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PepsiCo Inc. (NYSE:PEP)

Sanford Bernstein Strategic Decisions Conference

May 29, 2013 11:00 AM ET

Executives

Indra K. Nooyi - Chairman and CEO

Hugh F. Johnston - CFO

Analysts

Ali Dibadj - Sanford C. Bernstein & Co.

Ali Dibadj - Sanford C. Bernstein & Co.

It’s your last meeting before lunch. I’m Ali Dibadj, Bernstein’s beverages and snacks and household & personal products analyst. And we have with us today the CEO and Chairman of PepsiCo, Indra Nooyi and Hugh Johnston, the CFO. They kick off a really great set of consumer packaged goods companies that are presenting this week during the conference and we really hope you can listen to many of those presentations.

Now on Pepsi, they’re clearly a house of very, very strong brands. From Pepsi to Ruffles, to Lay’s, Gatorade, Tropicana, you name it, $22 billion brands around the world. Leveraging those brands with a little bit of a help from a restructuring and reinvestment plan that started last year, we’re really starting to see Pepsi turn the corner, showing signs of improvement. However, we’re starting to see as well North American carbonated soft drinks volumes remain challenged, regulation becoming a bigger and bigger issue, emerging markets posing a margin mix threat, activist investors rearing their heads, and as well as competition around every corner.

So to give us a sense of how Pepsi fits in that context, we look to Indra during the presentation and Q&A. And as is tradition for the Q&A, if you have any questions during the presentation, please write them on the cards, hand them through the aisles, and we will ask them at the end.

With that, Indra let me hand it over to you.

Indra K. Nooyi

Thank you. Thank you Ali and good morning everyone. It’s a real pleasure to be with you here today and Ali thank you for teeing up all the question session to be asked afterwards. Before we begin, please take note of our Safe Harbor statements, which can also be found on our website under the investors tab.

Over the past decade, PepsiCo has been the picture of a consistent durable high performing consumer packaged goods Company. We generate more than $65 billion in net revenue. We’ve been consistently delivering mid single-digit organic revenue growth. We have very attractive core operating margins and returns on net invested capital, each of which stand at 15%. We’ve drawn earnings per share at a 9% compound annual growth rate. We’ve increased dividends per share at 14% compound annual growth rate and we returned $53 billion in cash to shareholders to combination of dividends and share repurchases.

And this performance has translated to very strong consistent shareholder returns with PepsiCo outpacing the S&P 500 on an annualized basis by 170 basis points over the past five years and 140 basis points over the last 10 years. At the same time that we’ve performed, we also made the required investments to transform the Company to address a number of macro trends that are reshaping our Company and position our Company for long-term growth. This is what we did.

We expanded our presence in faster growing developing and emerging markets in response to a shift in the sources of global growth. We continue to balance the portfolio of offerings to include more nutritional products. And we increased the permissibility of our social snacks and beverages by reducing calories and sodium to address the growing aging population and consumers growing concerned with health and wellness.

Disruptive technologies have become part of day to day operations driven largely by the internet, because social medias becoming an ever increasing powerful force is a greater availability of sophisticated tools for product formulations and food safety and security are now greatly enhanced by the fact that more tools are available to ensure ingredient traceability.

From response to all of that, we stepped up by investment in R&D significantly and we increased our investments in digital capabilities and food safety and quality. We also invested to enhance our brands strength and our revenue management skills to give us pricing power and built a culture of productivity to deal with the reality of a rapidly volatile environment and inflationary commodity environment.

We designed sustainability into everything we do in response to a growing environmental consciousness. And we completely revamped our talent management processes and composition to address this conundrum of the global talent supply demand mismatch. Thanks to all the heavy lifting. The Company we have built is positioned to deliver long-term, top tier sustained financial performance and value creation for our shareholders.

We believe that PepsiCo is capable in the long-term of delivering mid single-digit revenue growth, which is mostly organic and its balanced, driven by a balanced portfolio of products including good for you, better for you and fun for your products and from a geographical perspective developing and emerging markets contributing disproportionately to our growth.

We think PepsiCo is capable of delivering high single-digit EPS growth on a core constant currency basis and core constant currency operating profit will grow ahead of revenue growth with margins expanding 30 to 50 basis points a year, and management operating cash flow excluding certain items to grow inline with a net income growth and returns on invested capital expansion of 50 basis points for year on average supported by highly disciplined capital allocation. And healthy return of cash to shareholders through dividends and share repurchases building on our long track record.

Now these are the same goals we shared with you early in 2012 and we remain absolutely committed to working to achieve these goals. So, what I want to do in the balance of my presentation is to share with you our roadmap to achieve these goals, focus mostly on revenue growth, margin and profit growth, responsible capital allocation, which includes return of capital to our shareholders and then briefly touch on how we’re building talent, reinforcing our culture and executing behind clear focused priorities to create value.

So let me start with revenue growth. PepsiCo is a well architected portfolio competing in two focused categories both at attractive growth prospects. Both the snacks and beverages categories are projected to generate global growth of 5% or more. Convenient foods and beverages businesses are fairly evenly balanced with about half our revenue coming from each. And more importantly, our categories are highly complementary sharing the same customers, shoppers and consumers.

Within this mix of snacks and beverages, sits our very attractive global nutrition portfolio that consist of leading brands, such as Quaker, Tropicana, Naked Juice, and Gatorade for athletes. And we’re well positioned within these categories with a clear global number one position in global salty snacks and we have a strong number two global position in beverages with leadership or parity in a number of very important markets. And we’re among the top three leaders in mainstream everyday nutrition businesses.

We participate broadly in all segments of LRB. So our growth is largely driven by the category growth. In snacks on the other hand, we’re focused on salty snacks alone. So, our growth comes not only from growth within our categories, but by also innovating to social occasions from adjacent macro snack categories.

Geographically our portfolio spans (indiscernible) with a strong presence in developing and emerging markets, which today account for 35% of our total net revenue which is a 800 basis points improvement compared to just five years ago, 800 basis points improvement. Our geographic diversification also gives us a lot of runway to grow, because the consumption of our products grows at GDP per capita grows. In fact, there is a sweet spot between $10,000 and $20,000 GDP per capita where the rate of adoption and frequency of purchase of our products both snacks and beverages really accelerate.

So as we look at our geographic portfolio, there are a number of markets that are in this sweet spot and that’s what’s fueling our growth today. Just as importantly, there are many markets yet to enter the sweet spot representing tremendous future growth potential. Even a relatively new emerging markets for PepsiCo we’ve had good presence, I mean, we’ve had good success in quickly ramping up our presence and our competitiveness.

Let me just give you one example in Sub-Saharan, Africa, Uganda. In that business, we entered 15 years ago and our CSD business in Uganda has grown by 25 share points in just the past decade and the same is true in markets such as Tanzania and Nigeria. In Tanzania our share has grown by 30 points and in Nigeria we’ve grown to a 40 share of the market in a relatively short time. So we have wide spaces and we’re going to go after that growth.

And to compliment the strong geographic balance, we also have a very strong brand portfolio that connects with consumers. 22 of our iconic brands have estimated annual retail sales surpassing $1 billion each, a number that’s doubled over the past 12 years. And like our products, these brands span everything from fun for you to better for you to good for you.

Our brands have typically the number one or number two position in their respective categories. In fact, our Banner Sun anchored by Lay’s is the number one global food brand overall and Pepsi is the number two global brand in the liquid refreshment beverage category. But more than the 22 billion, 22 brands are at over a $1 billion in retail sales, we have another 40 brands that have retail sales between $250 million and a $1 billion. These brands play a very important role in our broader portfolio whether it’s a strong relevance in a local market, their niche appeal in unique channels or their ability to communicate superb premium positioning.

The other thing about our brands is that they’re critically important to retailers. Now here is a slide which shows the 40 largest CPG brands in the U.S. Not just food and beverage, but also includes household products. PepsiCo has nine of the top 40 trademarks in retail. We have four of the top 10 trademarks of retail and more importantly we have three of the top five. This shows both the importance of the categories in which we compete in and how well positioned we’re within these important categories.

We are an important partner to our customers because our success is directly linked with their success. And we’re making our powerful brands even stronger. In 2012, we took a number of important steps to increase our brand strength. We increased the level of investment in all our brands by 50 basis points from 5.2% of sales to 5.7% of net revenue and we continue to increase our brand support in 2013.

We are focusing our investment behind 12 mega brands and we’re levering the scale and size of our biggest brands. We are also working to increase the effectiveness and efficiency of our investments. We directed more of our investments through activities directly consumer facing, shifting money from non-working to working A&M, by rationalizing the number of agency partnerships and by leveraging and coordinating the creative and production activities on a global basis for our global brands.

An important component of our consumer facing media is leveraging social and digital media through a highly successful programs like Doritos Crash the Super Bowl and Lay’s Do us a Flavor. We’ve strengthen our brands by improving the activation of our global sports properties like the NFL, Major League Baseball and by leveraging them across multiple brand platforms and by driving execution from national media to local market to in-store presence.

And for brands like Pepsi we’re finding the interesting intersections between sports and music. For example we coordinated our global partnership with Beyonce, last year, or earlier this year, linking a sponsorship of the Super Bowl halftime show and the recent launch of Beyonce’s first global ad for brand Pepsi.

And we also continue to refine our tools on how we measure our return on A&M investment by capturing consumer equity scores at a more refined level and better understanding the complex interactions of all elements of our marketing mix, on purchase and consumption decisions. Over time, our expectation is that this will lead to higher returns on our marketing investments. Because our products and brands have such broad appeal we have tremendous growth run rate with opportunities to create solutions that address each day part and virtually every cohort group, every need, state and occasion.

We’ve also invested substantially over the past six years to strengthen our R&D capability across the Company. We create a new long-term research capabilities with outstanding talent. We tighten the linkages between our shopper and consumer insights in R&D, leveraging our proprietary demand moments framework to sharpen the focus of our innovation effort and make our new products more incremental to our total growth.

Late in 2012 for the first time in our Company’s history, we established a design capability. Our goal is to use design in the early stages of innovation to create truly memorable experiences for our consumers. And we’re leveraging our global scale by consolidating our investments around promising new platforms as well as accelerating our ability to lift and shift great ideas from one market to another.

We are also just beginning to explore the opportunity for reverse innovation, leveraging fully our learnings in developing and emerging markets to yield the benefits of thinking more holistically about designing a product here, packaging and equipment that have low costs without sacrificing quality or performance. In fact we setup a value innovation center out in India to see how we can bring emerging market learning to lower cost of what we do here in the western world.

We’ve had good recent successes with innovation that gives us real encouragement that our investments and focus are beginning to payoff. Trop 50, Pepsi Next, Tropicana Farmstand, Doritos Locos Tacos, Mountain Dew Kickstart, Quaker Real Medleys, all of these are examples of innovation – recent innovation that have had remarkable success. Our goal is to increase the contribution of new products to our total net revenue and in 2012 we achieved this aim and we’re on track to continue to increase this contribution of new product to our overall revenue.

Revenue management and price pack architecture also play an important role in our revenue growth. By customizing packaging for specific channels, we’re able to drive greater distribution. And by offering a greater variety of packages to consumers, we increase our products relevance to consumption occasions.

Our DSD model gives us access to micro level trading data and together with local demographic data, we’re able to refine our store level shelf set to provide the perfect assortment for an individual store’s consumers, which in turn helps us increase the velocity of our products. We are also able to use a wide variety of packaging configuration to achieve certain magic price points to appeal to the value minded consumer.

PepsiCo strength lies in the fact that our portfolio is diverse, but it’s highly focused and more importantly related. Our snacks and beverages appeal to the same customers, the same shoppers, and the same consumers. They benefit from the same trends of convenience and on the go life styles and they have high levels of coincidence of purchase and consumption.

As the second largest food and beverage business in the world, the largest in many key markets such as U.S., Russia, India, and among the top five in Mexico and Brazil and Turkey, just mentioning a few, we’re viewed as a critical growth driver by our retail partners. This position allows us to work with our customers as one PepsiCo in deep creative and unique ways to drive the success of our business and consequently theirs.

In developing markets – in developing and emerging markets actually our snacks business is actually supported by our beverage businesses, which tend to be much more established and have larger scale. Our snacks business benefits from our beverages business, trade knowledge and relationships and it also benefits from the marketing powers associated with the beverage business and the media scale that our beverage business uniquely bring to the market.

In developed markets on the other hand, our snacks business is increasingly benefited from our beverage business, food service relationships. The recent success of Doritos Locos Tacos only happened because Pepsi had a long-term relationship with Taco Bell, with Mountain Dew and all of the beverages in a proprietary Mountain Dew Baja Blast that we’ve launched with Taco Bell many years ago. And building on that relationship we were able to bring Doritos Locos Tacos to the market with Taco Bell.

But ultimately the proof of this relatedness of the portfolio is what happened in the marketplace. We measure the success of our Power of One initiatives by tracking whether PepsiCo is earning an advantage share of snacks and beverages when these items are purchased together and we’re. Our market share is two to four points higher in the U.S. when snacks and beverages are purchased together and this advantage has been growing.

So let me bring all of the stuff on revenue together. Our product and geographic portfolios are balanced and well supported by strong brand building, innovation and marketplace execution. From a category perspective, we expect our global beverage portfolio to grow organic revenue in the low to mid single digits and our global snacks to grow mid single digits.

From a market perspective, we expect developed markets to grow in the low to mid single digits and our developing and emerging markets to grow in the high single to the low double-digit range. With this growth profile we expect about 2/3s of our growth to come from snacks and from a geographic perspective, about 2/3s of our growth to come from our developing and emerging markets.

Our business mix will gradually shift to being more heavily weighted towards snacks and being more heavily weighted towards developing and emerging markets than we’re today and this should enable us to sustainably grow our organic revenue mid single digits. And our recent results bear this out. For the past five consecutive quarters, we delivered on a mid single-digit organic revenue growth target.

Moving on now to margin and profit growth. We leverage our $20 billion plus global purchasing scale and centralized procurement to drive lower costs. Our scale also enables us to develop proprietary advantaged agricultural practices and seek varieties that drive high yields at a lower cost. The scale also allows us to invest in new manufacturing and packaging technologies that increase throughput at a lower cost. That allows us to increase integrate our logistics network across the lines of business and it allows us to operate highly efficient DSD systems that benefit from large drop sizes in smaller markets and in big developed markets we can actually transfer knowledge across the DSD systems.

We continue to optimize our go to market models by leveraging new technologies and by continuing to push the boundaries of rethinking how the work actually gets done. Our GES initiatives, which dramatically re-conceptualizes the traditional plant, warehouse to store model is a great example of how we’re rethinking our go to market systems. And we’re also very proud of all the efforts we’ve made on our sustainability efforts to reduce our impact on the environment and more importantly drastically lower our costs by reducing the amount of water, energy and packaging that we use.

We also leverage the scale of our partners, especially in our beverage business where our primary model outside the United States is a franchise model. For example, as most of you know recently we partnered with Tingyi, China’s largest beverage manufacturer. Through the partnership, the PepsiCo-Tingyi system is 1.5 times the size of the next largest competitor in China. In addition, this partnership is enabling us to more quickly expand our national footprint into wide spaces by leveraging Tingyi’s existing well established manufacturing and distribution network.

Similarly, we benefit from the scale of our bottlers in other markets where PepsiCo is the number two beverage player on its own, but together with a scale of our bottling partners, our scale improves dramatically. In fact, in our international beverage businesses our bottling partners almost doubled our scale when viewed on a system basis.

We’re also enhancing profitability and returns by driving productivity. We’ve executed a comprehensive restructuring program and accelerated our productivity efforts across the value chain how we make, how we move and how we sell our products. We’ve de-layered the organization and we’ve improved efficiency of the company. We’ve reduced our headcount and we’ve rationalized our supply chain to reduce our cost and investments in our fixed assets. And as a company we’ll continue to drive productivity across the entire value chain and across all of our businesses.

We have a robust pipeline of projects, from leveraging best in class supply chain activities around the world to increasing automation across the value chain, from raw material handling through the route truck to implementing new processing technologies that enable us both to increase asset utilization and reduce the input costs. And the sum of all these changes, from small actions repeated millions of times to utilizing new technology that changes the overall cost of key processes, gives us high confidence that we’ll deliver on the three year $3 billion productivity target through 2014, and we’re pleased with the progress we have made.

Our current productivity run is about $1 billion per year which is really double the rate we were at before 2012. And as a result we’re achieving reductions in operating expenses and allowing us to reinvest savings in the business and provide a more competitive cost structure.

Even more encouraging than this as the organization is engaged and accelerated our productivity efforts over the past few years, we’ve been able to find more ideas and bigger ideas to drive even more productivity, and a big enabler of these productivity programs has been the globalization of our key functions like operations and R&D and the implementation of a common IT platform including SAP across all of our businesses globally. Both of these have allowed us to standardize processes and metrics across the company. It’s provided us greater visibility into performance metrics and has allowed us to deploy our best practices globally and we’re increasingly adopting new processes to reduce cost by accelerating new business models like GES, implementing new technologies that reduced energy use and material waste or increase throughout through the system.

We’re designing products with flexible formulations that allow us to make sure that we can work with the right ingredient base to win this commodity volatility and we’re focusing R&D resources on lower cost designs with no compromise on functionality, and we’re driving performance and lower cost by leveraging best practices both by pushing the performance of every operation to proven best practices within the company and by raising the bar in the best in class with aggressive use of relevant outside benchmarking. As a result of all of this we’re well down the path on identifying our next big tranche of productivity that will extend beyond our 2014 program.

Let me move now to capital allocation including how we allocate capital to cash returns to shareholders. Our business generates a lot of cash. A substantial percentage of our earnings converted to cash flow. As you can see from this chart, we’ve consistently converted on average about 90% of our earnings through core management operating cash flow and we expect our business to continue to generate strong cash flow with cash flow growing in line with net income and maintaining at roughly the 90% convergence cycle that we’ve historically been at.

We have a long and impressive record of returning this cash flow to our shareholders. Over the past 10 years as we mentioned earlier, we’ve returned $53 billion to shareholders in the form of dividends and share repurchases. And in 2013, we plan to return another $6.4 billion in cash through dividend and share repurchases.

We fully appreciate and understand that disciplined capital allocation is one of the most important factors in generating attractive sustained long-term total shareholder return. So, let me be clear on how we prioritize allocation of capital and drive ROIC improvement. Our first priority is to invest in the business. We’re going to manage capital spending to no more than 5% of revenue. These investments have very attractive returns on investment, well in excess of cost of capital and ahead of our overall ROIC.

With that said we continually find ways to improve our returns by driving greater fixed asset utilization or by reducing the cost of adding capacity. Our second priority is to pay dividends to our shareholders. We have raised the divided for 41 consecutive years through both consistent earnings growth and by raising our payout ratio over time. Continuity of dividends and growth in annual dividends per share are a point of great pride to PepsiCo and we view them as a vitally important element of our total shareholder return.

Our third priority is to strengthen our market positions and create value through responsible tuck in acquisitions generally less than $500 million a year in total which equates to a relatively small percentage of our free cash flow. We have build tremendous capability in the company in evaluating and integrating tuck in acquisitions and we have very disciplined strategic and financial guidelines to ensure that these tuck-ins are value creating.

And our fourth capital allocation priority of course is to return the residual cash to our shareholders through share repurchases within the confines of maintaining a capital structure that provides us ready access to the debt capital market at attractive rates. We own the CP market from time-to-time throughout the year and we strive to maintain a capital structure that gives us access to the Tier 1 commercial paper market. Our capital allocation approach is an important contributor to our targeted ROIC improvement of approximately 50 basis points per year and will also contribute to total shareholder return through capital appreciation of our equity and dividend yield.

Moving on to talent and culture. The progress we’ve made and the future achievement of our goals absolutely rests on the quality of our organization, our people and our culture. I think PepsiCo the company is blessed with a highly talented and a committed group of general managers and functional experts in all of the areas like R&D, marketing, supply chain. Many of them have decades of invaluable experience in the industry or with PepsiCo.

Over the past 6 years we had actually globalize this knowledge base by leveraging all of the information technology I talked to you about and we’ve organized in a way that’s allowed us to seamlessly connect the company around the globe so that our best practices and ideas travel faster and deeper into the organization. And where we’ve needed it? We’ve augmented our team with exceptional outside external talent which brings in new perspectives and the skill set’s to our company. And we reinforced our culture of execution by aligning our incentives behind those outcomes that are most critical to long-term value creation.

Everyone in the organization is focused primarily on delivering market share sensibly, operating profit and cash flow and ROIC targets, along with individual goals related to productivity, market place execution, innovation, sustainability and Power of One. But the team goals are delivering market share sensibly, operating profit, cash flow and ROIC. So that’s the basic walk around on why we believe we can deliver our long-term guidance. And as you look ahead as a company our priorities are very clear. In developed market snacks where we have high market shares and margins we intend to defend and grow our share of salty snacks. We want to grow organically into the broader macro snacks space and we want to leverage our beverage business to increase our presence in the food service business.

In developed market beverages where we have good market positions, we intend to sensibly defend our LRB share and improve margins and returns. We’re going to look for every productivity opportunity to make sure we have all the breathing room in that business. We are going to exploit R&D to achieve product disruption and differentiation as we have talked to you about, and we will continue to explore all options to improve margins and returns in our North American beverage business as we’ve previously discussed with you.

In our developing and emerging businesses where we have highest salty snack shares in most markets and leadership or apparently beverage positions in many key markets. We intend to continue to build strong share positions, capture our fair share of growing beverage occasions and selectively pursue tuck in acquisitions to build out our scale and our geographic footprint. And in this nutrition business we’re one of the leading players globally in everyday nutrition.

We intend to continue to benefit from the outside growth of this category leveraging the presence and scale of our existing businesses. By executing on these priorities supported by our fundamentals of grand building, innovation, supply chain, talent development of Power of One we’re confident that we’re positioning ourselves to deliver on our long-term financial goals.

So to summarize; we’ve transformed our business to sustainably deliver top tier results in a rapidly changing environment. We are disciplined about capital allocation with a strong bias to return increasing sums of cash to our shareholders. Our strategy and priorities are clear. We want to deliver on our financial targets appropriately balancing market share, profitability and returns. And we believe PepsiCo is well positioned to deliver sustainable, consistent and durable performance and returns.

Thank you, and with that let me turn it back to, Ali. Thank you, Ali.

Ali Dibadj - Sanford C. Bernstein & Co.

Thanks, Indra. As you join us, I’m going to try and take advantage of the time we have left to move relatively quickly through some questions. I may even try to take advantage if there’s no one in this room after us to try to go a little bit long, but we’ll see. Just to start off, I want to go back to a slide it was either 11 or 12 in your presentation where you talk about three of the top five brands in the U.S. in retail, and all of them are beverages brands. Digging down a little bit deeper into the Pepsi America Beverages business, can you talk a little bit about the volume trends you’re seeing, last quarter down five, volume plus five pricing. What do you think drives that? Do you think that’s a secular issue, a cyclical issue and you may have seen report or may not have report of growth comparing the cigarette industry to the U.S. Carbonated Soft Drinks industry. Does that philosophy even apply?

Indra K. Nooyi

I think the first thing we have to do is talk about LRB not just about CSD Ali, very, very important. If you look at the beverage market in the U.S. it's a big market, it's highly profitable, generates a lot of U.S. cash. It's over a $100 billion market, $20 billion 8 ounce cases, 60% of the market is non-carbs and within carbonated soft drinks colas are a smaller percentage and declining. So, I think there is a maniacal focus on cola is not the right way to look at a beverage market that is so huge. If you look at the overall LRB category, it's very important that all the players play a sensible game in this business. And what we’ve been trying to do is to say, in a category that’s growing at population, that’s the overall growth of the category. You take some pricing where it's relevant. You get pricing through innovation. You execute better and that’s what you’ve got to do. I think short-term pricing actions to pursue volume is a wrong strategy in this sort of a market, and the more people focus on carbonated soft drink volume and the more people focus on cola volume, you’re going to see more irrational behavior in the market place.

Ali Dibadj - Sanford C. Bernstein & Co.

So this quarter I think PAB was down five in terms of volume and up five in terms of pricing, so I understand you don’t love talking about carbonated soft drinks and I get why because the trends there are difficult. But if you can take a step back and look at just PAB, what do you think was driving that volume decline? It wasn’t just you, it was for the category overall.

Indra K. Nooyi

The weather was awful in the first 6 to 8 weeks of the quarter, really bad. Then we had this whole payroll tax issue that hit the consumer. So the consumer went into some distress in the first part of the year. And as I said I think on the earnings call Ali, do not talk about the year based on the first quarter, because the first quarter is always plagued with either a warm winter or a cold winter, you’ve got the up and down the street that gets impacted with storms or snow or whatever it is. So, I think a better run rate is to talk about Q2, Q3. Having said that, the LRB category is going through changes, the market is shifting more towards non-carbs, the market is shifting more to non-cola beverages like Mountain Dew which continues to grow and perform at very attractive rates. And I think what we feel good about, as I look at the LRB category between sports drinks, tea, coffee, flavored CSD. If you look at each of these businesses we have phenomenal brands in each of these markets. We’re the number one player in pretty much every category. So I look at the future and say this category has not had much innovation, later on what we’re doing in R&D, big profitable category with lots of U.S. cash flow, lets see how the game plays out.

Ali Dibadj - Sanford C. Bernstein & Co.

So, let’s see how this game plays out from a structural perspective as well, right. We’ve seen very difficult trends in carbonated soft drinks for a while, I understand that it's only 40%, 50% of the category; what is the trend that you’ve seen over the past several years of carbonated soft drinks volume continuing to be negative, regulation improving, consumer self regulation that’s really happening as well. How does that influence how you think about the structure of your North American business in particular the bottler that you bought and how you think that should look in two years, one year?

Indra K. Nooyi

I’m smiling Ali, because three years ago I’m sitting with investors and a lot of the sales side people who told me that I was wrong in saying the CSD market was going to decline; that was actually going to grow. We anticipated the decline of the carbonated soft drink market and we started to invest in technology to break all of the compromises that people didn’t want to make. So for example, when we go and talk to consumers especially the United States, they love carbonated soft drinks, the love the bubbles, they love the caffeine, they love the taste of cola. What do they not like? They don’t like the sugar levels. And recently they don’t like artificial sweeteners. So we knew we had to address both these barriers. When they said they didn’t like the sugar levels, they didn’t like the extent of sugar in the business they want it at a lower sugar level, and they wanted it without any artificials. So the investments we started to make in R&D was natural sweeteners that work in colas, Stevia unfortunately does not work well in colas and we started to play around mid-calorie drinks to see how does the taste actually work. And Pepsi Next actually is holding its own and it's a great tasting mid-calorie product, so we know there’s a consumer for mid-calorie product. So now with the work we’re doing on natural sweeteners that and the work we’re doing on flavoring agents coming through the pipelines, we actually believe that if you let this go too long in another three or five years the consumer will walk away from CSDs but while the consumer still remains in love with CSD, if we can address the barriers to consumption we can actually bring back the lapsed users. It may never be the high levels of consumption that we had when we were young. The new consumer has too many choices that they’re playing around with, but I actually think there is a once in a lifetime opportunity to bring the consumer back to CSD.

Ali Dibadj - Sanford C. Bernstein & Co.

So, you’re placing a lot of weight on this Stevia based Reb D, it seems like innovation, let’s say.

Indra K. Nooyi

I didn’t say Stevia or Reb D. Good try.

Ali Dibadj - Sanford C. Bernstein & Co.

I’ll say it, see if you blink twice. How does all of that influence what the structure of the bottlers will be going forward?

Indra K. Nooyi

I don’t know if one influences the other. I think …

Ali Dibadj - Sanford C. Bernstein & Co.

Shouldn’t it though?

Indra K. Nooyi

Yes or no, I mean we can always be a concentrated company and supply those ingredients to the bottlers. I think the bottling business came back to us as it did for the industry because the way the bottling equation was set up given the realities of the market place for the no win situation for the industry. So, I think it was done both offensively and defensively. Defensively to protect the business, offensively because, if you’re going to make a change you better have control over the most important lever which is the go to market fees in order to make the change. So, I think it was the right decision at that time, painful decision I’ll be honest with you, but it was the right decision at that time. I think going forward if anybody would contemplate anything structured with bottling requires very careful thought, because the worst outcome is to do something, just to reverse it in five years after that. The only people that are rich in that process are the bankers. So I think we just have to be very, very sensible in how we think about the separation.

Ali Dibadj - Sanford C. Bernstein & Co.

And by February you’re going to tell us.

Indra K. Nooyi

We’re going to tell us what our plans are for North American Beverage business.

Ali Dibadj - Sanford C. Bernstein & Co.

And what's off the table at this point or what (indiscernible).

Indra K. Nooyi

I can’t share all that with you Ali. Keep trying.

Ali Dibadj - Sanford C. Bernstein & Co.

Okay. If you take a step back and you talk about the snacks business, the Frito business results have been very successful in the U.S. There’s a very clear margin differential between the U.S. and the rest of the world. Some countries like Mexico maybe a little bit higher, but on average as you do believe that you said two thirds of your growth will come from the emerging markets, two thirds will be snacks, there’s a clear weight on your margins, quick downward pull on your margins. How do you think about that? How does that impact how you talk about margins for the overall company and what you’re going to do to try to help that?

Indra K. Nooyi

So, I mean, we actually run the math on this. Let’s say, given the growth we have in the developed markets, given the growth we have in developing markets and emerging markets and remember all these margins are different. So, if you look at sort of a hierarchy or margins the U.S. sits on top. For the Mexico margins are pretty attractive, margin for China or India maybe lower. So the real thing that we balance constantly is we model this thing out, given the differing growth rates. Where do we need to get productivity? Where do we need to get more growth? We work those out to say the net result, will it result in a 30 to 50 basis point improvement in operating margin. And based on the mix of countries, the anticipated growth rate; our productivity initiatives in many markets. We have tremendous confidence that we can get that operating margin expansion.

Ali Dibadj - Sanford C. Bernstein & Co.

And is it mainly based I guess, because you’re investing to get distribution in the emerging markets it's all in snacks, some of the other businesses. Is it mainly then going to be developed market margin improvement particularly in North America?

Indra K. Nooyi

Not really, because the chart which showed that between 10,000 and 20,000 the curve goes up rapidly. So, why don’t you put the infrastructure in place as the growth comes your margins start improving rapidly. And the best example …

Ali Dibadj - Sanford C. Bernstein & Co.

But it's still lower, right, I mean, there wasn’t a jump 15 basis points in a year.

Indra K. Nooyi

Not in a year, of course not, I mean if they did it would be almost irresponsible management I’d say. But I’d say as the markets grow margins steadily improve. So they’re not as dilutive as you might think they are because they contribute to the top line, they contribute to the bottom line and the net results in the 30 to 50 basis points. At the end of the day, if you want to maintain a growth company you have to have a mix of different growth rates in the top line and the bottom line. Markets that grow at very low levels, yeah you can get margin expansions but that growth might, you’ll struggle if you didn’t have other markets to get the top line growth going and then the bottom line comes with it. So, I think it's a classic growth share matrix, I mean we’re just working this through and we’ve got a portfolio where each of the pieces contributes its weight to the 30 to 50 basis point improvement.

Ali Dibadj - Sanford C. Bernstein & Co.

So it sounds like the belief right now is that there is organic scale benefit going to the emerging markets that improves your margins.

Indra K. Nooyi

That’s right.

Ali Dibadj - Sanford C. Bernstein & Co.

What about the inorganic path? A lot of folks have talked about other snacks businesses out there. Your former colleague, Irene, speaks tomorrow here at the conference, what do you think about the Mondelez business and how that could inorganically help you get to that scale faster?

Indra K. Nooyi

As a company we’re architected to deliver high single-digit EPS growth. And as I said to you in our food and snacks business our growth comes from taking businesses from other snacking businesses. So, in the developed markets we go after every other macro-snack occasion. In emerging markets we have huge runway for growth in terms of building penetration and frequency. So we have enough growth on our own. Our belief is that we do not need any transformation M&A to accomplish our goals, and we’re very happy with the PepsiCo portfolio and that’s how it's going to be.

Ali Dibadj - Sanford C. Bernstein & Co.

Have you been approached to think about that more and do more analysis on that?

Indra K. Nooyi

We don’t comment on those kinds of things, Ali. All that I’ll tell you is we’re very happy with our portfolio.

Ali Dibadj - Sanford C. Bernstein & Co.

Okay. So stepping back to the North American market and again your competitive situation here clearly fighting coke from a category trend perspective; can you talk a little about the pricing trends that you’ve seen, does it remain rational and particularly if you come out a memorial day weekend what have you seen on the market place?

Indra K. Nooyi

It depends on the region of the country and the category. I think it's more rational now than it was perhaps in the later part of the first quarter, early second quarter. But I think any time you see poor weather patterns and you see demand falling off as consequent category demand, you tend to see some interesting pricing action as people try to push short-term volume. But I’d say by and large it's getting more rational. Let me put it this way, we are being very rational.

Ali Dibadj - Sanford C. Bernstein & Co.

And are your competitors?

Indra K. Nooyi

I think so. So far we have seen pretty rational behavior from competition.

Ali Dibadj - Sanford C. Bernstein & Co.

Okay. I will try to push my time given there’s no one else in this room. From a cost cutting perspective you mentioned some examples out there and you’re ready you mentioned for the next tranche of cost cutting. How much more room do you think there is? You’ve talked in the past of an aspirational 500 basis points higher than today’s EBITDA margins. Do you think that’s still an aspiration and what are the steps to get there?

Indra K. Nooyi

Once we’re through with this next tranche of productivity Ali, let’s come back and talk about this because talking about it piecemeal doesn’t help. What we do is set goals, but then productivity at PepsiCo is a discipline not just an aspiration. We take every program we landed. We don’t talk about it until we have some of the 90% certainty of delivering it and our program management officer has taken it over. So when we’re ready to talk about it lets come back and we’ll talk about it holistically.

Ali Dibadj - Sanford C. Bernstein & Co.

Can you even tell us what the buckets that you’re going to go after?

Indra K. Nooyi

Everything that I’ve talked about best practice sharing, we’re dialing that up even more, more shared services. If you’re looking at everything inside the company, how do we do work, how do we make our processes more common, how do we reduce the number of spans and layers, we look and nothing is off the table.

Ali Dibadj - Sanford C. Bernstein & Co.

Okay.

Indra K. Nooyi

And this didn’t happen because we just woke up over night and said productivity. It's a journey we’ve been on for a long time and by putting in the SAP systems to run the company it's given us more visibility, so we’re able to do this now. If we didn’t have those systems we wouldn’t be able to do what we’re doing now.

Ali Dibadj - Sanford C. Bernstein & Co.

Okay.

Hugh F. Johnston

To that point, Ali. Operating expense is a $28 billion bucket inside of PepsiCo. With that size bucket of course there is always lots of opportunity to go and do more and that’s really where the lot of management is spending it's time on as in addition to driving the top line finding more and more opportunities for productivity. So we view that as a source of fuel for years to come.

Ali Dibadj - Sanford C. Bernstein & Co.

Okay. A couple of quick questions; one on regulation. Tell us your views on what we should expect from regulation in the U.S. and overseas on some of your categories?

Indra K. Nooyi

We hear noise about regulation now and then. I think ultimately when the rubber hits the road good sense prevails, that regulation is not going to address whatever issues the regulation was intended to address. That requires a balanced set of phys ed in schools or incentives for healthy nutrition. Having said that, I don’t think we should run a business on hope or hoping that regulation goes away or doesn’t happen. What we’re doing is transforming the portfolio. As I said increasing the permissibility of our front view products, dialing up are better for you, and significantly beefing up our good for you portfolio. At the end of the day, the best portfolio gives you insulation, not necessarily just fighting governmental actions. So that’s what we’re focused on.

Ali Dibadj - Sanford C. Bernstein & Co.

Okay. You mentioned Power of One in the context of Doritos Tacos Locos, can you give us any other example where you’ve really found Power of One to be enormously powerful. We keep searching and often times we don’t find perhaps because it's in internal discussion as opposed to what we see externally.

Indra K. Nooyi

I think the best example I can tell you is that, as we look into the future the lines between snacks beverages are blurring. I don’t know if Naked Juice is a snack or a beverage. Many beverages as they get more viscous, are eating into the snacks occasion and many snacks that used to be consumed as a dry snack are now being eaten in different ways. So think about our business as being drinkable, spoonable and one-hand consumable. So, if you look at Quaker Real Medleys, it’s a spoonable product, but it’s also going to be a bar and it could also be a drinkable oats. So, I think increasingly you’re going to find people think about the convenience occasion as one continuum. We keep talking artificially about snacks and beverages only because some people used to track this industry differently. I think that’s over. This is convenience and the best way to think about it is all our products you can consume with a rip, twist, flip or tear, whether it’s snacks or beverages and that’s the business we’re in.

Ali Dibadj - Sanford C. Bernstein & Co.

Okay. And my last question, pushing time hard around A&M expense. You had originally said a year-ago approximately in February just down the street, that look we’re going to increase the advertising spend 5.7% roughly and keep it at that level. This first quarter we saw 50 basis point increase, do you think you’re going to need to spend it more and in that context we have a couple of questions about the social media, how does that play into your A&M going?

Indra K. Nooyi

We increase it to 5.7% as I mentioned in my prepared remarks Ali. We plan to increase, whenever we’ve reinvestment opportunities, where we see a return on investment in A&M, we intend to put it back in. Digital media, the ROI metrics depending on who you talk to, are either very attractive or we don’t know what the ROI is. At this point where we have had engaging digital campaigns, they’ve actually been able to cut through the clutter. And so our teams are now working on a better metric of a digital ROI, not the metric that many of those companies give us, all the digital companies give you ROI, which are good metrics, but we haven’t been able to resonate with them. So we’re developing our own. But right now what we’re saying is let’s just measure the consumer brand equity from the digital campaign. If the brand equity has caused improved, then we know the digital campaign is working, especially in brands that only live in the digital world. That’s how we’re looking at that.

Ali Dibadj - Sanford C. Bernstein & Co.

Okay. Thank you very much for your time. Thank you.

Indra K. Nooyi

Pleasure Ali. Thank you very much for your time.

Ali Dibadj - Sanford C. Bernstein & Co.

Thank you.

Indra K. Nooyi

Anytime.

Question-and-Answer Session

[No formal Q&A for this event]

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