciation |
(9,371 | ) | (8,464 | ) | |||||||||||
$ | 9,687 | $ | 8,681 | ||||||||||||
Depreciation expense |
$ | 1,182 | $ | 1,103 | $ | 1,062 | |||||||||
Amortizable intangible assets, net |
|||||||||||||||
Brands |
5 40 | $ | 1,288 | $ | 1,054 | ||||||||||
Other identifiable intangibles |
3 15 | 290 | 257 | ||||||||||||
1,578 | 1,311 | ||||||||||||||
Accumulated amortization |
(941 | ) | (781 | ) | |||||||||||
$ | 637 | $ | 530 | ||||||||||||
Amortization expense |
$ | 162 | $ | 150 | $ | 147 | |||||||||
Depreciation and amortization are recognized on a straight-line basis over an assets 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 2006 foreign exchange rates, is expected to be $49 million in 2007, $49 million in 2008, $47 million in 2009, $46 million in 2010 and $44 million in 2011.
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 Managements Discussion and Analysis.
Nonamortizable Intangible Assets
Perpetual brands and goodwill are assessed for impairment at least annually. If the carrying amount of a perpetual brand exceeds its fair value, as determined by its discounted cash flows, an impairment loss is recognized in an amount equal to that excess. Goodwill is evaluated using a two-step impairment test at the reporting unit level. A reporting unit can be a division or business within a division. The first step compares the book value of a reporting unit, including goodwill, with its fair value, as determined by its discounted cash flows. If the book value of a reporting unit exceeds its
74
fair value, we complete the second step to determine the amount of goodwill impairment loss that we should record. In the second step, we determine an implied fair value of the reporting units goodwill by allocating the fair value of the reporting unit to all of the assets and liabilities other than goodwill (including any unrecognized intangible assets). The amount of impairment loss is equal to the excess of the book value of the goodwill over the implied fair value of that goodwill. No impairment charges resulted from the required impairment evaluations. The change in the book value of nonamortizable intangible assets is as follows:
Balance, Beginning 2005 |
Acquisitions | Translation and Other |
Balance, End of 2005 |
Acquisitions | Translation and Other |
Balance, End of 2006 | |||||||||||||||||
Frito-Lay North |
|||||||||||||||||||||||
Goodwill |
$ | 138 | $ | | $ | 7 | $ | 145 | $ | 139 | $ | | $ | 284 | |||||||||
PepsiCo Beverages |
|||||||||||||||||||||||
Goodwill |
2,161 | | 3 | 2,164 | 39 | | 2,203 | ||||||||||||||||
Brands |
59 | | | 59 | | | 59 | ||||||||||||||||
2,220 | | 3 | 2,223 | 39 | | 2,262 | |||||||||||||||||
PepsiCo |
|||||||||||||||||||||||
Goodwill |
1,435 | 278 | (109 | ) | 1,604 | 183 | 145 | 1,932 | |||||||||||||||
Brands |
869 | 263 | (106 | ) | 1,026 | | 127 | 1,153 | |||||||||||||||
2,304 | 541 | (215 | ) | 2,630 | 183 | 272 | 3,085 | ||||||||||||||||
Quaker Foods |
|||||||||||||||||||||||
Goodwill |
175 | | | 175 | | | 175 | ||||||||||||||||
Corporate |
|||||||||||||||||||||||
Pension intangible |
5 | | (4 | ) | 1 | | (1 | ) | | ||||||||||||||
Total goodwill |
3,909 | 278 | (99 | ) | 4,088 | 361 | 145 | 4,594 | |||||||||||||||
Total brands |
928 | 263 | (106 | ) | 1,085 | | 127 | 1,212 | |||||||||||||||
Total pension intangible |
5 | | (4 | ) | 1 | | (1 | ) | | ||||||||||||||
$ | 4,842 | $ | 541 | $ | (209 | ) | $ | 5,174 | $ | 361 | $ | 271 | $ | 5,806 | |||||||||
75
2006 | 2005 | 2004 | ||||||||||
Income before income taxes continuing operations |
||||||||||||
U.S. |
$ | 3,844 | $ | 3,175 | $ | 2,946 | ||||||
Foreign |
3,145 | 3,207 | 2,600 | |||||||||
$ | 6,989 | $ | 6,382 | $ | 5,546 | |||||||
Provision for income taxes continuing operations |
||||||||||||
Current: U.S. Federal |
$ | 776 | $ | 1,638 | $ | 1,030 | ||||||
Foreign |
569 | 426 | 256 | |||||||||
State |
56 | 118 | 69 | |||||||||
1,401 | 2,182 | 1,355 | ||||||||||
Deferred: U.S. Federal |
(31 | ) | 137 | 11 | ||||||||
Foreign |
(16 | ) | (26 | ) | 5 | |||||||
State |
(7 | ) | 11 | 1 | ||||||||
(54 | ) | 122 | 17 | |||||||||
$ | 1,347 | $ | 2,304 | $ | 1,372 | |||||||
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 |
0.5 | 1.4 | 0.8 | |||||||||
Taxes on AJCA repatriation |
| 7.0 | | |||||||||
Lower taxes on foreign results |
(6.5 | ) | (6.5 | ) | (5.4 | ) | ||||||
Settlement of prior years audit |
| | (4.8 | ) | ||||||||
2006 Tax Adjustments |
(8.6 | ) | | | ||||||||
Other, net |
(1.1 | ) | (0.8 | ) | (0.9 | ) | ||||||
Annual tax rate |
19.3 | % | 36.1 | % | 24.7 | % | ||||||
Deferred tax liabilities |
||||||||||||
Investments in noncontrolled affiliates |
$ | 1,103 | $ | 993 | ||||||||
Property, plant and equipment |
784 | 772 | ||||||||||
Pension benefits |
| 863 | ||||||||||
Intangible assets other than nondeductible goodwill |
169 | 135 | ||||||||||
Zero coupon notes |
27 | 35 | ||||||||||
Other |
221 | 169 | ||||||||||
Gross deferred tax liabilities |
2,304 | 2,967 | ||||||||||
Deferred tax assets |
||||||||||||
Net carryforwards |
667 | 608 | ||||||||||
Stock-based compensation |
443 | 426 | ||||||||||
Retiree medical benefits |
541 | 400 | ||||||||||
Other employee-related benefits |
342 | 342 | ||||||||||
Pension benefits |
38 | | ||||||||||
Other |
592 | 520 | ||||||||||
Gross deferred tax assets |
2,623 | 2,296 | ||||||||||
Valuation allowances |
(624 | ) | (532 | ) | ||||||||
Deferred tax assets, net |
1,999 | 1,764 | ||||||||||
Net deferred tax liabilities |
$ | 305 | $ | 1,203 | ||||||||
76
2006 | 2005 | 2004 | ||||||||
Deferred taxes included within: |
||||||||||
Assets: |
||||||||||
Prepaid expenses and other current assets |
$ | 223 | $ | 231 | ||||||
Liabilities: |
||||||||||
Deferred income taxes |
$ | 528 | $ | 1,434 | ||||||
Analysis of valuation allowances |
||||||||||
Balance, beginning of year |
$ | 532 | $ | 564 | $ | 438 | ||||
Provision/(benefit) |
71 | (28 | ) | 118 | ||||||
Other additions/(deductions) |
21 | (4 | ) | 8 | ||||||
Balance, end of year |
$ | 624 | $ | 532 | $ | 564 | ||||
For additional unaudited information on our income tax policies, including our reserves for income taxes, see Our Critical Accounting Policies in Managements Discussion and Analysis.
Carryforwards, Credits and Allowances
Operating loss carryforwards totaling $6.1 billion at year-end 2006 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: $0.2 billion in 2007, $5.0 billion between 2008 and 2026 and $0.9 billion may be carried forward indefinitely. In addition, certain tax credits generated in prior periods of approximately $33.9 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. In 2005, we repatriated approximately $7.5 billion in earnings previously considered indefinitely reinvested outside the U.S. and recorded income tax expense of $460 million related to 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 30, 2006, we had approximately $10.8 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. In 2006, we recognized non-cash tax benefits of $602 million, substantially all of which related to the IRSs examination of our consolidated
77
income tax returns for the years 1998 through 2002. The IRS issued a Revenue Agents Report (RAR), and we are in agreement with their conclusion, except for one matter which we continue to dispute. The agreed adjustments relate to transfer pricing and various other transactions, including certain acquisitions, the public offering of PBG, as well as the restructuring of our international snack foods operations during that audit period. During 2004, we recognized $266 million of tax benefits related to the favorable resolution of certain previously open tax issues. In addition, in 2004, we recognized a tax benefit of $38 million upon agreement with the IRS on a previously open issue related to our discontinued restaurant operations.
The IRS has initiated their audits of our tax returns for the years 2003 through 2005. 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. We adjust these reserves, as well as the related interest, in light of changing facts and circumstances. 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 on our 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.
As further discussed in Note 2, we will adopt FIN 48 as of the beginning of our 2007 fiscal year.
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. A majority of our employees participate in our stock-based compensation programs. 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 $270 million in 2006, $311 million in 2005 and $368 million in 2004. Related income tax benefits recognized in earnings were $80 million in 2006, $87 million in 2005 and $103 million in 2004. Stock-based compensation cost capitalized in connection with our BPT initiative was $3 million in 2006, $4 million in 2005 and none in 2004. At year-end 2006, 36 million shares were available for future stock-based compensation grants. For additional unaudited information on our stock-based compensation program, see Our Critical Accounting Policies in Managements Discussion and Analysis.
Method of Accounting and Our Assumptions
We account for our employee stock options, which include grants under our executive program and broad-based SharePower program, under the fair value method of
78
accounting using a Black-Scholes valuation model to measure stock option expense at the date of grant. All stock option grants have an exercise price equal to the fair market value of our common stock on the date of grant and generally have a 10-year term. The fair value of stock option grants is amortized to expense over the vesting period, generally three years. Executives who are awarded long-term incentives based on their performance are offered the choice of stock options or RSUs. 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. 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 RSU is settled in a share of our stock after the vesting period. Vesting of RSU awards for senior officers is contingent upon the achievement of pre-established performance targets. There have been no reductions to the exercise price of previously issued awards, and any repricing of awards would require approval of our shareholders.
On January 1, 2006, we adopted SFAS 123R under the modified prospective method. Since we had previously accounted for our stock-based compensation plans under the fair value provisions of SFAS 123, our adoption did not significantly impact our financial position or our results of operations. Under SFAS 123R, actual tax benefits recognized in excess of tax benefits previously established upon grant are reported as a financing cash inflow. Prior to adoption, such excess tax benefits were reported as an operating cash inflow.
Our weighted-average Black-Scholes fair value assumptions are as follows:
2006 | 2005 | 2004 | ||||
Expected life |
6 yrs. | 6 yrs. | 6 yrs. | |||
Risk free interest rate |
4.5% | 3.8% | 3.3% | |||
Expected volatility |
18% | 23% | 26% | |||
Expected dividend yield |
1.9% | 1.8% | 1.8% |
A summary of our stock-based compensation activity for the year ended December 30, 2006 is presented below:
Our Stock Option Activity
Options(a) | Average Price(b) |
Average Life (years)(c) |
Aggregate Intrinsic Value(d) | ||||||||
Outstanding at January 1, 2006 |
150,149 | $ | 42.03 | ||||||||
Granted |
12,519 | 57.72 | |||||||||
Exercised |
(31,056 | ) | 38.61 | ||||||||
Forfeited/expired |
(3,863 | ) | 49.06 | ||||||||
Outstanding at December 30, 2006 |
127,749 | $ | 44.24 | 5.46 | $ | 2,339,562 | |||||
Exercisable at December 30, 2006 |
91,381 | $ | 41.02 | 4.42 | $ | 1,967,843 |
(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. |
(d) |
In thousands. |
79
Our RSU Activity
RSUs(a) | Average Intrinsic Value(b) |
Average Life (years)(c) |
Aggregate Intrinsic Value(d) | ||||||||
Outstanding at January 1, 2006 |
5,669 | $ | 50.70 | ||||||||
Granted |
2,992 | 58.22 | |||||||||
Converted |
(183 | ) | 50.00 | ||||||||
Forfeited/expired |
(593 | ) | 53.17 | ||||||||
Outstanding at December 30, 2006 |
7,885 | $ | 53.38 | 1.38 | $ | 493,201 | |||||
(a) |
RSUs are in thousands. |
(b) |
Weighted-average intrinsic value at grant date. |
(c) |
Weighted-average contractual life remaining. |
(d) |
In thousands. |
Other Stock-Based Compensation Data
2006 | 2005 | 2004 | |||||||
Stock Options |
|||||||||
Weighted-average fair value of options granted |
$ | 12.81 | $ | 13.45 | $ | 12.04 | |||
Total intrinsic value of options exercised(a) |
$ | 686,242 | $ | 632,603 | $ | 667,001 | |||
RSUs |
|||||||||
Total number of RSUs granted(a) |
2,992 | 3,097 | 3,077 | ||||||
Weighted-average intrinsic value of RSUs granted |
$ | 58.22 | $ | 53.83 | $ | 47.28 | |||
Total intrinsic value of RSUs converted(a) |
$ | 10,934 | $ | 4,974 | $ | 914 |
(a) |
In thousands. |
At December 30, 2006, there was $301 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 1.5 years.
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. and Canada 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.
80
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 that increase or decrease benefits for prior employee service (prior service cost/(credit)) is included in earnings 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.
On December 30, 2006, we adopted SFAS 158 which requires that we recognize the overfunded or underfunded status of our Plans as an asset or liability on our December 30, 2006 balance sheet. Subsequent changes in the funded status will be recognized through comprehensive income in the year in which they occur. SFAS 158 also requires that, beginning in 2008, our assumptions used to measure our annual pension and retiree medical expenses be determined as of the balance sheet date, and all plan assets and liabilities be reported as of that date. In accordance with SFAS 158, prior year amounts have not been adjusted.
The following illustrates the incremental effect of applying SFAS 158 on individual line items on our balance sheet as of December 30, 2006:
Before Application of SFAS 158 |
Adjustments | After Application of SFAS 158 | ||||||||
Other nonamortizable intangible assets |
$ | 1,229 | $ | (17 | ) | $ | 1,212 | |||
Other assets |
$ | 2,979 | $ | (1,999 | ) | $ | 980 | |||
Total assets |
$ | 31,946 | $ | (2,016 | ) | $ | 29,930 | |||
Accounts payable and other current liabilities |
$ | 6,475 | $ | 21 | $ | 6,496 | ||||
Other liabilities |
$ | 4,127 | $ | 497 | $ | 4,624 | ||||
Deferred income taxes |
$ | 1,419 | $ | (891 | ) | $ | 528 | |||
Total liabilities |
$ | 14,935 | $ | (373 | ) | $ | 14,562 | |||
Accumulated other comprehensive loss |
$ | 603 | $ | 1,643 | $ | 2,246 | ||||
Total common shareholders equity |
$ | 17,090 | $ | (1,643 | ) | $ | 15,447 |
Selected financial information for our pension and retiree medical plans is as follows:
Pension | Retiree Medical | |||||||||||||||||||||||
2006 | 2005 | 2006 | 2005 | 2006 | 2005 | |||||||||||||||||||
U.S. | International | |||||||||||||||||||||||
Change in projected benefit liability |
||||||||||||||||||||||||
Liability at beginning of year |
$ | 5,771 | $ | 4,968 | $ | 1,263 | $ | 952 | $ | 1,312 | $ | 1,319 | ||||||||||||
Service cost |
245 | 213 | 52 | 32 | 46 | 40 | ||||||||||||||||||
Interest cost |
319 | 296 | 68 | 55 | 72 | 78 | ||||||||||||||||||
Plan amendments |
11 | | 8 | 3 | | (8 | ) | |||||||||||||||||
Participant contributions |
| | 12 | 10 | | | ||||||||||||||||||
Experience (gain)/loss |
(163 | ) | 517 | 20 | 203 | (34 | ) | (45 | ) | |||||||||||||||
Benefit payments |
(233 | ) | (241 | ) | (38 | ) | (28 | ) | (75 | ) | (74 | ) | ||||||||||||
Settlement/curtailment loss |
(7 | ) | | (6 | ) | | | | ||||||||||||||||
Special termination benefits |
4 | 21 | | | 1 | 2 | ||||||||||||||||||
Foreign currency adjustment |
| | 126 | (68 | ) | | | |||||||||||||||||
Other |
| (3 | ) | 6 | 104 | 48 | | |||||||||||||||||
Liability at end of year |
$ | 5,947 | $ | 5,771 | $ | 1,511 | $ | 1,263 | $ | 1,370 | $ | 1,312 | ||||||||||||
81
Pension | Retiree Medical | |||||||||||||||||||||||
2006 | 2005 | 2006 | 2005 | 2006 | 2005 | |||||||||||||||||||
U.S. | International | |||||||||||||||||||||||
Change in fair value of plan assets |
||||||||||||||||||||||||
Fair value at beginning of year |
$ | 5,086 | $ | 4,152 | $ | 1,099 | $ | 838 | $ | | $ | | ||||||||||||
Actual return on plan assets |
513 | 477 | 112 | 142 | | | ||||||||||||||||||
Employer contributions/funding |
19 | 699 | 30 | 104 | 75 | 74 | ||||||||||||||||||
Participant contributions |
| | 12 | 10 | | | ||||||||||||||||||
Benefit payments |
(233 | ) | (241 | ) | (38 | ) | (28 | ) | (75 | ) | (74 | ) | ||||||||||||
Settlement/curtailment loss |
(7 | ) | | | | | | |||||||||||||||||
Foreign currency adjustment |
| | 116 | (61 | ) | | | |||||||||||||||||
Other |
| (1 | ) | (1 | ) | 94 | | | ||||||||||||||||
Fair value at end of year |
$ | 5,378 | $ | 5,086 | $ | 1,330 | $ | 1,099 | $ | | $ | | ||||||||||||
Reconciliation of funded status |
||||||||||||||||||||||||
Funded status |
$ | (569 | ) | $ | (685 | ) | $ | (181 | ) | $ | (164 | ) | $ | (1,370 | ) | $ | (1,312 | ) | ||||||
Adjustment for fourth quarter contributions |
6 | 5 | 13 | 4 | 16 | 19 | ||||||||||||||||||
Unrecognized prior service cost/(credit) |
| 5 | | 17 | | (113 | ) | |||||||||||||||||
Unrecognized experience loss |
| 2,288 | | 474 | | 402 | ||||||||||||||||||
Net amount recognized |
$ | (563 | ) | $ | 1,613 | $ | (168 | ) | $ | 331 | $ | (1,354 | ) | $ | (1,004 | ) | ||||||||
Amounts recognized |
||||||||||||||||||||||||
Other assets |
$ | 185 | $ | 2,068 | $ | 6 | $ | 367 | $ | | $ | | ||||||||||||
Intangible assets |
| | | 1 | | | ||||||||||||||||||
Other current liabilities |
(19 | ) | | (2 | ) | | (84 | ) | | |||||||||||||||
Other liabilities |
(729 | ) | (479 | ) | (172 | ) | (41 | ) | (1,270 | ) | (1,004 | ) | ||||||||||||
Minimum pension liability |
| 24 | | 4 | | | ||||||||||||||||||
Net amount recognized |
$ | (563 | ) | $ | 1,613 | $ | (168 | ) | $ | 331 | $ | (1,354 | ) | $ | (1,004 | ) | ||||||||
Amounts included in accumulated other |
||||||||||||||||||||||||
Net loss |
$ | 1,836 | $ | | $ | 475 | $ | | $ | 364 | $ | | ||||||||||||
Prior service cost/(credit) |
13 | | 24 | | (101 | ) | | |||||||||||||||||
Minimum pension liability |
| 24 | | 4 | | | ||||||||||||||||||
Total |
$ | 1,849 | $ | 24 | $ | 499 | $ | 4 | $ | 263 | $ | | ||||||||||||
Components of the (decrease)/increase in net loss |
||||||||||||||||||||||||
Change in discount rate |
$ | (123 | ) | $ | 365 | $ | 2 | $ | 194 | $ | (30 | ) | $ | 61 | ||||||||||
Employee-related assumption changes |
(45 | ) | 57 | 6 | 2 | | | |||||||||||||||||
Liability-related experience different from assumptions |
5 | 95 | 6 | 7 | (4 | ) | (54 | ) | ||||||||||||||||
Actual asset return different from expected return |
(122 | ) | (133 | ) | (30 | ) | (73 | ) | | | ||||||||||||||
Amortization of losses |
(164 | ) | (106 | ) | (29 | ) | (15 | ) | (21 | ) | (26 | ) | ||||||||||||
Other, including foreign currency adjustments and 2003 Medicare Act |
(3 | ) | (3 | ) | 46 | (22 | ) | 17 | (52 | ) | ||||||||||||||