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PepsiCo Inc. (NYSE:PEP)

Q1 2007 Earnings Call

April 25, 2007 11:00 am ET

Executives

Jamie Caulfield - IR

Indra Nooyi - CEO and Chairman Elect

John Compton - North America CEO

Mike White - Vice-Chairman and CEO

Richard Goodman - CFO

Dawn Hudson - President and CEO of Pepsi-Cola North America

Analysts

Judy Hong - Goldman Sachs

Lauren Torres - HSBC

Bill Pecoriello - Morgan Stanley

Christine Farkas - Merrill Lynch

Mark Greenberg - Deutsche Bank

Matthew Riley - Morningstar

Bryan Spillane - Banc of America Securities

Mark Swartzberg - Stifel Nicolaus

Kaumil Gujjarwal - UBS

Presentation

Operator

Good morning and welcome to PepsiCo's First Quarter 2007 Earnings Call. Your lines have been placed on listen-only, until the question-and-answer session. (Operator Instructions).

Today's call is being recorded, and will be archived for 14 days. It is now my pleasure to introduce Mr. Jamie Caulfield, Vice President of Investor Relations. Sir, you may begin.

Jamie Caulfield

Thank you Operator, and good morning, everyone. Thank you all of you for joining us this morning. Today's webcast includes a slide presentation that can be accessed at our PepsiCo.com website.

Before we begin, please take note of our cautionary statement. This conference call includes forward-looking statements based on our current expectations and projections about future events. Our actual results could differ materially from those anticipated in such forward-looking statements, but we undertake no obligation to update any such statements.

Please see our filings with the Securities and Exchange Commission including our Annual Report on Form 10-K, for a discussion of specific risks that may affect our performance.

You should refer to the investor section of PepsiCo's website under the heading ‘PepsiCo Financial Press Releases’ to find disclosure and a reconciliations of non-GAAP financial measures that may be used by management when discussing PepsiCo's financial results with investors and analysts.

This morning's prepared remarks will be made by Indra Nooyi, Pepsico's CEO and Chairman Elect, Mike White, PepsiCo's Vice-Chairman and CEO of PepsiCo International, John Compton, CEO of PepsiCo North America, and Richard Goodman, PepsiCo's CFO. Dawn Hudson, CEO of Pepsi-Cola North America is also with us this morning for question-and-answer. We have one housekeeping item this morning. We put out a press release and 8-K earlier in the quarter reflecting two changes to PepsiCo international's reporting.

One, the reporting calendar for a number of the PI operating units was changed from four week periods to months. This has no impact on the full year reported results, but it does make the first quarter smaller as it goes from having 12 weeks to having just two months January and February.

Each of the remaining quarters becomes a bit longer as a result of the reporting change. With this change almost all the reporting units with NPI are now on a monthly calendar. This simplifies our accounting close processes and [aims] in our compliance or statutory reporting requirements. It's also helpful as we move PI operating units to the SAP platform.

The second change effecting PI is that income from our non consolidated international bottling interest was reclassified from the bottler equity income line to the PI line of business. This change was made to be consistent with PepsiCo's internal management accountability. It appears virtually all the sale side analysts updated their models and quarterly estimates over the past few weeks to reflect the changes. But we're mentioning it again just to make sure there is no confusion.

Now it's my pleasure to introduce, Indra Nooyi.

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Indra Nooyi

Thank you Jamie and good morning everyone. Thank you for joining us this morning. I appreciate the opportunity to discuss PepsiCo's first quarter performance and our outlook for 2007. As you saw in this morning's release, we are off to a very good start for 2007. Worldwide snacks volume grew 7%, worldwide beverages grew 3.5%, net revenue was up 9%, division operating profit grew 9% and EPS grew 17%.

Before Mike and John talk in more detail about their businesses, let me share a few observations on the quarter's results and our outlook for the full year. As I look at the performance across our operating divisions there are few key things that emerge.

The first is the broad based strength of our businesses. All of our operating divisions had very good top line growth and within each division the sources of growth were diverse. Whether it was growth from the core and new platforms or it was broad based geographic growth or growth across trademarks.

We also saw this quarter, both the strength of our portfolio and the flexibility it gives us in meeting our financial goals. As we experienced difficult overlaps or cost pressures in the particular business or in an individual market, we were able to take advantage of the counter balancing positives in other parts of our business to manage through these challenges and at the same time generate strong, consistent overall performance.

Point two is the breadth of our innovation. We shared much of our innovation with many of you at our investor meeting in October and many other products you saw and sampled there have now hit the market with good success. For example, we've launched Flat Earth at Frito-Lay and Gatorade AM and both are off to a very good start.

At the start time, our core businesses are doing extremely well. Take Doritos for example, this is a big established business that generates more than $1.5 billion in annual sales in North America, and its volume grew 13% this quarter. Our Gamesa in Mexico, which is one of our big three international business. We had spectacular growth at Gamesa this quarter, with volume up double digits.

The third point is how well the businesses are managing, the pricing and productivity levers to offset input cost inflation. In some cases, this involves from surgical pricing to offset more modest inflation, or as at Tropicana managing through a major reset of category pricing in the face of significant inflation. And finally, we are pleased with both the integration and business performance of our recent tuck-in acquisition. Stacy's, Izze, Naked Juice, Duyvis, Sakata, Bluebird, have been very good recent strategic tuck-in acquisitions, and all of them are performing on or ahead of expectations.

As I look forward, I am truly excited about our business. All of our businesses have positive momentum and our portfolio is working. PepsiCo North America is performing very well. In spite of difficult overlaps and significant cost inflations. PepsiCo International continues to benefit from a stable global macroeconomic environment and excellent on the ground execution by our management teams. And we're now seeing the scale benefits in many of our international businesses as they drive power-of-one advantages.

Next, as pleased as I am with the performance of our recent tuck-in acquisitions, I am equally excited about the prospects for future tuck-in. We have the richest acquisition pipeline I've seen, with promising opportunities to fill wide spaces, add scale and obtain new capabilities.

Finally, we have a terrific management team leading our businesses. Mike White, our Vice-Chairman and CEO of International and John Compton, leading North America are both terrific Executives doing a great job. They are ably supported by extremely talented operating executives and many function leaders. And most importantly, the team is really working well together. This is what gives me tremendous confidence in our prospects. So, with that let me turn the call over to John Compton to discuss the North American business in more detail. John?

John Compton

Well, thank you Indra. I am pleased share with you our North American results this morning. For those of you who are at CAGNY, I want to remind you of the imperatives that we discussed for both our food and beverage businesses. The imperatives are important as they contributed to our first quarter performance.

You may remember that across our Frito-Lay and Quaker Foods businesses, we said that, we would three things. One, that we would improve the core business. Two, that we would drive premium health and wellness innovation. And three, that we would balance productivity and price. And as you saw in our announcement this morning, both our food businesses performed well.

Let me talk about each, starting first with Frito-Lay. Consistent with the fourth quarter results of 2006, Q1 2007 results for Frito-Lay were very good. Volume was up 3.5%, revenues were up 7% and operating profit was just up over 7% so, a very healthy algorithm.

The performance was driven in part by improvements to the core business. As Indra mentioned, Doritos capitalized on its tremendous momentum from the end of last year and registered another double-digit quarter with net sales growth of 14%. Over the past year, the team at Frito-Lay has focused on every aspect of this business. Flavor innovation, packaging innovation, marketing innovation, and in Q1 you saw the results of their efforts. Likewise Tostitos had another strong quarter with net sales growth of almost 10%. The base business is growing. Tostitos Scoops continues to do very well and our new multigrain products in big scoops had very good results.

Our gifts business, which is highly incremental to our overall business, was an important contributor growing over 10%. The growth was fueled by new items like Tostitos brand new all Natural Picante Sauce and new Southwestern Ranch in Creamy Spinach Dips. The perfect complement to our new Flour Tostitos's chip product.

Finally, we've completed the conversion to sunflower oil across all of our Potato Chip brands eliminating almost 50% of the saturated fats. Net, our core business at Frito-Lay performed well.

Our second imperative to drive premium heath and wellness innovation is best exemplified by the strong growth in SunChips. SunChips performed exceedingly well. We added more manufacturing capacity for SunChips in February and we continue to run flat out. SunChips revenue was up more than 30% again this quarter. Complementing SunChips is our newest brand in Frito-Lay Flat Earth. We launched Flat Earth mid way through the quarter and we are pleased with both the retail trade and consumer acceptance.

The Quaker snacks platform at Frito-Lay continues to perform well with net sales up over 20%. These products are very much on trend with our health conscious consumers and we expanded the line with the new Granola Bites, Baked Muffin Bars and many delights in the first quarter and all are off to a very good start.

In total, our premium health and wellness innovation added to 17% growth in our Smart Spot eligible products. And despite input cost inflation, the team did a nice job balancing productivity and price as margins at Frito-Lay improved 10 basis points and that included a 13% increase in A&M.

Overall the Frito-Lay North American P&L was very well balanced we continue to invest in the long term health of the business, we are managing with a good mix of surgical pricing and ongoing productivity programs to achieve solid top line and bottom line growth.

Likewise Quaker Foods in North America had a very good quarter, particularly on the top line with volume and revenue each up 5%. Quaker had solid growth in its core portfolio with Quaker Oatmeal growing 8%, behind new products like Crunchy Instant Quaker Oats and an extension of the Quaker Oats weight control line. And profits in QFNA grew 3% despite higher supply chain costs. Net, a very good start for the year at both Frito-Lay and Quaker Foods.

Now let me turn to PBNA. You will remember that our beverage imperatives are to reinvent CSDs for profitable growth, to accelerate our growth in the profitable hydration segments and to expand our lead in non-carbs. And following these imperatives PepsiCo beverages North America had solid volume and revenue growth and operating profit was about what we anticipated given the difficult comparisons.

We felt good that we overcame significant inflation in the Tropicana business and the 1% overall PBNA profit decline was managed within the total PepsiCo portfolio. Overall, bottler case sales volume was up 1%, and that was against 5% growth in the first quarter of last year. So, on a two year basis we are up 6% outgrowing the overall LRB category.

In the quarter, our CSD volume was down 3% in line with the category and in line with our expectations. As we look out through the balance for the year, we expect to see consumer momentum build from the choreography program we launched at the beginning of Q1. Choreography is much more than a packaging update. It’s a 360 degree marketing campaign, reflected on television, radio, print, outdoor, packaging and online. Choreography is truly changing the way we interact with consumers.

Innovation will accelerate as we move into the year with a launch of Diet Pepsi Max this summer and Tava later this year. Likewise, we are launching our new Diet Pepsi packaging in a new advertising campaign focused on our superior Cola taste.

Now turning to our second imperative, we had very good growth across our broad hydration portfolio with enhanced waters leading the growth driven by Aquafina, Alive and Propel. Importantly, Gatorade had low single-digit volume growth lapping more than 20% growth from the previous year. Both are shipments and the measured channel data reflect positive volume performance.

We launched Gatorade AM in the quarter, and it's performing right on our expectations. We are very pleased with the end market execution and consumer response. And as we've said in the past we expect the normalized growth on this business to be in the high single-digits to low double digits. And if you look at the performance on a two year basis, we're comfortably in that range. The second quarter will be another tough overlap and then the comparisons ease a bit. Overall, we remain very excited about the Gatorade business.

Finally, we are pleased with our efforts to extend our lead in other non-carbonated beverages. In the quarter, we had 7% growth and this included the impact of the Tropicana pure premium decline. Within non-carbs, Lipton continued to perform very well and grew over 40%. We continue to benefit from our strong position in this very healthy category, and robust a innovation which continues this year with the introduction of Lipton Pure Leaf, which is hitting the stores now.

Importantly, we are gaining traction on energy drinks, which were up more than 40% in the quarter, with new products launched under our core energy trademarks, Amp Cherry Overdrive and our All Natural SoBe essentials.

And as Indra mentioned, we are happy with the progress on all of our recent acquisitions. Our integration and business performance on the both Izze and Naked Juice acquisitions are ahead of our expectations.

On the operations front, we are encouraged with the progress on the expansion of Gatorade's manufacturing capacity. We bought four new Gatorade manufacturing lines on during the first quarter. We didn’t get the full productivity benefit of the lines in Q1, because they were only up and running in the latter half of the quarter. So, we'll start to see the full impact of these lines in the balance of the year.

Keep in mind, we'll to continue have some level in investment as the year progresses as we build out the new plant in Pryor, Oklahoma. Net, our new capacity adds efficiency to our network and to invest in the Gatorade supply chain.

In our net front, I am pleased to report that our new plant in Whitfield, Virginia received the leadership and energy in environmental designed gold certification from the U.S. Green Building Council.

With this recognition, Whitfield becomes the largest lead gold certified food or beverage facility in the world. This recognition is based on the efficient use of resources like water and energy. So it's good for the environment, and it's good for our bottom line.

Finally, we are pleased with the performance on Tropicana. It is completely against our DNA to have a business and volume decline. The Tropicana Pure Premium is a special case because of the significant increase in the cost of oranges. We've executed a series of price increases and although volumes are down, our revenues are up, the price increases are sticking, and the P&L on this business is much healthier.

So to summarize our North American business, we are off to a strong start and have very good momentum. Each of our divisions is executing well against our strategic imperatives with good results. All of which make me feel good about our prospects for the balance of the year.

Let me now turn the call over to Mike for our international business.

Mike White

Thanks, John. Similarly I am very pleased with Internationals’ first quarter performance. We had very strong top-line growth in both snacks and beverages, as well as very good flow-through to the bottom-line.

As you saw in the announcement, operating profit was up 29% which drove a 130 basis point increase in operating margins. Now our profit growth did benefit from Forex and some amortization fall-off. But even allowing for these items, profit growth was still very, very strong and our operating margins did expand.

I would keep in mind to remind you as Jamie said; it was a short quarter January, February only for PI, and therefore relatively small part of our full year. Having said that, growth in the quarter as Indra pointed out was very well balanced across all of our businesses. Both snacks and beverages developed as well as emerging markets and in every one of our regions.

In particular our snacks volume was very strong, as you saw up 13% with each of our regions posting double-digit gains. This growth has been driven by the combination of both innovation and strong execution at the front line. Our innovation was evident I would say in three broad areas.

First, as I've said before, we continue to innovate to make our products very locally relevant. I think snacks is unique in that regard, that with flavorings and seasonings we were able to do some very unique things with our business locally. Among the many examples this quarter, one of my favorites is White Mushroom Lays in Russia, and one of Indra's favorites, Bell Peppers 'n' Cream in India. And we also have spicy seafood in Thailand.

Second, we are also in international accelerating our health and wellness agenda. This means continuing our roll-out of healthy oils into new markets, introducing reduced salt products, and expanding our products with those in grains as well.

Finally in innovation, we are sharing successful new products across all of our markets, we've been doing that for a number of years. So for instance in the UK, we took the North American Baked Lay's platform to Walkers, and it's performing very well. And by the same token, John’s team at Frito-Lay North America has introduced our Australian rice snack product, Sakata into some natural food channels in the United States.

As Indra pointed out, particularly notable in our quarter snack performance was Gamesa in Mexico, the leading cookie in that country. We had excellent growth at Gamesa for both the premium and value ends of our cookie and cracker business there. I would say our team down there really has that business firing on all cylinders from great innovation, to terrific advertising, to world class retail execution.

Our beverage volume grew 7% which lapped a 16% growth, our toughest growth rate to lap in the first quarter of last year 2006. Carbonated soft drinks grew across each of our major trademarks. Trademark Pepsi growth is being supported by the global choreography program John earlier, and the rollout of Pepsi Max both in developed low sugar markets as well as in emerging and developing markets especially in Latin America.

And our 7UP business is off to a fantastic start behind the rollout of 7UP H2O. Our non-core business also had a strong quarter growing double digits with strength across the portfolio particularly in Gatorade, Tropicana and Lipton; and across geographies as well.

We continue to focus on Gatorade in our key markets in Latin America and Italy, where we experienced double-digit growth. But we're also moving Gatorade with success in to promising expansion markets like China, India and Russia. Tropicana had very strong performance in our core markets both the UK and France, and we are making good progress in new developing markets like Russia.

Finally, in non-carbs Lipton Tea had a fantastic broad-based double-digit growth in the quarter, and was particularly strong in Turkey, Poland and Russia. And frankly, I think, we are just scratching the surface on the global growth potential of the Lipton ready-to-drink tea brand.

Now on the cost side, I am really pretty pleased and proud of the work our teams have done managing some real commodity cost increases in the quarter. We stepped up our procurement efforts working with the global procurement team to help mitigate inflationary pressures, and we are offsetting the impact with productivity initiatives and some judicious pricing in our field businesses.

The net result of these efforts is evident in our operating margin expansion in the quarter. Now, I should point out, inflationary pressures on commodities will increase in its impact on our business in the balance of the year, so we'll need to continue to manage this issue carefully.

Finally, I am very pleased with the performance of our recent tuck-in acquisitions, whether it’s the nut business Duyvis in Europe, the Sakata Rice Snacks business in Australia or the Bluebird salty snacks business we just acquired in New Zealand, the leading snack company in New Zealand. They are all tracking well.

And in the case of Duyvis nuts and Sakata Rice Snacks, we’ve also gained new growth platforms that we think we can leverage in many new markets globally around the world. So net, I would say, our international business is off to a very good start, most especially our snacks business.

The strong performance is broad-based across all of our geographies and businesses, we are seeing great success with our innovation in the marketplace, and or businesses continue to execute extremely well, thanks to the terrific talent I'm fortunate to have in the field around the world. And yes, we are also benefiting from continued solid macros in developing markets

Taken together, these factors give me confidence in PI's ability to continue to contribute in a meaning full way to PepsiCo’s overall growth. So, with that let me turn it over to my friend and our CFO Richard Goodman.

Richard Goodman

Thanks very much Mike and good morning everyone. I'll cover up on our below-the-line items for the quarter, and our outlook for the balance of the year. As you saw in the release this morning, corporate cost decreased by $35 million in the quarter. Within corporate cost, Departmental G&A was essentially flat. So the biggest single driver of the decrease was the year-on-year impact of certain hedge positions for which we do not get hedge accounting treatment, and which we therefore mark-to-market each quarter.

In Q1, the overlaps produced a larger delta than normal. We had a loss last year of $10 million, and again this year of $17 million. Keep in mind that over the duration of the contracts, the mark-to-market impact in corporate cost is zero with a net gain and loss on the hedge ultimately being reflected in division operating profit.

Although equity income was essentially flat reflecting the profit pickup on our non-consolidated Anchor bottling interest, principally PBG and PAS. I would like to remind you that as a result of the reclassification that Jamie mentioned at the beginning of the call, our international bottling interests are now reflected in PepsiCo International line of business. Also within the bottling equity income line is the gain in our sale of PBG shares.

For the quarter, the gain was roughly equal to the gain we recorded in the first quarter of 2006. So there was no incremental benefit from the share sales year-over-year. Our tax rate for the quarter was 25.6%, which was down 240 basis points versus last year. It was also significantly below our full year guidance of 27.7%.

The decline was largely driven by the timing of some specific tax planning items and an audit settlement. The difference between this quarters 25.6% and the 27.7% we are assuming for the full year added about 3 percentage points to our first quarter EPS growth.

As we mentioned in our last call, the adoption of FIN 48 means that the quarterly tax rates will be much more variable than in the past. Our weighted average diluted share count declined by 1.3 percentage points, which reflected the impact of our share repurchase program.

Moving onto cash flow, cash provided by operating activities was $626 million in the quarter, which compares to a $173 million cash flow in the first quarter of 2006. The 2006 performance was impacted by a $420 million tax payment related to our international cash repatriation. Beyond that, the elements of cash flow performance are fairly straight forward. We had a net use of working capital, which was driven by seasonality and the growth in our business.

Capital spending was $267 million which is consistent with our full year CapEx forecast. And we returned $1.4 billion to shareholders, $498 million in dividend, and $884 million in share repurchases. Let me turn now to our balance of the year outlook.

Both Mike and John commented on our operating division effective management of input cost .Cost overall have been consistent with our expectations and our outlook for the full year is essentially in line with what we shared on our last conference call.

Foreign currency provided a modest benefit to the P&L overall. With strength in the pound and Euro more than offsetting weakness in the Mexican Peso and Canadian dollar. We expect to see continued modest Forex upside for the balance of the year.

For the full year we expect earnings per share of at least $3.30. And given the strength of our first quarter, we are feeling much more confident in that outlook. As you model out the year, I’d like to remind you that the second quarter is our toughest comparison for the remainder of the year. Finally, both our cash flow and CapEx targets are consistent with our previous guidance. We expect $7 billion in cash from operating activities and $2.6 billion in capital spending.

Let me now turn it back to Indra.

Indra Nooyi

Thanks Richard, and let me just sum it up and say that we are pleased with the results for the first quarter. The strength of the top line and bottom line indicates we've got the right strategies in place, and our teams are executing them effectively. The businesses all have good momentum, and as Richard just mentioned that gives us increased confidence in our outlook for the full year.

Before we open it up to questions, I'd like to share some news about my favorite Investor Relations person Jamie Caulfield. Jamie will be moving on from his current role as Head of Pepsico's Investor Relations to work with Rahid Hamida, Head of Corporate Strategy, supporting our international acquisition work. I mentioned to you in the earlier part of my comments that our acquisition pipeline is very full. So, we are happy now to have a person of Jamie's caliber focused on this critical area.

Now Jamie would like me to stop here and say some good things about him, but Jamie doesn't have to remind me because a lot of people want to say great things about you. But I'd like to just summarize it by saying it is a stellar job articulating the Pepsico growth story and he took a very strong IR function and further strengthened it. And many of you have reached out to me to tell me just that. And Jamie was rated the best in the industry by the Intuitional Investor magazine. But most importantly Jamie does his job with a smile and a great attitude and his trademark sense of humor. And Jamie I know I speak for Mike, John, Richard and Steve Reinemund in saying that, you did a great job for us. I am glad you are just to run the corner, working on M&A and taking that to a new level, but we will miss you in Investor Relations.

I am also very pleased to announce that Jamie will be succeeded by Jane Nielsen. Jane is rejoining PepsiCo from the Pepsi Bottling Group, where she is the Vice President of Finance for North America. She is no stranger to PepsiCo, she spent five years at PCNA before joining PBG in 2002. And before the time in PCNA, she worked in the corporate strategy and development group and I was in it many years ago. I've worked with Jane in the past and she is an outstanding executive. I am really excited to be working with her again.

Both Jamie and Jane are committed to making the transition absolutely seamless and will be working together for the next several months to make sure that's the case.

Operator, we'll now be glad to open lines for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question is from Judy Hong of Goldman Sachs.

Judy Hong - Goldman Sachs

M&A Indra, I am wondering, if you could just give us a little bit more forms to your comment about the robust pipeline of tuck-in acquisition, specifically some of the sizes of the deals that you are looking at and the just balancing this comment with a view that the asset prices seem generally high, if you look at the bottler marketplace. If you can just comment on that?

Indra Nooyi

Well Judy, you know in the past years, we've always talked about a rich acquisition pipeline. And I think in several calls, we have talked about a pipeline that runs anywhere from 10 to 20 deals. But then, we end up doing maybe one, because we apply fairly strict financial and strategic criteria. And we were very careful not to overpay for acquisitions. What we are seeing now is the pipeline where the hit rate is likely to be much higher. These are properties that are uniquely suited to PepsiCo's strengths because they're an extension of our businesses and so we can afford to pay a fair value for these businesses and realize the synergies. And they range in size from businesses that are $5 million to $10 million we are looking in a some very, very small deals. The businesses, if they pan out could run a couple of billion dollars. So we are looking at the whole range. Again the hit rate looks like it's going to be better this year than it's ever been and all of the acquisitions we're looking at are either filling out wide spaces, getting us in the geographies we've not been in, but are very complimentary to our portfolio or adding new capabilities that we desperately wanted. So we're feeling good about this portfolio, this acquisition pipeline.

Judy Hong - Goldman Sachs

Great. And if I can just follow up with a question on Frito-Lay, just looking at the 13% A&M spending increased in the quarter, may be if you can give us a little bit more color in terms of where the spending is going to and how we should think about the increase for the balance of the year and the pay offs that you are seeing from a volume perspective on some of these spending increases?

Indra Nooyi

John?

John Compton

Good morning Judy. The increase was largely on the incremental effect of rolling Flat Earth into the market place. We didn't wanted take A&M away from Lay or Doritos or Tostitos to make that launch. So the full year increase that we have that Frito-Lay is largely going to launching Flat Earth to help us build up that new platform.

Judy Hong - Goldman Sachs

Okay. Thank you.

Operator

Thank you. Your next question is from Lauren Torres of HSBC.

Lauren Torres - HSBC

Good morning. I was hoping you could provide us with an update on your cost environment? May be particularly Corn and Sweetener and Orange Costs? And also talk about your confidence for the remainder of the year as far as managing this cost inflation?

Indra Nooyi

Richard?

Richard Goodman

Yes Lauren, as we talked about on the last call we have really a very diversified basket of input and we are really tracking exactly where we thought we would be. In any kinds of situation like this you have some puts and takes, some of the costs are little bit higher than you expected, on corn some of the cost on energy are little bit lowered. But as we look out of course we experienced in the first quarter and this is what we anticipate for the balance of the year we are going to be very, very close to the numbers that we had, thought we would be at.

Lauren Torres - HSBC

And I guess also you are thinking about what you are doing for the rest of the year be it through productivity mix and pricing? Is there one area in that respect that you going to be a little bit more relying on than you originally thought?

Richard Goodman

Well, I mean I think as Mike talked about, I think that we are always that we are going to continue to step up the productivity initiatives, because we are just in an environment in which commodity costs and other costs are going to be very volatile. And we need to make sure that we are balancing off our ability to provide value to the consumers, while still absorbing those costs. So we have a huge emphasis on productivity and as we said earlier on we are taking surgical pricing and being very disciplined in how we take it and monitoring how that impacts our volume as well. And that's true both internationally as well as domestically.

Lauren Torres - HSBC

Okay. Thank you.

Operator

Thank you. Your next question is from Bill Pecoriello of Morgan Stanley.

Bill Pecoriello - Morgan Stanley

Good morning everyone, question on international, a couple of things. Mike, one is with the strong emerging market macro backdrop that we are seeing along with the strong execution described, it seems like you are really well positioned even though Q1 is a small quarter to certainly sustain profit growth above that, mid-teen, long term growth you'd given you can talk about how much this emerging market macro backdrop that we are seeing a lot of category is contributing. And then, in terms of the tuck-in pipeline on international if you can talk about some priorities, on filling in some of that space, whether it'd be certain geographies or non-carbonated beverages in markets like China, local snacks et cetera.

Indra Nooyi

Mike.

Mike White

Sure, good morning Bill. In clearly emerging market macros have been solid, but I don't know that I would say that the first quarter macros were any all that dramatically different then they were in the fourth quarter or the third quarter last year. They can continue to be very solid. And I think the strength in our emerging markets has really been a combination of I think innovation and execution, in the way we are building out our business. So, in terms of the full year, I'm real pleased with the first quarter, but I just would remind you its two months out of the year. It’s a short quarter and it’s a small quarter from the seasonality basis. So, I think we -- I am sticking to kind of the direction that I gave last October frankly overall, but I am pleased with the performance.

The other thing I think that is the underneath the numbers. We had very-very strong performance in some of our large developed businesses like Gamesa that helped the quarter. We also had some things that kind of broke our way that we didn’t quite expect or planned for in the quarter. And the other thing that was interesting was that, a lot of the smaller portfolio what I call kind of my [G30] if you will of smaller emerging markets from Venezuela to Vietnam to markets like that, Egypt and South Africa had very-very strong performance in the quarter. So, it was very diversified in terms of the markets overall. So, I'm pretty happy with the performance overall for the quarter.

Obviously, and we're going to try advantage of that to drive continued strength for balance of the year. But as I said, it's a short quarter, we've got some commodity cost challenges balance of year. So, for the moment, I expect with full year guidance that we have given.

In terms of acquisitions, as Indra, said, we're very active on that. We obviously don’t talk specific acquisition, nor do I want to tell my competitor, where I'm targeting. But clearly, I think, we have said before that, in terms of snacks, we continued to look to strengthen our portfolio in wide spaces. There are still opportunities in geographies, virtually everywhere I would say, for the snacks business with a particular focus on emerging markets. But not exclusively, so frankly, we're seeing some opportunities come up in the couple of developed markets in Europe as well. So, it's never over until it's over, and so, I think we have got good opportunities, and of course we continue to look for ways to strengthen our portfolio on the beverage side with a focus on emerging markets and broadening our beverage portfolio.

Bill Pecoriello - Morgan Stanley

Thank you.

Operator

Thank you, your next question is from Christine Farkas of Merrill Lynch.

Christine Farkas - Merrill Lynch

Thank you, good morning. Maybe we can dive a little bit more in the Gatorade. Volumes were up low single digits in the quarter against a very tough comp. We see a similar comp in the second quarter. Can you just discuss trends perhaps as the quarter progressed getting into the second quarter, with Powerade potentially not taking pricing? How are seeing the dynamics, both in the food stores and in CMG as well?

Dawn Hudson

John?

John Compton

Yeah, Christine, Gatorade performed, right where we thought that it was going to perform coming out of the fourth quarter. We said this in first quarter of this year and to some degree in the second quarter the volume growth given the laps that we'd like to look at this business on a three year basis and we're continuing to see double-digit growth in that business on a two year basis and we had low single-digit growth in the quarter. It did improve as the quarter went along, particularly as AM guidance into the marketplace and got seeded. And Propel, as the new advertising campaign that has launched has also done very well and that has helped both on the Propel business.

So we're optimistic about Gatorade. I feel good about where we stand right now. I think the pricing actions, that our competitor has or hasn’t taken is somewhat irrelevant to us, because Gatorade has a good share position. We don't really look at their price points necessarily. We stay committed to the business for the long term. We're happy with the pricing that we have today and the pricing that we've taken going forward.

Christine Farkas - Merrill Lynch

Okay, great. And just as a housekeeping John with the orange juice prices coming off or moderating here, how is the overall hedging position? Can you take it advantage of their [seriousness] in that commodity.

John Compton

I'll have Richard pick it up but I'll tell you this having watched the FCOJ futures in the last year and half, we got to not look at anyone given day or week. They fluctuate all over the board at least they recently now I'll let Richard pick up from here.

Richard Goodman

Yeah, I think clearly they've come down and we're and that would be nice if it sustains that because kind it mean in part as well, if there's more oranges available and that there -- and the overall pricing and productivity environment will be different. So, but from a ability to hedge it obviously we're looking, we always look at the -- at our ability to do that and we're taking advantage of that as we can.

Christine Farkas - Merrill Lynch

Okay, great. And the final question on CSDs internationally. Certainly strong overall beverage growth 7% volume growth, but perhaps Mike you could talk about the carbonated market in Mexico and the UK, some big material market which might be seeing some challenges?

Mike White

That's sure Christine. Overall in beverages I think we had a solid quarter. You have to keep in mind we were lapping some very, very strong numbers, particularly in Asia from last year. So our overlaps were quite tough in Asia, and I think that probably impacted the number that you are looking at in terms of our Asia performance.

Just to comment on Mexico; Mexico first I guess, certainly I was disappointed in our CST performance in the quarter in Mexico. We've kind of done a field strip of the business. The weather was not great, but I nevertheless was still not happy with our performance. But I think that the teams collectively have re-looked at our strategies both in the market place, and in terms of execution, and in terms of the pricing, and in marketing calendar. And I feel pretty good about the balance of the year, but Mexico is a focus and I would say we've got more work to do there.

The U.K business performed very well for us in the quarter, where Pepsi Max continues to be very strong in the U.K. And we had very solid growth in the U.K. We had excellent support from our retailers there, Tesco in particular. And so I was really pleased with the strength particularly of Pepsi Max in our retail execution programs in the U.K. So net-net I would say I feel pretty good about overall beverage performance. As I said had a bit of an overlap issue in India and China, which kind of soften those numbers just to tab.

Christine Farkas - Merrill Lynch

Okay, great. And a quick congratulations to Jamie, it sounds like you are going to be very busy.

Jamie Caulfield

Thank you.

Indra Nooyi

That's our goal.

Operator

Thank you. (Operator Instructions). Your next question is from Mark Greenberg of Deutsche Bank.

Mark Greenberg - Deutsche Bank

Thanks and good morning. Indra in light of what's a strong cash flow and earnings performance, I am surprised you continue to endorse the same guidance for earnings and share repurchase. I'd like to dig in to the acquisition pipeline a bit, and hopefully get some sense from you as to have that plays into the Board's current thinking with regards to dividend and share repurchase.

Your balance sheet continues to be very unleveraged. Even if you guys are able to pull-off three or four of the deals with the magnitude you're alluding to, you still got an awful lot of balance sheet flexibility. So, can you help me square that with current thinking on dividend and share repurchase. Thanks.

Indra Nooyi

Good morning Mark, good to hear from you. Let me toss this over to Richard Goodman, our CFO who will answer these questions for you.

Richard Goodman

As you know Mark on the dividend, the dividend we set at Board meeting in conjunction with our annual meeting which is just in a couple of weeks. Any change in dividend policy is announced then. As far as any other changes in leverage, we really have nothing to afford at this point. At the same time as Indra point out, there is a huge pipeline on the acquisition front, and that's one of the reasons that we have a strong balance sheet to be able to take advantage of multiple opportunities that are happening across the globe. And we are in a very good position to be able to do that right now.

Mark Greenberg - Deutsche Bank

Just on the huge work, because I think that's everything is relative there. Indra you talked about business opportunities at $1 billion to $2 billion. Are you talking about those are enterprises that generate $1 billion to $2 billion in sales or are those to the size of the enterprise value?

Indra Nooyi

I am talking of the Enterprise value?

Mark Greenberg - Deutsche Bank

Okay. So, again if you guys did three or four of those, you are coming pretty come funding that from cash, yet your balance sheet’s still pretty unlevered.

Indra Nooyi

Richard.

Richard Goodman

No, I don’t think that. You remember our balance sheet also includes the debt that we have from our bottlers as well, from a rating agency standpoint. And so, it's not quite as pristine as it looks. Remember, at that the current time we are returning all of the cash flow that we have to shareholders. So, if we do a significant amount of acquisition, then we would wind up potentially taking on additional debt for that.

Mark Greenberg - Deutsche Bank

Thank you.

Indra Nooyi

Thanks Mark.

Operator

Thank you. Your next question is from Matthew Riley of Morningstar

Matthew Riley - Morningstar

Good morning and congratulations Jamie.

Jamie Caulfield

Thank you.

Indra Nooyi

Thank you, Matthew.

Matthew Riley - Morningstar

I was wondering, when you talk about returning to profitable growth in the North American CSD market. Is that dependent on taking large share, a large volume, to value shift in the industry or are you anticipating a large secular recovery in the overall market?

Indra Nooyi

So we’ll talk to Dawn Hudson, Head of PepsiCo in the North America, who is here. Dawn?

Dawn Hudson

First of all in the CSD market, I think we continue to see the consumer shift from carbonated soft drinks to non-carbonated. This is how people have been drinking for a long time in their home.

And when they go out and live life on the go and want a ready-to-drink beverage, they are continuing to take more on the non-carbon area. So we don’t a fundamental change to that. But I think it would be a mistake to say the category is tanking.

Consumers still continue to really like carbonated soft drinks. And there are some really opportunities to position new brands against new unmet needs, and to continue to write brands frankly like Mountain Dew or Sierra Mist that are still in the areas of the markets that are growing.

So, we continue to see growth opportunity on the volume side, and we want to make sure that that is captured as well in a profitable way for both ourselves and for the system.

So I guess in closer I'd say, innovation has opportunities, segment that are growing within the market has opportunities, and we’ll attack those in a balanced way between volume and profits.

Indra Nooyi

And Dawn I think you would fair to add that our promotional activity has also not been targeted in the past. Some of it has been [grateful]. So I think we are cleaning that up and getting more targeted in our promotional activity.

Dawn Hudson

As Indar commented we continue to invest in the market, but we are careful to in ways that we think provide long term value.

Matthew Riley - Morningstar

Okay. Thank you.

Operator

Thank you. Your next question is from Bryan Spillane of Banc of America Securities.

Bryan Spillane - Banc of America Securities

Hi. Good morning.

Indra Nooyi

Good morning Bryan.

Bryan Spillane - Banc of America Securities

Question for Mike White. If you look at your business now, how much benefit are you getting from just taking real local price increases? And I guess my impression in the past years is that, that hasn’t really been a lever you’ve pulled. So, given how strong the macro backdrop is, is that something you're benefiting from at all now and what's the opportunity in the future?

Mike White

Good morning Bryan. It gets awfully hard to talk about PI as a whole on a question like that, because pricing and cost are so locally -- but I'll try and give you at least a little bit of a local color for what's kind of running through the P&L, because it does range. In some of our businesses it's minimal in terms of pricing say 1% to 2%.

There are a couple of significant challenges, and I would say it’s primarily Mexico, where we are facing significant commodity cost challenges for the year. Hence we had to take some significant pricing.

And I think I may have mentioned on the last call. If I take Sabritas as an example, I was very pleased with Sabritas’s performance in the first quarter, it's our largest salty snack business.

But our volume for the quarter was up modestly, it did benefit a little bit from those extra [training] days. But even ex that, the volume was flattish, and we had to take about a 6% price increase. So if look at any elasticity model, I was quiet pleased with the performance of Sabritas on that.

So it could make sense, Sabritas are both looking at some meaningful pricing on the order of 5% or 6% to deal with extraordinarily high commodity cost. But I wouldn't say that's necessarily given us a windfall in terms of gross margin flow through. It’s really just trying to offset the extraordinarily challenging commodity cost that we're facing.

On the other hand in a lot other emerging markets; Russia, India, China I would say its modest if any pricing. In Europe snacks were getting a probably a couple percent of pricing. So I would say it’s not extraordinary other than the Mexico part of the story, but I am quite pleased that we've been able to make the pricing stick, and also that we've been able to hold the consumer in Sabritas in particular. I would say I was real pleased with the progress the team made there in the quarter.

Bryan Spillane - Banc of America Securities

So is there an opportunity going forward. I guess I think of these developing countries like Russia for instance, where purchasing power is rising. Is there an opportunity to start raising prices more or also more value-added products may be?

Mike White

Yeah, I think its more of the later Bryan I was about say. These countries are still very price-sensitive. You have a huge slope of the population that doesn't have huge amounts of money, and so small price increases can make a huge difference on the core product and there is still so much growth opportunity. Because the per capita consumption is still just a fraction of what it is even in other emerging markets much less than developed markets like the United States.

But what I do see happening is the rise of the middle class in markets like India, China and Russia is absolutely opening up opportunities for us to find ways to sell more of our value-added products. I frankly wouldn’t have dreamt of being able to sell in those markets five, six, seven years ago. And we are seeing good take on those products.

We just launched for instance in China, a Soya drink, that is a premium quality product and it's off to a very good start in the markets that we have got it going.

Bryan Spillane - Banc of America Securities

Great, thanks. And just Jamie thanks again for all your help over the years.

Jamie Caulfield

Thanks Bryan.

Operator

Thank you. Your next question is from Mark Swartzberg of Stifel Nicolaus

Mark Swartzberg - Stifel Nicolaus

Thanks Operator. Good morning everyone.

Indra Nooyi

Good morning Mark.

Mark Swartzberg - Stifel Nicolaus

John, on Gatorade and it's encouraging to hear your comments on how things are laying out there. I was hoping we could peel a little bit more here. As it relates to the price increase, can you give us a sense of how when you net all these things out relative to the incremental cost from the [clients] and others, how do things shake out in terms of how that affected margin structure for Gatorade?

And then secondly, I think it was implemented about March 19. You’ve talked in some direction about how things are going. But can you give us a little bit of a sense of what kind of reception you are getting at retail since that price increase?

John Compton

Yeah, I’d be happy again Mark to say that, the full year Gatorade plan is pretty happening exactly as we originally laid out. Pricing was a part of the algorithm as we started the year. In the warehouse business, when you announce a price increase you typically spin back with customers for the first 60 days of that increase and we are in the midst of the that right now.

In the back half of the year, the net affect of the pricing will be much less than the list pricing increase that we took, because we still want to be relevant with our promotional pricing that we have in the marketplace.

And I’ll just remind you, it's the first price increase we've had on Gatorade in the last five, six, seven years. It’s a relatively modest price increase in the scheme of things. And we are not looking to expand our margins through pricing and things like that. This is a business that has a real base business growth still ahead of it and that's the actions that we took.

Mark Swartzberg - Stifel Nicolaus

And reception at retail?

John Compton

Has been fine. Like I said we are four weeks into it, a little over four weeks into it and so far so good.

Mark Swartzberg - Stifel Nicolaus

Great, thank you and again thank you Jamie.

Jamie Caulfield

Thanks Mark.

Operator

Thank you. Your final question is from Kaumil Gujjarwal, of UBS.

Kaumil Gujjarwal - UBS

Thanks, good afternoon everybody.

Indra Nooyi

Good afternoon Kaumil.

Kaumil Gujjarwal - UBS

Richard, could you update us on the SAP rollout, and what levels of cost savings you've identified so far, and if there is things surfacing that may be you hadn’t initially [thought].

Richard Goodman

Well, I think the SAP rollout is going extremely well. We had a couple of modules implemented at the end of last year, and those went well. The next set of implementation is scheduled at the beginning of 2008. And what we are seeing is a continuation of the cost pretty much.

This year and last year is pretty similar from an overall cost standpoint forward, and we will probably begin to see really substantive cost savings on a go forward basis starting later or 2008 after we have the next set of implementations.

We’ve got some stuff on the supply chain side so far that we've implemented primarily in procurement, but most of the rest of the stuff will be after we have the next set of implementations and then obviously when we get on to Frito-Lay as well.

Kaumil Gujjarwal - UBS

Got it. Thank you and then Mike if you could give us a little bit of help on what profit growth overall you are looking for international because you've done over 24 for sometime now and maybe what you are targeting for the next few years?

Mike White

Well Kaumil if I give you the answer to that question, I'll have Indra writing that down. I don't know. Yes, so I was just being [fussy] just but look we had a very short quarter. I mean I was real pleased with the results we had a number of one off items that broke our way. I still believe that we are in the mid to high teens on kind of a flight path. And this quarter we did better than that and if we really get conviction that we can kind of blow past 20 on a consistent basis I'll let you know. But I've still got several very large businesses, as I said before Gamesa's, Sabritas' and Walker's which have margins in excess of 20% which have shares in excess of 60% and which have high per capita consumption and little bit of drag on the Mexican Peso. And so the net of those businesses, which are still 40% of my profit base they going to grow similar to North American rates or maybe a point better.

But in that ball park and so it really is driven by how strong we can drive the growth and the balance of the portfolio. What I can tell you is that the good thing about it is that it is very broad based, probably far more broad based geographically then I think is widely understood. It is not just Russia, India and China in fact they are doing fine but it is countries like Turkey, Vietnam, South Africa

Vietnam, South Africa, Argentina and we've had good performance across Venezuela, across a number of markets, and I think it's the diversity of that emerging market portfolio which gives me great confidence from a risk standpoint that we can continue to manage it successfully, but I am delighted with the progress, it's just, it's awfully early in the year after our shortest quarter and our smallest from the seasonality standpoint to go beyond that at this point. So --

Kaumil Gujjarwal - UBS

Thanks, thanks everyone and Jamie, congratulations, it's been a pleasure.

Operator

Thank you. I would like to hand the floor over to Indra Nooyi for closing remarks.

Indra Nooyi

Thank you for all your questions and on behalf of Mike, John, Richard and Jamie, let me just say thank you to all of you for your time and attention today. We appreciate your interest in PepsiCo and look forward to speaking with you soon. Thank you.

Operator

Thank you. This concludes PepsiCo's conference call. You may now disconnect.

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Source: PepsiCo Q1 2007 Earnings Call Transcript
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