coverL01OBCv3.qxd 3/6/06 9:17 PM Page 1 coverL01IFCv3.qxd 3/6/06 9:48 PM Page ifc2 On any day, around the world, at any moment and in many place s, millions of consumers enjoy our brands. Here’s how we keep the momentum going. Financial Highlights PepsiCo, Inc. and Subsidiaries ($ in millions except per share amounts; all per share amounts assume dilution) Net Revenue Total: $32,562 Division Operating Profit Total: $6,710 35% 5% PepsiCo International Quaker Foods North America 24% PepsiCo International 8% Quaker Foods North America 28% 32% Frito-Lay North America 30% 38% Frito-Lay North America PepsiCo Beverages North America PepsiCo Beverages North America 2005 2004 % Chg(a) Summary of Operations Total net revenue $32,562 $29,261 Division operating profit Total operating profit Net income(b) Earnings per share(b) $6,710 $6,098 $5,922 $5,259 $4,536 $4,004 $2.66 $2.32 Other Data Management operating cash flow(c) $4,204 $3,705 Net cash provided by operating activities Capital spending $5,852 $5,054 $1,736 $1,387 Common share repurchases $3,012 $3,028 Dividends paid Long-term debt $1,642 $1,329 $2,313 $2,397 11 10 13 13 15 13 16 25 (0.5) 24 (3.5) Contents 1 PepsiCo at a Glance . . . . . . . . . . . . . . . . . . . . . . . 2 Letter to Shareholders . . . . . . . . . . . . . . . . . . . . . . 6 Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Health & Wellness . . . . . . . . . . . . . . . . . . . . . . . . . 10 Innovation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Execution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 International . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sustainability . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Corporate Officers and Principal Divisions . . . . . . . . 20 PepsiCo Board of Directors . . . . . . . . . . . . . . . . . . . 21 Advisory Boards African American Advisory Board . . . . . . . . . . . . . 22 Latino/Hispanic Advisory Board . . . . . . . . . . . . . . 23 Blue Ribbon Health and Wellness Advisory Board . . . . . . . . . . . . . . . . . 24 Financial Review Management’s Discussion and Analysis and Consolidated Financial Statements . . . . . . . . 25 Our Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Our Critical Accounting Policies . . . . . . . . . . . . . . . 34 Our Financial Results . . . . . . . . . . . . . . . . . . . . . . . 40 Consolidated Statement of Income . . . . . . . . . . . . . 50 Consolidated Statement of Cash Flows . . . . . . . . . . 51 Consolidated Balance Sheet . . . . . . . . . . . . . . . . . . 52 Consolidated Statement of Common Shareholders’ Equity . . . . . . . . . . . . . . . 53 Notes to Consolidated Financial Statements . . . . . . 54 Management’s Responsibility for Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . 72 Management’s Report on Internal Control over Financial Reporting . . . . . . . . . . . . . . . . . . . 73 Report of Independent Registered Public Accounting Firm . . . . . . . . . . . . . . . . . . . 74 . . . . . . . . . . . . . . . . . . . . 75 Selected Financial Data Reconciliation of GAAP and Non-GAAP Information . . . . . . . . . . . . . . . . . . . . . 76 76 Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Primary Websites PepsiCo, Inc. — www.pepsico.com Frito-Lay North America — www.fritolay.com Pepsi-Cola North America — www.pepsiworld.com Tropicana North America — www.tropicana.com Quaker Foods — www.quakeroats.com Gatorade — www.gatorade.com Smart Spot — www.smartspot.com Common Stock Information Stock Trading Symbol – PEP Stock Exchange Listings The New York Stock Exchange is the principal market for PepsiCo common stock, which is also listed on the Amsterdam, Chicago and Swiss Stock Exchanges. Shareholders At year-end 2005, there were approximately 197,500 shareholders of record. Dividend Policy We target an annual dividend payout of approximately 45% of prior year’s net income from continuing operations. Dividends are usually declared in late January or early February, May, July and November and paid at the end of March, June and September and the beginning of January. The dividend record dates for these payments are March 10 and, subject to approval by the Board of Directors, expected to be June 9, September 8 and December 8, 2006. We have paid consecutive quarterly cash dividends since 1965. Amounts in the chart reflect pre-merger PepsiCo for the dates prior to its merger with The Quaker Oats Company. Shareholder Information Annual Meeting The Annual Meeting of Shareholders will be held at Frito-Lay Corporate Headquarters, 7701 Legacy Drive, Plano, Texas, on Wednesday, May 3, 2006, at 9 a.m. local time. Proxies for the meeting will be solicited by an inde- pendent proxy solicitor. This Annual Report is not part of the proxy solicitation. Inquiries Regarding Your Stock Holdings Beneficial Shareholders (shares held by your broker in the name of the brokerage house) should direct communi- cations on all administrative matters to your stockbroker. Registered Shareholders (shares held by you in your name) should address communications concerning statements, dividend payments, address changes, lost certificates and other administrative matters to: The Bank of New York Shareholder Services Department P.O. Box 11258 Church Street Station New York, NY 10286-1258 Telephone: 800-226-0083 Cash Dividends Declared Per Share (In $) .850 .575 .595 .630 1.01 212-815-3700 (Outside the U.S.) E-mail: shareowners@bankofny.com Website: www.stockbny.com or Manager Shareholder Relations PepsiCo, Inc. 700 Anderson Hill Road Purchase, NY 10577 Telephone: 914-253-3055 01 02 03 04 05 Stock Performance PepsiCo was formed through the 1965 merger of Pepsi-Cola Company and Frito-Lay, Inc. A $1,000 investment in our stock made on December 31, 2000 was worth about $1,284 on December 31, 2005, assuming the reinvestment of dividends into PepsiCo stock. This performance represents a compounded annual growth rate of 5%. The closing price for a share of PepsiCo common stock on the New York Stock Exchange was the price as report- ed by Bloomberg for the years ending 2001-2005. These amounts reflect the closing price of pre-merger PepsiCo prior to our merger with The Quaker Oats Company. Past performance is not necessarily indicative of future returns on investments in PepsiCo common stock. Year-end Market Price of Stock Based on calendar year-end (In $) 60 40 20 0 01 02 03 04 05 In all correspondence or telephone inquiries, please mention PepsiCo, your name as printed on your stock certificate, your Social Security number, your address and telephone number. SharePower Participants (employees with SharePower options) should address all questions regarding your account, outstanding options or shares received through option exercises to: Merrill Lynch/SharePower Stock Option Unit 1600 Merrill Lynch Drive Mail Stop 06-02-SOP Pennington, NJ 08534 Telephone: 800-637-6713 (U.S., Puerto Rico and Canada) 609-818-8800 (all other locations) In all correspondence, please provide your account number (for U.S. citizens, this is your Social Security number), your address, your telephone number and mention PepsiCo SharePower. For telephone inquiries, please have a copy of your most recent statement available. Employee Benefit Plan Participants PepsiCo 401(k) Plan & PepsiCo Stock Purchase Program The PepsiCo Savings & Retirement Center at Fidelity P.O. Box 770003 Cincinnati, OH 45277-0065 Telephone: 800-632-2014 (Overseas: Dial your country’s AT&T Access Number +800-632-2014. In the U.S., access numbers are available by calling 800-331-1140. From anywhere in the world, access numbers are available online at www.att.com/traveler.) Website: www.netbenefits.fidelity.com PepsiCo Stock Purchase Program – for Canadian employees: Fidelity Stock Plan Services P.O. Box 5000 Cincinnati, OH 45273-8398 Telephone: 800-544-0275 Website: www.iStockPlan.com/ESPP Please have a copy of your most recent statement available when calling with inquiries. If using overnight or certified mail send to: Fidelity Investments 100 Crosby Parkway Mail Zone KC1F-L Covington, KY 41015 Shareholder Services Dividend Reinvestment Plan A brochure explaining this convenient plan, for which PepsiCo pays all administrative costs, is available on our website www.pepsico.com or from our transfer agent: The Bank of New York Dividend Reinvestment Department P.O. Box 1958 Newark, NJ 07101-9774 Telephone: 800-226-0083 Direct Deposit of Dividends Information on the Direct Deposit service is available from our transfer agent: The Bank of New York Shareholder Services Department P.O. Box 11258 Church Street Station New York, NY 10286-1258 Telephone: 800-226-0083 212-815-3700 (Outside the U.S.) Financial and Other Information PepsiCo’s 2006 quarterly earnings releases are expected to be issued the weeks of April 24, July 10, October 9, 2006, and February 5, 2007. Copies of PepsiCo’s SEC reports, earnings and other financial releases, corporate news and additional company information are available on our website www.pepsico.com. If you have questions regarding PepsiCo’s financial performance contact: Jamie Caulfield Vice President, Investor Relations PepsiCo, Inc. 700 Anderson Hill Road Purchase, NY 10577 Telephone: 914-253-3035 Independent Auditors KPMG LLP 345 Park Avenue New York, NY 10154-0102 Telephone: 212-758-9700 Corporate Headquarters PepsiCo, Inc. 700 Anderson Hill Road Purchase, NY 10577 Telephone: 914-253-2000 PepsiCo Website: www.pepsico.com © 2006 PepsiCo, Inc. (a) Percentage changes above and in text are based on unrounded amounts. (b) In 2005, excludes the impact of AJCA tax charge, the 53rd week and restructuring charges. In 2004, excludes certain prior year tax benefits, and restructuring and impairment charges. See page 76 for reconciliation to net income and earnings per share on a GAAP basis. (c) Includes the impact of net capital spending. Also, see “Our Liquidity, Capital Resources and Financial Position” in Management’s Discussion and Analysis. When market or market share is referred to in this report, the markets and share are defined by the sources of the information, primarily Information Resources, Inc. and ACNielsen. The Measured Channel Information excludes certain customers such as Wal*Mart that do not report data to these services. PepsiCo’s Annual Report contains many of the valuable trademarks owned and/or used by PepsiCo and its subsidiaries and affiliates in the United States and internationally to distinguish products and services of outstanding quality. WEIGHT WATCHERS and its POINTS values are registered trademarks of Weight Watchers. STAR WARS, EPISODE III, REVENGE OF THE SITH, YODA and DARTH VADER are trademarks owned by Lucasfilm Ltd. XBOX 360 is a trademark of Microsoft Corporation. TREASURYVISION is a service mark owned by Citicorp Corporation. America On the MoveTM is an initiative of the nonprofit organization, The Partnership to Promote Healthy Eating and Active Living (The Partnership: www.americaonthemove.org). Design: Eisenman Associates. Printing: L.P. Thebault. Photography: Stephen Wilkes, Ben Rosenthal, PhotoBureau, Andy Robinson, Nellie Solitrenick, Charlie Samuels, Jonathan Kirn. Special thanks to Cumberland Farms. Printed on recycled and recyclable paper. Paper manufactured using “Green Power.” letter_L01P01_05v3.qxd 3/4/06 12:04 PM Page 1 PepsiCo at a Glance $ in Millions Frito-Lay North America 4.5% PepsiCo Beverages North America 4% Volume Growth Volume Growth Net Revenue $10,322 $9,560 $9,091 2003 2004 2005 Operating Profit $2,529 $2,389 $2,242 Net Revenue $9,146 $8,313 $7,733 2003 2004 2005 Operating Profit $2,037 $1,911 $1,690 2003 2004 2005 2003 2004 2005 PepsiCo International Net Revenue Volume Growth Snacks 7% Quaker Foods North America Net Revenue Volume Growth 9% $11,376 Beverages 11% $9,862 $8,678 2003 2004 2005 Operating Profit $1,607 $1,323 $1,061 2003 2004 2005 $1,467 $1,526 $1,718 2003 2004 2005 Operating Profit $470 $475 $537 2003 2004 2005 11 letter_L01P01_05v3.qxd 3/4/06 12:04 PM Page 2 Dear Shareholders: With profitable growth across all divisions, on every continent and across both convenient food and beverage categories, PepsiCo delivered a very strong 2005. The company’s continued focus on health and wellness, and innovation — coupled with its efforts to build big, muscular brands and powerful go-to-market systems — generated industry leading results. • Volume grew 7%. • Net revenue grew 11%. • Division operating profit grew 10%. • Earnings per share grew 15%.* • Total return to shareholders was 15% compared with 5% for the S&P. • Cash flow from operations was $5.9 billion and manage- ment operating cash flow was $4.2 billion.** What’s particularly pleasing about these results is the balance they represent. Whether it’s between foods and beverages, North American and International operations, or even different parts of the day, our portfolio of leading brands finds convenient ways into consumers’ lives any time of day, anywhere across the globe. That’s why this year’s report focuses on what your company is doing to capture growth opportunities on any given day across the world. It’s a departure from previous annual reports which focused primarily on each division’s operating performance. While you can still find division summaries in this report, we want to give you a more holistic view of how your company is seeking to capture growth opportunities. You’ll see these opportunities addressed in the key themes in the pages that follow, but we also recognize that there are specific ques- tions to which many investors seek answers. Over the last year, we’ve 2005 Scorecard 7% 11% 10% Volume Net Revenue Division Operating Profit 25% 15% 15% Earnings Per Share* Total Return to Shareholders Return on Invested Capital* * See page 76. ** See page 49. 2 Steve Reinemund Chairman and Chief Executive Officer collected key questions shareholders most often ask about our businesses; they reflect issues we spend significant time and energy addressing. And first, on just about everyone’s list, is what PepsiCo is doing in the area of health and wellness. There is a lot in the press about the “obesity epidemic.” How urgent is the obesity issue, and does it pose a risk to PepsiCo’s business? There is no question that obesity is a significant issue gaining increased attention and importance in many nations. Public health is a complex issue that requires partnerships across public and private sectors to find solutions that help consumers. That’s why, while we view this issue as a challenge, we also see the growing interest in health and wellness as a growth opportunity. Given that North America revenues from our Smart Spot eligible products — more than 250 products that contribute to healthier lifestyles — grew at more than two-and-one-half times the rate of the rest of our portfolio in 2005, it’s clear that our strategy is aligned with the interests of our consumers and retail partners. And it’s the right thing to do for our business. As a result, our commitment to health and wellness has never been stronger. We believe the solution to consumers’ health and wellness needs — and the obesity epidemic in particular — lies in the concept of energy balance; that is, finding balance between the calories consumed and the calories burned. It requires companies like PepsiCo to be part of the solution — a priority on which we will continue to take action. Whether it’s reformulating our products with lower sugar, fat or sodium, adding new or additional ingredients that deliver health benefits, or developing entirely new products, we’ve committed considerable resources to doing what we do best — giving con- sumers what they want. We’ve also committed to supporting active lifestyles and marketing responsibly, and I’d encourage you to read details surrounding all our work in health and wellness later in this report. letter_L01P01_05v3.qxd 3/4/06 12:04 PM Page 3 Your commitment to the International business seems to be paying off. What are the drivers of growth in your International business, and do you expect the growth to continue at the same pace? The outstanding growth achieved by our International business in 2005 is the result of years of investment and the implementation of a deliberate strategy to create scale in key interna- tional markets that will deliver profitable growth. As the fastest growing division at PepsiCo — and now the largest revenue generator — PepsiCo International’s strategy clearly is delivering results. To give more perspective on why we’re encour- aged about our international growth prospects, the portfolio of international markets is both broaden- ing and strengthening, as we deliver exciting new products, tailored to local tastes, to consumers in more than 200 countries and territories. We’re particularly pleased with our growing presence in key emerging markets such as Brazil, China, India and Russia. We’re very proud of the growth generated through our brands. Our performance is directly attributable to the passionate people who run our businesses in our international markets, each and every day of the year, adapting our products, pack- aging and distribution systems to a wide variety of tastes and market conditions. We continue to expect our International business to grow at about twice the rate of our North American businesses, though favorable global macroeconomics clearly contributed to our 2005 performance which exceeded that expectation. What is the role of acquisitions in PepsiCo’s future growth? We continue to believe that small, strategic, or “tuck in” acquisitions, will help propel our future growth. Our recent acquisitions of Sakata in Australia, Star Foods in Poland, Punica in Germany, P.J. Smoothies in the United Kingdom and Stacy’s Pita Chips in the United States, are clear examples of how smaller acquisitions that offer considerable Earnings Per Share* $2.66 $2.32 $2.05 Management Operating Cash Flow ** $ in Millions $4,204 $3,705 $3,032 2003 2004 2005 2003 2004 2005 * See page 76. ** See page 49. synergies with our existing businesses can help us grow in new geographies and new categories. In each case, we exercise a disciplined approach to assessing any opportunity, carefully reviewing both strategic and financial criteria to ensure a fit with PepsiCo. It’s important to understand that while acquisitions have a role to play in our growth plans, we believe we’ll continue to experience strong “organic” growth in our existing portfolio of businesses. They’re equipped with big, muscular brands, they have room to grow, and they receive constant investment and attention. The carbonated soft drink category in North America has slowed in recent years. What does this trend mean for PepsiCo’s growth prospects? While our carbonated soft drink business was down in North America in 2005, we’re convinced that, over time, growth can be restored as we continue to invest in innovation for our carbonated beverages. Our diet carbonated soft drinks continue to grow in North America, an indication that consumers will remain engaged with the category if we offer car- bonated soft drinks they desire. Importantly, if you look at the total liquid refresh- ment beverage (LRB) category in North America — meaning all beverage occasions except for coffee, alcohol, tap and bulk water — you’ll see it’s growing at about 2.5% annually. This is consistent with his- torical growth rates for LRB, and PepsiCo is very well positioned to capture this growth. That’s because we have an advantaged portfolio of non-carbonated beverages, which is exactly where the growth in LRB is, and where we believe it continues to head. PepsiCo’s line-up of waters, sports drinks, teas and energy drinks includes lead- ing brands, and they illustrate how an advantaged portfolio of non-carbonated beverages can deliver great products for consumers, and solid returns for retailers and shareholders. How are you preparing to grow PepsiCo’s top line? In a word, innovation — the lifeblood of any con- sumer products company. PepsiCo views this capa- bility as a critical and sustainable competitive advantage. It is the reason we spend considerable time and dollars filling our pipeline with an array of consumer propositions to address needs for conven- ient foods and beverages. We use a thoughtful and balanced approach to funding innovation and putting resources in place to support it. Some examples of that balance include balancing good-for-you and better-for-you product innovation with resources earmarked for our fun-for-you portfolio. In 2005, for example, our investment in new Aquafina FlavorSplash and new Gatorade Lemonade drove growth with our Smart Spot portfolio, while Lay’s Cheddar and Sour Cream U.S. Category Leaders #2 Carbonated Soft Drinks # 1 S p o r t s D r i n k #1 PET Water (non-jug) #1 Chilled Juices & Juice Drinks # 1 E n h a n c e d W a t e r # 1 t o - D r R e a d y - f e e C o f i n k #2Ready-to-Drink Tea 3 letter_L01P01_05v3.qxd 3/4/06 12:04 PM Page 4 U.S. Category Leaders #1 Potato Chips # 1 To r t i l l a C h i p s #1CornChips # 1 i g r a i n t M u l S n a c k # 1 E x t r u d e d S n a c k s #2Pretzels 4 flavored potato chips contributed to solid growth with our Lay’s brand. But it also means balancing investment between carbonated and non-carbonated beverages, and balancing between “close-in” ideas like line exten- sions, and entirely new product platforms that don’t exist today. We’ve implemented new ways of coordinating the collection of insights from consumers and retail partners so we can better share those insights across our businesses, and generate ideas that have a greater chance of suc- cess in the marketplace. I think it’s important to understand that innovation isn’t limited to products. Across PepsiCo, we’re constantly innovating to strengthen our go-to-market systems and to find structures that drive faster, more efficient and more cost- effective decision making. A current example is our Business Process Transformation, or BPT, a comprehensive, multi-year initiative that centers on moving all of PepsiCo to a common set of processes for key business activities, with current efforts focused on North America. More than a year ago, you announced PepsiCo’s Business Process Transformation (BPT) initiative. What are the objectives of this program, and what is its status? Through larger acquisitions and mergers over the years, such as Tropicana and Quaker, we’ve recog- nized the need to seamlessly integrate formerly independent information systems. We’re also committed to harmonizing key business processes such as Finance, Consumer Insights, Purchasing and Supply Chain and continuously improving our customer service. We’re supporting these processes with common Information Technology applications, linking our systems so that key pieces of data supporting all our businesses flow seamlessly from system to system. 2005 was a big year of preparation for the first deployment of our new, integrated system, which started its phased roll out in early 2006. In fact, on January 16, the very first of these new capabilities began its roll out. Several of our North American plants, along with our Global Procurement team, now have streamlined tools and processes used for purchasing materials other than commodities, packaging and ingredients. Additional capabilities will be rolled out over the next several years. When complete, we expect to have an infra- structure that will support better, faster decisions, allowing us to capture more growth opportunities, and better serve our customers. Importantly, it will also leverage PepsiCo’s scale for efficiency and effectiveness. On the cost side, a number of key commodities have seen high rates of inflation. How is PepsiCo managing in an environment of increasing costs? There is no doubt that 2005 was a challenging year for input costs — especially energy and plas- tics resin. Between several major hurricanes hitting the United States and inflation, we saw some expected and some unexpected pressure on our margins, but we managed those cost pressures and met our financial targets. And we expect 2006 to be challenging as well, largely reflecting increased energy and commodity costs. However, we have solid plans in place to off- set these rising costs through productivity programs and hedging strategies, and expect to carefully manage pricing to help offset some of the inflation. PepsiCo’s businesses generate a great deal of cash, and the Company’s balance sheet is very conservative. Why don’t you put more debt on the balance sheet and use the proceeds to increase the dividend or increase share repurchases? PepsiCo does generate considerable cash, and we are disciplined about how cash is reinvested in the business. Over the past three years, $5.7 billion has been reinvested in the businesses through capital expenditures and acquisitions, and $12.0 billion has been returned to shareholders through a combination of dividends and share repurchases. In essence, any cash we have not reinvested in the business has been returned to our shareholders. And, we are pleased with our current capital structure and debt ratings, which give us ready access to capital markets and keep our cost of borrowing down. PepsiCo’s focus on people — specifically diversity and inclusion — has been a priority in previous reports. What results have you delivered through this focus and what changes have you made? In terms of the diversity of our workforce, we’ve seen a significant increase in the number of women and people of color who’ve joined PepsiCo in various functions and at various levels. Since 2000, the percentage of women in management positions in the United States has risen from 20% to 25%. The number of people of color in management positions has climbed from 15% to almost 22% — we made a gain of about 2 points of growth in 2005 alone. This change in the workforce has contributed to our growth through product ideas, greater insights about consumers and connections into growing urban and ethnic communities. While a diverse workforce is important, we must also create an inclusive environment where every- one — regardless of race, gender, physical ability or sexual orientation — feels valued, engaged, and wants to be part of our growth. It is only through letter_L01P01_05v3.qxd 3/4/06 12:04 PM Page 5 As we have with previous reports, we’ve includ- ed a section on corporate social responsibility to highlight what we’ve accomplished in 2005, and I invite you to visit our website as well to read our report in detail. More importantly, I hope the contents of this annual report — along with even more details that are published on our website — will help you understand that your company is addressing the challenges ahead with the strength of muscular brands, a growing and powerful go-to-market sys- tem, a commitment to innovation, and passionate, diverse people committed to growing the business in responsible ways. This is the PepsiCo that is poised to deliver on our commitment to responsible growth at any time, and on any day. Steve Reinemund Chairman and Chief Executive Officer inclusion that we will fully unleash innovation and growth for our business. To capture this potential, we made some changes in 2005. For example, to put accounta- bility for diversity and inclusion squarely in the hands of our people, and into our divisions, we formed the PepsiCo Diversity & Inclusion Governance Council. Representatives from each division and various functions comprise the coun- cil, and its chair reports directly to me. I also asked each of my direct reports to take ownership for the development of specific employ- ee groups. Whether it is African Americans, Latinos, white males, women, or other groups of PepsiCo employees, each has a voice at the most senior decision-making entity at your company. In the context of people issues, corporate responsibility is a hot topic. How are you ensuring PepsiCo associates are acting in accordance with the law, and — beyond the law — doing the right thing? The need for trust between corporations and the general public is as big as ever, and investors rightly should ask this question of every company. PepsiCo’s focus on values remains honed on a commitment to every shareholder — to deliver sustained growth, through empowered people, operating with responsibility and building trust. This commitment, along with six guiding principles (found on page 7), is what we aspire to each and every day. It complements our approach to corporate governance, the strength of our financial controls, and the company’s Worldwide Code of Conduct. U.S. Category Leaders #1Hot Cereal # 1 G r i t s # 1 R i c e S i d e D i s h e s #1 Brand PancakeSyrup 1 # P n a e k a c M i x Our Values and our Worldwide Code of Conduct are known to every PepsiCo associate and are presented in 38 languages on our web- site (www.pepsico.com). But the strength of any such commitment is not in the words themselves, but in how they are lived every day. We continuously remind our associates of the rewards that come with running the company in a legal, ethical and responsible way, along with the consequences of failing to do so. We want, and intend to be, a sustainable enterprise, and that demands our people act in responsible ways, and think about our businesses for the long term. A Word of Thanks to Sol Trujillo Sol Trujillo retired from the board when he was named chief executive officer of Telstra Corporation, the Australian telecommunications and information services company. Sol served for five years on our Board, providing valuable insights and advice. He has an astute understanding of consumers and provided excellent guidance during our merger with Quaker. His counsel and contributions will be greatly missed. Welcome to New Board Members Joining our Board of Directors in 2005 were Dina Dublon, Victor J. Dzau, M.D. and Alberto Ibargüen. Dina Dublon was, until October 2004, executive vice president and chief financial officer for JPMorgan Chase, the U.S.-based banking company with more than $1 trillion in assets. She brings a deep expertise in financial management that significantly enhances PepsiCo’s capability in this important area. She will serve on our Audit Committee. Dr. Dzau is one of the world’s foremost authorities on health issues, chancellor for health affairs at Duke University and president and chief executive officer of the Duke University Health System. His medical insights and business acumen will be invaluable as we strive to achieve our commitment to health and wellness. Alberto Ibargüen previously was chairman of the Miami Herald Publishing Company, a Knight Ridder subsidiary, and has served as publisher of the Miami Herald and El Nuevo Herald. In July 2005, he became president and chief executive officer of the John S. and James L. Knight Foundation, a major supporter of journalism programs and civic advancement. He brings both business and community expertise and will serve on the Audit Committee. — SSR 5 division_L01P06_15v5.qxd 3/8/06 7:13 PM Page 6 U.S. Convenient Food and Beverage Sales % Total Dollar Sales Snacks and Beverages PepsiCo 22% Kraft Foods 8% Coca-Cola 11% All Others 59% PepsiCo is the leading convenient food and beverage company in the United States. Our Competitive Advantages: Strong brands. World-class innovation. Powerful Go-to-Market systems. 6 Growth is our reason for being. In fact, growth is so much a part of PepsiCo’s DNA that it’s reflected in our values as our commitment to sustained growth. Fundamentally, there are two ways for a corporation to generate profitable growth for its shareholders: by increasing revenues and decreasing costs. It’s a relatively simple concept, but the longer a company is in business and the bigger it gets, the more difficult growth is to achieve. And in accomplishing these most basic — and difficult — priorities over time, the single biggest contributor to sustained growth lies in how the enterprise consistently delivers top-line growth and bottom-line performance. Over time, the way a company delivers growth will define the difference between its success and failure. PepsiCo Values “Sustained Growth” means consistent growth for our business as well as our people — growth year after year. “Empowered People” is the second piece of that commitment, as the decisions that drive the business come from tens of thousands of PepsiCo associates throughout the world who develop, manufacture and deliver our products. Empowered people act and think in ways that get the job done, and innovate to find new ways to achieve growth. “Responsibility and Trust” is the third piece of our commitment. It articulates that acting responsibly and earning the trust of our shareholders, customers, consumers and other stakeholders is a necessity for growth. Our growth must come the right way. It takes a lifetime to build that trust, and a single misstep can destroy it. Winning is only worth it if is done the right way — acting in a responsible way that will build trust. Top Line: Our Competitive Advantages Growing revenues, or the top line, requires constant care and investment in our competitive advantages. These are the strengths we bring to the marketplace that set us apart. These include our quality brands — products known and trusted by consumers around the world. We constantly revitalize these brands with packag- ing and product improvements and consumer promotions to keep them strong. When an opportunity to add new products that complement our portfolio comes along, we consider building them from within or acquiring new brands through smaller “tuck in” acquisitions, which can be integrated easily with our lines of business. Our ability to innovate is another competitive advantage. We look for opportunities to capitalize on the value of our brands by creating new products and varieties. By innovating to meet consumer needs and preferences, we fill division_L01P06_15v3.qxd 3/4/06 2:39 PM Page 7 consumption gaps and contribute to creating both healthier and indulgent choices for consumers, and bringing more enjoyment to their lives. Bringing those products to consumers is where our third major competitive strength comes into play: our strong, established delivery systems. They include direct-store-delivery, where our own associates load and set up the shelves; warehouse systems, where retailers store and replenish product; and dedicated teams to supply foodservice and vending customers. The strength and span of our systems help us quickly introduce a product into the market — which helps us put our products within easy reach whenever a consumer is thirsty or hungry. Bottom Line: A Constant Focus Through our Business Process Transformation initiative, we are equally focused on reducing expenses to produce a healthy bottom line. We’re streamlining our processes by employing new technology to meet customer and business needs. We’re finding new ways to capture the full value of every penny we earn, such as using a new treasury management program to invest revenues the same day we receive them. We’re consolidating our purchasing to secure more favorable prices and delivery. We’re developing state-of-the-art water programs, energy conservation methods and other environmental initiatives that will make our businesses more sustainable. None of this would happen without our people, the drivers of everything we do. They are among the most talented and dedicated individuals in the world. Each of these competitive strengths comes together to meet the needs of our consumers, shareholders and other stakeholders in creating sustainable growth on any day. Top Branded Food and Beverage Manufacturers $ Net Sales in Billions Food and Beverage sales. Excludes food ingredients, pet and agricultural products. Includes fruit and dairy. Nestlé Kraft Foods PepsiCo Unilever Coca-Cola Diageo Groupe Danone Cadbury Schweppes Anheuser-Busch General Mills 0 10 20 30 40 50 60 PepsiCo is the world’s third largest food and beverage company. 7 division_L01P06_15v5.qxd 3/8/06 7:14 PM Page 8 PepsiCo North America Revenues from Smart Spot Eligible Products % System Revenue Smart Spot 40% Non-Smart Spot 60% A wide variety of PepsiCo products carry the Smart Spot symbol to identify choices that can contribute to healthier lifestyles. Health and wellness represents one of our most critical opportunities for growth. In capturing this opportunity, we believe we can play a role in empowering and motivating consumers to lead healthier lifestyles, and we believe our actions are making a difference. Our focus on product reformulation — reducing sugar, fat or sodium or adding whole grains and healthier oils; our commitment to developing new products that support healthier eating; and our passion for promoting active lifestyles, all illustrate our drive to make it easier for our consumers to make choices that are part of healthier lifestyles. In 2005, we became the first major food and beverage company to promote healthier lifestyles — beyond products — to consumers through a major program called S.M.A.R.T., which encourages healthier eating and exercise habits. We realize that doing the right thing for our consumers and employees is doing the right thing for our business. In fact, our Smart Spot eligible products revenue grew more than two-and-one-half times faster than the rest of our portfolio in 2005. The Smart Spot symbol helps consumers find our products that can contribute to healthier lifestyles. Energy Balance The solution to the problem of increasing obesity rates is far from simple. It requires consumers to understand and achieve energy balance — the balance between calories consumed and calories expended through activity. To help consumers achieve energy balance, we’re providing them with convenient, healthier products they want to consume and that fit their busy lifestyles. We also are encouraging them to engage in physical activities they enjoy. Our Commitment to Healthier Choices Building on the foundation of brands like Quaker, Tropicana, Aquafina, Baked! and others, we’re putting more emphasis on making products with healthy ingredients — like oatmeal, water and juice — more convenient. For example, we’ve combined fruit and juice and made them more convenient through Tropicana FruitWise, a delicious line of fruit strips, bars and beverages that deliver one to two servings of fruit in a portable, convenient form. Our Quaker Milk Chillers product is another example. These dairy products have reduced calories and are fortified with calcium and seven essential vitamins. Other examples include: • Eliminating trans fats from Frito-Lay branded products in 2003. We were the first major food company to make this change. • Creating new reduced-sugar Instant Quaker Oatmeal varieties, and adding Take Heart and Weight Control versions to our instant oatmeal line-up. • Creating Tropicana Light ’n Healthy orange juice beverage, which has half the sugar and calories of orange juice. • Adding a new variety of flavored water to our Aquafina line-up with the introduction of FlavorSplash. This non-carbonated variety gives consumers a hint of flavor in their water, without adding calories. • Building on the success of Propel Fitness Water with the introduction of Propel Calcium, the first national fitness water with added calcium. E n ergy B a l an c e = c a lo r i es i n - c a lo r i es out division_L01P06_15v3.qxd 3/4/06 2:39 PM Page 9 Smart Spot Products Contribute to Healthier Choices In 2004, PepsiCo launched the Smart Spot symbol, the first-of-its-kind designation that makes it easier for consumers to identify PepsiCo products which can contribute to healthier lifestyles. And in 2005, our Canadian business introduced a similar program to consumers. Products with the Smart Spot designation in the United States meet nutrition criteria based on authoritative statements from the U.S. Food and Drug Administration (FDA) and the National Academy of Sciences. Those criteria define limits for fat — including saturated and trans fats — cholesterol, added sugar and sodium. The criteria also are used to identify products formulated to have specific health or wellness benefits, or products reduced in calories or ingredients such as fat or sugar. For more information visit www.smartspot.com. Our Commitment to Promoting Healthier Lifestyles As a leading food and beverage company, we believe we have a role in supporting programs that help consumers with the “calories out” side of the equation as well. The PepsiCo S.M.A.R.T. lifestyle program involves five simple steps for healthier living. The S.M.A.R.T. program is supported with a national advertising campaign. And in 2006, PepsiCo plans to build 12 Smart Spot playgrounds in inner city locations across the county. Our goal is to support more active lifestyles for families and kids — and get them to “move more.” Impacting Local Communities PepsiCo is proud to be the national presenting sponsor of America On the Move (AOM), a national program dedicated to helping individuals, families and communities make positive changes to health and quality of life. AOM recommends taking 2,000 more steps and consuming 100 fewer calories a day to stop weight gain. Working with AOM, PepsiCo has partnered with the National Urban League and the National Council of La Raza to address common health concerns that affect African Americans and Latinos. Both organizations are tailoring AOM’s approach to help people initiate and maintain meaningful and measurable behavior changes that support healthy eating and active living habits. In Mexico, the PepsiCo Foundation has partnered with Fundación Actívate to pilot Activa2, an energy balance program for youth which encourages healthy eating habits and exercise. Our Commitment to Schools and Educators Schools want to provide children with the right food and beverage choices, too. That’s why PepsiCo provides a wide range of offerings in schools, including Smart Spot products in particular. New products that are appropriate for kids are being introduced first in schools — products like reduced-fat Baked! Cheetos snacks. We are working with our bottlers and vending distributors to establish guidelines on school offerings, again with an emphasis on Smart Spot products. To help educate kids about energy balance, PepsiCo and America On the Move developed a lesson plan called Balance First. This program reached 3 million elementary age students in 2004. In 2005, we continued to distribute the lesson plans to elementary schools. And in partnership with Discovery Education, we’ve distributed the Balance First program to 15,000 middle schools in the United States — virtually every middle school in the nation. In partnership with the American Beverage Association, PepsiCo and other industry members developed a school vending policy aimed at providing lower-calorie and/or nutritious beverages and limiting the availability of soft drinks in schools. Children in Washington D.C. say thank you for their new Smart Spot playground. 9 division_L01P06_15v5.qxd 3/8/06 7:14 PM Page 10 PepsiCo estimated worldwide retail sales: $85 billion Largest PepsiCo Brands Estimated Worldwide Retail Sales $ in Billions Pepsi-Cola Diet Pepsi Mountain Dew (diet and regular) Gatorade Thirst Quencher Lay’s Potato Chips Doritos Tortilla Chips Tropicana Pure Premium Orange Juice 7UP (outside U.S.) Cheetos Cheese Flavored Snacks Quaker Cereals Aquafina Bottled Water Ruffles Potato Chips Mirinda Lipton Tea Tostitos Tortilla Chips Sierra Mist (diet and regular) Fritos Corn Chips 5 20 10 0 PepsiCo now has 17 powerful brands known around the world that each generate annual retail sales of more than $1 billion. 15 Whether it’s a new product, improvement to an existing product, new packaging or a unique promotion, we’re relentless in our drive to keep our products relevant to consumers. March of New Products Early in the year, Pepsi-Cola North America capitalized on our leading Aquafina brand with FlavorSplash, a zero-calorie water made with natural fruit flavors and sweetened with Splenda no-calorie sweetener. Our SoBe team built on the strength of its South Beach Diet program-endorsed Lean line with two new flavors: Lean Energy and Lean Mango Melon. The Pepsi-Lipton Tea Partnership unveiled a new Diet Sweet version of ready-to-drink Lipton Iced Tea. We also kept our carbonated soft drink brands top of mind. Building sales of our flagship Pepsi brand, Pepsi-Cola introduced Pepsi Lime and Diet Pepsi Lime, a pair of colas featuring the popular lime flavor. Pioneering a new category of “energy sodas,” Pepsi-Cola launched MDX, a beverage touting the familiar citrus flavor of Mountain Dew, but fueled by a “power pack” of ingredients including ginseng, guarana, taurine and D-ribose. The march of our new products continued when Tropicana introduced Tropicana Pure Premium Essentials with Fiber — the first national orange juice with added fiber. It delivers as much fiber as a whole orange in every 8-ounce glass. Then we gave lemonade a new meaning with the introduction of a Gatorade Lemonade, a line that combines the refreshing taste of lemonade with the scientifically supported formula of Gatorade Thirst Quencher. At Frito-Lay North America, we reformulated all our Quaker Chewy granola bars to remove trans fat — plus we reformulated many of them to reduce sugar by 25% and add calcium. Many of these bars now bear the Smart Spot symbol and our new package graphics reinforce the linkage to Quaker Oatmeal. In our Oberto meat snacks line, distributed by Frito-Lay, we introduced Oh Boy! Oberto Beef Jerky Crisps, a first- of-its-kind snack that bridges the gap between beef jerky and traditional snack chips. At our Quaker Foods business, we added to our successful Life Cereal line with the introduction of Life Vanilla Yogurt Crunch — combining Life Cereal with yogurt-coated clusters while delivering nine essential vitamins and minerals and providing a good source of calcium and fiber. Quaker also introduced new Weight Control instant oatmeal, a quick, convenient way to eat a nutritious breakfast that is high in fiber and a good source of protein, and Quaker Oatmeal-To-Go bars, which provide all the nutrition of a bowl of instant oatmeal. U.S. Convenient Foods Sales % Retail Sales in Measured Channels. Includes chips, pretzels, ready-to-eat popcorn, crackers, dips, snack nuts/seeds, meat snacks, yogurt, bars, cookies, pastry, sweet, and other snacks. Procter & Gamble 1% Master Foods 4% General Mills 5% PepsiCo 15% Kellogg 5% Hershey 6% Private Label 8% Kraft Foods 12% Others 44% Frito-Lay is the leading convenient snack food business in measured channels in the United States. division_L01P06_15v3.qxd 3/4/06 2:40 PM Page 11 Hundreds of innovations help drive our growth in international markets. Pepsi Cino, the first cola-coffee flavor combination from a major beverage company, was a dynamic new entry to the carbonated soft drink arena. 7UP H2O, a sugar-free sparkling water infused with the flavor of 7UP, was launched in Argentina and proved highly appealing to consumers interest- ed in lighter beverages. In China, the relaunch and expansion of Gatorade helped us capture a solid position in the growing sports drink category. And we expanded Tropicana in Europe, Asia and the Middle East. Capturing Consumer Attention with Packaging Packaging captures attention and gives us an opportunity to tell consumers about our brands. For example, Lipton Original received a makeover. It’s now in 16-ounce glass bottles that include a logo noting the brand’s naturally protective antioxidants. We introduced new striking black and silver graphics to highlight reformulated Pepsi ONE. SoBe Beverages celebrated its tenth anniversary by unveiling new graphics for the entire 20-ounce product line, scheduled to be on the shelves in 2006. The Tropicana Light ’n Healthy packaging was the first juice beverages to carry Weight Watchers’ proprietary POINTS values on the packaging. Outside the United States, one highlight of our packaging innovation was a new 7UP plastic bottle with a distinctive, proprietary shape that features bold graphics and is attracting lots of attention on store shelves. Promotions that Keep Our Brands Top of Mind Pepsi-Cola used music to help keep our brands top of mind. The Pepsi iTunes giveaway offered 200 million free songs. In mid-year, Pepsi and Yahoo! announced a partnership to bring music to fans with “Smash on Yahoo! Music,” an adaptation of the “Pepsi Smash” summer concert TV program. With “Call Upon Yoda,” an instant-win sweepstakes, Pepsi-Cola took advantage of the release of the highly anticipated movie “Star Wars: Episode III, Revenge of the Sith.” Frito-Lay joined by launching Star Wars-inspired Twisted Cheetos snacks, which temporarily turned the color of consumers’ tongues into “Yoda Green” or “Darth Vader Dark.” Pepsi was back with our “Go Pro” sweepstakes, a sports fan’s fantasy that offered the chance to win trips to select professional sporting events across the country. Then Pepsi turned up the volume even higher with its highly successful Mountain Dew promotion that gave away an Xbox 360 next-generation video game and entertainment system every ten minutes. Mountain Dew made news with Mountain Dew (MD) Films and Universal Pictures joint release of “First Descent,” the story of the rise of snowboarding. Our SoBe business kept the action going all year with concert tours, support of major surfing events, supercross/motocross racing and skateboarding — activities that reflect active lives of “Team Lizard” fans. Gatorade gave its brands local visibility through the Gatorade Athlete of the Year award program which recognizes young athletes. PepsiCo Beverages North America Carbonated Soft Drink Volume vs. Non-Carbonated Soft Drink Volume Non-Carbonated Soft Drinks 35% Carbonated Soft Drinks 65% Carbonated soft drinks generate the largest volumes. U.S. Liquid Refreshment Beverage Market Share % Volume in Measured Channels Other 20% Private Label 14% PepsiCo 26% Coca-Cola 24% Cadbury Schweppes 10% Nestlé 6% PepsiCo has the leading share of the liquid refreshment beverage market. P e p s i C o B e v e r a g e s N o r t h A m e r i c a C a r b o n a t e d S o f t D r i n k R e v e n u e v s . N o n - C a r b o n a t e d S o f t D r i n k R e v e n u e C a r b o n a t e d S o f t D r i n k s 3 3 % N o n - C a r b o n a t e d S o f t D r i n k s 6 7 % N o n - c a r b o n a t e d s o f t d r i n k s g e n e r a t e l a r g e s t r e v e n u e . t h e 11 division_L01P06_15v4.qxd 3/6/06 10:23 PM Page 12 U.S. Frito-Lay North America Distribution Channels % Volume Canada 8% Other 8% Supermarket/ Grocery 39% Convenience 11% Foodservice/ Vending 9% Mass Merchandiser/ Warehouse/Club 25% Frito-Lay North America distributes to some 430,000 retail outlets each week. U.S. PepsiCo Beverage Distribution Channels % Volume Restaurant/ Foodservice/ Vending 27% Convenience/ Gas/Chilled DSD/ Other Small Format 17% Mass Merchandiser/ Supercenters/ Club/Drug/Other 21% Grocery 35% PepsiCo beverages are distributed by a powerful go-to-market system which includes company-owned operations, independently-owned franchised bottlers and warehouse delivery systems. 12 Our goal is to have our products in arm’s reach whenever and wherever consumers want them. And we’re delivering — literally. For example, our brands include seven of the 13 largest food and beverage brands sold in U.S. supermarkets. Whether they’re new or brand- loyal consumers, each consumer must be able to find our products in order to buy them. That’s why the strength of our selling, distribution and internal systems is so critical. From stocking shelves and creating displays in supermarkets, to making sure the small corner deli has our products, our front-line teams go the distance. They are supported by an infrastructure dedicated to streamlining our processes and enhancing our growth through efficiency. For example, we are consolidating global purchasing to ensure we leverage our spending, and we are revamping our business processes to give our customers what they need. Our Distribution Systems Most of our sales are delivered through direct-store-delivery (DSD) distribution systems, where a dedicated team delivers the product to the stores and places our products on the shelves. This gives us the opportunity to merchandise our products and make sure they are always available. It gives the route salesperson the ability to meet the specific needs of any retailer. Our system reached hundreds of thousands of retail outlets this way, from tiny convenience stores to the largest supermarkets, helping us distribute new product offerings in record time. In 2005, we started to add 475 new distribution routes at Frito-Lay in the United States — our largest addition in nearly a decade. Internationally, our sales force of almost 35,000 reaches nearly every corner of the globe. Our Gatorade and shelf-stable Tropicana juices, as well as many of our Quaker and other less perishable products, are delivered through one of the largest warehouse delivery systems in the world. Tropicana Pure Premium comes fresh through a refrigerated ware- house or chilled direct-store-delivery system. Our distribution systems are designed to meet the needs of our customers. For example, Frito-Lay sells its Gamesa cookies and crackers through warehouse, third-party distributors, direct shipment and DSD. When taken together, over the past three years, PepsiCo products delivered through all these methods contributed more to the growth in U.S. supermarkets than any other company. An equally robust system is dedicated to delivering our products to foodservice and vending customers. New beverage partners include Taco John’s and Arby’s — high-traffic restaurants. Taco John’s operates and franchises more than 400 quick-serve restaurants in 27 states. Arby’s consists of nearly 3,500 restaurants worldwide, including more than 1,000 in the United States. Pepsi-Cola expanded its partnership with Metromedia Restaurant Group (MRG), which has more than 800 restaurants. The new partnership adds Bennigan’s and Steak & Ale restaurants to the existing relationship with Ponderosa and Bonanza Steakhouses. O u r d istr i but i on sy st em s D i rec t - st o re - de li very B roker -w a re h ous e Foo d s er vi c e and ven d in g division_L01P06_15v3.qxd 3/4/06 2:40 PM Page 13 Business Process Transformation/Project One Up Execution begins long before our products are delivered. PepsiCo’s Business Process Transformation (BPT) initiative is addressing the changing market and needs of our customers. In the past, PepsiCo divisions operated on separate information systems and had varying business processes. In 2004, we embarked on a journey to change our business model to better meet the needs of our retail customers. The most central piece of our BPT efforts is an implementation called Project One Up, so named because it will allow us to “one up” the competition. It’s a multi-year project to simplify and synchronize our business processes and tools into one common platform. We believe Project One Up will help PepsiCo in key areas: • Customer insights — We will collect more and better consumer behavior and marketing insights to increase sales. • Procurement — We will consolidate and optimize purchasing to reduce costs and ensure supply. • Supply chain — We will manufacture and distribute our products faster and more efficiently, based on the increased information and new processes. • Finance — We will consolidate billing and provide more complete and responsive financial data to our trading partners. • Go-to-market — We will share information throughout PepsiCo faster and with more efficiency, improving customer service. We have a dedicated team of representatives from various divisions and functions working on Project One Up. Making Every Penny Count Innovation can improve our processes. When our treasury team required a banking system with global visibility to optimize PepsiCo’s investments, they teamed with Citigroup to develop a web-based tool called “TreasuryVision” that provides views of real-time balances, cash positions, investments and borrowings worldwide. Every day, in countries around the world, our sales force receives payments from stores for products and deposits those funds across hundreds of bank accounts. In the past, there may have been a lag of up to several days before our treasury team had access to these funds. The new system will provide visibility to these funds and will enable us to invest them more efficiently. 0 Top Contributors to U.S. Supermarket Growth $ Retail Sales in Millions 2002-2005 Kellogg Coca-Cola -600 -400 -200 0 200 400 600 800 During the period from 2002 to 2005, PepsiCo was the largest contributor to U.S. supermarket growth. Largest Food Brands in U.S. Supermarkets Estimated $ Retail Sales in Millions. Excludes alcoholic beverages. Coca-Cola Pepsi-Cola Tropicana Pure Premium Juice Gatorade Fresh Express Salad Diet Coke Campbell’s Soup Oscar Mayer Lunchmeat Dole Fresh Cut Salad Lay’s Potato Chips Diet Pepsi Mountain Dew Doritos Tortilla Chips 1000 500 Seven of PepsiCo’s brands rank among the best-selling food and beverage brands in U.S. supermarkets. No other company comes close. 1500 division_L01P06_15v4.qxd 3/6/06 11:01 PM Page 14 g r o w t h i s I n t e r n a t i o n a l l e o u r s i n g o p p o r t u n i t y . l a r g e s t With 95% of the world’s population located outside North America, international growth is our single largest opportunity. Our strategies are focused: • Build on our snack leadership position. • Focus on the strengths of our beverages. • Grow through acquisitions. • Take advantage of our scale. Our snack business is the largest in the world, and our brands are recognized in markets Build on Our Snack Leadership Position ranging from Mexico to the United Kingdom to Thailand. Yet, in some of the largest developing markets, such as China and India, per-capita consumption is still small and many consumers have never tasted our brands. To us, that means vast opportunities. We’re building our existing business by offering consumers more variety and conven- ience, including flavors tailored to local tastes. For example, in China we offer Lay’s potato chips in flavors that include Hangzhou Stewed Meat, Hokkaido Crab and Cool Cucumber. Providing products and programs that address consumers’ growing interest in health and wellness also drives our success. In the United Kingdom, we lowered the saturated fat in our standard Walkers crisps by 70% and launched Potato Heads, a highly success- ful range of crisps for children, also with 70% less saturated fat and no artificial flavors or preservatives. In Mexico, we have driven strong growth of the healthy segment with brands such as Nutritas, an extruded snack, and Sun Chips multigrain snacks. Focus on the Strengths of Our Beverages Our international beverage volume has grown consistently during the past four years. Through our company-owned and franchise-owned bottlers, we make and market an array of major brands, including Pepsi-Cola, 7UP, Mirinda and Mountain Dew. Our portfolio We work relentlessly to keep our brands strong, exciting and locally relevant, with a also includes various local soft drink brands. continuous flow of product news and package innovations, and exciting marketing programs — often leveraging the universal appeal of music and sports. We also offer consumers a portfolio of non-carbonated beverages that includes our Gatorade, Tropicana and Aquafina brands, as well as Lipton teas through our joint ven- ture with Unilever. Tropicana is now available in more than 30 countries and we’ve expanded the presence of Gatorade, the world’s leading sports drink, into markets such as China and India. Acquisitions offer additional opportunities to build our business and enter new markets Grow through Acquisitions and categories. We now have full ownership of Snack Ventures Europe, Continental PepsiCo Beverage Volume Outside North America % System Volume by Region Includes Pepsi-Cola, 7UP, Gatorade, Tropicana and other beverages. United Kingdom/ Europe/ Middle East/Africa 45% Asia/Pacific 26% Latin America 29% PepsiCo beverages are distributed locally by company-owned and franchised bottlers. PepsiCo Snack Volume Outside North America % System Volume by Region Latin America 55% Asia/Pacific 10% United Kingdom/ Europe/ Middle East/Africa 35% PepsiCo has the largest snack business in the world. 14 division_L01P06_15v4.qxd 3/6/06 10:46 PM Page 15 PepsiCo products are available in more than 200 countries and territories. continental Europe. Europe’s largest snack food company, with operations in Holland, France, Belgium, Spain, Portugal, Greece, the Baltics, Hungary and Russia. Adding Star Foods to our portfolio strengthened our position as Poland’s mar- ket leader in potato chips and gave us the largest position in the broader savory snack category, which includes potato chips, pretzels, nuts and extruded snacks. We also acquired Sakata Australia, the market leader in rice snacks. This allows us to offer a wider array of choices in “better-for-you” snacks to con- In Germany, we expanded and strengthened our beverage portfolio with the sumers in Australia and other countries. acquisition of Punica Getränke GmbH, a leading maker of fruit juices and juice drinks. The purchase dramatically expanded our juice business in In the Netherlands, Belgium and France, we are waiting for regulatory approval to complete the acquisition of Sara Lee Corporation’s European nut business in these countries, to further expand our market presence. We continually seek opportunities to take greater advantage of the combined scale Take Advantage of Our Scale of our business. For example, in the United Kingdom we have Power of One teams calling on customers to offer both beverages and snacks. In Mexico, we conduct joint promotions that include both Pepsi products and Sabritas snacks. And, in many parts of the world, we have merged our snack and beverage organizations to operate more efficiently, broadening the skills of our people and encouraging Coordinated purchasing has driven substantial productivity gains; we buy cross-business sharing of ideas. through PepsiCo’s Global Procurement group for strategic materials and through regional procurement systems where it makes more sense to source locally. This has contributed to steady improvement in operating margins since 2002. Snack Volume Growth by Region % System Volume Growth United Kingdom/Europe/Middle East/Africa Asia/Pacific Latin America 0 2 4 6 8 10 12 14 Beverage Volume Growth by Region % System Volume Growth United Kingdom/Europe/Middle East/Africa Asia/Pacific Latin America 0 2 4 6 8 10 12 14 PepsiCo International beverages and snacks generated growth across all regions. Net Revenues Outside North America % Net Revenues Snacks and Foods 72% Beverages 28% Nearly three-fourths of PepsiCo International revenues are generated by snacks and foods. 15 division_L01P16_19v4.qxd 3/4/06 2:48 PM Page 16 Focus Areas • Values • Diversity and Inclusion • Health and Wellness • Water • Packaging Sustainability lives at the intersection of public and business interests. It encompasses citizenship and corporate social responsibility, which are about doing the right things for society and for the business. It encompasses the health of the corporation, which is about fulfilling our mission of creating financial rewards and growth. A History of Responsibility PepsiCo has always been a responsible corporation. Our Worldwide Code of Conduct had guided our actions for decades, and we have been a consistent contributor to our communities and to the nonprofit organizations that support our society. We have been recognized as a leading company in areas such as diversity and inclusion, purchasing from women-owned and minority-owned suppliers, corporate governance, environmental stewardship and social leadership. We provide our associates with a broad menu of benefits and competitive compensation. We recognize our responsibility to consumers to provide safe, quality products, and to offer product choices that help them meet their needs, whether it is a need for pure refreshment and fun, or for foods and beverages that make it easier and more enjoyable for them to lead healthier lives. We recognize that is not enough. Our Sustainability Journey In 2003, we took the first steps on a journey to become a more sustainable corpora- tion. We voluntarily adopted the Global Reporting Initiative (GRI) guidelines as a template for reporting on our economic, environmental and social performance — the “triple bottom line” — and a measure of our sustainability. In 2004, we took another important step with the establishment of our Sustainability Task Force, comprised of senior executives from all our divisions. Throughout 2004 and 2005, the Sustainability Task Force defined our sustainability vision and we determined our key focus areas: values, diversity and inclusion, health and wellness, and the environment, especially water and packaging. We placed empha- sis on the development of environmental standards and metrics. The Sustainability Task Force, working with PepsiCo’s Environmental Task Force, developed consistent metrics for tracking our progress in the areas of water and energy. These measures are being introduced into all our divisions. A sound Environmental Management System (EMS) is basic to sustainability. In 2005, PepsiCo developed a framework that establishes rigorous procedures for manag- ing our environmental impacts. Previously, each division had distinct environmental programs and processes. We have targeted 2006 to begin the process of implementing our new EMS framework across our businesses. Further progress was made on our Capital Expenditure Filter, a process that ensures that sustainability issues are formally considered in all major capital expenditure proposals. We piloted the filter on two projects, a new Gatorade plant in Virginia and a new warehouse in Arizona. The filter proved to be a valuable tool in decision-making, Our M ission We aspire to make PepsiCo the world’s premier consumer products company, focused on convenient foods and beverages. We seek to produce healthy financial rewards for investors as we provide oppor- tunities for growth and enrichment to our employees, our business partners and the communities in which we operate. And in everything we do, we strive to act with honesty, openness, fairness and integrity. PepsiCo Supplier Diversity Spending $ in Millions $ 921 $ 526 2001 2005 Spending with women and minority suppliers has grown at a compounded annual rate of more than 15%. 16 division_L01P16_19v5.qxd 3/6/06 11:13 PM Page 17 Contribution Summary PepsiCo Foundation Corporate Contributions Divisions Estimated In-Kind Donations Total The PepsiCo Foundation and PepsiCo committed $2.0 million in disaster relief related to the tsunami in Southeast Asia. The PepsiCo Foundation contributed $2.1 million in relief directed to victims of Hurricane Katrina. PepsiCo Foundation and PepsiCo committed $2.0 million in relief for Pakistan earthquake victims. The PepsiCo Foundation contributed $500,000 to establish water projects in China and another $385,000 for projects in India. In-kind donations include food, beverages, equipment and services at cost to PepsiCo. $21.6 Million 4.3 Million 3.7 Million 20.8 Million $50.4 Million C o rpo r at e G o vern an c e Rec o gn i z e d Independent organizations rate companies on the quality of their corporate governance. For the fifth consecutive time, PepsiCo scored a 10 out of 10 rating from Governance Metrics International. Institutional Shareholders Services said PepsiCo outperformed 97.1% of the S&P 500 companies and 98.1% of the companies in the food, beverage and tobacco group. helping us identify potential environmental impacts, such as watershed protection, green building design opportunities, renewable energy usage and biodiversity. We are seeking opportunities to implement our minimization and optimization philosophy, both reducing our impacts and seeking ways to reach optimal solutions. For example, Gatorade is installing state-of-the-art high speed lines that minimize product spillage. The lines use advanced air rinsing of empty Gatorade bottles. Values Each year, every PepsiCo associate is asked to review our Worldwide Code of Conduct and recom- mit to living by it. Associates receive training in the Code, which is available in 38 languages and is accessible from both our internal and external websites. In 2005, we took additional steps to ensure that key associates understand every aspect of our Code. We developed online and written training and certification that approximately 25,000 executives and associates are required to complete. We report the results of these programs to our Board of Directors. During the year, we improved our Speak Up line — a free hotline operated by a third party — which PepsiCo associates may call to report any issue of concern, including those relating to values, Code of Conduct and accounting and auditing issues. The line is accessible from anywhere around the world and callers may remain anonymous. Diversity and Inclusion We are becoming a much more diverse and global company. Actively working to create a more diverse workforce and supplier base helps us better understand customers and consumers. A focus on developing an inclusive atmosphere where all associates feel they can succeed helps PepsiCo succeed. Each of our employee networks is represented at the most senior levels by an executive reporting to our chief executive officer. Our U.S. groups include African-Americans, Latinos, Asian, Women, White Males, Gay/Bisexual/Lesbian/Transgender (GBLT) and our newest group, “Enable,” for individuals with different abilities. We launched an electronic employee newsletter dedicated to diversity and inclusion. These new initiatives, plus ongoing programs and the continued counsel of our Ethnic Advisory Boards, are leading to better business insights and decisions. Our program to increase spending with women and minority suppliers was in the spotlight when PepsiCo Chairman and Chief Executive Officer Steve Reinemund was named chairman of the National Minority Supplier Development Council (NMSDC). Selected Diversity & Inclusion Awards • Hispanic Magazine: “100 Companies Providing the Most Opportunity for Hispanics.” • The National Association for Female Executives (NAFE): “NAFE 2005 Top 30 Companies for Executive Women.” • Latina Style Magazine: “50 Best Companies.” • New York Urban League: Corporate citizenship, hiring, supplier relations and philanthropic practices. • DiversityInc: No. 1 for African Americans, No.1 for Latinos, No. 2 for Recruitment and Retention, No. 4 for Asian Americans, No. 5 for Gay/Lesbian employees, No. 8 for Supplier Diversity and No.4 for overall diversity. • Women’s Business Enterprise National Council: “America’s Top Corporations for Women’s Business Enterprises.” • The Hispanic Association on Corporate Responsibility: Corporate Index. • 100% on the Human Rights Corporate Equality Index. • Black Enterprise: “30 Best Companies for Diversity.” • FORTUNE magazine: Top employers for minorities. • Black Collegian magazine: “Top 100 Diversity Employers.” • FORTUNE magazine: “Top Employers for Women.” We h ave a b out 1 5 7 , 0 0 0 a s s oc i at es w o r ldw i de . U.S. Diversity and Inclusion Statistics At Mid Year Total 14 Board of Directors Senior Managers 15 All Employees 60,634 7,130 All Managers Women 4 4 16,029 1,810 % 29% 27% 26% 25% Minority 4 3 17,214 1,550 % 29% 20% 28% 22% Our Board of Directors is pictured on page 21. Our Senior Managers are named on page 20. In 2005, we increased the percentage of our women managers by one point and our minority managers by two points. Our international operations also made significant progress in achieving diversity goals with the number of women in executive positions increasing by more than 30% in 2005. 17 division_L01P16_19v4.qxd 3/4/06 2:48 PM Page 18 Water Employee Health and Wellness Consumers are not the only beneficiaries of our focus on health and wellness. Our associates also reap the advantages. HealthRoads is our innovative wellness benefit offered in North America. The program promotes healthier lifestyles through a combination of personalized coaching, fitness and nutrition programs, online tools, resources and worksite wellness initiatives. HealthRoads offers a variety of programs that encourage associates to improve their health. A Personal Health Assessment provides information tailored to the associate’s unique health needs and recommends steps for improving health. The program includes initiatives such as America On the Move (AOM), weight management programs and 5 A-Day, a program where participants are encouraged to eat at least five servings of fruit and vegetables a day for better health. Water is a key sustainability priority for our company. We work closely with govern- ments, municipalities and technical experts to make sure that our water practices are responsible. Over the years, we have voluntarily developed many programs to reduce, reuse and recycle water, and that commitment is stronger than ever. We also work proactively to improve water supplies in communities where quality or quantity is a problem. And we readily donate water when disasters strike. Every PepsiCo division is engaged in water projects. In Europe and Asia, we harvest rainwater to help restore aquifers. In countries like India, where water shortages can be severe, we are building community infrastructure to help meet needs. In Kerala, India, for example, Pepsi-Cola increased the water supply for that drought-stricken community by digging new wells. In the United States, our conservation efforts include reducing our use of water through conservation techniques, using recycled water for plant maintenance and using wastewater to irrigate crops used for animal feed. In China, PepsiCo Foundation is partnering with China Women’s Development Foundation (CWDF) — which is part of the All China Women’s Federation — on a research and development initiative designed to expand availability of safe drinking water for the people of Western and Central China. In India, PepsiCo is providing support to the Energy and Resources Institute (TERI) to create sustainable state-of- the-art water resources management processes in the community. Packaging — particularly that of our beverage containers — is another key sustain- Packaging ability priority. PepsiCo fully supports the Environmental Protection Agency’s (EPA) hierarchy: Reduce, Reuse, Recycle. • Reduce: PepsiCo has reduced the weight of our beverage packaging significantly and uses nearly 60% less packaging now than in 1990 to deliver the same amount of soft drinks. • Reuse: Our aluminum cans contain approximately 50% previously used aluminum materials. Our glass bottles contain between 25%-35% of previously used material. In 2002, PepsiCo committed to include 10% recycled content in 18 division_L01P16_19v5.qxd 3/6/06 11:30 PM Page 19 In South Africa, our Simba lion mascot helped build awareness of HIV/AIDS on World AIDS Day. Selected Awards • Mexican Center for Philanthropy: Sabritas, our snack business in Mexico, is named a “Socially Responsible Business.” • Frito-Lay North America: Environmental Protection Agency (EPA) Star Partner of the Year Award for Leadership in Energy Management. • National Business Group on Health: “Best Employers for Healthy Lifestyles.” • Frito-Lay distribution center in Rochester, NY: Certified by the U.S. Green Building Council and granted LEED (Leadership in Energy and Environmental Designs) Gold Status. • Occupational Hazards magazine: “America’s Safest Companies.” • AIDS Response Standard Organization: PepsiCo Thailand, “Certificate of Gold Level.” • California Waste Reduction Award Program (WRAP): Frito-Lay Modesto plant as a “Top 10 WRAP of the Year Winner.” • FORTUNE magazine: “America’s Most Admired Companies.” Our CEO and CFO have issued the certifications required by the Securities and Exchange Commission (SEC) regarding the quality of PepsiCo's public disclosure. PepsiCo also has submitted its CEO certification as required by the New York Stock Exchange (NYSE). our carbonated soft drink plastic bottles in the United States by 2005. Thanks to our bottlers, PepsiCo met that goal on schedule. • Recycle: While beverage containers are the most recycled consumer packaging in the United States, we recognize that recovery rates need to increase. We helped found a new organization, the Beverage Product Environmental Council (BPEC), to increase beverage container recycling rates. We continue to be careful stewards of our environment in other areas. For example, Tropicana minimizes waste by using every part of the orange as well as its by-products after juice is extracted. Frito-Lay recovers starch from potatoes for use in other industrial and food processes. Similarly, all our businesses are working to reduce, reuse and recycle throughout the manufacturing process. In India, through an innovative partnership, PepsiCo has begun working with Exnora International and the Women’s Self Help Groups, both non-governmental groups, and the Pammal Municipality on a collaborative venture to establish an infrastructure to manage household solid waste. Early in 2005, we announced a global HIV/AIDS policy. In South Africa, we intro- HIV/AIDS duced a company-sponsored program that offers full treatment. On World AIDS Day, our Simba lion mascot helped build awareness. We also focused on other high risk areas. In China, India, Russia and Thailand, workplace programs are underway build- ing awareness, increasing prevention and improving access to information and care. For example, in China we kicked off a hotline to answer questions on HIV/AIDS in a safe and confidential manner. The hotline also provides information on qualified treatment facilities. Our business in Thailand was recognized by the Thai government for its work on HIV/AIDS. GRI Report is Online You may have noticed that this year we have not included our Global Reporting Initiative (GRI) report in this annual report. There are two reasons: 1. The report is increasing in size and complexity and including it in the annual report was less practical and efficient. 2. The vast quantities of paper required to produce a printed sustainability report seemed paradoxical. Putting our report online saves approximately 210 tons of wood from trees.* This year, we will move to a web-based report. You will be able to find the report and more information on our activities on our corporate website www.pepsico.com under the GRI tab. We are reporting on new indicators, including providing our political and charitable contributions policies with detailed reports on these contributions. We are also updating our report on HIV/AIDS and other indicators as appropriate. *Environmental impact estimates were made using Environmental Defense Paper Calculator. For more information, visit www.papercalculator.org. Visit us on www.pepsico.com 19 bod_L01P20_24v3.qxd 3/6/06 11:52 PM Page 20 Corporate Officers and Principal Divisions EXECUTIVE OFFICES PepsiCo, Inc. 700 Anderson Hill Road Purchase, NY 10577 tel. (914) 253-2000 O u r t o p 1 5 e x e c u t i v e s h a v e m o r e t h a n 2 0 0 y e a r s o f P e p s i C o e x p e r i e n c e a m o n g t h e m . Co-Founder of PepsiCo Donald M. Kendall Over 55 years of PepsiCo experience. Corporate Officers Steven S Reinemund Chairman of the Board and Chief Executive Officer 57. 21 years. Indra K. Nooyi President and Chief Financial Officer 50. 12 years. Peter A. Bridgman Senior Vice President and Controller 53. 20 years. Albert P. Carey President, PepsiCo Sales 54. 24 years. James Kozlowski Senior Vice President, Global Procurement 55. 20 years. Tod J. MacKenzie Senior Vice President, Corporate Communications 48. 18 years. Matthew M. McKenna Senior Vice President, Finance 55. 12 years. Margaret D. Moore Senior Vice President, Human Resources 58. 32 years. Lionel L. Nowell III Senior Vice President and Treasurer 51. 6 years. Clay G. Small Senior Vice President, Managing Attorney 56. 24 years. Larry D. Thompson Senior Vice President, Government Affairs, General Counsel and Secretary 60. 1 year. Principal Divisions and Officers Frito-Lay North America 7701 Legacy Drive Plano, TX 75024 972-334-7000 Irene B. Rosenfeld Chairman and Chief Executive Officer 52. 1 year. PepsiCo International 700 Anderson Hill Road Purchase, NY 10577 914-253-2000 Michael D. White Chairman and Chief Executive Officer 54. 16 years. Pepsi-Cola North America 700 Anderson Hill Road Purchase, NY 10577 914-253-2000 Dawn Hudson President and Chief Executive Officer 48. 9 years. QTG (Quaker Tropicana Gatorade) 555 West Monroe Street Chicago, IL 60661 312-821-1000 John C. Compton President and Chief Executive Officer 44. 22 years. 20 Listings include age and years of PepsiCo experience. bod_L01P20_24v2.qxd 3/4/06 3:06 PM Page 21 PepsiCo Board of Directors Seated, left to right: Victor J. Dzau, M.D., Sharon Percy Rockefeller, Steven S Reinemund, Franklin A. Thomas, Robert E. Allen. Standing, left to right: Arthur C. Martinez, Indra K. Nooyi, John F. Akers, Alberto Ibargüen, Ray L. Hunt, Cynthia M. Trudell, Daniel Vasella, James J. Schiro, Dina Dublon. John F. Akers Former Chairman of the Board and Chief Executive Officer, International Business Machines 71. Elected 1991. Robert E. Allen Former Chairman of the Board and Chief Executive Officer, AT&T Corp. 71. Elected 1990. Dina Dublon Consultant, Retired Chief Financial Officer, JPMorgan Chase 52. Elected 2005. Victor J. Dzau, M.D. Chancellor for Health Affairs, President & Chief Executive Officer, Duke University Health Systems, Duke University Medical Center 60. Elected 2005. Ray L. Hunt Chief Executive Officer, Hunt Oil Company and Chairman, Chief Executive Officer and President, Hunt Consolidated, Inc. 62. Elected 1996. Alberto Ibargüen President and Chief Executive Officer, John S. and James L. Knight Foundation 62. Elected 2005. Arthur C. Martinez Former Chairman of the Board, President and Chief Executive Officer, Sears, Roebuck and Co. 66. Elected 1999. James J. Schiro Chief Executive Officer, Zurich Financial Services 60. Elected 2003. Indra K. Nooyi President and Chief Financial Officer, PepsiCo 50. Elected 2001. Steven S Reinemund Chairman of the Board and Chief Executive Officer, PepsiCo 57. Elected 1996. Sharon Percy Rockefeller President and Chief Executive Officer, WETA Public Stations 61. Elected 1986. Franklin A. Thomas Consultant, TFF Study Group 71. Elected 1994. Cynthia M. Trudell President, Sea Ray Group 52. Elected 2000. Daniel Vasella Chairman of the Board and Chief Executive Officer, Novartis AG 52. Elected 2002. Listings include age and year elected a PepsiCo director. 21 bod_L01P20_24v2.qxd 3/4/06 3:06 PM Page 22 O u r E t h n i c A d v i s o r y B o a r d s p r o v i d e m a n a g e m e n t w i t h v i e w p o i n t s o n e x t e r n a l i s s u e s r e l a t e d t o d i v e r s i t y e s p e c i a l i n c l u s i o n , a n d t h e m a r k e t p l a c e . l y i n Ethnic Advisory Boards Board membership is established for external individuals based on their diverse backgrounds, experiences and points of view. These boards provide counsel and advice on a range of business areas including: • Marketing to targeted communities. • Building alliances with retailers. Seated, left to right: Ray M. Robinson, Benaree Pratt Wiley, Earl G. Graves, Sr., Dawn Hudson, Keith Clinkscales. Standing, left to right: Kweisi Mfume, Amy Hilliard, Warren M. Thompson, Jerri DeVard, Glenda McNeal, John Compton, Johnny F. Johnson, Roderick D. Gillum, Darlene Williamson, Ph.D., Robert Holland, Reverend Dr. Franklyn Richardson, Darwin N. Davis, Sr., Clarence Avant, Reverend Al Sharpton. African American Advisory Board Clarence Avant Chairman, Interior Music Joined 1999. Keith Clinkscales Senior Vice President and General Manager, ESPN Publishing Joined 1999. John Compton President and Chief Executive Officer, QTG Joined 2005. Darwin N. Davis, Sr. Consultant, Retired Senior Vice President, AXA/Equitable Joined 1999. Jerri DeVard Senior Vice President, Brand Management and Marketing Communications, Verizon Communications Joined 2002. Roderick D. Gillum Vice President, Corporate Responsibility and Diversity, General Motors Joined 2005. Earl G. Graves, Sr. Chairman, Earl G. Graves Ltd. Chairman of the Advisory Board Joined 1999. Amy Hilliard President and Chief Executive Officer, The Hilliard Group & The ComfortCake Co. Joined 1999. Robert Holland Partner, Williams Capital Joined 1999. Dawn Hudson President and Chief Executive Officer, Pepsi-Cola North America Joined 1999. 22 Johnny F. Johnson Chief Executive Officer, KA Management Joined 1999. Reverend Al Sharpton President, National Action Network Joined 1999. Warren M. Thompson Chairman and Chief Executive Officer, Thompson Hospitality Corporation, Inc. Joined 2002. Benaree Pratt Wiley Retired President and Chief Executive Officer, The Partnership Joined 2002. Darlene Williamson, Ph.D. Former President and Chief Executive Officer, Performax Consulting Services Joined 1999. Glenda McNeal Senior Vice President Global Partnerships, American Express Joined 1999. Kweisi Mfume Former President and Chief Executive Officer, National Association for the Advancement of Colored People (NAACP) Joined 2005. Reverend Dr. Franklyn Richardson Senior Minister, Grace Baptist Church Joined 1999. Ray M. Robinson Chairman, Citizens Trust Bank Joined 1999. bod_L01P20_24v2.qxd 3/4/06 3:06 PM Page 23 • Creating products for a more diverse consumer base. • Developing a more diverse supplier base and other business relationships. Some of our businesses outside the United States also are forming similar boards. For example, our Canada business recently convened an Asian Advisory Board. • Promoting PepsiCo’s diversity and inclusion efforts. • Recommending diverse talent for employment opportunities. • Encouraging the expansion of diversity representation among PepsiCo employees. • Providing a perspective on diversity and inclusion issues or questions. Our African American Advisory Board was formed in 1999. The Latino/Hispanic Advisory Board was established in 2000. We welcome Roderick D. Gillum, Kweisi Mfume and John Compton, who moves from the Latino/Hispanic Advisory Board, to the African American Advisory Board. We regret the passing of our esteemed member, Johnnie L. Cochran. To our Latino/ Hispanic Advisory Board, we welcome Maria Contreras-Sweet. Sea ted , le f t to r igh t : G i lbe r t A ran za , I rene Ro sen fe ld , Raú l Y zagu i r re , Ma r ia Con t re ra s -Swee t , Ca r lo s H . A rce , Ph .D . S tand ing , le f t to r igh t : Vic to r A r ia s , J r. , Ca r lo s A . Sa lad r iga s , Debo rah Ro sado Shaw, I sabe l Va ldé s , R ica rdo R . Fe rnánde z , Ph .D . , Doug la s X . Pa t iño , Ph .D . , Raque l Ma lo . Latino/Hispanic Advisory Board Gilbert Aranza President, Star Concessions The MultiRestaurant Group Joined 2000. Maria Contreras-Sweet President, Fortius Holdings, LLC. Joined 2005. Douglas X. Patiño, Ph.D. Vice Chancellor Emeritus and Professor, California State University Joined 2000. Deborah Rosado Shaw Chief Executive Officer, Dream BIG! Enterprises, LLC Joined 2000. Carlos H. Arce, Ph.D. President and Founder, NuStats Joined 2000. Victor Arias, Jr. Partner, Heidrick & Struggles Joined 2000. Ricardo R. Fernández, Ph.D. President, Lehman College, The City University of New York Joined 2003. Raquel Malo Director, High Performance Nutrition, Human Performance Institute Joined 2004. Irene Rosenfeld Chairman and Chief Executive Officer, Frito-Lay North America Joined 2004. Carlos A. Saladrigas Chairman, Premier American Bank Joined 2003. Isabel Valdés Consultant, Author, Public Speaker Joined 2001. Raúl Yzaguirre Presidential Professor, Center for Community Development and Civil Rights, Arizona State University Chairman of the Advisory Board Joined 2000. 23 bod_L01P20_24v2.qxd 3/4/06 3:06 PM Page 24 Blue Ribbon Health and Wellness Advisory Board PepsiCo’sBlue Ribbon Health and Wellness Advisory Board addresses the growing opportunity in health and wellness. The Board provides advice and expertise on a variety of health and wellness initiatives including: • Improving the healthfulness of our existing products. • Evaluating our efforts to develop new better-for- you and good-for-you products. • Providing access to resources that promote health and encourage active lifestyles. • Identifying emerging opportunities in the area of health and wellness. • Connecting us to thought leaders and policy makers in the area of health and wellness. Our international businesses are seeking advice in a similar manner. For example, Brazil has created the PepsiCo Panel of Experts, made up of renowned scientists and professionals in the areas of physical activity, cardiology, endocrinology, nutrition and pediatrics. Front row, left to right: Kristy F. Woods, M.D., M.P.H., Gro Brundtland, M.D., Antonia Demas, Ph.D., David Heber, M.D., Ph.D., Dean Ornish, M.D., Ph.D., Samuel Ward Casscells, III, M.D., Brock Leach, Susan Love, M.D. Second row, left to right: Janet E. Taylor, M.D., James Hill, Ph.D. Back row, left to right: Kenneth Cooper, M.D., M.P.H., Mario Maranhão, M.D., George Graham, Ph.D., Pamela Peeke, M.D., M.P.H., Fernando Trevino, Ph.D., M.P.H., Kenneth Gladish, Ph.D., David Kessler, M.D., J.D., Ambassador Thomas S. Foley, Governor James B. Hunt, Jr. Gro Brundtland, M.D. Former Director General, World Health Organization, United Nations, Former Prime Minister, Norway Joined 2004. Samuel Ward Casscells, IlI, M.D. John Edward Tyson Distinguished Professor of Medicine & Public Health and Vice President for Biotechnology, University of Texas Health & Science Center at Houston Joined 2003. Kenneth Cooper, M.D., M.P.H. President and Founder, The Cooper Aerobics Center Joined 2003. Antonia Demas, Ph.D. Director, Food Studies Institute Joined 2003. Ambassador Thomas S. Foley Partner, Akin, Gump, Strauss, Hauer & Feld, LLP, Former Speaker of the U.S. House of Representatives and Former U.S. Ambassador to Japan Joined 2003. Kenneth Gladish, Ph.D. National Executive Director, YMCA of the USA Joined 2003. George Graham, Ph.D. Chairman, Department of Kinesiology, Pennsylvania State University Joined 2003. David Heber, M.D., Ph.D. Professor of Medicine & Public Health Director, UCLA Center for Human Nutrition Joined 2003. James Hill, Ph.D. Professor of Pediatrics & Medicine, University of Colorado Health Sciences Center, Founder, America On the Move Joined 2003. Governor James B. Hunt, Jr. Attorney, Womble Carlyle Sandridge & Rice, Former Governor of North Carolina Joined 2003. David Kessler, M.D., J.D. Dean, School of Medicine, Vice Chancellor for Medical Affairs, University of California, San Francisco Joined 2003. 24 Brock Leach Retired Senior Vice President, New Growth Platforms and Chief Innovation Officer, PepsiCo Joined 2003. Susan Love, M.D. Professor of Surgery, The David Geffen School of Medicine at UCLA and Founder of Lluminari, multimedia women's health company Joined 2003. Pamela Peeke, M.D., M.P.H. Assistant Professor, University of Maryland School of Medicine, Expert and speaker in nutrition, stress and integrative medicine Joined 2003. Janet E. Taylor, M.D. Clinical Instructor, Pediatric Psychiatry, Harlem Hospital, President/CEO, Mind Projects, Inc., Lluminari Expert Network Joined 2004. Mario Maranhão, M.D. Immediate Past President, World Heart Federation, Professor of Cardiology, Evangelic School of Medicine and Hospital Joined 2004. Dean Ornish, M.D. Founder and Director, Preventive Medicine Research Institute, Chairman of the Advisory Board Joined 2003. Fernando Trevino, Ph.D., M.P.H. Dean, School of Public Health, University of North Texas, Past President, World Federation of Public Health Associations, Former Executive Director, American Public Health Association Joined 2004. Kristy F. Woods, M.D., M.P.H. Professor of Medicine and Director, Maya Angelou Research Center on Minority Health, Wake Forest University School of Medicine, Maya Angelou Research Center on Minority Health Joined 2005. mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 25 Management’s Discussion and Analysis and Consolidated Financial Statements Our Business Our Operations ...................................................... 26 Notes to Consolidated Financial Statements Note 1 — Basis of Presentation and Our Divisions.. 54 Our Customers....................................................... 27 Note 2 — Our Significant Accounting Policies........ 57 Our Distribution Network ........................................ 28 Note 3 — Restructuring and Impairment Charges Our Competition .................................................... 28 Other Relationships................................................ 28 Our Business Risks ................................................ 29 Our Critical Accounting Policies Revenue Recognition .............................................. 34 and Merger-Related Costs ................... 58 Note 4 — Property, Plant and Equipment and Intangible Assets ......................... 58 Note 5 — Income Taxes ....................................... 60 Note 6 — Stock-Based Compensation ................... 61 Note 7 — Pension, Retiree Medical and Savings Plans 63 Brand and Goodwill Valuations ................................ 35 Note 8 — Noncontrolled Bottling Affiliates ............ 65 Income Tax Expense and Accruals ........................... 36 Note 9 — Debt Obligations and Commitments ....... 67 Stock-Based Compensation Expense ........................ 36 Note 10 — Risk Management ................................. 68 Pension and Retiree Medical Plans.......................... 38 Note 11 — Net Income per Common Share from Our Financial Results Items Affecting Comparability ................................. 40 Results of Continuing Operations — Consolidated Review 41 Results of Continuing Operations — Division Review ..... 43 Frito-Lay North America....................................... 44 PepsiCo Beverages North America ........................ 45 PepsiCo International .......................................... 46 Quaker Foods North America................................ 47 Our Liquidity, Capital Resources and Financial Position 48 Consolidated Statement of Income Consolidated Statement of Cash Flows Consolidated Balance Sheet Consolidated Statement of Common Shareholders’ Equity 50 51 52 53 Continuing Operations ........................ 69 Note 12 — Preferred and Common Stock ................ 70 Note 13 — Accumulated Other Comprehensive Loss .. 70 Note 14 — Supplemental Financial Information ....... 71 Management’s Responsibility for Financial Reporting Management’s Report on Internal Control over Financial Reporting Report of Independent Registered Public Accounting Firm Selected Financial Data Reconciliation of GAAP and Non-GAAP Information Glossary 72 73 74 75 76 76 25 mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 26 Our Business 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 76. Tabular dollars are presented in millions, except per share amounts. All per share amounts reflect common per share amounts, assume dilution unless noted, and are based on unrounded amounts. Percentage changes are based on unrounded amounts. Our Operations We are a leading, global snack and bever- age company. We manufacture, market and sell a variety of salty, convenient, sweet and grain-based snacks, carbonated and non-carbonated beverages and foods. We are organized into four divisions: • Frito-Lay North America, • PepsiCo Beverages North America, • PepsiCo International, and • Quaker Foods North America. Our North American divisions operate in the United States and Canada. Our international divisions operate in over 200 countries, with our largest operations in Mexico and the United Kingdom. Additional information concerning our divisions and geographic areas is presented in Note 1. Frito-Lay North America Frito-Lay North America (FLNA) manufac- tures or uses contract manufacturers, mar- kets, sells and distributes branded snacks. These snacks include Lay’s potato chips, Doritos tortilla chips, Cheetos cheese flavored snacks, Tostitos tortilla chips, Fritos corn chips, branded dips, Ruffles potato chips, Quaker Chewy granola bars, Rold Gold pretzels, Sun Chips multigrain snacks, Munchies snack mix, Grandma’s cookies, Lay’s Stax potato crisps, Quaker Quakes corn and rice snacks, Quaker Fruit & Oatmeal bars, Cracker Jack candy coated All of our divisions positively contributed to net revenue and operating profit growth in 2005. popcorn and Go Snacks. FLNA branded products are sold to independent distribu- tors and retailers. PepsiCo Beverages North America PepsiCo Beverages North America (PBNA) manufactures or uses contract manufactur- ers, markets and sells beverage concen- trates, fountain syrups and finished goods, under various beverage brands including Pepsi, Mountain Dew, Gatorade, Tropicana Pure Premium, Sierra Mist, Tropicana juice drinks, Mug, Propel, SoBe, Tropicana Twister, Dole and Slice. PBNA also manu- factures, markets and sells ready-to-drink tea and coffee products through joint ventures with Lipton and Starbucks. In addition, PBNA licenses the Aquafina water brand to its bottlers and markets this brand. PBNA sells concentrate and finished goods for some of these brands to bottlers licensed by us, and some of these branded products are sold directly by us to independent distributors and retailers. The franchise bottlers sell our brands as finished goods to independent distributors and retailers. PBNA’s volume reflects sales to its independent distributors and retail- ers, and the sales of beverages bearing our trademarks that franchise bottlers have reported as sold to independent distributors and retailers. Net Revenue Contribution to Growth Operating Profit Contribution to Growth QFNA 6% PI 46% FLNA 23% PBNA 25% QFNA 10% FLNA 23% PI 46% PBNA 21% 26 mdav26L01P25_49v4.qxd 3/6/06 11:21 PM Page 27 PepsiCo International PepsiCo International (PI) manufactures through consolidated businesses as well as through noncontrolled affiliates, a number of leading salty and sweet snack brands including Gamesa and Sabritas in Mexico, Walkers in the United Kingdom, and Smith’s in Australia. Further, PI manufac- tures or uses contract manufacturers, markets and sells many Quaker brand snacks. PI also manufactures, markets and sells beverage concentrates, fountain syrups and finished goods under the brands Pepsi, 7UP, Mirinda, Gatorade, Mountain Dew and Tropicana. These Our Customers Our customers include franchise bottlers and independent distributors and retailers. We normally grant our bottlers exclusive contracts to sell and manufacture certain beverage products bearing our trademarks within a specific geographic area. These arrangements specify the amount to be paid by our bottlers for concentrate and full goods and for Aquafina royalties, as well as the manufacturing process required for product quality. Since we do not sell directly to the consumer, we rely on and provide financial incentives to our customers to assist in the distribution and promotion of our products. For our independent distributors and retail- ers, these incentives include volume-based rebates, product placement fees, promo- tions 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 incen- tives include coupons, pricing discounts and promotions, such as sweepstakes and other promotional offers. Advertising support is directed at advertising programs and supporting bottler media. New product brands are sold to franchise bottlers, independent distributors and retailers. However, in certain markets, PI operates its own bottling plants and distribution facilities. PI also licenses the Aquafina water brand to certain of its franchise bottlers. PI reports two measures of volume. Snack volume is reported on a system-wide basis, which includes our own volume and the volume sold by our noncontrolled affiliates. Beverage volume reflects com- pany-owned and franchise bottler sales of beverages bearing our trademarks to independent distributors and retailers. Quaker Foods North America Quaker Foods North America (QFNA) man- ufactures or uses contract manufacturers, markets and sells cereals, rice, pasta and other branded products. QFNA’s products include Quaker oatmeal, Aunt Jemima mixes and syrups, Quaker grits, Cap’n Crunch and Life ready-to-eat cereals, Rice-A-Roni, Pasta Roni and Near East side dishes. These branded products are sold to independent distributors and retailers. support includes targeted consumer and retailer incentives and direct marketplace support, such as point-of-purchase materi- als, product placement fees, media and advertising. Vending and cooler equipment placement programs support the acquisi- tion and placement of vending machines and cooler equipment. The nature and type of programs vary annually. The level of bottler funding is at our discretion because these incentives are not required by the terms of our bottling contracts. Retail consolidation has increased the importance of major customers and further consolidation is expected. Sales to Wal- Mart Stores, Inc. represent approximately 9% of our total worldwide net revenue; and our top five retail customers currently represent approximately 26% of our 2005 North American net revenue, with Wal-Mart representing approximately 11%. These percentages include concentrate sales to our bottlers which are used in finished goods sold by them to these retailers. In addition, sales to The Pepsi Bottling Group (PBG) represent approximately 10% of our total net revenue. See “Our Related Party Bottlers” and Note 8 for more information on our anchor bottlers. Our customers include franchise bottlers and independent distributors and retailers. Our Related Party Bottlers We have ownership interests in certain of our bottlers. Our ownership is less than 50% and since we do not control these bottlers, we do not consolidate their results. We include our share of their net income based on our percentage of eco- nomic ownership in our income statement as bottling equity income. We have designated three related party bottlers, PBG, PepsiAmericas, Inc. (PAS) and Pepsi Bottling Ventures LLC (PBV), as our anchor bottlers. Our anchor bottlers distribute approximately 62% of our North American beverage volume and approximately 19% of our international beverage volume. Our anchor bottlers participate in the bottler funding programs described above. Approximately 8% of our total 2005 sales incentives are related to these bottlers. See Note 8 for additional information on these related parties and related party commitments and guarantees. 27 mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 28 Broker-Warehouse Some of our products are delivered from our manufacturing plants and warehouses to customer warehouses and retail stores. These less costly systems generally work best for products that are less fragile and perishable, have lower turnover, and are less likely to be impulse purchases. Foodservice and Vending Our foodservice and vending sales force distributes snacks, foods and beverages to third-party foodservice and vending distributors and operators, and for certain beverages, distributes through our bottlers. This distribution system supplies our products to schools, businesses, stadiums, restaurants and similar locations. Direct-store-delivery enables us to merchandise with maximum visibility and appeal. Our Distribution Network Our products are brought to market through direct-store-delivery, broker-warehouse and foodservice and vending distribution networks. The distribution system used depends on customer needs, product characteristics and local trade practices. Direct-Store-Delivery We and our bottlers operate direct-store- delivery systems that deliver snacks and beverages directly to retail stores where the products are merchandised by our employ- ees 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. Our Competition Our businesses operate in highly competi- tive markets. We compete against global, regional, local and private label manufac- turers on the basis of price, quality, product variety and effective distribution. In measured channels, our chief beverage competitor, The Coca-Cola Company, has a slightly larger share of carbonated soft drink (CSD) consumption in the U.S., while we have a larger share of chilled juices and isotonics. In addition, The Coca-Cola Company maintains a significant CSD share advantage in many markets outside North America. Further, our snack brands hold significant leadership positions in the snack industry worldwide. Our snack brands face local and regional competitors, as well as national and global snack competitors, and compete on issues related to price, quality, variety and distribution. Success in this competitive environment is dependent on effective promotion of existing products and the introduction of new products. We believe that the strength of our brands, innovation and marketing, coupled with the quality of our products and flexibility of our distribution network, allow us to compete effectively. Other Relationships Certain members of our Board of Directors also serve on the boards of certain vendors and customers. Those Board members do not participate in our vendor selection and negotiations nor in our customer negotia- tions. 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. 28 mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 29 Our Business Risks We are subject to risks in the normal course of business due to adverse developments with respect to: • product demand, • our reputation, • information technology, • supply chain, • retail consolidation and the loss of major customers, • global economic and environmental conditions, • the regulatory environment, • workforce retention, • raw materials and energy, • competition, and • market risks. Demand for our products may be adversely affected by changes in consumer preferences and tastes. We are a consumer products company operating in highly competitive markets and rely on continued demand for our products. To generate revenues and profits, we must sell products that appeal to our customers and to consumers. Any signifi- cant changes in consumer preferences and our inability to anticipate and react to such Our success depends on our ability to respond to consumer trends, such as consumer health concerns about obesity, product attributes and ingredients. 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 and consumer demographics could result in reduced demand for our products. Consumer preferences may shift due to a variety of factors, including the aging of the general population, changes in social trends, changes in travel, vacation or leisure activity patterns or a downturn in economic conditions, which may reduce consumers’ willingness to purchase premium branded products. Our continued success is also dependent on our product innovation, including maintaining a robust pipeline of new products, and the effec- tiveness of our advertising campaigns and marketing programs. There can be no assurance as to our continued ability to develop and launch successful new prod- ucts or variants of existing products, or to effectively execute advertising campaigns and marketing programs. In addition, both the launch and ongoing success of new products and advertising campaigns are inherently uncertain, especially as to their appeal to consumers. Any damage to our reputation could have an adverse effect on our business, financial condi- tion and results of operations. Maintaining a good reputation globally is critical to selling our branded products. If we fail to maintain high standards for product quality, safety and integrity, our reputation could be jeopardized. Adverse publicity about these types of concerns, whether or not valid, may reduce demand for our products or cause production and delivery disruptions. If any of our products becomes unfit for consumption, mis- branded or causes injury, we may have to Maintaining a good reputation globally is critical to selling our branded products. engage in a product recall and/or be subject to liability. A widespread product recall or a significant product liability judgment could cause our products to be unavailable for a period of time, which could further reduce consumer demand and brand equity. Failure to maintain high ethical, social and environmental standards for all of our operations and activities could also jeopardize our reputation. Damage to our reputation or loss of consumer confidence in our products for any of these reasons could have a material adverse effect on our business, financial condition and results of operations, as well as require additional resources to rebuild our reputation. If we are not able to build and sustain proper information technology infrastructure, our business could suffer. We depend on information technology as an enabler to operating efficiently and interfacing with customers, as well as maintaining financial accuracy and efficiency. If we do not allocate, and effectively manage, the resources necessary to build and sustain the proper technology infrastructure, we could be subject to transaction errors, processing inefficiencies, the loss of customers, business disruptions, or the loss of or damage to intellectual property through security breach. We have embarked on a multiyear Business Process Transformation (BPT) ini- tiative that includes the delivery of an SAP enterprise resource planning application, as well as the migration to common busi- ness processes across our North American operations. There can be no certainty that 29 mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 30 these programs will deliver the expected benefits. The failure to deliver our goals may impact our ability to (1) process trans- actions 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 antici- pate the necessary readiness and training needs, could lead to business disruption. Our ability to make, move and sell products is critical to our success. As with all large systems, our informa- tion systems could be penetrated by outside parties intent on extracting information, corrupting information or disrupting business processes. Such unauthorized access could disrupt our business and could result in the loss of assets. Disruption of our supply chain could have an adverse effect on our business, financial condition and results of operations. Our ability to make, move and sell prod- ucts is critical to our success. Damage or disruption to our manufacturing or distribution capabilities due to weather, natural disaster, fire or explosion, terrorism, pandemic, strikes or other reasons could impair our ability to manufacture or sell our products. Failure to take adequate steps to mitigate the likelihood or potential impact of such events, or to effectively manage such events if they occur, could adversely affect our business, financial condition and results of operations, as well as require additional resources to restore our supply chain. Trade consolidation or the loss of any key customer could adversely affect our financial performance. There is a greater concentration of our customer base around the world generally due to the continued consolidation of retail trade. As retail ownership becomes more concentrated, retailers demand lower pricing and increased promotional programs. Further, as larger retailers increase utiliza- tion 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. We must maintain mutually beneficial relationships with our key customers, including our retailers and anchor bottlers, to effectively compete. Loss of any of our key customers could have an adverse effect on our business, financial condition and results of operations. See “Our Customers,” “Our Related Party Bottlers” and Note 8 to our consolidated financial statements for more information on our customers, including our anchor bottlers. Our business may be adversely impacted by unfavorable economic or environmental con- ditions or political or other developments and risks in the countries in which we operate. Unfavorable global economic or environ- mental changes, political conditions or other developments may result in business disruption, supply constraints, foreign currency devaluation, inflation, deflation or decreased demand. Economic conditions in North America could also adversely impact growth. For example, rising fuel costs may impact the sales of our products in convenience stores where our products are generally sold in higher margin single serve packages. Our international opera- tions accounted for over a third of our evenue for the period ended December 31, 2005. Unstable economic and political conditions or civil unrest in the countries in which we operate could have adverse impacts on our business results or financial condition. Regulatory decisions and changes in the legal and regulatory environment could increase our costs and liabilities or limit our business activities. The conduct of our businesses, and the production, distribution, sale, advertising, labeling, safety, transportation and use of many of our products, are subject to vari- ous laws and regulations administered by federal, state and local governmental agencies in the United States, as well as to foreign laws and regulations administered by government entities and agencies in markets in which we operate. In many jurisdictions, compliance with competition laws is of special importance to us due to our competitive position in those jurisdictions. These laws and regulations may change, sometimes dramatically, as a result of political, economic or social events. Changes in laws, regulations or governmental policy and the related interpretations may alter the environment Changes in laws, regulations or governmental policy may alter the environment in which we do business. in which we do business and, therefore, may impact our results or increase our costs or liabilities. Such regulatory environment changes include changes in food and drug laws, laws related to advertising and deceptive marketing practices, accounting standards, taxation requirements, competition laws and environmental laws, including California Proposition 65 and the regulation of water consumption and treat- ment. In particular, governmental bodies in countries where we operate may impose new labeling, product or production requirements, or other restrictions. Regulatory authorities under whose laws we operate may also have enforcement powers that can subject us to actions such as product recall, seizure of products or other sanctions, which could have an adverse effect on our sales or damage our reputation. See also “Regulatory Environment and Environmental Compliance.” If we are unable to hire or retain key employees, it could have a negative impact on our business. Our continued growth requires us to develop our leadership bench and to implement programs, such as our long- term incentive program, designed to retain talent. However, there is no assurance that we will continue to be able to hire or retain key employees. We compete to hire new employees, and then must train them and develop their skills and competencies. Our 30 mdav26L01P25_49v4.qxd 3/6/06 11:21 PM Page 31 operating results could be adversely affected by increased costs due to increased competition for employees, higher employee turnover or increased employee benefit costs. Any unplanned turnover could deplete our institutional knowledge base and erode our competitive advantage. Our operating results may be adversely affected by increased costs or shortages of raw materials. We are exposed to the market risks arising from adverse changes in commodity prices, affecting the cost of our raw materials and energy. The raw materials and energy which we use for the production of our products are largely commodities that are subject to price volatility and fluctuations in availability caused by changes in global supply and demand, weather conditions, agricultural uncertainty or governmental controls. We purchase these materials and energy mainly in the open market. If com- modity 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 with- out suffering reduced volume, revenue and operating income. Our business could suffer if we are unable to compete effectively. Our businesses operate in highly competi- tive markets. We compete against global, regional and private label manufacturers on the basis of price, quality, product vari- ety and effective distribution. Increased competition and anticipated actions by our competitors could lead to downward pres- sure on prices and/or a decline in our mar- ket share, either of which could adversely affect our results. See “Our Competition” for more information about our competitors. 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 involve the use of derivatives. Certain derivatives are desig- nated as either cash flow or fair value hedges and qualify for hedge accounting treatment, while others do not qualify and are marked to market through earnings. We do not use derivative instruments for trading or speculative purposes and we limit our exposure to individual counterparties to manage credit risk. The fair value of our derivatives fluctuates based on market rates and prices. The sensitivity of our derivatives to these market fluctuations is discussed below. See Note 10 for further We do not use derivative instruments for trading or speculative purposes. 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. Commodity Prices Our open commodity derivative contracts had a face value of $89 million at December 31, 2005 and $155 million at December 25, 2004. The open derivative contracts designated as accounting hedges resulted in net unrecognized gains of $39 million at December 31, 2005 and an unrecognized loss of $1 million at December 25, 2004. We estimate that a 10% decline in commodity prices would have reduced our unrecognized gains on open contracts to $35 million in 2005 and increased our unrecognized losses to $9 million in 2004. The open derivatives contracts that were not designated as accounting hedges resulted in net recog- nized losses of $3 million in 2005 and $2 million in 2004. 31 mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 32 We estimate that a 10% decline in commodity prices would have increased our recognized losses on open contracts to $4 million in 2005 and to $5 million in 2004. In 2006, we expect continued pricing pressures on our raw materials and energy costs. We expect to be able to mitigate the impact of these increased costs through our hedging strategies and ongoing productivity initiatives. Foreign Exchange Financial statements of foreign sub- sidiaries 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 compo- nent of accumulated other comprehensive loss within shareholders’ equity under the caption currency translation adjustment. Our operations outside of the U.S. generate over a third of our net revenue of which Mexico, the United Kingdom and Canada comprise nearly 20%. As a result, we are exposed to foreign currency risks, including unforeseen economic changes and political unrest. During 2005, net favorable foreign currency, primarily increases in the Mexican peso, Brazilian real, and Canadian dollar, contributed over 1 percentage point to net revenue growth. Currency declines which are not offset could adversely impact our future results. Exchange rate gains or losses related to foreign currency transactions are recognized as transaction gains or losses in the income statement as incurred. We may enter into derivatives to manage our exposure to foreign currency transaction risk. Our foreign currency derivatives had a total face value of $1.1 billion at December 31, 2005 and $908 million at December 25, 2004. The contracts desig- nated as accounting hedges resulted in net unrecognized losses of $9 million at December 31, 2005 and $27 million at December 25, 2004. We estimate that an unfavorable 10% change in the exchange rates would have resulted in unrecognized losses of $81 million in 2005 and $110 million in 2004. The contracts not desig- nated as accounting hedges resulted in net recognized gains of $14 million and less than $1 million at December 31, 2005 and December 25, 2004, respectively. These gains were almost entirely offset by changes in the underlying hedged items, resulting in no net impact on earnings. Interest Rates We centrally manage our debt and invest- ment portfolios considering investment opportunities and risks, tax consequences and overall financing strategies. We may use interest rate and cross currency interest rate swaps to manage our overall interest expense and foreign exchange risk. These instruments effectively change the interest rate and currency of specific debt issuances. These swaps are entered into concurrently with the issuance of the debt that they are intended to modify. The notional amount, interest payment and maturity date of the swaps match the principal, interest payment and maturity date of the related debt. Our counterparty credit risk is considered low because these swaps are entered into only with strong creditworthy counterparties, are generally settled on a net basis and are of relatively short duration. Assuming year-end 2005 and 2004 variable rate debt and investment levels, a one point increase in interest rates would have decreased net interest expense by $8 million in 2005 and $11 million in 2004. Stock Prices A portion of our deferred compensation lia- bility 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. 32 mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 33 Our Approach to Managing 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 In 2005, we continued our effort to drive risk mitigation focus to where risks can be most efficiently and effectively managed. 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 manage- ment group which identifies, assesses, prioritizes and addresses primarily strategic and reputational risks; • Division Risk Committees (DRCs), com- prised of cross-functional senior manage- ment teams which meet regularly each year to identify, assess, prioritize and address division-specific operating risks; • PepsiCo’s Risk Management Office, which manages the overall process, provides ongoing guidance, tools and analytical support to the PERC and the DRCs, identifies and assesses potential risks, and facilitates ongoing communi- cation between the parties, as well as to PepsiCo’s Audit Committee; and • PepsiCo Corporate Audit, which confirms the ongoing effectiveness of the risk management framework through periodic audit and review procedures. In 2005, we continued our effort to drive risk mitigation focus to where risks can be most efficiently and effectively managed and reinforced ownership and accountability for risk management within the business. Some highlights include: • With respect to product demand, we continued to focus on the development of products that respond to consumer trends, such as comsumer health con- cerns about obesity, product attributes and ingredients, including reformulating products to lower sugar, fats, and sodium; adding ingredients that deliver health benefits; and expanding our offering of portion-controlled packages. Smart Spot eligible products continued to be the fastest growing part of our North American product portfolio. We continued to focus on marketing our products in ways that promote healthier lifestyles. We helped create and endorsed the American Beverage Association’s new schools policy, which defines the types of products that may be sold in schools. We actively promoted healthy energy balance through our national sponsorship of America On the Move, a program designed to help families take simple steps to maintain a healthy energy balance. • We enhanced the coordination of our Division-led product integrity efforts through the creation of the PepsiCo Product Integrity Council (PPIC), a cross-functional forum to share leading practices and confer about areas of potential risk. Smart Spot eligible products continued to be the fastest growing part of our North American product portfolio. • We continued to enhance our internal IT infrastructure, by consolidating and updating technology and retiring older technology, as well as improving our information security capabilities. • We continued implementation of our BPT initiative, which we believe will enable us to remain in step with the changing needs of our customers. Overall BPT project governance is provided through steering committees headed by senior executives and a team is in place to drive effective risk man- agement and quality processes and to build an internal control environment compliant with the Sarbanes-Oxley Act. • We continue to assess our capability to mitigate potential business disruptions and evaluate an integrated approach to business disruption management, including disaster recovery, crisis management, and business continuity. • We established a compliance and ethics leadership structure, appointing an SVP, Deputy General Counsel who is focusing on business practices and compliance, prioritizing projects to enhance the effectiveness of our compliance and We established a compliance and ethics leadership structure in 2005. ethics program, including developing a multilingual Code of Conduct training program that will be rolled out in 2006. • We have implemented human resource programs which focus on diversity and inclusion, leadership development, suc- cession planning, and employee work-life flexibility, and are aimed at hiring, developing, and retaining our talented and motivated workforce. 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-look- ing statements” are based on currently available competitive, financial and eco- nomic 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 above 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. 33 mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 34 Our Critical Accounting Policies An appreciation of our critical accounting policies is necessary to understand our financial results. These policies may require management to make difficult and subjective judgments regarding uncertainties, and as a result, such estimates may significantly impact our financial results. The precision of these estimates and the likelihood of future changes depend on a number of underlying variables and a range of possible outcomes. Other than our accounting for stock-based compensation and pension plans, our critical accounting policies do not involve the choice between alternative methods of accounting. We applied our critical accounting policies and estimation methods consistently in all material respects, and for all periods presented, and have discussed these policies with our Audit Committee. Our critical accounting policies arise in conjunction with the following: • revenue recognition, • stock-based compensation expense, and • pension and retiree medical plans. • income tax expense and accruals, • brand and goodwill valuations, In connection with our ongoing BPT initiative, we aligned certain accounting policies across our divisions in 2005. We conformed our methodology for calculating our bad debt reserves and modified our policy for recognizing revenue for products shipped to customers by third-party carriers. Additionally, we conformed our method of accounting for certain costs, primarily warehouse and freight. These changes reduced our net revenue by $36 million and our operating profit by $60 million in 2005. We also made certain reclassifications on our Consolidated Statement of Income in the fourth quarter of 2005 from cost of sales to selling, general and administrative expenses in connection with our BPT initiative. These reclassifications resulted in reductions to cost of sales of $556 million through the third quarter of 2005, $732 million in the full year 2004 and $688 million in the full year 2003, with corresponding increases to selling, general and administrative expenses in those periods. These reclassifications had no net impact on operating profit and have been made to all periods presented for comparability. There have been no new accounting pronouncements issued or effective during 2005 that have had, or are expected to have, a material impact on our consolidated financial statements. Revenue Recognition Our products are sold for cash or on credit terms. Our credit terms, which are estab- lished in accordance with local and industry practices, typically require payment within 30 days of delivery in the U.S. and may allow discounts for early payment. We rec- ognize 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 dam- aged 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 34 out-of-date products. Our bottlers have a similar replacement policy and are respon- sible for the products they distribute. Our policy is to provide customers with product when needed. In fact, our com- mitment 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 lim- iting the quantity of product. For product delivered through our other distribution networks, customer inventory levels are monitored. As discussed in “Our Customers,” we offer sales incentives and discounts through various programs to customers and consumers. Sales incentives and discounts are accounted for as a reduction of sales and totaled $8.9 billion in 2005, $7.8 billion in 2004 and $7.1 billion in 2003. Sales incentives include payments to customers for performing merchandising activities on our behalf, such as payments for in-store displays, payments to gain distribution of new products, payments for shelf space and discounts to promote lower retail prices. A number of our sales incentives, such as bottler funding and customer volume rebates, are based on annual tar- gets, and accruals are established during the year for the expected payout. These accruals are based on contract terms and our historical experience with similar pro- grams and require management judgment with respect to estimating customer partic- ipation and performance levels. Differences between estimated expense and actual incentive costs are normally insignificant and are recognized in earnings in the mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 35 period such differences are determined. The terms of most of our incentive arrange- ments 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 arrange- ments extend beyond one year. For example, fountain pouring rights may extend up to 15 years. The costs incurred to obtain these arrangements are recognized over the contract period as a reduction of revenue, Differences between estimated expense and actual incentive costs are normally insignificant and are recognized in earnings in the period such differences are determined. and the remaining balances of $321 million at year-end 2005 and $337 million at year-end 2004 are included in current assets and other assets in our Consolidated Balance Sheet. We estimate and reserve for our bad debt exposure based on our experience with past due accounts. In 2005, our method of determining the reserves was conformed across our divisions in connection with our BPT initiative, as discussed above. Bad debt expense is classified within selling, general and administrative expenses in our Consolidated Statement of Income. forecasts and operating plans. These assumptions could be adversely impacted by certain of the risks discussed in “Our Business Risks.” We did not recognize any impairment charges for perpetual brands or goodwill in the years presented. As of December 31, 2005, we had $5.2 billion of perpetual brands and goodwill, of which 70% related to Tropicana and Walkers. We did not recognize any impairment charges for perpetual brands or goodwill in the years presented. Brand and Goodwill Valuations We sell products under a number of brand names, many of which were developed by us. The brand development costs are expensed as incurred. We also purchase brands and goodwill in acquisitions. Upon acquisition, the purchase price is first allo- cated 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 indefi- nite 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. Goodwill, including the goodwill that is part of our noncontrolled bottling invest- ment balances, and perpetual brands are not amortized. Perpetual brands and good- will are assessed for impairment at least annually to ensure that discounted future cash flows continue to exceed the related book value. A perpetual brand is impaired if its book value exceeds its fair value. Goodwill is evaluated for impairment if the book value of its reporting unit exceeds its fair value. A reporting unit can be a division or business within a division. If the fair value of an evaluated asset is less than its book value, the asset is written down to fair value based on its discounted future cash flows. Amortizable brands are only evaluated for impairment upon a significant change in the operating or macroeconomic envi- ronment. If an evaluation of the undis- counted 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 operat- ing and macroeconomic changes and to estimate future cash flows. Assumptions used in our impairment evaluations, such as forecasted growth rates and our cost of capital, are consistent with our internal 35 mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 36 Income Tax Expense and Accruals Our annual tax rate is based on our income, statutory tax rates and tax plan- ning opportunities available to us in the various jurisdictions in which we operate. Significant judgment is required in deter- mining our annual tax rate and in evaluat- ing our tax positions. We establish reserves when, despite our belief that our tax return positions are fully supportable, we believe that certain positions are subject to challenge and that we may not succeed. We adjust these reserves, as well as the related interest, in light of changing facts and circumstances, such as the progress of a tax audit. See Note 5 for additional information regarding our tax reserves. An estimated effective tax rate for a year is applied to our quarterly operating results. In the event there is a significant or unusual item recognized in our quarterly operating results, the tax attributable to that item is separately calculated and recorded at the same time as that item. We consider the tax benefits from the resolution of prior year tax matters to be such items. Tax law requires items to be included in our tax returns at different times than the items are reflected in our financial statements. As a result, our annual tax rate reflected in our financial statements is dif- ferent than that reported in our tax returns (our cash tax rate). Some of these differ- ences 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 We repatriated approximately $7.5 billion in earnings previously considered indefinitely reinvested outside the U.S. in the fourth quarter of 2005 in connection with the AJCA. already recorded the tax benefit in our income statement. We establish valuation allowances for our deferred tax assets when we believe expected future taxable income is not likely to support the use of a deduction or credit in that tax jurisdiction. Deferred tax liabilities generally represent tax expense recognized in our financial statements for which payment has been deferred, or expense for which we have already taken a deduction in our tax return but we have not yet recognized as expense in our financial statements. Stock-Based Compensation Expense We believe that we will achieve our best results if our employees act and are rewarded as business owners. Therefore, we believe stock ownership and stock- based incentive awards are the best way to align the interests of employees with those of our shareholders. Historically, following competitive market practices, we have used stock option grants as our primary form of long-term incentive compensation. These grants are made at the current stock price, meaning each employee’s exercise price is equivalent to our stock price on the date of grant. Employees must gener- ally provide three additional years of serv- ice to earn the grant, referred to as the vesting period. Our options generally have a 10-year term, which means our employ- ees would have up to seven years after the 36 vesting period to elect to pay the exercise price to purchase one share of our stock for each option exercised. Employees bene- fit 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. We believe that we will achieve our best results if our employees act and are rewarded as business owners. The American Jobs Creation Act of 2004 (AJCA) created a one-time incentive for U.S. corporations to repatriate undis- tributed international earnings by providing an 85% dividends received deduction. As approved by our Board of Directors in July 2005, we repatriated approximately $7.5 billion in earnings previously consid- ered indefinitely reinvested outside the U.S. in the fourth quarter of 2005. In 2005, we recorded income tax expense of $460 million associated with this repatria- tion. Other than the earnings repatriated, we intend to continue to reinvest earnings outside the U.S. for the foreseeable future and therefore have not recognized any U.S. tax expense on these earnings. At December 31, 2005, we had approxi- mately $7.5 billion of undistributed international earnings. In 2005, our annual tax rate for contin- uing operations was 36.1% compared to 24.7% in 2004 as discussed in “Other Consolidated Results.” The tax rate in 2005 increased 11.4 percentage points primarily as a result of the AJCA tax charge and the absence of the 2004 tax benefits related to the favorable resolution of cer- tain open tax items. For 2006, our annual tax rate is expected to be 28.0%, primarily reflecting the absence of the AJCA tax charge and changes in our concentrate sourcing around the world. Our new executive compensation pro- gram, which became effective in 2004, strengthens the relationship between pay and individual performance through greater differentiation in the amount of base pay, bonus and stock-based compensation based on an employee’s job level and per- formance. The new program results in a shift of both cash and stock-based com- pensation to our top performing executives. In addition, our new program provides executives, who are awarded long-term incentives based on their performance, with a choice of stock options or restricted stock units (RSUs). RSU expense is based on the fair value of PepsiCo stock on the date of grant and is amortized over the vesting period, generally three years. Each restricted stock unit can be settled in a mdav26L01P25_49v3.qxd 3/4/06 3:04 AM Page 37 share of our stock after the vesting period. Executives who elect RSUs receive one RSU for every four stock options that would have otherwise been granted. Senior officers do not have a choice and are granted 50% stock options and 50% RSUs. Vesting of RSU awards for senior officers is contingent upon the achievement of pre-established performance targets. We also continued, as we have since 1989, to grant an annual award of stock options to all eligible employees, based on job level or classification under our broad- based stock option program, SharePower. As part of the new compensation program which began in 2004, the SharePower pro- gram grant was reduced by approximately 50% for employees in the U.S. and replaced with matching contributions of PepsiCo stock to our 401(k) savings plans. We did not reduce the SharePower award for international employees and continued using tenure, in addition to job level and classification, as a basis for the award. For additional information on our 401(k) savings plans, see Note 7. Method of Accounting We account for our employee stock options under the fair value method of accounting using a Black-Scholes valuation model to measure stock-based compensation expense at the date of grant. We adopted Statement of Financial Accounting Standards (SFAS) 123R, Share-Based Payment, under the modified prospective method in the first quarter of 2006. We do not expect our adoption of SFAS 123R to materially impact our financial statements. Our divisions are held accountable for stock-based compensation expense and, therefore, this expense is allocated to our divisions as an incremental employee compensation cost. The allocation of stock- based compensation expense is approximately 29% to FLNA, 22% to PBNA, 31% to PI, 4% to QFNA and 14% to corporate unallocated expenses. The expense allocated to our divisions excludes any impact of changes in our Black-Scholes assumptions during the year which reflect market conditions over which division management has no control. Therefore, any variances between allocated expense and our actual expense are recognized in corporate unallocated expenses. Our Assumptions Our Black-Scholes model estimates the expected value our employees will receive from the options based on a number of assumptions, such as interest rates, employee exercises, our stock price and dividend yield. Our weighted-average fair value assumptions include: Expected life Risk free interest rate Expected volatility Expected dividend yield Estimated 2006 6 yrs. 3.8% 21% 1.9% 2005 6 yrs. 3.8% 23% 1.8% 2004 6 yrs. 3.3% 26% 1.8% 2003 6 yrs. 3.1% 27% 1.15% 2006 Estimated Expense and Sensitivity of Assumptions Our stock-based compensation expense, including RSUs, is as follows: Stock-based compensation expense Estimated 2006 $296 2005 $311 2004 $368 If we assumed a 100 basis point change in the following assumptions, our estimated 2006 stock-based compensation expense would increase/(decrease) as follows: Risk free interest rate Expected volatility Expected dividend yield 100 Basis Point Increase $6 $2 $(9) 100 Basis Point Decrease $(6) $(2) $10 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. If the expected life were assumed to be one year longer, our estimated 2006 stock-based compensation expense would increase by $12 million. If the expected life were assumed to be one year shorter, our estimated 2006 stock-based compensa- tion expense would decrease by $7 million. As noted, changing the assumed expected life impacts all of the Black-Scholes valuation assumptions as the risk free interest rate, expected volatility and expected dividend yield are estimated over the expected life. 37 mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 38 Pension and Retiree Medical Plans Our assumptions reflect our historical experience and management’s best judg- ment regarding future expectations. Some of these assumptions require significant management judgment and could have a material impact on the measurement of our pension and retiree medical benefit expenses and obligations. The assumptions used to measure our annual pension and retiree medical expenses are determined as of September 30 (measurement date) and all plan assets and liabilities are generally reported as of that date. At each measurement date, the dis- count rate is based on interest rates for high-quality, long-term corporate debt securities with maturities comparable to our liabilities. In the U.S., we utilize the Moody’s AA Corporate Index yield and adjust for the differences between the aver- age duration of the bonds in this Index and the average duration of our benefits liabili- ties based upon a published index. The expected return on pension plan assets is based on our historical experi- ence, our pension plan investment strategy and our expectations for long-term rates of return. Our pension plan investment strat- egy is reviewed annually and is based upon plan liabilities, an evaluation of market conditions, tolerance for risk, and cash requirements for benefit payments. We use a third-party advisor to assist us in deter- mining our investment allocation and mod- eling our long-term rate of return assumptions. Our current investment allo- cation target for our U.S. plans is 60% in equity securities, with the balance in fixed income securities and cash. Our expected long-term rate of return assumptions on U.S. plan assets is 7.8%, reflecting an estimated long-term return of 9.3% from equity securities and an estimated 5.8% from fixed income securities. Approximately 80% of our pension plan assets relate to our U.S. plans. We use a market-related value method that recognizes each year’s asset gain or loss over a five-year period. Therefore, it takes five years for the gain or loss from any one year to be fully included in the other gains and losses calculation described below. Other gains and losses resulting from actual experience differing from our assumptions and from changes in our assumptions are also determined at each measurement date. If this net accumulated gain or loss exceeds 10% of the greater of plan assets or liabilities, a portion of the net gain or loss is included in expense for the following year. The cost or benefit of plan changes which increase or decrease benefits for prior employee service (prior service cost) is included in expense on a straight-line basis over the average remain- ing service period of those expected to benefit, which is approximately 11 years for pension expense and approximately 13 years for retiree medical. Our pension plans cover full-time employ- ees in the U.S. and certain international employees. Benefits are determined based on either years of service or a combination of years of service and earnings. U.S. retirees are also eligible for medical and life insur- ance benefits (retiree medical) if they meet age and service requirements. Generally, our share of retiree medical costs is capped at specified dollar amounts that vary based upon years of service, with retirees contributing the remainder of the cost. Our Assumptions The determination of pension and retiree medical plan obligations and associated expenses requires the use of assumptions to estimate the amount of the benefits that employees earn while working, as well as the present value of those benefits. Annual pension and retiree medical expense The discount rate is based on interest rates for high-quality, long-term corporate debt securities with maturities comparable to our liabilities. 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 (inter- est 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 meas- ure our annual pension and retiree medical expense include: • the interest rate used to determine the Weighted-average assumptions for pension and retiree medical expense are the following: 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. Pension Expense discount rate Expected rate of return on plan assets Expected rate of compensation increases Retiree medical Expense discount rate Current health care cost trend rate 2006 5.6% 7.7% 4.4% 5.7% 10.0% 2005 6.1% 7.8% 4.3% 6.1% 11.0% 2004 6.1% 7.8% 4.4% 6.1% 12.0% 38 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 taxa- tion to the employee only upon receipt of plan benefits. Generally, we do not fund our pension plans when our contributions would not be currently deductible. Our pension contributions for 2005 were $803 million, of which $729 million was discretionary. In 2006, we expect contributions to be about $250 million with approximately $200 million expected to be discretionary. Our cash payments for retiree medical are estimated to be $85 million in 2006. As our retiree medical plans are not subject to regulatory funding requirements, we fund these plans on a pay-as-you-go basis. For estimated future benefit payments, including our pay-as-you-go payments as well as those from trusts, see Note 7. mdav26L01P25_49v4.qxd 3/6/06 11:21 PM Page 39 Future Expense An analysis of the estimated change in pension and retiree medical expense follows: Pension Retiree Medical 2005 expense Decrease in discount rate Increase in experience loss/(gain) amortization Impact of contributions Other, including impact of 2003 Medicare Act 2006 estimated expense Our 2006 pension expense is estimated to be approximately $405 million and retiree medical expense is estimated to be approximately $126 million. These esti- mates incorporate the 2006 assumptions, as well as the impact of the increased pension plan assets resulting from our discretionary contributions of $729 million in 2005 and the impact of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (Medicare Act) as discussed in Note 7. Changes in our 2006 assumptions include updates to the lump sum discount rate for the U.S. plans and to the mortality tables for certain international plans. The estimated increase of $69 million in net experience loss amortization included in estimated 2006 pension expense primarily reflects the recognition of lower than expected returns and past asset losses, which account for approximately $36 million of the increase, as well as assumption changes and demographic experience, which account for approximately $20 million of the increase. Pension service costs, measured at a fixed discount rate but including the effect of demographic assumption changes, as well as the effects of gains and losses due to demographics, are reflected in division results. The effect of changes in discount and asset return rates, gains and losses other than those due to demographics, and the impact of funding are reflected in cor- porate unallocated expenses. Approximately $26 million of the increased pension and retiree medical expense in 2006 will be reflected in corporate unallocated expenses. $329 84 69 (63) (14) $405 $135 6 (3) – (12) $126 Based on our current assumptions which reflect our prior experience, current plan provisions, and expectations for future experience, and assuming the Board approves annual discretionary contributions of approximately $200 million, we expect our pension expense to remain relatively flat in 2007. In 2008, we expect our pension expense to begin to decline, with the expense dropping to approximately $305 million by 2011 as unrecognized experience losses are amortized. If our assumptions and our plan provisions for retiree medical remain unchanged and our Our 2006 pension expense is estimated to be approximately $405 million and retiree medical expense is estimated to be approximately $126 million. experience mirrors these assumptions, we expect our annual retiree medical expense beyond 2006 to approximate $130 million. Sensitivity of Assumptions A decrease in the discount rate or in the expected rate of return assumptions would increase pension expense. The estimated impact of a 25 basis point decrease in the discount rate on 2006 pension expense is an increase of approximately $39 million. The estimated impact on 2006 pension expense of a 25 basis point decrease in the expected rate of return assumption is 39 mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 40 Our Financial Results Items Affecting Comparability The year-over-year comparisons of our financial results are affected by the following items: Net revenue 53rd week ........................................................................................................................................................................... Operating profit 53rd week ........................................................................................................................................................................... 2005 restructuring charges ................................................................................................................................................ 2004 restructuring and impairment charges...................................................................................................................... Net income AJCA tax charge.................................................................................................................................................................. 53rd week........................................................................................................................................................................... 2005 restructuring charges................................................................................................................................................ 2004 restructuring and impairment charges ..................................................................................................................... Net tax benefits — continuing operations......................................................................................................................... Tax benefit from discontinued operations .......................................................................................................................... Net income per common share — diluted AJCA tax charge................................................................................................................................................................. 53rd week .......................................................................................................................................................................... 2005 restructuring charges............................................................................................................................................... 2004 restructuring and impairment charges .................................................................................................................... Net tax benefits — continuing operations ........................................................................................................................ Tax benefit from discontinued operations.......................................................................................................................... For the items and accounting changes affecting our 2003 results, see Note 1 and our 2003 Annual Report. 2005 $418 $75 $(83) – $(460) $57 $(55) – – – $(0.27) $0.03 $(0.03) – – – 2004 – – – $(150) – – – $(96) $266 $38 – – – $(0.06) $0.15 $0.02 productivity program. Savings from this productivity program have been used to offset increased marketplace spending. AJCA Tax Charge As approved by our Board of Directors in July 2005, in the fourth quarter of 2005 we repatriated approximately $7.5 billion in earnings previously considered indefinitely reinvested outside the U.S. in connection with the AJCA. In 2005, we recorded income tax expense of $460 million associated with this repatriation. 53rd week In 2005, we had an additional week of results (53rd week). Our fiscal year ends on the last Saturday of each December, resulting in an additional week of results every five or six years. 2005 Restructuring Charges In the fourth quarter of 2005, we incurred restructuring charges of $83 million to reduce costs in our operations, principally through headcount reductions. 2004 Restructuring and Impairment Charges In the fourth quarter of 2004, we incurred restructuring and impairment charges of $150 million in conjunction with the consolidation of FLNA’s manufacturing network in connection with its ongoing Net Tax Benefits — Continuing Operations In the fourth quarter of 2004, we recog- nized $45 million of tax benefits related to the completion of the U.S. Internal Revenue Service (IRS) audit for pre-merger Quaker open tax years. In the third quarter of 2004, we recognized $221 million of tax benefits related to a reduction in for- eign tax accruals following the resolution of certain open tax issues with foreign tax authorities, and a refund claim related to prior U.S. tax settlements. Tax Benefit from Discontinued Operations In the fourth quarter of 2004, we reached agreement with the IRS for an open issue related to our discontinued restaurant operations which resulted in a tax benefit of $38 million. 40 mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 41 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 vary- ing products in different package sizes and in different countries. Servings Since our divisions each use different measures of physical unit volume (i.e., kilos, pounds and case sales), a common servings metric is necessary to reflect our consolidated physical unit volume. Our divisions’ physical volume measures are converted into servings based on U.S. Food and Drug Administration guidelines for single-serving sizes of our products. Total servings increased 7% in 2005 compared to 2004 as servings for bever- ages worldwide grew over 7% and servings for snacks worldwide grew 6%. All of our divisions positively contributed to the total servings growth. Total servings increased 6% in 2004 compared to 2003 as servings for beverages worldwide grew 7% and serv- ings for snacks worldwide grew over 5%. Net Revenue and Operating Profit 2005 Net revenue increased 11% reflecting, across all divisions, increased volume, favorable effective net pricing, and net favorable foreign currency movements. The volume gains contributed 6 percentage points, the effective net pricing contributed 3 percentage points and the net favorable foreign currency movements contributed over 1 percentage point. The 53rd week contributed over 1 percentage point to revenue growth and almost 1 percentage point to volume growth. Total operating profit increased 13% and margin increased 0.2 percentage points. Division operating profit increased 10% and margin decreased 0.2 percentage points. The operating profit gains primarily reflect leverage from the revenue growth, partially offset by higher selling and distri- bution (S&D) expenses and increased cost of sales, largely due to higher raw materials, energy, and S&D labor costs, as well as higher advertising and marketing expenses. In 2005, division operating profit margin reflects our current year restructuring actions, while total operating profit margin benefited from a favorable comparison to prior year restructuring and impairment charges. The additional week in 2005 contributed over 1 percentage point to both total and division operating profit growth. 2004 Division net revenue increased 8%, prima- rily due to strong volume gains across all divisions, favorable product mix, primarily Division net revenues Divested businesses Total net revenue Division operating profit Corporate unallocated Merger-related costs Impairment and restructuring charges Divested businesses Total operating profit 2005 $32,562 – $32,562 $6,710 (788) – – – $5,922 2004 $29,261 – $29,261 $6,098 (689) – (150) – $5,259 2003 $26,969 2 $26,971 $5,463 (502) (59) (147) 26 $4,781 Division operating profit margin Total operating profit margin 20.6% 18.2% 20.8% 18.0% 20.3% 17.7% Change 2005 11% 2004 8% 11% 10% 14% 13% (0.2) 0.2 8% 12% 38% 10% 0.5 0.3 at PBNA and PI, and net favorable foreign currency movements. The volume gains contributed over 4 percentage points, the favorable mix contributed almost 2 percent- age points, and the net favorable foreign currency contributed almost 2 percentage points to division net revenue growth. Total operating profit increased 10% and margin increased 0.3 percentage points. Division operating profit increased 12% and division margin increased 0.5 percentage points. These gains reflect leverage from the revenue growth, partially offset by increased selling, general and administrative expenses, primarily corpo- rate unallocated expenses. In addition, total operating profit growth reflects the absence of merger-related costs in 2004. Corporate Unallocated Expenses Corporate unallocated expenses include the costs of our corporate headquarters, centrally managed initiatives such as our BPT initiative, unallocated insurance and benefit programs, foreign exchange trans- action and certain commodity derivative gains and losses, as well as profit-in-inven- tory elimination adjustments for our noncontrolled bottling affiliates and certain other items. In 2005, corporate unallocated expenses increased 14%. This increase primarily reflects higher costs associated with our BPT initiative which contributed 7 percentage points, increased support behind health and wellness and innovation initiatives which contributed 5 percentage points, and Corporate departmental expenses and restructuring charges which each contributed 2 percentage points to the increase. In 2005, items of a non- recurring nature included charges of $55 million to conform our method of accounting across all divisions, primarily for warehouse and freight costs, and a gain of $25 million in connection with the 41 mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 42 settlement of a class action lawsuit related to our purchases of high fructose corn syrup from 1991 to 1995. In 2004, we recorded a charge of $50 million for the settlement of a contractual dispute with a former business partner. In 2004, corporate unallocated expenses increased 38%. Higher employee-related costs contributed 18 percentage points of the increase, an accrual recognized in the fourth quarter for the settlement of a contractual dispute with a former business partner represented 10 percent- age points of the increase and higher costs related to our BPT initiative contributed 4 percentage points of the increase. Corporate departmental expenses increased 2% compared to prior year. Other Consolidated Results Bottling equity income includes our share of the net income or loss of our noncon- trolled 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 con- tinue to sell shares of PBG stock to trim our ownership to the level at the time of PBG’s initial public offering, since our ownership has increased as a result of PBG’s share repurchase program. During 2005, we sold 7.5 million shares of PBG stock. The resulting lower ownership per- centage reduces the equity income from PBG that we recognize. 2005 Bottling equity income increased 46% reflecting $126 million of pre-tax gains on our sales of PBG stock, as well as stronger bottler results. In the first quarter of 2006, PBG and PAS adopted SFAS 123R which will negatively impact our bottling equity income. Net interest expense increased 4% reflecting the impact of higher debt levels, substantially offset by higher investment rates and cash balances. The tax rate increased 11.4 percentage points reflecting the $460 million tax charge related to our repatriation of undis- tributed international earnings, as well as the absence of income tax benefits of $266 million recorded in the prior year related to a reduction in foreign tax accru- als following the resolution of certain open tax items with foreign tax authorities and a Bottling equity income Interest expense, net Annual tax rate Net income — continuing operations Net income per common share — continuing operations — diluted 2005 $557 $(97) 36.1% 2004 $380 $(93) 24.7% 2003 $323 $(112) 28.5% $4,078 $4,174 $3,568 $2.39 $2.41 $2.05 Change 2005 2004 46% 4% (2)% (1)% 18% (17)% 17% 18% The offsetting increase in deferred com- pensation costs is reported in corporate unallocated expenses. The annual tax rate decreased 3.8 per- centage points compared to the prior year, primarily as a result of tax benefits from the resolution of open items with tax authorities in both years, as discussed in “Items Affecting Comparability.” The tax benefits reduced our tax rate by 2.6 per- centage points. Increased benefit from concentrate operations and favorable changes arising from agreements with the IRS in the fourth quarter of 2003 also contributed to the decline in rate. Net income from continuing operations increased 17% and the related net income per common share from continuing opera- tions increased 18%. These increases primarily reflect the solid operating profit growth and our lower annual tax rate. The absence of merger-related costs in 2004 and increased bottling equity income also contributed to the growth. refund claim related to prior U.S. tax set- tlements. This increase was partially offset by increased international profit which is taxed at a lower rate. Net income from continuing operations decreased 2% and the related net income per common share from continuing operations decreased 1%. These decreases reflect the impact of the tax items discussed above, partially offset by our operating profit growth, increased bottling equity income, which includes the gain on our PBG stock sale, the impact of the 53rd week, a favorable comparison to prior year restructuring and impairment charges, and for net income per share, the impact of our share repurchases. 2004 Bottling equity income increased 18%, primarily reflecting increased earnings from our anchor bottlers and favorable comparisons from international bottling investments, primarily as a result of the nationwide strike in Venezuela in early 2003. Net interest expense declined 17% pri- marily due to favorable interest rates and higher average cash balances, partially offset by higher average debt balances and lower gains in the market value of invest- ments used to economically hedge a por- tion of our deferred compensation liability. 42 mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 43 Results of Continuing Operations — Division Review The results and discussions below are based on how our Chief Executive Officer monitors the performance of our divisions. Prior year amounts exclude the results of divested businesses. For additional information on these items and our divisions, see Note 1. Net Revenue, 2005 Net Revenue, 2004 % Impact of: Volume Effective net pricing Foreign exchange Acquisition/divestitures % Change(b) FLNA $10,322 $9,560 PBNA $9,146 $8,313 PI $11,376 $9,862 4.5% 3 0.5 – 8% 4%(a) 5 – – 10% 8%(a) 2.5 3 2 15% QFNA $1,718 $1,526 9% 3 1 – 13% FLNA $9,560 $9,091 PBNA $8,313 $7,733 PI $9,862 $8,678 Net Revenue, 2004 Net Revenue, 2003 % Impact of: Volume Effective net pricing Foreign exchange Acquisition/divestitures % Change(b) (a) For beverages sold to our bottlers, net revenue volume growth is based on our concentrate shipments and equivalents. (b) Amounts may not sum due to rounding. 7%(a) 2 4 1 14% 3%(a) 4 – – 7% 3% 2 – – 5% 3% – 1 – 4% QFNA $1,526 $1,467 Total $32,562 $29,261 6% 3 1 0.5 11% Divested Businesses – $2 Total $29,261 $26,971 – – – – N/A 4% 2 2 – 8% 43 mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 44 Frito-Lay North America Net revenue Operating profit 2005 Net revenue grew 8% reflecting volume growth of 4.5% and positive effective net pricing driven by salty snack pricing actions and favorable mix on both salty and convenience foods products. Pound volume grew primarily due to mid single- digit growth in trademark Lay’s potato chips, high single-digit growth in salty trademark Tostitos, double-digit growth in Santitas, mid single-digit growth in trade- mark Cheetos, high single-digit growth in Dips and Fritos, and double-digit growth in Sun Chips. These gains were partially offset by the discontinuance of Toastables and Doritos Rollitos. Overall, salty snacks rev- enue grew 8% with volume growth of 5%, and convenience foods products revenue grew 13% with volume growth of 1%. Convenience foods products revenue benefited from favorable mix. The additional week contributed 2 percentage points to volume and net revenue growth. Operating profit grew 6% reflecting positive effective net pricing actions and volume growth. This growth was offset by 2005 $10,322 $2,529 2004 $9,560 $2,389 % Change 2003 $9,091 $2,242 2005 8 6 2004 5 7 higher S&D costs resulting from increased labor and benefit charges and fuel costs; higher cost of sales, driven by raw materi- als, 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 FLNA volume grew 4.5% in 2005 and 3% in 2004. of fourth quarter charges to reduce costs in our operations, principally through head- count reductions. The additional week con- tributed 2 percentage points to operating profit growth. Products qualifying for our new Smart Spot program represented approximately 13% of net revenue. These products expe- rienced double-digit revenue growth, while the balance of the portfolio had high sin- gle-digit revenue growth. See our website at www.smartspot.com for additional information on our Smart Spot program. 2004 Net revenue grew 5% reflecting volume growth of 3% and positive effective net pricing due to salty snack pricing actions and favorable mix. Pound volume grew primarily due to new products, single-digit growth in Lay’s Classic potato chips, strong double-digit growth in Variety Pack and mid single-digit growth in Tostitos and Fried Cheetos. Lay’s Stax and Doritos Rollitos led the new product growth. These gains were partially offset by single-digit declines in Doritos and Fritos and double-digit declines in Rold Gold and Quaker Toastables. Operating profit grew nearly 7% reflect- ing the positive pricing actions and volume growth. Higher commodity costs, driven by corn oil and energy costs were largely offset by cost leverage generated from ongoing productivity initiatives. Smart Spot eligible products repre- sented approximately 10% of 2004 FLNA net revenue. These products experienced high single-digit revenue growth and the balance of the portfolio had mid single- digit revenue growth. 44 mdav26L01P25_49v4.qxd 3/6/06 11:21 PM Page 45 PepsiCo Beverages North America Net revenue Operating profit 2005 Net revenue grew 10% and volume grew 4%. The volume increase was driven by a 16% increase in non-carbonated bever- ages, partially offset by a 1% decline in CSDs. Within non-carbonated beverages, Gatorade, Trademark Aquafina, Tropicana juice drinks, Propel and SoBe all experi- enced 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 Gatorade, Trademark Aquafina, Tropicana juice drinks, Propel and SoBe all experienced double-digit volume growth in 2005. 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 vol- ume growth as bottler volume is reported based on a calendar month. 2005 $9,146 $2,037 2004 $8,313 $1,911 % Change 2003 $7,733 $1,690 2005 10 7 2004 7 13 Net revenue also benefited from 5 per- centage points of favorable effective net pricing, reflecting the continued migration from CSDs to non-carbonated beverages and price increases taken in the first quar- ter, primarily on concentrate and Tropicana Pure Premium, partially offset by increased trade spending in the current year. The additional week in 2005 contributed 1 percentage point to net revenue growth. Operating profit increased nearly 7%, primarily reflecting net revenue growth. This increase was partially offset by higher raw material, energy, and transportation costs, as well as increased advertising and marketing expenses. The additional week in 2005 contributed 1 percentage point to operating profit growth and was fully offset by a 1 percentage point decline related to charges taken in the fourth quarter of 2005 to reduce costs in our operations, principally through headcount reductions. Smart Spot eligible products repre- sented almost 70% of net revenue. These products experienced double-digit revenue growth, while the balance of the portfolio grew in the low single-digit range. 2004 Net revenue increased 7% and volume increased 3%. The volume increase reflects non-carbonated beverage growth of 10% and a slight increase in CSDs. The non-carbonated beverage growth was fueled by double-digit growth in Gatorade, Aquafina and Propel, as well as the intro- duction of bottler-distributed Tropicana juice drinks. Tropicana Pure Premium increased slightly for the year. The carbon- ated soft drink performance reflects a low single-digit increase in Trademark Mountain Dew and a slight increase in Trademark Sierra Mist, offset by a slight decline in Trademark Pepsi. Across the trademarks, high single-digit diet CSD growth was substantially offset by a low single-digit decline in regular CSDs. The increase in Trademark Mountain Dew reflects growth in both Diet and regular Mountain Dew and the limited time only offering of Mountain Dew Pitch Black, substantially offset by declines in both Mountain Dew Code Red and LiveWire. The performance of Trademark Pepsi reflects declines in regular Pepsi, Pepsi Twist and Pepsi Blue, mostly offset by increases in Diet Pepsi and the introduction of Pepsi Edge. Favorable product mix contributed 3 percentage points to net revenue growth, primarily reflecting a migration to non-carbonated beverages. Additionally, concentrate and fountain price increases taken in the first quarter contributed 1 percentage point to net revenue growth. Operating profit increased 13% reflect- ing the net revenue growth, partially offset by higher selling, general and administra- tive costs, as well as costs related to marketplace initiatives. Smart Spot eligible products represented over 60% of net revenue. These products experienced high single-digit revenue growth, and the balance of the portfolio had mid single-digit revenue growth. 45 mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 46 2005 $11,376 $1,607 2004 $9,862 $1,323 % Change 2003 $8,678 $1,061 2005 15 21 2004 14 25 single-digit growth at Gamesa in Mexico coupled with double-digit growth in Egypt, Venezuela, Turkey and Brazil. Beverage volume grew 12%, comprised of 14% in our Europe, Middle East & Africa region, 15% in our Asia Pacific region and 8% in our Latin America region. Broad-based increases were led by double- digit growth in the Middle East and China, high single-digit growth in Mexico and dou- ble-digit growth in India, Germany, Russia and Venezuela. Favorable comparisons as a result of the 2003 national strike in Venezuela and the German deposit law impact contributed to the growth in Venezuela and Germany. Both carbonated soft drinks and non-carbonated beverages grew at double-digit rates. Net revenue grew 14% driven by the broad-based volume growth and favorable mix. Foreign currency impact contributed 4 percentage points of growth driven by the favorable British pound and euro, partially offset by the unfavorable Mexican peso. Acquisitions contributed less than 1 percentage point. Operating profit grew 25% driven largely by the volume and favorable mix. The favorable comparison of certain reserve actions taken in 2003 on poten- tially unrecoverable beverage assets contributed 2 percentage points of growth. Foreign currency impact contributed almost 3 percentage points of growth driven by the favorable British pound and euro, partially offset by the unfavorable Mexican peso. points of growth reflecting the favorable Mexican peso and Brazilian real, partially offset by the unfavorable British pound. Acquisitions and divestitures contributed almost 2 percentage points of growth. The additional week contributed 1 percentage point to revenue growth. Cumulatively, the impact of foreign currency, acquisitions and divestitures, and the additional week on net revenue was 5 percentage points. Operating profit grew 21% driven largely by the broad-based volume growth and favorable effective net pricing, partially offset by increased energy and raw material costs. Foreign currency contributed 4 percentage points of growth based on the favorable Mexican peso and Brazilian real. The net favorable impact from acquisition and divestiture activity, primarily the acquisition of General Mills’ minority interest in Snack Ventures Europe in Q1 2005, contributed 2 percentage International snacks volume grew 7% and international beverage volume grew 11% in 2005. points of growth. The additional week con- tributed 1 percentage point to operating profit growth which was fully offset by a 1 percentage point decline in operating profit growth related to fourth qua rter charges to reduce costs in our operations and rationalize capacity. 2004 International snacks volume grew 8%, comprised of 7% in our Latin America region, 8% in our Europe, Middle East & Africa region and 14% in our Asia Pacific region. These gains were driven by high single-digit growth at Sabritas in Mexico, strong double-digit growth in India, low PepsiCo International Net revenue Operating profit 2005 International snacks volume grew 7%, reflecting growth of 11% in the Europe, Middle East & Africa region, 5% in the Latin America region and 6% in the Asia Pacific region. Acquisition and divestiture activity, principally the divestiture last year of our interest in a South Korea joint venture, reduced Asia region volume by 11 percentage points. The 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 46 mdav26L01P25_49v2.qxd 3/1/06 11:17 PM Page 47 Quaker Foods North America Net revenue Operating profit 2005 Net revenue increased 13% and volume increased 9%. The volume increase reflects double-digit growth in Oatmeal, Aunt Jemima syrup and mix, Rice-A-Roni and Pasta Roni, as well as high single-digit growth in Cap’n Crunch cereal and mid single-digit growth in Life cereal. Higher effective net pricing contributed nearly 3 percentage points of growth reflecting favorable product mix, the settlement of prior year trade spending accruals and price increases on ready-to-eat cereals taken in the third quarter of 2004. Favorable Canadian exchange rates contributed nearly 1 percentage point to net revenue growth. The additional week in 2005 contributed approximately 2 percentage points to both net revenue and volume growth. Operating profit increased 13% reflect- ing 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 2005 $1,718 $537 2004 $1,526 $475 2003 $1,467 $470 % Change 2005 13 13 2004 4 1 decline in Cap’n Crunch cereal. The Life cereal growth was led by the introduction of Honey Graham Life. Favorable product mix, reflecting growth in higher revenue per pound brands, was offset by promotional spending behind new products. Favorable Canadian exchange rates contributed 1 percentage point to net revenue growth. Operating profit increased 1% reflecting the net revenue growth, substantially offset by an unfavorable cost of sales comparison and higher advertising and marketing costs. Smart Spot eligible products repre- sented approximately half of net revenue and had high single-digit revenue growth. The balance of the portfolio was flat. primarily due to higher energy and raw materials costs in the latter part of 2005. The additional week in 2005 contributed approximately 2 percentage points to operating profit growth. QFNA volume increased 9% in 2005 reflecting double-digit growth in Oatmeal, Aunt Jemima syrup and mix, Rice-A-Roni and Pasta Roni. 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. 2004 Net revenue increased 4% and volume increased 3%. The volume increase reflects high single-digit growth in Oatmeal and double-digit growth in Life cereal, partially offset by a mid single-digit 47 mdav26L01P25_49v4.qxd 3/6/06 11:21 PM Page 48 Our Liquidity, Capital Resources and Financial Position Our strong cash-generating capability and financial condition give us ready access to capital markets throughout the world. Our principal source of liquidity is our operating cash flow. This cash-generating capability is one of our fundamental strengths and provides us with substantial financial flexibility in meeting operating, investing and financing needs. In addition, we have revolving credit facilities that are further discussed in Note 9. Our cash provided from operating activities is somewhat impacted by seasonality. Working capital needs are impacted by weekly sales, which are generally highest in the third quarter due to seasonal and holiday-related sales patterns, and generally lowest in the first quarter. 2005 Cash Utilization Other, net $70 Short-term borrowings $1,848 Cash proceeds from sale of PBG stock $214 Stock option exercises $1,099 Operating activities $5,852 Long-term debt $152 Acquisitions $1,095 Dividends $1,642 Short-term investments $991 Capital spending $1,736 Share repurchases $3,031 Source of Cash Use of Cash gram, we have repurchased $5.1 billion of shares, leaving $1.9 billion of remaining authorization. We target an annual divi- dend payout of approximately 45% of prior year’s net income from continuing opera- tions. Each spring we review our capital structure with our Board, including our div- idend 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 evalu- ating our cash from operating activities. Operating Activities In 2005, our operations provided $5.9 billion of cash compared to $5.1 billion in the prior year. The increase reflects our solid business results, as well as lower taxes paid in the current year as 2004 tax payments included a $760 million tax payment related to our 2003 settlement with the IRS. This increase was partially offset by $803 million of pension plan contributions in the current year, of which $729 million was discretionary, compared to pension payments of $458 million in the prior year, of which $400 million was discretionary. Investing Activities In 2005, we used $3.5 billion, primarily reflecting capital spending of $1.7 billion, acquisitions of $1.1 billion, primarily the $750 million acquisition of General Mills’ minority interest in Snack Ventures Europe, and net purchases of short-term invest- ments of $1.0 billion. These amounts were partially offset by the proceeds from our sale of PBG stock of $214 million. In 2004, we used $2.3 billion for investing, primarily reflecting capital spending of $1.4 billion and short-term investments of almost $1.0 billion. In the first quarter of 2006, we com- pleted our acquisition of Stacy’s Pita Chip Company which was funded with existing domestic cash. This acquisition will be included in the first quarter of 2006 as an investing activity in our Condensed Consolidated Statement of Cash Flows. We anticipate net capital spending of approximately $2.2 billion in 2006, which is above our long-term target of approxi- mately 5% of net revenue. Planned capital spending in 2006 includes increased investments in manufacturing capacity to support growth in our China snack and beverage operations and our North American Gatorade business, as well as increased investment in support of our ongoing BPT initiative. We expect capital spending to return to our long-term targeted rate following 2006. Financing Activities In 2005, we used $1.9 billion, primarily reflecting common share repurchases of $3.0 billion and dividend payments of $1.6 billion, partially offset by net proceeds from short-term borrowings of $1.8 billion and stock option proceeds of $1.1 billion. This compares to $2.3 billion used for financing in 2004, primarily reflecting share repurchases at a cost of $3.0 billion and dividend payments of $1.3 billion, partially offset by net issuances of short-term borrowings of $1.1 billion and proceeds from exercises of stock options of nearly $1.0 billion. In 2004, our Board of Directors author- ized a new $7.0 billion share repurchase program. Since inception of the new pro- 48 mdav26L01P25_49v4.qxd 3/6/06 11:21 PM Page 49 2004 Cash Utilization 2003 Cash Utilization Other, net $69 Stock option exercises $965 Short-term borrowings $1,112 Operating activities $5,054 Other, net $64 Stock option exercises $689 Operating activities $4,328 Short-term investments $969 Dividends $1,329 Capital spending $1,387 Share repurchases $3,055 Long-term debt $589 Short-term investments $950 Dividends $1,070 Capital spending $1,345 Share repurchases $1,945 Source of Cash Use of Cash Source of Cash Use of Cash 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. Net cash provided by operating activities Capital spending Sales of property, plant and equipment Management operating cash flow Management operating cash flow was used primarily to repurchase shares and pay dividends. We expect to continue to return approximately all of our management operating cash flow to our shareholders through dividends and share repurchases. However, see “Our Business Risks” for certain factors that may impact our operating cash flows. Credit Ratings Our debt ratings of Aa3 from Moody’s and A+ from Standard & Poor’s contribute to our ability to access global capital markets. We have maintained strong investment grade ratings for over a decade. Our Moody’s rating reflects an upgrade from A1 to Aa3 in 2004 due to the strength of our balance sheet and cash flows. Each rating is considered strong investment grade and is in the first quartile of their respective 2005 $ 5,852 (1,736) 88 $ 4,204 2004 $ 5,054 (1,387) 38 $ 3,705 2003 $ 4,328 (1,345) 49 $ 3,032 ranking systems. These ratings also reflect the impact of our anchor bottlers’ cash flows and debt. that these guarantees would require any cash payment. See Note 9 for a description of our off-balance sheet arrangements. Credit Facilities and Long-Term Contractual Commitments See Note 9 for a description of our credit facilities and long-term contractual commitments. Financial Position Significant changes in our Consolidated Balance Sheet from December 25, 2004 to December 31, 2005 not discussed above were as follows: Off-Balance Sheet Arrangements It is not our business practice to enter into off-balance sheet arrangements, other than in the normal course of business, nor is it our policy to issue guarantees to our bottlers, noncontrolled affiliates or third parties. However, certain guarantees were necessary to facilitate the separation of our bottling and restaurant operations from us. As of year-end 2005, we believe it is remote • Other assets increased primarily reflect- ing our increased pension contributions in the current year. • Income taxes payable increased primarily reflecting $460 million of taxes accrued related to our repatriation of interna- tional earnings in connection with the AJCA to be paid in the first quarter of 2006. 49 stmentsv24L01P50_53v3.qxd 3/6/06 11:49 PM Page 50 Consolidated Statement of Income PepsiCo, Inc. and Subsidiaries Fiscal years ended December 31, 2005, December 25, 2004 and December 27, 2003 (in millions except per share amounts) 2005 Net Revenue........................................................................................................................... $32,562 Cost of sales........................................................................................................................... Selling, general and administrative expenses ........................................................................ Amortization of intangible assets........................................................................................... Restructuring and impairment charges.................................................................................. Merger-related costs............................................................................................................... Operating Profit..................................................................................................................... Bottling equity income............................................................................................................ Interest expense...................................................................................................................... Interest income....................................................................................................................... Income from Continuing Operations before Income Taxes ................................................. Provision for Income Taxes................................................................................................... Income from Continuing Operations..................................................................................... Tax Benefit from Discontinued Operations ........................................................................... 14,176 12,314 150 – – 5,922 557 (256) 159 6,382 2,304 4,078 – 2004 $29,261 12,674 11,031 147 150 – 5,259 380 (167) 74 5,546 1,372 4,174 38 2003 $26,971 11,691 10,148 145 147 59 4,781 323 (163) 51 4,992 1,424 3,568 – Net Income ............................................................................................................................ $ 4,078 $ 4,212 $ 3,568 Net Income per Common Share — Basic Continuing operations ....................................................................................................... Discontinued operations.................................................................................................... Total .................................................................................................................................. Net Income per Common Share — Diluted Continuing operations ....................................................................................................... Discontinued operations.................................................................................................... Total .................................................................................................................................. * Based on unrounded amounts. See accompanying notes to consolidated financial statements. $2.43 – $2.43 $2.39 – $2.39 $2.45 0.02 $2.47 $2.41 0.02 $2.44* $2.07 – $2.07 $2.05 – $2.05 Net Revenue Operating Profit $26,971 $29,261 $32,562 $4,781 $5,259 $5,922 2003 2004 2005 2003 2004 2005 Income from Continuing Operations Net Income per Common Share — Continuing Operations $4,174 $4,078 $3,568 $2.41 $2.39 $2.05 2003 2004 2005 2003 2004 2005 50 stmentsv24L01P50_53v1.qxd 3/1/06 11:19 PM Page 51 Consolidated Statement of Cash Flows PepsiCo, Inc. and Subsidiaries Fiscal years ended December 31, 2005, December 25, 2004 and December 27, 2003 (in millions) Operating Activities Net income................................................................................................................................. Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization ............................................................................................. Stock-based compensation expense..................................................................................... Restructuring and impairment charges ............................................................................... Cash payments for merger-related costs and restructuring charges ................................... Tax benefit from discontinued operations............................................................................. Pension and retiree medical plan contributions ................................................................... Pension and retiree medical plan expenses.......................................................................... Bottling equity income, net of dividends .............................................................................. Deferred income taxes and other tax charges and credits ................................................... Merger-related costs............................................................................................................. Other non-cash charges and credits, net ............................................................................. Changes in operating working capital, excluding effects of acquisitions and divestitures Accounts and notes receivable........................................................................................ Inventories ...................................................................................................................... Prepaid expenses and other current assets .................................................................... Accounts payable and other current liabilities................................................................ Income taxes payable...................................................................................................... Net change in operating working capital.............................................................................. Other..................................................................................................................................... 1,308 311 – (22) – (877) 464 (411) 440 – 145 (272) (132) (56) 188 609 337 79 Net Cash Provided by Operating Activities .............................................................................. 5,852 Investing Activities Snack Ventures Europe (SVE) minority interest acquisition ....................................................... Capital spending ....................................................................................................................... Sales of property, plant and equipment..................................................................................... Other acquisitions and investments in noncontrolled affiliates ................................................ Cash proceeds from sale of PBG stock ...................................................................................... Divestitures................................................................................................................................ Short-term investments, by original maturity More than three months — purchases ................................................................................ More than three months — maturities ................................................................................ Three months or less, net ..................................................................................................... (750) (1,736) 88 (345) 214 3 (83) 84 (992) Net Cash Used for Investing Activities..................................................................................... (3,517) Financing Activities Proceeds from issuances of long-term debt .............................................................................. Payments of long-term debt ...................................................................................................... Short-term borrowings, by original maturity More than three months — proceeds................................................................................... More than three months — payments ................................................................................. Three months or less, net ..................................................................................................... Cash dividends paid .................................................................................................................. Share repurchases — common ................................................................................................. Share repurchases — preferred ................................................................................................ Proceeds from exercises of stock options................................................................................... Net Cash Used for Financing Activities.................................................................................... Effect of exchange rate changes on cash and cash equivalents ............................................... Net Increase/(Decrease) in Cash and Cash Equivalents......................................................... Cash and Cash Equivalents, Beginning of Year ....................................................................... 25 (177) 332 (85) 1,601 (1,642) (3,012) (19) 1,099 (1,878) (21) 436 1,280 2005 2004 2003 $ 4,078 $ 4,212 $ 3,568 1,264 368 150 (92) (38) (534) 395 (297) (203) – 166 (130) (100) (31) 216 (268) (313) (24) 5,054 – (1,387) 38 (64) – 52 (44) 38 (963) (2,330) 504 (512) 153 (160) 1,119 (1,329) (3,028) (27) 965 (2,315) 51 460 820 1,221 407 147 (109) – (605) 277 (276) (286) 59 101 (220) (49) 23 (11) 182 (75) (101) 4,328 – (1,345) 49 (71) – 46 (38) 28 (940) (2,271) 52 (641) 88 (115) 40 (1,070) (1,929) (16) 689 (2,902) 27 (818) 1,638 Cash and Cash Equivalents, End of Year ................................................................................. $ 1,716 $ 1,280 $ 820 See accompanying notes to consolidated financial statements. 51 stmentsv24L01P50_53v4.qxd 3/7/06 11:35 AM Page 52 Consolidated Balance Sheet PepsiCo, Inc. and Subsidiaries December 31, 2005 and December 25, 2004 (in millions except per share amounts) ASSETS Current Assets 2005 2004 Cash and cash equivalents................................................................................................................................... $ 1,716 $ 1,280 Short-term investments ........................................................................................................................................ Accounts and notes receivable, net....................................................................................................................... Inventories............................................................................................................................................................. Prepaid expenses and other current assets........................................................................................................... Total Current Assets ....................................................................................................................................... Property, Plant and Equipment, net .................................................................................................................... Amortizable Intangible Assets, net...................................................................................................................... Goodwill................................................................................................................................................................. Other nonamortizable intangible assets................................................................................................................ Nonamortizable Intangible Assets.................................................................................................................. Investments in Noncontrolled Affiliates .............................................................................................................. Other Assets ......................................................................................................................................................... 3,166 4,882 3,261 1,693 618 10,454 8,681 530 4,088 1,086 5,174 3,485 3,403 2,165 3,445 2,999 1,541 654 8,639 8,149 598 3,909 933 4,842 3,284 2,475 Total Assets................................................................................................................................................ $31,727 $27,987 LIABILITIES AND SHAREHOLDERS’ EQUITY Current Liabilities Short-term obligations .......................................................................................................................................... $ 2,889 $ 1,054 Accounts payable and other current liabilities...................................................................................................... Income taxes payable............................................................................................................................................ Total Current Liabilities .................................................................................................................................. Long-Term Debt Obligations................................................................................................................................. Other Liabilities .................................................................................................................................................... Deferred Income Taxes........................................................................................................................................ 5,971 546 9,406 2,313 4,323 1,434 5,599 99 6,752 2,397 4,099 1,216 Total Liabilities................................................................................................................................................ 17,476 14,464 Commitments and Contingencies Preferred Stock, no par value ............................................................................................................................. Repurchased Preferred Stock............................................................................................................................. Common Shareholders’ Equity Common stock, par value 1 2/3¢ per share (issued 1,782 shares)....................................................................... Capital in excess of par value............................................................................................................................... Retained earnings ................................................................................................................................................. Accumulated other comprehensive loss ................................................................................................................ Less: repurchased common stock, at cost (126 and 103 shares, respectively) ................................................... Total Common Shareholders’ Equity .............................................................................................................. 41 (110) 30 614 21,116 (1,053) 20,707 (6,387) 14,320 41 (90) 30 618 18,730 (886) 18,492 (4,920) 13,572 Total Liabilities and Shareholders’ Equity ................................................................................................ $31,727 $27,987 See accompanying notes to consolidated financial statements. 52 stmentsv24L01P50_53v3.qxd 3/6/06 11:49 PM Page 53 Consolidated Statement of Common Shareholders’ Equity PepsiCo, Inc. and Subsidiaries Fiscal years ended December 31, 2005, December 25, 2004 and December 27, 2003 (in millions) Common Stock 2005 2004 2003 Shares 1,782 Amount 30 $ Shares 1,782 Amount 30 $ Shares 1,782 Amount 30 $ Capital in Excess of Par Value Balance, beginning of year........................................... Stock-based compensation expense............................. Stock option exercises(a) ............................................... Balance, end of year..................................................... Retained Earnings Balance, beginning of year........................................... Net income ................................................................... Cash dividends declared — common .......................... Cash dividends declared — preferred ......................... Cash dividends declared — RSUs ............................... Other ............................................................................ Balance, end of year..................................................... Accumulated Other Comprehensive Loss Balance, beginning of year .......................................... Currency translation adjustment.................................. Cash flow hedges, net of tax: Net derivative gains/(losses) .................................. Reclassification of (gains)/losses to net income .... Minimum pension liability adjustment, net of tax ............................................................... Unrealized gain on securities, net of tax ...................... Other ............................................................................ Balance, end of year..................................................... Repurchased Common Stock Balance, beginning of year........................................... Share repurchases........................................................ Stock option exercises .................................................. Other ............................................................................ Balance, end of year..................................................... Total Common Shareholders’ Equity ................................ Comprehensive Income Net income .................................................................. Currency translation adjustment.................................. Cash flow hedges, net of tax........................................ Minimum pension liability adjustment, net of tax ....... Unrealized gain on securities, net of tax ...................... Other ............................................................................ Total Comprehensive Income........................................... 618 311 (315) 614 18,730 4,078 (1,684) (3) (5) – 21,116 (886) (251) 54 (8) 16 24 (2) (1,053) (4,920) (2,995) 1,523 5 (6,387) $14,320 2005 $4,078 (251) 46 16 24 (2) $3,911 (103) (54) 31 – (126) 548 368 (298) 618 15,961 4,212 (1,438) (3) (2) – 18,730 (1,267) 401 (16) 9 (19) 6 – (886) (3,376) (2,994) 1,434 16 (4,920) $13,572 2004 $4,212 401 (7) (19) 6 – $4,593 (77) (58) 32 – (103) (a) Includes total tax benefit of $125 million in 2005, $183 million in 2004 and $340 million in 2003. See accompanying notes to consolidated financial statements. 207 407 (66) 548 13,489 3,568 (1,082) (3) – (11) 15,961 (1,672) 410 (11) (1) 7 1 (1) (1,267) (2,524) (1,946) 1,096 (2) (3,376) $11,896 2003 $3,568 410 (12) 7 1 (1) $3,973 53 (60) (43) 26 – (77) R1_notes_v26.qxd 3/1/06 11:06 PM Page 54 Notes to Consolidated Financial Statements Note 1 — Basis of Presentation and Our Divisions Basis of Presentation Our financial statements include the con- solidated accounts of PepsiCo, Inc. and the affiliates that we control. In addition, we include our share of the results of cer- tain 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 noncon- trolled bottling affiliates is reported in our income statement as bottling equity income. Bottling equity income also includes any changes in our ownership interests of these affiliates. In 2005, bot- tling equity income includes $126 million of pre-tax gains on our sales of PBG stock. See Note 8 for additional information on our noncontrolled bottling affiliates. Our share of other noncontrolled affiliates is included in division operating profit. Intercompany balances and transactions are eliminated. In 2005, we had an addi- tional 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. Our Divisions We manufacture or use contract manufac- turers, market and sell a variety of salty, sweet and grain-based snacks, carbonated and non-carbonated beverages, and foods through our North American and interna- tional business divisions. Our North American divisions include the United States and Canada. The accounting poli- cies for the divisions are the same as those described in Note 2, except for certain allocation methodologies for stock-based compensation expense and pension and retiree medical expense, as described in the unaudited information in “Our Critical Accounting Policies.” Additionally, begin- 54 In connection with our ongoing BPT initiative, we aligned certain accounting policies across our divisions in 2005. We conformed our methodology for calculating our bad debt reserves and modified our policy for recognizing revenue for products shipped to customers by third-party carriers. Additionally, we conformed our method of accounting for certain costs, primarily warehouse and freight. These changes reduced our net revenue by $36 million and our operating profit by $60 million in 2005. We also made certain reclassifications on our Consolidated Statement of Income in the fourth quarter of 2005 from cost of sales to selling, general and administrative expenses in connection with our BPT initiative. These reclassifications resulted in reductions to cost of sales of $556 million through the third quarter of 2005, $732 million in the full year 2004 and $688 million in the full year 2003, with corresponding increases to selling, general and administrative expenses in those periods. These reclassifi- cations had no net impact on operating profit and have been made to all periods presented for comparability. The preparation of our consolidated financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that affect reported amounts of assets, liabilities, revenues, expenses and disclosure of contingent assets and liabilities. Estimates are used in determin- ing, among other items, sales incentives accruals, future cash flows associated with impairment testing for perpetual brands and goodwill, useful lives for intangible assets, tax reserves, stock-based compen- sation and pension and retiree medical accruals. Actual results could differ from these estimates. See “Our Divisions” below and for additional unaudited information on items affecting the comparability of our consolidated results, see “Items Affecting Comparability” in Management’s Discussion and Analysis. Tabular dollars are in millions, except per share amounts. All per share amounts reflect common per share amounts, assume dilution unless noted, and are based on unrounded amounts. Certain reclassifica- tions were made to prior years’ amounts to conform to the 2005 presentation. ning 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 com- modity price risk and were not entered into for speculative purposes. Such derivatives are marked to market with the resulting gains and losses recognized as a compo- nent of corporate unallocated expense. These gains and losses are reflected in division results when the divisions take delivery of the underlying commodity. Therefore, division results reflect the contract purchase price of the energy or other commodities. Division results are based on how our Chairman and Chief Executive Officer evaluates our divisions. Division results exclude certain Corporate-initiated restruc- turing and impairment charges, merger- related costs and divested businesses. For additional unaudited information on our divisions, see “Our Operations” in Management’s Discussion and Analysis. notesv26L01P54_76v6.qxd 3/8/06 5:31 PM Page 55 Frito-Lay North America (FLNA) PepsiCo Beverages North America (PBNA) PepsiCo International (PI) Quaker Foods North America (QFNA) FLNA...................................................................... PBNA..................................................................... PI ......................................................................... QFNA ..................................................................... Total division ........................................................ Divested businesses ............................................. Corporate .............................................................. Restructuring and impairment charges................ Merger-related costs............................................. Total...................................................................... 2005 $10,322 9,146 11,376 1,718 32,562 – – 32,562 – – $32,562 2004 Net Revenue $ 9,560 8,313 9,862 1,526 29,261 – – 29,261 – – $29,261 2003 2005 $ 9,091 7,733 8,678 1,467 26,969 2 – 26,971 – – $26,971 $2,529 2,037 1,607 537 6,710 – (788) 5,922 – – $5,922 2004 Operating Profit $2,389 1,911 1,323 475 6,098 – (689) 5,409 (150) – $5,259 2003 $2,242 1,690 1,061 470 5,463 26 (502) 4,987 (147) (59) $4,781 Division Net Revenue Division Operating Profit QFNA 5% FLNA 32% PI 35% PBNA 28% QFNA 8% PI 24% FLNA 38% PBNA 30% Divested Businesses During 2003, we sold our Quaker Foods North America Mission pasta business. The results of this business are reported as divested businesses. Corporate Corporate includes costs of our corporate headquarters, centrally managed initia- tives, such as our BPT initiative, unallo- cated insurance and benefit programs, foreign exchange transaction gains and losses, and certain commodity derivative gains and losses, as well as profit-in-inven- tory elimination adjustments for our non- controlled bottling affiliates and certain other items. Restructuring and Impairment Charges and Merger-Related Costs — See Note 3. 55 notesv26L01P54_76v4.qxd 3/7/06 1:44 AM Page 56 Other Division Information FLNA PBNA PI QFNA Total division Corporate(a) Investments in bottling affiliates 2005 $ 5,948 6,316 9,983 989 23,236 5,331 3,160 $31,727 2004 Total Assets $ 5,476 6,048 8,921 978 21,423 3,569 2,995 $27,987 2003 $ 5,332 5,856 8,109 995 20,292 2,384 2,651 $25,327 2005 $ 512 320 667 31 1,530 206 – $1,736 2004 Capital Spending $ 469 265 537 33 1,304 83 – $1,387 2003 $ 426 332 521 32 1,311 34 – $1,345 (a) Corporate assets consist principally of cash and cash equivalents, short-term investments, and property, plant and equipment. Total Assets Other 27% FLNA 19% Capital Spending QFNA 2% Other 12% QFNA 3% PI 31% PBNA 20% PI 38% FLNA 30% PBNA 18% Net Revenue Canada 4% United Kingdom 6% Mexico 10% Other 19% United States 61% Long-Lived Assets Other 22% Canada 3% United Kingdom 10% Mexico 5% United States 60% FLNA PBNA PI QFNA Total division Corporate U.S. Mexico United Kingdom Canada All other countries 2003 2005 2004 Amortization of Intangible Assets $ 3 $ 75 68 1 147 – $147 $ 3 76 71 – 150 – $150 3 75 66 1 145 – $145 2005 2003 2004 Depreciation and Other Amortization $ 420 258 382 36 1,096 21 $1,117 $ 416 245 350 36 1,047 29 $1,076 $ 419 264 420 34 1,137 21 $1,158 2005 2004 Net Revenue(a) 2003 $19,937 $18,329 $17,377 2,642 2,724 1,510 1,692 1,147 1,309 4,295 5,207 $32,562 $29,261 $26,971 3,095 1,821 1,509 6,200 2005 2004 Long-Lived Assets(b) 2003 $10,723 $10,212 $ 9,907 869 878 1,724 1,896 508 548 3,123 3,339 $17,870 $16,873 $16,131 902 1,715 582 3,948 (a) Represents net revenue from businesses operating in these countries. (b) Long-lived assets represent net property, plant and equipment, nonamortizable and net amortizable intangible assets and investments in noncontrolled affiliates. These assets are reported in the country where they are primarily used. 56 R1_notes_v26.qxd 3/1/06 11:06 PM Page 57 Note 2 — Our Significant Accounting Policies Revenue Recognition We recognize revenue upon shipment or delivery to our customers based on written sales terms that do not allow for a right of return. However, our policy for direct-store- delivery (DSD) and chilled products is to remove and replace damaged and out-of- date products from store shelves to ensure that our consumers receive the product quality and freshness that they expect. Similarly, our policy for warehouse distrib- uted products is to replace damaged and out-of-date products. Based on our histori- cal experience with this practice, we have reserved for anticipated damaged and out- of-date products. For additional unaudited information on our revenue recognition and related policies, including our policy on bad debts, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis. We are exposed to concentration of credit risk by our customers, Wal-Mart and PBG. Wal-Mart represents approxi- mately 9% of our net revenue, including concentrate sales to our bottlers which are used in finished goods sold by them to Wal-Mart; and PBG represents approxi- mately 10%. We have not experienced credit issues with these customers. Sales Incentives and Other Marketplace Spending We offer sales incentives and discounts through various programs to our customers and consumers. Sales incentives and dis- counts are accounted for as a reduction of revenue and totaled $8.9 billion in 2005, $7.8 billion in 2004 and $7.1 billion in 2003. While most of these incentive arrangements have terms of no more than one year, certain arrangements extend beyond one year. For example, fountain pouring rights may extend up to 15 years. Costs incurred to obtain these arrange- ments are recognized over the contract period and the remaining balances of $321 million at December 31, 2005 and $337 million at December 25, 2004 are included in current assets and other assets in our Consolidated Balance Sheet. For additional unaudited information on our sales incentives, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis. Other marketplace spending includes the costs of advertising and other marketing activities and is reported as selling, general and administrative expenses. Advertising expenses were $1.8 billion in 2005, $1.7 billion in 2004 and $1.6 billion in 2003. Deferred advertising costs are not expensed until the year first used and consist of: • media and personal service prepayments, • promotional materials in inventory, and • production costs of future media advertising. Deferred advertising costs of $202 mil- lion and $137 million at year-end 2005 and 2004, respectively, are classified as prepaid expenses in our Consolidated Balance Sheet. Distribution Costs Distribution costs, including the costs of shipping and handling activities, are reported as selling, general and administra- tive expenses. Shipping and handling expenses were $4.1 billion in 2005, $3.9 billion in 2004 and $3.6 billion in 2003. Cash Equivalents Cash equivalents are investments with original maturities of three months or less which we do not intend to rollover beyond three months. Software Costs We capitalize certain computer software and software development costs incurred in connection with developing or obtaining computer software for internal use. Capitalized software costs are included in property, plant and equipment on our Consolidated Balance Sheet and amortized on a straight-line basis over the estimated useful lives of the software, which gener- ally do not exceed 5 years. Net capitalized software and development costs were $327 million at December 31, 2005 and $181 million at December 25, 2004. 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 lia- bilities for contingencies and commitments when a loss is probable and estimable. For additional information on our commit- ments, see Note 9. Other Significant Accounting Policies Our other significant accounting policies are disclosed as follows: • Property, Plant and Equipment and Intangible Assets — Note 4 and, for additional unaudited information on brands and goodwill, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis. • Income Taxes — Note 5 and, for addi- tional unaudited information, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis. • Stock-Based Compensation Expense — Note 6 and, for additional unaudited information, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis. • Pension, Retiree Medical and Savings Plans — Note 7 and, for additional unaudited information, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis. • Risk Management — Note 10 and, for additional unaudited information, see “Our Business Risks” in Management’s Discussion and Analysis. There have been no new accounting pronouncements issued or effective during 2005 that have had, or are expected to have, a material impact on our consoli- dated financial statements. 57 notesv26L01P54_76v5.qxd 3/7/06 12:01 PM Page 58 Note 3 — Restructuring and Impairment Charges and Merger-Related Costs 2005 Restructuring Charges In the fourth quarter of 2005, we incurred a charge of $83 million ($55 million after- tax or $0.03 per share) in conjunction with actions taken to reduce costs in our opera- tions, principally through headcount reduc- tions. Of this charge, $34 million related to FLNA, $21 million to PBNA, $16 million to PI and $12 million to Corporate (recorded in corporate unallocated expenses). Most of this charge related to the termination of approximately 700 employees. We expect the substantial portion of the cash payments related to this charge to be paid in 2006. 2004 and 2003 Restructuring and Impairment Charges In the fourth quarter of 2004, we incurred a charge of $150 million ($96 million after-tax or $0.06 per share) in conjunc- tion with the consolidation of FLNA’s manufacturing network as part of its ongo- ing productivity program. Of this charge, $93 million related to asset impairment, 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. Through December 31, 2005, we have paid $47 million and incurred non-cash charges of $10 million, leaving substantially no accrual. In the fourth quarter of 2003, we incurred a charge of $147 million ($100 million after-tax or $0.06 per share) in conjunction with actions taken to streamline our North American divisions and PepsiCo International. These actions were taken to increase focus and eliminate redundancies at PBNA and PI and to improve the efficiency of the supply chain at FLNA. Of this charge, $81 million related to asset impairment, reflecting $57 million for the closure of a snack plant in Kentucky, the retirement of snack manufacturing lines in Maryland and Arkansas and $24 million for the closure of a PBNA office building in Florida. The remaining $66 million included employee- related costs of $54 million and facility and other exit costs of $12 million. Employee-related costs primarily reflect the termination costs for approximately 850 sales, distribution, manufacturing, research and marketing employees. As of December 31, 2005, all terminations had occurred and substantially no accrual remains. Merger-Related Costs In connection with the Quaker merger in 2001, we recognized merger-related costs of $59 million ($42 million after-tax or $0.02 per share) in 2003. Note 4 — Property, Plant and Equipment and Intangible Assets Average Useful Life 2005 2004 2003 Property, plant and equipment, net Land and improvements Buildings and improvements Machinery and equipment, including fleet and software Construction in progress 10 – 30 yrs. 20 – 44 5 – 15 Accumulated depreciation Depreciation expense Amortizable intangible assets, net Brands Other identifiable intangibles 5 – 40 3 – 15 Accumulated amortization Amortization expense $ 685 3,736 11,658 1,066 17,145 (8,464) $ 8,681 $1,103 $1,054 257 1,311 (781) $ 530 $150 $ 646 3,605 10,950 729 15,930 (7,781) $ 8,149 $1,062 $1,008 225 1,233 (635) $ 598 $147 $1,020 $145 Depreciation and amortization are recognized on a straight-line basis over an asset’s estimated useful life. Land is not depreciated and construction in progress is not depreciated until ready for service. Amortization of intangible assets for each of the next five years, based on average 2005 foreign exchange rates, is expected to be $152 million in 2006, $35 million in 2007, $35 million in 2008, $34 mil- lion in 2009 and $33 million in 2010. Depreciable and amortizable assets are only evaluated for impairment upon a significant change in the operating or macroeconomic environment. In these circumstances, if an evaluation of the undiscounted cash flows indicates impair- ment, 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 revi- sion. For additional unaudited information on our amortizable brand policies, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis. 58 R1_notes_v26.qxd 3/1/06 11:06 PM Page 59 Nonamortizable Intangible Assets Perpetual brands and goodwill are assessed for impairment at least annually to ensure that discounted future cash flows continue to exceed the related book value. A perpetual brand is impaired if its book value exceeds its fair value. Goodwill is evaluated for impairment if the book value of its reporting unit exceeds its fair value. A reporting unit can be a division or business within a division. If the fair value of an evaluated asset is less than its book value, the asset is written down based on its discounted future cash flows to fair value. No impairment charges resulted from the required impairment evaluations. The change in the book value of nonamortizable intangible assets is as follows: Balance, Beginning 2004 Acquisition Translation and Other Balance, End of 2004 Acquisition Translation and Other Balance, End of 2005 $ 130 $ – $ $ 138 $ – $ Frito-Lay North America Goodwill PepsiCo Beverages North America Goodwill Brands PepsiCo International Goodwill Brands Quaker Foods North America Goodwill Corporate Pension intangible Total goodwill Total brands Total pension intangible 2,157 59 2,216 1,334 808 2,142 175 2 3,796 867 2 $4,665 – – – 29 – 29 – – 29 – – $29 8 4 – 4 72 61 133 – 3 84 61 3 $148 2,161 59 2,220 1,435 869 2,304 175 5 3,909 928 5 $ 4,842 – – – 278 263 541 – – 278 263 – $541 7 3 – 3 (109) (106) (215) – (4) (99) (106) (4) $(209) $ 145 2,164 59 2,223 1,604 1,026 2,630 175 1 4,088 1,085 1 $5,174 59 notesv26L01P54_76v4.qxd 3/7/06 1:45 AM Page 60 Note 5 — Income Taxes Income before income taxes — continuing operations U.S.................................................................................................................................................... Foreign.............................................................................................................................................. Provision for income taxes — continuing operations Current: U.S. Federal....................................................................................................................... Foreign .............................................................................................................................. State ................................................................................................................................. Deferred: U.S. Federal ....................................................................................................................... Foreign .............................................................................................................................. State ................................................................................................................................. Tax rate reconciliation — continuing operations U.S. Federal statutory tax rate .......................................................................................................... State income tax, net of U.S. Federal tax benefit.............................................................................. Taxes on AJCA repatriation................................................................................................................ Lower taxes on foreign results .......................................................................................................... Settlement of prior years’ audit ........................................................................................................ Other, net.......................................................................................................................................... Annual tax rate ................................................................................................................................. Deferred tax liabilities Investments in noncontrolled affiliates ............................................................................................ Property, plant and equipment ......................................................................................................... Pension benefits ............................................................................................................................... Intangible assets other than nondeductible goodwill....................................................................... Zero coupon notes ............................................................................................................................ Other................................................................................................................................................. Gross deferred tax liabilities............................................................................................................. Deferred tax assets Net carryforwards ............................................................................................................................. Stock-based compensation............................................................................................................... Retiree medical benefits................................................................................................................... Other employee-related benefits....................................................................................................... Other................................................................................................................................................. Gross deferred tax assets ................................................................................................................. Valuation allowances........................................................................................................................ Deferred tax assets, net.................................................................................................................... Net deferred tax liabilities ................................................................................................................ 2005 $3,175 3,207 $6,382 $1,638 426 118 2,182 137 (26) 11 122 $2,304 35.0% 1.4 7.0 (6.5) – (0.8) 36.1% $ 993 772 863 135 35 169 2,967 608 426 400 342 520 2,296 (532) 1,764 $1,203 Deferred taxes included within: Prepaid expenses and other current assets.................................................................................. Deferred income taxes .................................................................................................................. $231 $1,434 Analysis of valuation allowances Balance, beginning of year............................................................................................................... (Benefit)/provision........................................................................................................................ Other (deductions)/additions........................................................................................................ Balance, end of year......................................................................................................................... $564 (28) (4) $532 60 2004 $2,946 2,600 $5,546 $1,030 256 69 1,355 11 5 1 17 $1,372 35.0% 0.8 – (5.4) (4.8) (0.9) 24.7% $ 850 857 669 153 46 157 2,732 666 402 402 379 460 2,309 (564) 1,745 $ 987 $229 $1,216 $438 118 8 $564 2003 $3,267 1,725 $4,992 $1,326 341 80 1,747 (274) (47) (2) (323) $1,424 35.0% 1.0 – (5.5) (2.2) 0.2 28.5% $487 (52) 3 $438 R1_notes_v26.qxd 3/1/06 11:06 PM Page 61 For additional unaudited information on our income tax policies, including our reserves for income taxes, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis. Carryforwards, Credits and Allowances Operating loss carryforwards totaling $5.1 billion at year-end 2005 are being carried forward in a number of foreign and state jurisdictions where we are permitted to use tax operating losses from prior peri- ods to reduce future taxable income. These operating losses will expire as follows: $0.1 billion in 2006, $4.1 billion between 2007 and 2025 and $0.9 billion may be carried forward indefinitely. In addition, certain tax credits generated in prior peri- ods of approximately $39.4 million are available to reduce certain foreign tax liabilities through 2011. We establish valuation allowances for our deferred tax assets when the amount of expected future taxable income is not likely to support the use of the deduction or credit. Undistributed International Earnings The AJCA created a one-time incentive for U.S. corporations to repatriate undistrib- uted international earnings by providing an 85% dividends received deduction. As approved by our Board of Directors in July 2005, we repatriated approximately $7.5 billion in earnings previously consid- ered indefinitely reinvested outside the U.S. in the fourth quarter of 2005. In 2005, we recorded income tax expense of $460 mil- lion associated with this repatriation. Other than the earnings repatriated, we intend to continue to reinvest earnings outside the U.S. for the foreseeable future and, there- fore, have not recognized any U.S. tax expense on these earnings. At December 31, 2005, we had approximately $7.5 bil- lion of undistributed international earnings. Reserves A number of years may elapse before a par- ticular matter, for which we have established a reserve, is audited and finally resolved. The number of years with open tax audits varies depending on the tax jurisdiction. During 2004, we recognized $266 million of tax benefits related to the favorable resolu- tion of certain open tax issues. In addition, in 2004, we recognized a tax benefit of $38 million upon agreement with the IRS on an open issue related to our discontinued restaurant operations. At the end of 2003, we entered into agreements with the IRS for open years through 1997. These agreements resulted in a tax benefit of $109 million in the fourth quarter of 2003. As part of these agreements, we also resolved the treatment of certain other issues related to future tax years. The IRS has initiated their audits of our tax returns for the years 1998 through 2002. Our tax returns subsequent to 2002 have not yet been examined. While it is often difficult to predict the final outcome or the timing of resolution of any particular tax matter, we believe that our reserves reflect the probable outcome of known tax contin- gencies. Settlement of any particular issue would usually require the use of cash. Favorable resolution would be recognized as a reduction to our annual tax rate in the year of resolution. Our tax reserves, covering all federal, state and foreign jurisdictions, are presented in the balance sheet within other liabilities (see Note 14), except for any amounts relating to items we expect to pay in the coming year which are included in current income taxes payable. For further unaudited information on the impact of the resolution of open tax issues, see “Other Consolidated Results.” Note 6 — Stock-Based Compensation Our stock-based compensation program is a broad-based program designed to attract and retain employees while also aligning employees’ interests with the interests of our shareholders. Employees at all levels participate in our stock-based compensa- tion program. In addition, members of our Board of Directors participate in our stock- based compensation program in connec- tion with their service on our Board. Stock options and RSUs are granted to employ- ees under the shareholder-approved 2003 Long-Term Incentive Plan (LTIP), our only active stock-based plan. Stock-based compensation expense was $311 million in 2005, $368 million in 2004 and $407 million in 2003. Related income tax benefits recognized in earnings were $87 million in 2005, $103 million in 2004 and $114 million in 2003. At year- end 2005, 51 million shares were avail- able for future executive and SharePower grants. For additional unaudited informa- tion on our stock-based compensation pro- gram, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis. cise price of previously issued awards, and any repricing of awards would require approval of our shareholders. SharePower Grants SharePower options are awarded under our LTIP to all eligible employees, based on job level or classification, and in the case of international employees, tenure as well. All stock option grants have an exercise price equal to the fair market value of our common stock on the day of grant and generally have a 10-year term with vesting after three years. Executive Grants All senior management and certain middle management are eligible for executive grants under our LTIP. All stock option grants have an exercise price equal to the fair market value of our common stock on the day of grant and generally have a 10-year term with vesting after three years. There have been no reductions to the exer- Beginning in 2004, executives who are awarded long-term incentives based on their performance are offered the choice of stock options or RSUs. RSU expense is based on the fair value of PepsiCo stock on the date of grant and is amortized over the vesting period, generally three years. Each restricted stock unit can be settled in a share of our stock after the vesting period. Executives who elect RSUs receive one RSU for every four stock options that would have otherwise been granted. Senior offi- cers do not have a choice and are granted 50% stock options and 50% RSUs. Vesting of RSU awards for senior officers is contingent upon the achievement of pre-established performance targets. We granted 3 million RSUs in both 2005 and 2004 with weighted-average intrinsic val- ues of $53.83 and $47.28, respectively. 61 notesv26L01P54_76v3.qxd 3/4/06 3:09 AM Page 62 Method of Accounting and Our Assumptions We account for our employee stock options under the fair value method of accounting using a Black-Scholes valuation model to measure stock-based compensation expense at the date of grant. We adopted SFAS 123R, Share-Based Payment, under the modified prospective method in the first quarter of 2006. We do not expect our adoption of SFAS 123R to materially impact our financial statements. Our Stock Option Activity(a) Our weighted-average Black-Scholes fair value assumptions include: Expected life Risk free interest rate Expected volatility Expected dividend yield 2005 6 yrs. 3.8% 23% 1.8% 2004 6 yrs. 3.3% 26% 1.8% 2003 6 yrs. 3.1% 27% 1.15% Outstanding at beginning of year Granted Exercised Forfeited/expired Outstanding at end of year Exercisable at end of year Options 174,261 12,328 (30,945) (5,495) 150,149 89,652 2005 Average Price(b) $40.05 53.82 35.40 43.31 42.03 40.52 Options 198,173 14,137 (31,614) (6,435) 174,261 94,643 2004 Average Price(b) $38.12 47.47 30.57 43.82 40.05 36.41 2003 Options Average Price(b) 190,432 41,630 (25,833) (8,056) 198,173 $36.45 39.89 26.74 43.56 38.12 97,663 32.56 Stock options outstanding and exercisable at December 31, 2005(a) Range of Exercise Price $14.40 to $21.54 $23.00 to $33.75 $34.00 to $43.50 $43.75 to $56.75 Options Outstanding Options Average Price(b) Average Life(c) $ 20.01 30.46 39.44 49.77 42.03 905 14,559 82,410 52,275 150,149 3.56 yrs. 3.07 5.34 7.17 5.67 Options Exercisable Options Average Price(b) Average Life(c) $20.01 30.50 39.19 49.48 40.52 905 14,398 48,921 25,428 89,652 3.56 yrs. 3.05 4.10 6.09 4.45 (a) Options are in thousands and include options previously granted under Quaker plans. No additional options or shares may be granted under the Quaker plans. (b) Weighted-average exercise price. (c) Weighted-average contractual life remaining. Our RSU Activity(a) Outstanding at beginning of year Granted Converted Forfeited/expired Outstanding at end of year (a) RSUs are in thousands. (b) Weighted-average intrinsic value. (c) Weighted-average contractual life remaining. Other stock-based compensation data 2005 Average Intrinsic Value(b) $47.30 53.83 48.73 50.51 50.70 RSUs 2,922 3,097 (91) (259) 5,669 Average Life(c) 1.8 yrs. RSUs – 3,077 (18) (137) 2,922 2004 Average Intrinsic $ Value(b) – 47.28 47.25 47.25 47.30 Average Life(c) 2.2 yrs. Weighted-average fair value of options granted Total intrinsic value of options/RSUs exercised/converted(a) Total intrinsic value of options/RSUs outstanding(a) Total intrinsic value of options exercisable(a) (a) In thousands. 2005 $13.45 $632,603 $2,553,594 $1,662,198 Stock Options 2004 $12.04 $667,001 $2,062,153 $1,464,926 2003 $11.21 $466,719 $1,641,505 $1,348,658 RSUs 2005 2004 $4,974 $334,931 $914 $151,760 At December 31, 2005, there was $315 million of total unrecognized compensation cost related to nonvested share-based compensation grants. This unrecognized compensation is expected to be recognized over a weighted-average period of 1.6 years. 62 notesv26L01P54_76v5.qxd 3/7/06 12:56 PM Page 63 Note 7 — Pension, Retiree Medical and Savings Plans Our pension plans cover full-time employ- ees in the U.S. and certain international employees. Benefits are determined based on either years of service or a combination of years of service and earnings. U.S. retirees are also eligible for medical and life insurance benefits (retiree medical) if they meet age and service requirements. Generally, our share of retiree medical costs is capped at specified dollar amounts, which vary based upon years of service, with retirees contributing the remainder of the costs. We use a September 30 measurement date and all plan assets and liabilities are generally reported as of that date. The cost or benefit of plan changes that increase or decrease benefits for prior employee service (prior service cost) is included in expense on a straight-line basis over the average remaining service period of employees expected to receive benefits. The Medicare Act was signed into law in December 2003 and we applied the provi- sions of the Medicare Act to our plans in 2005 and 2004. The Medicare Act provides a subsidy for sponsors of retiree medical plans who offer drug benefits equivalent to those provided under Medicare. As a result of the Medicare Act, our 2005 and 2004 retiree medical costs were $11 million and $7 million lower, respectively, and our 2005 and 2004 lia- bilities were reduced by $136 million and $80 million, respectively. We expect our 2006 retiree medical costs to be approxi- mately $18 million lower than they other- wise would have been as a result of the Medicare Act. For additional unaudited information on our pension and retiree medical plans and related accounting policies and assump- tions, see “Our Critical Accounting Policies” in Management’s Discussion and Analysis. Weighted-average assumptions Liability discount rate........................................................ Expense discount rate........................................................ Expected return on plan assets ......................................... Rate of compensation increases........................................ Components of benefit expense Service cost....................................................................... Interest cost...................................................................... Expected return on plan assets ........................................ Amortization of prior service cost/(benefit)....................... Amortization of experience loss......................................... Benefit expense................................................................. Settlement/curtailment loss ............................................. Special termination benefits............................................. Total.................................................................................. 2005 5.7% 6.1% 7.8% 4.4% $ 213 296 (344) 3 106 274 – 21 $ 295 2004 U.S. 6.1% 6.1% 7.8% 4.5% $ 193 271 (325) 6 81 226 4 19 $ 249 Pension 2003 2005 2004 International 2003 Retiree Medical 2004 2005 2003 6.1% 6.7% 8.3% 4.5% 5.1% 6.1% 8.0% 4.1% 6.1% 6.1% 8.0% 3.9% 6.1% 5.7% 6.4% 6.1% 8.0% 3.8% – – 6.1% 6.1% – – 6.1% 6.7% – – $ 153 245 (305) 6 44 143 – 4 $ 147 $ 32 55 (69) 1 15 34 – – $ 34 $ 27 47 (65) 1 9 19 1 1 $ 21 $ 24 39 (54) – 5 14 – – $ 14 $ 40 78 – (11) 26 133 – 2 $135 $ 38 72 – (8) 19 121 – 4 $125 $ 33 73 – (3) 13 116 – – $116 63 notesv26L01P54_76v5.qxd 3/7/06 1:07 PM Page 64 2005 2004 2005 2004 2005 2004 Pension Retiree Medical U.S. International Change in projected benefit liability Liability at beginning of year Service cost Interest cost Plan amendments Participant contributions Experience loss/(gain) Benefit payments Settlement/curtailment loss Special termination benefits Foreign currency adjustment Other Liability at end of year Liability at end of year for service to date Change in fair value of plan assets Fair value at beginning of year Actual return on plan assets Employer contributions/funding Participant contributions Benefit payments Settlement/curtailment loss Foreign currency adjustment Other Fair value at end of year $4,968 213 296 – – 517 (241) – 21 – (3) $5,771 $4,783 $4,152 477 699 – (241) – – (1) $5,086 Funded status as recognized in our Consolidated Balance Sheet $ (685) Funded status at end of year 5 Unrecognized prior service cost/(benefit) 2,288 Unrecognized experience loss 5 Fourth quarter benefit payments $1,613 Net amounts recognized Net amounts as recognized in our Consolidated Balance Sheet $2,068 Other assets – Intangible assets (479) Other liabilities 24 Accumulated other comprehensive loss $1,613 Net amounts recognized Components of increase in unrecognized experience loss Decrease in discount rate Employee-related assumption changes Liability-related experience different from assumptions Actual asset return different from expected return Amortization of losses Other, including foreign currency adjustments and 2003 Medicare Act Total $ 365 57 95 (133) (106) (3) $ 275 $4,456 193 271 (17) – 261 (205) (9) 18 – – $4,968 $4,164 $3,558 392 416 – (205) (9) – – $4,152 $ (817) 9 2,013 5 $1,210 $1,572 – (387) 25 $1,210 $ – 196 65 (67) (81) (5) $108 Selected information for plans with liability for service to date in excess of plan assets Liability for service to date Projected benefit liability Fair value of plan assets $ (374) $ (815) $8 $(320) $(685) $11 $ 952 32 55 3 10 203 (28) – – (68) 104 $1,263 $1,047 $ 838 142 104 10 (28) – (61) 94 $1,099 $(164) 17 474 4 $ 331 $367 1 (41) 4 $331 $194 2 7 (73) (15) (22) $ 93 $(65) $(84) $33 $758 27 47 1 9 73 (29) (2) 1 67 – $952 $779 $687 77 37 9 (29) (2) 59 – $838 $(113) 13 380 7 $ 287 $294 5 (37) 25 $287 $ 4 65 4 (12) (9) 26 $ 78 $(191) $(227) $161 $1,319 40 78 (8) – (45) (74) – 2 – – $1,312 $ – – 74 – (74) – – – $ – $(1,312) (113) 402 19 $(1,004) $ – – (1,004) – $(1,004) $ 61 – (54) – (26) (52) $(71) $1,264 38 72 (41) – 58 (76) – 4 – – $1,319 $ – – 76 – (76) – – – $ – $(1,319) (116) 473 19 $ (943) $ – – (943) – $(943) $ – 109 31 – (19) (82) $ 39 $(1,312) $(1,312) $– $(1,319) $(1,319) $– Of the total projected pension benefit liability at year-end 2005, $765 million relates to plans that we do not fund because the funding of such plans does not receive favorable tax treatment. 64 notesv26L01P54_76v4.qxd 3/7/06 1:45 AM Page 65 Future Benefit Payments Our estimated future benefit payments are as follows: Pension Retiree medical 2006 $235 $85 2007 $255 $90 2008 $275 $90 2009 $300 $95 2010 $330 $100 2011-15 $2,215 $545 These future benefits to beneficiaries include payments from both funded and unfunded pension plans. Pension Assets The expected return on pension plan assets is based on our historical experi- ence, our pension plan investment guide- lines, and our expectations for long-term rates of return. We use a market-related value method that recognizes each year’s asset gain or loss over a five-year period. Therefore, it takes five years for the gain or loss from any one year to be fully included in the value of pension plan assets that is used to calculate the expected return. Our pension plan investment guidelines are established based upon an evaluation of market conditions, tolerance for risk and cash requirements for benefit payments. Our investment objective is to ensure that funds are available to meet the plans’ ben- efit obligations when they are due. Our investment strategy is to prudently invest plan assets in high-quality and diversified equity and debt securities to achieve our long-term return expectation. Our target allocation and actual pension plan asset allocations for the plan years 2005 and 2004, are below. Pension assets include approximately 5.5 million shares of PepsiCo common stock with a market value of $311 million in 2005, and 5.5 million shares with a market value of $267 million in 2004. Our investment policy limits the investment in PepsiCo stock at the time of investment to 10% of the fair value of plan assets. Asset Category Equity securities Debt securities Other, primarily cash Total Actual Allocation Target Allocation 60% 40% – 100% 2005 60% 39% 1% 100% 2004 60% 39% 1% 100% Retiree Medical Cost Trend Rates An average increase of 10% in the cost of covered retiree medical benefits is assumed for 2006. This average increase is then projected to decline gradually to 5% in 2010 and thereafter. These assumed health care cost trend rates have an impact on the retiree medical plan expense and liability. However, the cap on our share of retiree medical costs limits 2005 service and interest cost components 2005 benefit liability 1% Increase $3 $38 1% Decrease $(2) $(33) the impact. A 1 percentage point change in the assumed health care trend rate would have the following effects: Savings Plans Our U.S. employees are eligible to partici- pate in 401(k) savings plans, which are voluntary defined contribution plans. The plans are designed to help employees accumulate additional savings for retire- ment. We make matching contributions on a portion of eligible pay based on years of service. In 2005 and 2004, our matching contributions were $52 million and $35 million, respectively. Note 8 — Noncontrolled Bottling Affiliates Our most significant noncontrolled bottling affiliates are PBG and PAS. Approximately 10% of our net revenue in 2005, 2004 and 2003 reflects sales to PBG. The Pepsi Bottling Group In addition to approximately 41% and 42% of PBG’s outstanding common stock that we own at year-end 2005 and 2004, respectively, we own 100% of PBG’s class B common stock and approximately 7% of the equity of Bottling Group, LLC, PBG’s principal operating subsidiary. This gives us economic ownership of approximately 45% and 46% of PBG’s combined opera- tions at year-end 2005 and 2004, respec- tively. In 2005, bottling equity income includes $126 million of pre-tax gains on our sales of PBG stock. 65 notesv26L01P54_76v4.qxd 3/7/06 1:45 AM Page 66 PBG’s summarized financial information is as follows: Current assets Noncurrent assets Total assets Current liabilities Noncurrent liabilities Minority interest Total liabilities Our investment Net revenue Gross profit Operating profit Net income 2005 $ 2,412 9,112 $11,524 $2,598 6,387 496 $9,481 $1,738 $11,885 $5,632 $1,023 $466 2004 $ 2,183 8,754 $10,937 $1,725 6,818 445 $8,988 $1,594 $10,906 $5,250 $976 $457 2003 $10,265 $5,050 $956 $416 PepsiAmericas At year-end 2005 and 2004, we owned approximately 43% and 41% of PepsiAmericas, respectively, and their summarized financial information is as follows: Current assets Noncurrent assets Total assets Current liabilities Noncurrent liabilities Total liabilities Our investment Net revenue Gross profit Operating profit Net income 2005 $ 598 3,456 $4,054 $ 722 1,763 $2,485 $968 $3,726 $1,562 $393 $195 2004 $ 530 3,000 $3,530 $ 521 1,386 $1,907 $924 $3,345 $1,423 $340 $182 2003 $3,237 $1,360 $316 $158 Our investment in PBG, which includes the related goodwill, was $400 million and $321 million higher than our ownership interest in their net assets at year-end 2005 and 2004, respectively. Based upon the quoted closing price of PBG shares at year-end 2005 and 2004, the calculated market value of our shares in PBG, exclud- ing our investment in Bottling Group, LLC, exceeded our investment balance by approximately $1.5 billion and $1.7 billion, respectively. Our investment in PAS, which includes the related goodwill, was $292 million and $253 million higher than our owner- ship interest in their net assets at year-end 2005 and 2004, respectively. Based upon the quoted closing price of PAS shares at year-end 2005 and 2004, the calculated market value of our shares in PepsiAmericas exceeded our investment balance by approximately $364 million and $277 million, respectively. In January 2005, PAS acquired a regional bottler, Central Investment Corporation. The table above includes the results of Central Investment Corporation from the transaction date forward. Related Party Transactions Our significant related party transactions involve our noncontrolled bottling affiliates. We sell concentrate to these affiliates, which is used in the production of carbon- ated soft drinks and non-carbonated bever- ages. We also sell certain finished goods to these affiliates and we receive royalties for the use of our trademarks for certain products. Sales of concentrate and finished goods are reported net of bottler funding. For further unaudited information on these bottlers, see “Our Customers” in Management’s Discussion and Analysis. These transactions with our bottling affiliates are reflected in our consolidated financial statements as follows: Net revenue Selling, general and administrative expenses Accounts and notes receivable Accounts payable and other current liabilities 2005 $4,633 $143 $178 $117 2004 $ 4,170 $114 $157 $95 2003 $3,699 $128 Such amounts are settled on terms consistent with other trade receivables and payables. See Note 9 regarding our guaran- tee of certain PBG debt. In addition, we coordinate, on an aggre- gate basis, the negotiation and purchase of sweeteners and other raw materials requirements for certain of our bottlers with suppliers. Once we have negotiated the contracts, the bottlers order and take delivery directly from the supplier and pay the suppliers directly. Consequently, these transactions are not reflected in our consolidated financial statements. As the 66 contracting party, we could be liable to these suppliers in the event of any nonpay- ment by our bottlers, but we consider this exposure to be remote. notesv26L01P54_76v3.qxd 3/4/06 3:10 AM Page 67 Note 9 — Debt Obligations and Commitments Short-term debt obligations Current maturities of long-term debt Commercial paper (3.3% and 1.6%) Other borrowings (7.4% and 6.6%) Amounts reclassified to long-term debt Long-term debt obligations Short-term borrowings, reclassified Notes due 2006-2026 (5.4% and 4.7%) Zero coupon notes, $475 million due 2006-2012 (13.4%) Other, due 2006-2014 (6.3% and 6.2%) Less: current maturities of long-term debt obligations 2005 2004 $ 143 3,140 356 (750) $2,889 $ 750 1,161 312 233 2,456 (143) $2,313 $ 160 1,287 357 (750) $1,054 $ 750 1,274 321 212 2,557 (160) $2,397 The interest rates in the above table reflect weighted-average rates as of year-end. Short-term borrowings are reclassified to long-term when we have the intent and ability, through the existence of the unused lines of credit, to refinance these borrow- ings on a long-term basis. At year-end 2005, we maintained $2.1 billion in corporate lines of credit subject to normal banking terms and conditions. These credit facilities support short-term debt issuances and remained unused as of December 31, 2005. Of the $2.1 billion, $1.35 billion expires in May 2006 with the remaining $750 million expiring in June 2009. In addition, $181 million of our debt was outstanding on various lines of credit maintained for our international divisions. These lines of credit are subject to normal banking terms and conditions and are committed to the extent of our borrowings. Interest Rate Swaps We entered into interest rate swaps in 2004 to effectively convert the interest rate of a specific debt issuance from a fixed rate of 3.2% to a variable rate. The vari- able weighted-average interest rate that we pay is linked to LIBOR and is subject to change. The notional amount of the inter- est rate swaps outstanding at December 31, 2005 and December 25, 2004 was $500 million. The terms of the interest rate swaps match the terms of the debt they modify. The swaps mature in 2007. At December 31, 2005, approximately 78% of total debt, after the impact of the associated interest rate swaps, was exposed to variable interest rates, compared to 67% at December 25, 2004. In addition to vari- able rate long-term debt, all debt with matu- rities of less than one year is categorized as variable for purposes of this measure. Cross Currency Interest Rate Swaps In 2004, we entered into a cross currency interest rate swap to hedge the currency exposure on U.S. dollar denominated debt of $50 million held by a foreign affiliate. The terms of this swap match the terms of the debt it modifies. The swap matures in 2008. The unrecognized gain related to this swap was less than $1 million at December 31, 2005, resulting in a U.S. dollar liability of $50 million. At December 25, 2004, the unrecognized loss related to this swap was $3 million, resulting in a U.S. dollar liability of $53 million. We have also entered into cross currency interest rate swaps to hedge the currency exposure on U.S. dollar denominated intercompany debt of $125 million. The terms of the swaps match the terms of the debt they modify. The swaps mature over the next two years. The net unrecognized gain related to these swaps was $5 million at December 31, 2005. The net unrecog- nized loss related to these swaps was less than $1 million at December 25, 2004. Long-Term Contractual Commitments Payments Due by Period Long-term debt obligations(a) .......................................................... Operating leases ............................................................................. Purchasing commitments(b) ............................................................ Marketing commitments.................................................................. Other commitments......................................................................... Total $2,313 769 4,533 1,487 99 $9,201 $ 2006 – 187 1,169 412 82 $1,850 2007-2008 $1,052 253 1,630 438 10 $3,383 2009-2010 2011 and beyond $ 385 197 959 256 1 $1,798 $ 876 132 775 381 6 $2,170 (a) Excludes current maturities of long-term debt of $143 million which are classified within current liabilities. (b) Includes approximately $13 million of long-term commitments which are reflected in other liabilities in our Consolidated Balance Sheet. The above table reflects non-cancelable commitments as of December 31, 2005 based on year-end foreign exchange rates. 67 R1_notes_v26.qxd 3/1/06 11:07 PM Page 68 Most long-term contractual commit- ments, except for our long-term debt obligations, are not recorded in our Consolidated Balance Sheet. Non-cance- lable operating leases primarily represent building leases. Non-cancelable purchasing commitments are primarily for oranges and orange juices to be used for our Tropicana brand beverages. Non-cancelable marketing commitments primarily are for sports marketing and with our fountain customers. Bottler funding is not reflected in our long-term contractual commitments as it is negotiated on an annual basis. See Note 7 regarding our pension and retiree medical obligations and discussion below regarding our commitments to noncontrolled bottling affiliates and former restaurant operations. 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. In connection with these transactions, we have guaranteed $2.3 billion of Bottling Group, LLC’s long-term debt through 2012 and $28 million of YUM! Brands, Inc. (YUM) outstanding obligations, primarily property leases, through 2020. The terms of our Bottling Group, LLC debt guarantee are intended to preserve the structure of PBG’s separation from us and our payment obligation would be triggered if Bottling Group, LLC failed to perform under these debt obligations or the structure signifi- cantly changed. Our guarantees of certain obligations ensured YUM’s continued use of certain properties. These guarantees would require our cash payment if YUM failed to perform under these lease obligations. See “Our Liquidity, Capital Resources and Financial Position” in Management’s Discussion and Analysis for further unaudited information on our borrowings. Note 10 — Risk Management We are exposed to the risk of loss arising from adverse changes in: • commodity prices, affecting the cost of our raw materials and energy, • foreign exchange risks, • interest rates, • stock prices, and • discount rates affecting the measure- ment of our pension and retiree medical liabilities. In the normal course of business, we manage these risks through a variety of strategies, including the use of derivatives. Certain derivatives are designated as either cash flow or fair value hedges and qualify for hedge accounting treatment, while oth- ers do not qualify and are marked to market through earnings. See “Our Business Risks” in Management’s Discussion and Analysis for further unaudited information on our business risks. For cash flow hedges, changes in fair value are deferred in accumulated other comprehensive loss within shareholders’ equity until the underlying hedged item is recognized in net income. For fair value hedges, changes in fair value are recognized immediately in earnings, consistent with the underlying hedged item. Hedging transac- tions are limited to an underlying exposure. As a result, any change in the value of our derivative instruments would be substan- tially offset by an opposite change in the value of the underlying hedged items. Hedging ineffectiveness and a net earnings impact occur when the change in the value of the hedge does not offset the change in the value of the underlying hedged item. If the derivative instrument is terminated, we continue to defer the related gain or loss and include it as a component of the cost of the underlying hedged item. Upon determi- nation that the underlying hedged item will not be part of an actual transaction, we recognize the related gain or loss in net income in that period. We also use derivatives that do not qualify for hedge accounting treatment. We account for such derivatives at market value with the resulting gains and losses reflected in our income statement. We do not use derivative instruments for trading or speculative purposes and we limit our exposure to individual counterparties to manage credit risk. Commodity Prices We are subject to commodity price risk because our ability to recover increased costs through higher pricing may be limited in the competitive environment in which we operate. This risk is managed through the use of fixed-price purchase orders, pricing agreements, geographic diversity and derivatives. We use deriva- tives, with terms of no more than two years, to economically hedge price fluctua- tions related to a portion of our anticipated commodity purchases, primarily for natural gas and diesel fuel. For those derivatives that are designated as cash flow hedges, any ineffectiveness is recorded immedi- ately. However, our commodity cash flow hedges have not had any significant inef- fectiveness for all periods presented. We classify both the earnings and cash flow impact from these derivatives consistent with the underlying hedged item. During the next 12 months, we expect to reclas- sify gains of $24 million related to cash flow hedges from accumulated other comprehensive loss into net income. Foreign Exchange Our operations outside of the U.S. generate over a third of our net revenue of which Mexico, the United Kingdom and Canada comprise nearly 20%. As a result, we are exposed to foreign currency risks from unforeseen economic changes and political unrest. On occasion, we enter into hedges, primarily forward contracts with terms of no more than two years, to reduce the effect of foreign exchange rates. Ineffectiveness on these hedges has not been material. Interest Rates We centrally manage our debt and invest- ment 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 68 notesv26L01P54_76v3.qxd 3/4/06 3:11 AM Page 69 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. These swaps are entered into only with strong creditworthy counterparties, are settled on a net basis and are of relatively short duration. Stock Prices The portion of our deferred compensation liability that is based on certain market indices and on our stock price is subject to market risk. We hold mutual fund investments and prepaid forward contracts to manage this risk. Changes in the fair value of these investments and contracts are recognized immediately in earnings and are offset by changes in the related compensation liability. Fair Value All derivative instruments are recognized in our Consolidated Balance Sheet at fair value. The fair value of our derivative instru- ments is generally based on quoted market prices. Book and fair values of our derivative and financial instruments are as follows: 2005 2004 Book Value Fair Value Book Value Fair Value Assets Cash and cash equivalents(a) .................................................................................. Short-term investments(b)........................................................................................ Forward exchange contracts(c) ................................................................................. Commodity contracts(d)............................................................................................ Prepaid forward contract(e) ...................................................................................... Cross currency interest rate swaps(f) ....................................................................... Liabilities $35 Forward exchange contracts(c) ................................................................................. $8 Commodity contracts(d)............................................................................................ $3,451 Debt obligations....................................................................................................... $1 Interest rate swaps(g)............................................................................................... Cross currency interest rate swaps(f) ...................................................................... $3 Included in our Consolidated Balance Sheet under the captions noted above or as indicated below. In addition, derivatives are designated as accounting hedges unless otherwise noted below. $1,716 $3,166 $19 $41 $107 $6 $1,280 $2,165 $8 $7 $120 $– $1,716 $3,166 $19 $41 $107 $6 $15 $3 $5,202 $9 $– $15 $3 $5,378 $9 $– $1,280 $2,165 $8 $7 $120 $– $35 $8 $3,676 $1 $3 (a) Book value approximates fair value due to the short maturity. (b) Principally short-term time deposits and includes $124 million at December 31, 2005 and $118 million at December 25, 2004 of mutual fund investments used to manage a portion of market risk arising from our deferred compensation liability. (c) 2005 asset includes $14 million related to derivatives not designated as accounting hedges. Assets are reported within current assets and other assets and liabilities are reported within current liabilities and other liabilities. (d) 2005 asset includes $2 million related to derivatives not designated as accounting hedges and the liability relates entirely to derivatives not designated as accounting hedges. Assets are reported within current assets and other assets and liabilities are reported within current liabilities and other liabilities. (e) Included in current assets and other assets. (f) Asset included within other assets and liability included in long-term debt. (g) Reported in other liabilities. This table excludes guarantees, including our guarantee of $2.3 billion of Bottling Group, LLC’s long-term debt. The guarantee had a fair value of $47 million at December 31, 2005 and $46 million at December 25, 2004 based on an external estimate of the cost to us of transferring the liability to an independent financial institution. See Note 9 for additional information on our guarantees. Note 11 — Net Income per Common Share from Continuing Operations Basic net income per common share is net income available to common shareholders divided by the weighted average of com- mon shares outstanding during the period. Diluted net income per common share is calculated using the weighted average of common shares outstanding adjusted to include the effect that would occur if in-the-money employee stock options were exercised and RSUs and preferred shares were converted into common shares. Options to purchase 3.0 million shares in 2005, 7.0 million shares in 2004 and 49.0 million shares in 2003 were not included in the calculation of diluted earnings per common share because these options were out-of-the-money. Out-of-the- money options had average exercise prices of $53.77 in 2005, $52.88 in 2004 and $48.27 in 2003. 69 R1_notes_v26.qxd 3/1/06 11:07 PM Page 70 The computations of basic and diluted net income per common share from continuing operations are as follows: Net income Preferred shares: Dividends Redemption premium Net income available for common shareholders Basic net income per common share Net income available for common shareholders Dilutive securities: Stock options and RSUs ESOP convertible preferred stock Unvested stock awards Diluted Diluted net income per common share (a) Weighted-average common shares outstanding. 2005 Shares(a) 1,669 1,669 35 2 – 1,706 Income $4,078 (2) (16) $4,060 $2.43 $4,060 – 18 – $4,078 $2.39 2004 Shares(a) 1,696 1,696 31 2 – 1,729 Income $4,174 (3) (22) $4,149 $2.45 $4,149 – 24 – $4,173 $2.41 2003 Shares(a) 1,718 1,718 17 3 1 1,739 Income $3,568 (3) (12) $3,553 $2.07 $3,553 – 15 – $3,568 $2.05 Note 12 — Preferred and Common Stock As of December 31, 2005 and December 25, 2004, there were 3.6 billion shares of common stock and 3 million shares of convertible preferred stock authorized. The preferred stock was issued only for an employee stock ownership plan (ESOP) established by Quaker and these shares are redeemable for common stock by the ESOP participants. The preferred stock accrues dividends at an annual rate of $5.46 per share. At year-end 2005 and 2004, there were 803,953 preferred shares issued and 354,853 and 424,853 shares outstanding, respectively. Each share is convertible at the option of the holder into 4.9625 shares of common stock. The preferred shares may be called by us upon written notice at $78 per share plus accrued and unpaid dividends. As of December 31, 2005, 0.3 million outstanding shares of preferred stock with a fair value of $104 million and 17 million shares of common stock were held in the accounts of ESOP participants. As of December 25, 2004, 0.4 million outstand- ing shares of preferred stock with a fair value of $110 million and 18 million shares of common stock were held in the accounts of ESOP participants. Quaker made the final award to its ESOP plan in June 2001. Preferred stock Repurchased preferred stock Balance, beginning of year Redemptions Balance, end of year *Does not sum due to rounding. 2005 Shares 0.8 Amount $41 2004 Shares 0.8 Amount $41 2003 Shares 0.8 Amount $41 0.4 0.1 0.5 $ 90 19 $110* 0.3 0.1 0.4 $63 27 $90 0.2 0.1 0.3 $48 15 $63 Note 13 — Accumulated Other Comprehensive Loss Comprehensive income is a measure of income which includes both net income and other comprehensive income or loss. Other comprehensive loss results from items deferred on the balance sheet in shareholders’ equity. Other comprehensive (loss)/income was $(167) million in 2005, $381 million in 2004, and $405 million in 2003. The accumulated balances for each component of other comprehensive loss were as follows: Currency translation adjustment Cash flow hedges, net of tax(a) Minimum pension liability adjustment(b) Unrealized gain on securities, net of tax Other Accumulated other comprehensive loss 2005 $ (971) 27 (138) 31 (2) $(1,053) 2004 $(720) (19) (154) 7 – $(886) 2003 $(1,121) (12) (135) 1 – $(1,267) (a) Includes net commodity gains of $55 million in 2005. Also includes no impact in 2005, $6 million gain in 2004 and $8 million gain in 2003 for our share of our equity investees’ accumulated derivative activity. Deferred gains/(losses) reclassified into earnings were $8 million in 2005, $(10) million in 2004 and no impact in 2003. (b) Net of taxes of $72 million in 2005, $77 million in 2004 and $67 million in 2003. Also, includes $120 million in 2005, $121 million in 2004 and $110 million in 2003 for our share of our equity investees’ minimum pension liability adjustments. 70 notesv26L01P54_76v4.qxd 3/7/06 1:46 AM Page 71 Note 14 — Supplemental Financial Information 2005 2004 2003 Accounts receivable Trade receivables ..................................................... Other receivables ..................................................... Allowance, beginning of year ................................... Net amounts (credited)/charged to expense ........ Deductions(a)........................................................ Other(b)................................................................. Allowance, end of year ............................................. Net receivables ........................................................ Inventory(c) Raw materials.......................................................... Work-in-process ....................................................... Finished goods ......................................................... Accounts payable and other current liabilities Accounts payable ..................................................... Accrued marketplace spending................................ Accrued compensation and benefits ........................ Dividends payable.................................................... Insurance accruals .................................................. Other current liabilities............................................ Other liabilities Reserves for income taxes........................................ Other ........................................................................ Other supplemental information Rent expense............................................................ Interest paid ............................................................ Income taxes paid, net of refunds............................ Acquisitions(d) Fair value of assets acquired............................... Cash paid and debt issued.................................. SVE minority interest eliminated.......................... Liabilities assumed.............................................. (a) Includes accounts written off. $2,718 618 3,336 97 (1) (22) 1 75 $3,261 $ 738 112 843 $1,693 $1,799 1,383 1,062 431 136 1,160 $5,971 $1,884 2,439 $4,323 $228 $213 $1,258 $ 1,089 (1,096) 216 209 $ $2,505 591 3,096 105 18 (25) (1) 97 $2,999 $ 665 156 720 $1,541 $1,731 1,285 961 387 131 1,104 $5,599 $1,567 2,532 $4,099 $245 $137 $1,833 $ 78 (64) – $ 14 $116 32 (43) – $105 $231 $147 $1,530 $178 (71) – $107 (b) Includes collections of previously written-off accounts and currency translation effects. (c) Inventories are valued at the lower of cost or market. Cost is determined using the average, first-in, first-out (FIFO) or last-in, first-out (LIFO) methods. Approximately 17% in 2005 and 15% in 2004 of the inventory cost was computed using the LIFO method. The differences between LIFO and FIFO methods of valuing these inventories were not material. (d) In 2005, these amounts include the impact of our acquisition of General Mills, Inc.’s 40.5% ownership interest in SVE for $750 million. The excess of our purchase price over the fair value of net assets acquired is $250 million and is included in goodwill. We also reacquired rights to distribute global brands for $263 million which is included in other nonamortizable intangible assets. 71 R1_notes_v26.qxd 3/1/06 11:07 PM Page 72 Management’s Responsibility for Financial Reporting Audit Committee comprises independent directors with the financial literacy, knowledge and experience to provide appropriate oversight. We review our critical accounting policies, financial reporting and internal control matters with them and encourage their direct communication with KPMG LLP, with our General Auditor, and with our General Counsel. In 2005, we named a senior compliance officer to lead and coordinate our compliance policies and practices. Providing investors with financial results that are complete, transparent and understandable. The consolidated financial state- ments and financial information included in this report are the responsibility of management. This includes preparing the financial statements in accordance with accounting principles generally accepted in the U.S., which require estimates based on management’s best judgment. PepsiCo has a strong history of doing what’s right. We realize that great companies are built on trust, strong ethical standards and principles. Our financial results are delivered from that culture of accountability, and we take responsibility for the quality and accuracy of our financial reporting. Peter A. Bridgman Senior Vice President and Controller Indra K. Nooyi President and Chief Financial Officer Steven S Reinemund Chairman of the Board and Chief Executive Officer To Our Shareholders: At PepsiCo, our actions — the actions of all our associates — are governed by our Worldwide Code of Conduct. This code is clearly aligned with our stated values — a commitment to sustained growth, through empowered people, operating with responsibility and building trust. Both the code and our core values enable us to operate with integrity — both within the letter and the spirit of the law. Our code of conduct is reinforced consistently at all levels and in all countries. We have maintained strong governance policies and practices for many years. The management of PepsiCo is responsible for the objectivity and integrity of our consolidated financial statements. The Audit Committee of the Board of Directors has engaged independent registered public accounting firm, KPMG LLP, to audit our consolidated financial statements and they have expressed an unqualified opinion. We are committed to providing timely, accurate and understand- able information to investors. Our commitment encompasses the following: Maintaining strong controls over financial reporting. Our system of internal control is based on the control criteria framework of the Committee of Sponsoring Organizations of the Treadway Commission published in their report titled, Internal Control — Integrated Framework. The system is designed to provide reason- able assurance that transactions are executed as authorized and accurately recorded; that assets are safeguarded; and that accounting records are sufficiently reliable to permit the prepara- tion of financial statements that conform in all material respects with accounting principles generally accepted in the U.S. We maintain disclosure controls and procedures designed to ensure that information required to be disclosed in reports under the Securities Exchange Act of 1934 is recorded, processed, summa- rized and reported within the specified time periods. We monitor these internal controls through self-assessments and an ongoing program of internal audits. Our internal controls are reinforced through our Worldwide Code of Conduct, which sets forth our commitment to conduct business with integrity, and within both the letter and the spirit of the law. Exerting rigorous oversight of the business. We continuously review our business results and strategies. This encompasses financial discipline in our strategic and daily business decisions. Our Executive Committee is actively involved — from understanding strategies and alternatives to reviewing key initiatives and financial performance. The intent is to ensure we remain objective in our assessments, constructively challenge our approach to potential business opportunities and issues, and monitor results and controls. Engaging strong and effective Corporate Governance from our Board of Directors. We have an active, capable and diligent Board that meets the required standards for independence, and we welcome the Board’s oversight as a representative of our shareholders. Our 72 R1_notes_v26.qxd 3/1/06 11:07 PM Page 73 Management’s Report on Internal Control over Financial Reporting To Our Shareholders: Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) of the Exchange Act. Under the supervi- sion and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of our internal control over finan- cial reporting based upon the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on that evaluation, our management concluded that our internal control over financial reporting is effective as of December 31, 2005. KPMG LLP, an independent registered public accounting firm, has audited the consolidated financial statements included in this Annual Report and, as part of their audit, has issued their report, included herein, (1) on our management’s assessment of the effec- tiveness of our internal controls over financial reporting and (2) on the effectiveness of our internal control over financial reporting. Peter A. Bridgman Senior Vice President and Controller Indra K. Nooyi President and Chief Financial Officer Steven S Reinemund Chairman of the Board and Chief Executive Officer 73 notesv26L01P54_76v3.qxd 3/4/06 3:13 AM Page 74 Report of Independent Registered Public Accounting Firm accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over finan- cial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of PepsiCo, Inc. and Subsidiaries as of December 31, 2005 and December 25, 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with United States generally accepted accounting principles. Also, in our opinion, manage- ment’s assessment that PepsiCo, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control — Integrated Framework issued by COSO. Furthermore, in our opinion, PepsiCo, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control — Integrated Framework issued by COSO. KPMG LLP New York, New York February 24, 2006 Board of Directors and Shareholders PepsiCo, Inc.: We have audited the accompanying Consolidated Balance Sheet of PepsiCo, Inc. and Subsidiaries as of December 31, 2005 and December 25, 2004 and the related Consolidated Statements of Income, Cash Flows and Common Shareholders’ Equity for each of the years in the three-year period ended December 31, 2005. We have also audited management’s assessment, included in Management’s Report on Internal Control over Financial Reporting, that PepsiCo, Inc. and Subsidiaries maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). PepsiCo, Inc.’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effective- ness of internal control over financial reporting. Our responsibility is to express an opinion on these consolidated financial state- ments, an opinion on management’s assessment, and an opinion on the effectiveness of PepsiCo, Inc.’s internal control over financial reporting based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all mate- rial respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluat- ing the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluat- ing management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circum- stances. We believe that our audits provide a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted 74 notesv26L01P54_76v4.qxd 3/7/06 1:46 AM Page 75 Selected Financial Data (in millions except per share amounts, unaudited) Quarterly Net revenue 2005 2004 Gross profit(a) 2005 2004 2005 restructuring charges(b) 2005 2004 restructuring and impairment charges(c) 2004 AJCA tax charge(d) 2005 Net income(e) 2005 2004 Net income per common share — basic(e) 2005 2004 Net income per common share — diluted(e) 2005 2004 Cash dividends declared per common share 2005 2004 2005 stock price per share(f) High Low Close 2004 stock price per share(f) High Low Close First Fourth Quarter Quarter Quarter Quarter Second Third $6,585 $6,131 $7,697 $7,070 $8,184 $10,096 $8,803 $7,257 $3,715 $3,466 $4,383 $4,039 $4,669 $4,139 $5,619 $4,943 – – – – – – – – $83 $150 $468 $(8) $912 $804 $1,194 $1,059 $864 $1,364 $1,108 $985 $0.54 $0.47 $0.71 $0.62 $0.52 $0.80 $0.66 $0.58 $0.53 $0.46 $0.70 $0.61 $0.51 $0.79 $0.65 $0.58 $0.23 $0.16 $0.26 $0.23 $0.26 $0.23 $0.26 $0.23 $55.71 $51.34 $52.62 $53.00 $45.30 $50.93 $57.20 $51.78 $55.52 $55.48 $50.28 $54.95 $56.73 $52.07 $54.65 $55.71 $48.41 $50.84 $60.34 $53.55 $59.08 $53.00 $47.37 $51.94 The first, second, and third quarters consist of 12 weeks and the fourth quarter consists of 16 weeks in 2004 and 17 weeks in 2005. Five-Year Summary Net revenue Income from continuing operations Net income Income per common share — basic, continuing operations Income per common share — diluted, continuing operations Cash dividends declared per common share Total assets Long-term debt Return on invested capital(a) 2005 2004 2003 $32,562 $29,261 $26,971 $4,078 $3,568 $4,174 $4,078 $3,568 $4,212 $2.43 $2.45 $2.07 $2.39 $1.01 $2.41 $2.05 $0.630 $0.850 $31,727 $27,987 $25,327 $2,313 $1,702 $2,397 22.7% 27.4% 27.5% Five-Year Summary (Cont.) Net revenue Net income Income per common share — basic Income per common share — diluted Cash dividends declared per common share Total assets Long-term debt Return on invested capital(a) 2002 2001 $25,112 $23,512 $2,400 $3,000 $1.35 $1.69 $1.33 $1.68 $0.595 $0.575 $23,474 $21,695 $2,651 $2,187 25.7% 22.1% (a) Return on invested capital is defined as adjusted net income divided by the sum of average shareholders’ equity and average total debt. Adjusted net income is defined as net income plus net interest expense after tax. Net interest expense after tax was $62 million in 2005, $60 million in 2004, $72 million in 2003, $93 million in 2002, and $99 million in 2001. • As a result of the adoption of SFAS 142, Goodwill and Other Intangible Assets, and the consolidation of SVE in 2002, the data provided above is not comparable. • Includes restructuring and impairment charges of: Pre-tax After-tax Per share • Includes Quaker merger-related costs of: Pre-tax After-tax Per share 2005 $83 $55 $0.03 2004 $150 $96 $0.06 2003 $59 $42 $0.02 2003 $147 $100 $0.06 2002 $224 $190 $0.11 2001 $31 $19 $0.01 2001 $356 $322 $0.18 • The 2005 fiscal year consisted of fifty-three weeks compared to fifty-two weeks in our normal fiscal year. The 53rd week increased 2005 net revenue by an estimated $418 million and net income by an estimated $57 million or $0.03 per share. (a) Reflects net reclassifications in all periods from cost of sales to selling, general and administrative expenses related to the alignment of certain accounting policies in connection with our ongoing BPT initiative. See Note 1. (b) The 2005 restructuring charges were $83 million ($55 million or $0.03 per share after-tax). See Note 3. (c) The 2004 restructuring and impairment charges were $150 million ($96 million or $0.06 per share • Cash dividends per common share in 2001 are those of pre-merger PepsiCo prior to the effective date of the merger. • In the fourth quarter of 2004, we reached agreement with the IRS for an open issue related to our discontinued restaurant operations which resulted in a tax benefit of $38 million or $0.02 per share. after-tax). See Note 3. (d) Represents income tax expense associated with the repatriation of earnings in connection with the AJCA. See Note 5. (e) Fourth quarter 2004 net income reflects a tax benefit from discontinued operations of $38 million or $0.02 per share. See Note 5. (f) Represents the composite high and low sales price and quarterly closing prices for one share of PepsiCo common stock. 75 notesv26L01P54_76v4.qxd 3/7/06 1:47 AM Page 76 Reconciliation of GAAP and Non-GAAP Information We recognized a tax charge in 2005 related to the Company’s intention to repatriate $7.5 billion of international earnings under the provisions of the AJCA. In addition, we recorded restructuring charges in 2005 to reduce costs in some of our operations, princi- pally through headcount reductions, as well as restructuring and impairment charges in 2004 related to Frito Lay’s manufacturing consolidation. We also recognized certain tax benefits in 2004. In 2005, we have an additional week of results (53rd week) as our fiscal year ends on the last Saturday of each December, resulting in an additional week of results every five or six years. The financial measures listed below are not measures defined by generally accepted accounting principles. However, we believe investors should consider these measures as they are more indica- tive of our ongoing performance. Specifically, investors should consider the following: • Our 2005 net income and diluted EPS amounts without the impact of the AJCA tax charge, the 53rd week and the restruc- turing charges, and our 2004 net income and diluted EPS amounts without the impact of prior year tax benefits and restructuring and impairment charges; and • Our 2005 return on invested capital (ROIC) without the impact of the AJCA tax charge, the restructuring and impairment charges, the 53rd week and prior year tax benefits. Net Income Reconciliation Year Ended Reported net income Prior Year Tax Benefits AJCA Tax Charge 53rd Week Restructuring and Impairment Charges Net Income Excluding Prior Year Tax Benefits, AJCA Tax Charge, 53rd Week and Restructuring and Impairment Charges Diluted EPS Reconciliation Year Ended Reported diluted EPS Prior Year Tax Benefits AJCA Tax Charge 53rd Week Restructuring and Impairment Charges Net Income Excluding Prior Year Tax Benefits, AJCA Tax Charge, 53rd Week and Restructuring and Impairment Charges ROIC Reconciliation* Year Ended Reported ROIC AJCA Tax Charge ROIC Excluding AJCA Tax Charge Growth (3)% 2005 $4,078 – 460 (57) 55 2004 $4,212 (304) – – 96 $4,536 $4,004 13% Growth (2)% 2005 $ 2.39 – 0.27 (0.03) 0.03 2004 $ 2.44 (0.18) – – 0.06 $ 2.66 $ 2.32 15% 2005 23% 2 25% * Impact of restructuring and impairment charges, the 53rd week and prior year tax benefits on ROIC rounds to zero. Glossary Anchor bottlers: The Pepsi Bottling Group (PBG), PepsiAmericas, Inc. (PAS) and Pepsi Bottling Ventures (PBV). Bottler: customers who we have granted exclusive contracts to sell and manufacture certain beverage products bearing our trade- marks within a specific geographical area. Bottler funding: financial incentives we give to our bottlers to assist in the distribution and promotion of our beverage products. Business Process Transformation (BPT): our comprehensive multi-year effort to drive efficiencies. It includes efforts to physically consolidate, or integrate, key business functions to take advantage of our scale. It also includes moving to a common set of processes that underlie our key activities, and supporting them with common technology application. And finally, it includes our SAP installation, the computer system that will link all of our systems and processes. Concentrate Shipments and Equivalents (CSE): measure of our physical beverage volume to our customers. This measure is reported on our fiscal year basis. Consumers: people who eat and drink our products. Customers: franchise bottlers and inde- pendent distributors and retailers. CSD: carbonated soft drinks. Derivatives: financial instruments that we use to manage our risk arising from changes in commodity prices, interest rates, foreign exchange rates and stock prices. Direct-Store-Delivery (DSD): delivery system used by us and our bottlers to deliver snacks and beverages directly to retail stores where our products are merchandised. 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. Management operating cash flow: net cash provided by operating activities less capital spending plus sales of property, plant and equipment. It is our primary measure used to monitor cash flow performance. Marketplace spending: sales incentives offered through various programs to our customers and consumers, as well as advertising and other marketing activities. Servings: common metric reflecting our consolidated physical unit volume. Our divisions’ physical unit measures are con- verted into servings based on U.S. Food and Drug Administration guidelines for single-serving sizes of our products. Smart Spot: our initiative that helps consumers find our products that can contribute to healthier lifestyles. Transaction gains and losses: the impact on our consolidated financial statements of exchange rate changes arising from specific transactions. Translation adjustments: the impact of the conversion of our foreign affiliates’ financial statements to U.S. dollars for the purpose of consolidating our financial statements. 76 coverL01IFCv3.qxd 3/6/06 9:48 PM Page ifc2 On any day, around the world, at any moment and in many place s, millions of consumers enjoy our brands. Here’s how we keep the momentum going. Financial Highlights PepsiCo, Inc. and Subsidiaries ($ in millions except per share amounts; all per share amounts assume dilution) Net Revenue Total: $32,562 Division Operating Profit Total: $6,710 35% 5% PepsiCo International Quaker Foods North America 24% PepsiCo International 8% Quaker Foods North America 28% 32% Frito-Lay North America 30% 38% Frito-Lay North America PepsiCo Beverages North America PepsiCo Beverages North America 2005 2004 % Chg(a) Summary of Operations Total net revenue $32,562 $29,261 Division operating profit Total operating profit Net income(b) Earnings per share(b) $6,710 $6,098 $5,922 $5,259 $4,536 $4,004 $2.66 $2.32 Other Data Management operating cash flow(c) $4,204 $3,705 Net cash provided by operating activities Capital spending $5,852 $5,054 $1,736 $1,387 Common share repurchases $3,012 $3,028 Dividends paid Long-term debt $1,642 $1,329 $2,313 $2,397 11 10 13 13 15 13 16 25 (0.5) 24 (3.5) Contents 1 PepsiCo at a Glance . . . . . . . . . . . . . . . . . . . . . . . 2 Letter to Shareholders . . . . . . . . . . . . . . . . . . . . . . 6 Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Health & Wellness . . . . . . . . . . . . . . . . . . . . . . . . . 10 Innovation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Execution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 International . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sustainability . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Corporate Officers and Principal Divisions . . . . . . . . 20 PepsiCo Board of Directors . . . . . . . . . . . . . . . . . . . 21 Advisory Boards African American Advisory Board . . . . . . . . . . . . . 22 Latino/Hispanic Advisory Board . . . . . . . . . . . . . . 23 Blue Ribbon Health and Wellness Advisory Board . . . . . . . . . . . . . . . . . 24 Financial Review Management’s Discussion and Analysis and Consolidated Financial Statements . . . . . . . . 25 Our Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Our Critical Accounting Policies . . . . . . . . . . . . . . . 34 Our Financial Results . . . . . . . . . . . . . . . . . . . . . . . 40 Consolidated Statement of Income . . . . . . . . . . . . . 50 Consolidated Statement of Cash Flows . . . . . . . . . . 51 Consolidated Balance Sheet . . . . . . . . . . . . . . . . . . 52 Consolidated Statement of Common Shareholders’ Equity . . . . . . . . . . . . . . . 53 Notes to Consolidated Financial Statements . . . . . . 54 Management’s Responsibility for Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . 72 Management’s Report on Internal Control over Financial Reporting . . . . . . . . . . . . . . . . . . . 73 Report of Independent Registered Public Accounting Firm . . . . . . . . . . . . . . . . . . . 74 . . . . . . . . . . . . . . . . . . . . 75 Selected Financial Data Reconciliation of GAAP and Non-GAAP Information . . . . . . . . . . . . . . . . . . . . . 76 76 Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Primary Websites PepsiCo, Inc. — www.pepsico.com Frito-Lay North America — www.fritolay.com Pepsi-Cola North America — www.pepsiworld.com Tropicana North America — www.tropicana.com Quaker Foods — www.quakeroats.com Gatorade — www.gatorade.com Smart Spot — www.smartspot.com Common Stock Information Stock Trading Symbol – PEP Stock Exchange Listings The New York Stock Exchange is the principal market for PepsiCo common stock, which is also listed on the Amsterdam, Chicago and Swiss Stock Exchanges. Shareholders At year-end 2005, there were approximately 197,500 shareholders of record. Dividend Policy We target an annual dividend payout of approximately 45% of prior year’s net income from continuing operations. Dividends are usually declared in late January or early February, May, July and November and paid at the end of March, June and September and the beginning of January. The dividend record dates for these payments are March 10 and, subject to approval by the Board of Directors, expected to be June 9, September 8 and December 8, 2006. We have paid consecutive quarterly cash dividends since 1965. Amounts in the chart reflect pre-merger PepsiCo for the dates prior to its merger with The Quaker Oats Company. Shareholder Information Annual Meeting The Annual Meeting of Shareholders will be held at Frito-Lay Corporate Headquarters, 7701 Legacy Drive, Plano, Texas, on Wednesday, May 3, 2006, at 9 a.m. local time. Proxies for the meeting will be solicited by an inde- pendent proxy solicitor. This Annual Report is not part of the proxy solicitation. Inquiries Regarding Your Stock Holdings Beneficial Shareholders (shares held by your broker in the name of the brokerage house) should direct communi- cations on all administrative matters to your stockbroker. Registered Shareholders (shares held by you in your name) should address communications concerning statements, dividend payments, address changes, lost certificates and other administrative matters to: The Bank of New York Shareholder Services Department P.O. Box 11258 Church Street Station New York, NY 10286-1258 Telephone: 800-226-0083 Cash Dividends Declared Per Share (In $) .850 .575 .595 .630 1.01 212-815-3700 (Outside the U.S.) E-mail: shareowners@bankofny.com Website: www.stockbny.com or Manager Shareholder Relations PepsiCo, Inc. 700 Anderson Hill Road Purchase, NY 10577 Telephone: 914-253-3055 01 02 03 04 05 Stock Performance PepsiCo was formed through the 1965 merger of Pepsi-Cola Company and Frito-Lay, Inc. A $1,000 investment in our stock made on December 31, 2000 was worth about $1,284 on December 31, 2005, assuming the reinvestment of dividends into PepsiCo stock. This performance represents a compounded annual growth rate of 5%. The closing price for a share of PepsiCo common stock on the New York Stock Exchange was the price as report- ed by Bloomberg for the years ending 2001-2005. These amounts reflect the closing price of pre-merger PepsiCo prior to our merger with The Quaker Oats Company. Past performance is not necessarily indicative of future returns on investments in PepsiCo common stock. Year-end Market Price of Stock Based on calendar year-end (In $) 60 40 20 0 01 02 03 04 05 In all correspondence or telephone inquiries, please mention PepsiCo, your name as printed on your stock certificate, your Social Security number, your address and telephone number. SharePower Participants (employees with SharePower options) should address all questions regarding your account, outstanding options or shares received through option exercises to: Merrill Lynch/SharePower Stock Option Unit 1600 Merrill Lynch Drive Mail Stop 06-02-SOP Pennington, NJ 08534 Telephone: 800-637-6713 (U.S., Puerto Rico and Canada) 609-818-8800 (all other locations) In all correspondence, please provide your account number (for U.S. citizens, this is your Social Security number), your address, your telephone number and mention PepsiCo SharePower. For telephone inquiries, please have a copy of your most recent statement available. Employee Benefit Plan Participants PepsiCo 401(k) Plan & PepsiCo Stock Purchase Program The PepsiCo Savings & Retirement Center at Fidelity P.O. Box 770003 Cincinnati, OH 45277-0065 Telephone: 800-632-2014 (Overseas: Dial your country’s AT&T Access Number +800-632-2014. In the U.S., access numbers are available by calling 800-331-1140. From anywhere in the world, access numbers are available online at www.att.com/traveler.) Website: www.netbenefits.fidelity.com PepsiCo Stock Purchase Program – for Canadian employees: Fidelity Stock Plan Services P.O. Box 5000 Cincinnati, OH 45273-8398 Telephone: 800-544-0275 Website: www.iStockPlan.com/ESPP Please have a copy of your most recent statement available when calling with inquiries. If using overnight or certified mail send to: Fidelity Investments 100 Crosby Parkway Mail Zone KC1F-L Covington, KY 41015 Shareholder Services Dividend Reinvestment Plan A brochure explaining this convenient plan, for which PepsiCo pays all administrative costs, is available on our website www.pepsico.com or from our transfer agent: The Bank of New York Dividend Reinvestment Department P.O. Box 1958 Newark, NJ 07101-9774 Telephone: 800-226-0083 Direct Deposit of Dividends Information on the Direct Deposit service is available from our transfer agent: The Bank of New York Shareholder Services Department P.O. Box 11258 Church Street Station New York, NY 10286-1258 Telephone: 800-226-0083 212-815-3700 (Outside the U.S.) Financial and Other Information PepsiCo’s 2006 quarterly earnings releases are expected to be issued the weeks of April 24, July 10, October 9, 2006, and February 5, 2007. Copies of PepsiCo’s SEC reports, earnings and other financial releases, corporate news and additional company information are available on our website www.pepsico.com. If you have questions regarding PepsiCo’s financial performance contact: Jamie Caulfield Vice President, Investor Relations PepsiCo, Inc. 700 Anderson Hill Road Purchase, NY 10577 Telephone: 914-253-3035 Independent Auditors KPMG LLP 345 Park Avenue New York, NY 10154-0102 Telephone: 212-758-9700 Corporate Headquarters PepsiCo, Inc. 700 Anderson Hill Road Purchase, NY 10577 Telephone: 914-253-2000 PepsiCo Website: www.pepsico.com © 2006 PepsiCo, Inc. (a) Percentage changes above and in text are based on unrounded amounts. (b) In 2005, excludes the impact of AJCA tax charge, the 53rd week and restructuring charges. In 2004, excludes certain prior year tax benefits, and restructuring and impairment charges. See page 76 for reconciliation to net income and earnings per share on a GAAP basis. (c) Includes the impact of net capital spending. Also, see “Our Liquidity, Capital Resources and Financial Position” in Management’s Discussion and Analysis. When market or market share is referred to in this report, the markets and share are defined by the sources of the information, primarily Information Resources, Inc. and ACNielsen. The Measured Channel Information excludes certain customers such as Wal*Mart that do not report data to these services. PepsiCo’s Annual Report contains many of the valuable trademarks owned and/or used by PepsiCo and its subsidiaries and affiliates in the United States and internationally to distinguish products and services of outstanding quality. WEIGHT WATCHERS and its POINTS values are registered trademarks of Weight Watchers. STAR WARS, EPISODE III, REVENGE OF THE SITH, YODA and DARTH VADER are trademarks owned by Lucasfilm Ltd. XBOX 360 is a trademark of Microsoft Corporation. TREASURYVISION is a service mark owned by Citicorp Corporation. America On the MoveTM is an initiative of the nonprofit organization, The Partnership to Promote Healthy Eating and Active Living (The Partnership: www.americaonthemove.org). Design: Eisenman Associates. Printing: L.P. Thebault. Photography: Stephen Wilkes, Ben Rosenthal, PhotoBureau, Andy Robinson, Nellie Solitrenick, Charlie Samuels, Jonathan Kirn. Special thanks to Cumberland Farms. Printed on recycled and recyclable paper. Paper manufactured using “Green Power.” coverL01OBCv3.qxd 3/6/06 9:17 PM Page 1