PepsiCo Q2 2007 Earnings Call Transcript

| About: PepsiCo Inc. (PEP)
Wall Street Breakfast

PepsiCo Inc. (NYSE:PEP)

Q2 2007 Earnings Call

July 24, 2007 11:00 am ET


Jane Nielsen - IR

Indra Nooyi - Chairman, President, CEO

John Compton - CEO, PepsiCo North America

Mike White - Vice Chairman, CEO, PepsiCo

Richard Goodman - CFO

Dawn Hudson – Pepsi Cola CEO, North America


Robert van Brugge - Sanford Bernstein

Bonnie Herzog - Citigroup

Bill Pecoriello - Morgan Stanley

Marc Greenberg - Deutsche Bank

Lauren Torres - HSBC

Judy Hong - Goldman Sachs

Kaumil Gajrawala - UBS

John Faucher – JP Morgan

Christine Farkas - Merrill Lynch

Matthew Riley - Morningstar

Eric Katzman - Deutsche Bank



Good morning and welcome to PepsiCo's second quarter 2007 earnings conference call. (Operator Instructions) It is now my pleasure to introduce Miss Jane Nielsen, Vice President of Investor Relations. Ms. Nielsen, you may begin.

Jane Nielsen

Thank you, operator. Good morning, everyone. Thanks to all of you for joining us. Today's webcast includes a slide presentation that can be accessed at our 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 investors section of PepsiCo's website under the heading of PepsiCo Financial Press Releases to find disclosures and reconciliations of our 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 Chairman and CEO; 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 Q&A.

It's now my pleasure to introduce Indra Nooyi.

Indra Nooyi

Thank you, Jane. Good morning, everyone. Thank you for joining us. We appreciate the opportunity to discuss PepsiCo's second quarter performance and our outlook for 2007. As you saw in our announcement this morning, we delivered another very strong quarter. Coming into the year we knew that Q2 would be a particularly challenging overlap, so I'm very pleased to report 9% division operating profit growth on top of last year's 12% growth. This performance reflects both our strategically advantaged business model and the high level of execution of our 168,000 associates across the world.

Our categories of convenient snacks and beverages remain vibrant and our arsenal of leading brands continues to enable to us drive category-leading growth. Add to this our global footprint and powerful go to market systems, and the result is a portfolio with both a track record and a future of profitable growth.

Let me review the second quarter results. Worldwide snacks volume grew 6%, lapping 8%. Worldwide beverages grew 4%, lapping 10. Net revenue was up 10%, division operating profit grew 9%, net income increased 13% and EPS grew 15%. This strong performance reflects our ability to drive top and bottom line performance through operational excellence.

It's reflected in our year-to-date results with net revenue increasing 10%, division operating profit 9%, net income 13%, and earnings per share 15%. It's particularly impressive because every segment contributed to revenue and profit growth, both in the quarter and year-to-date.

Going forward, we expect our portfolio to continue delivering strong top line and operating profit growth for the balance of the year, which is why we're increasing our full year earnings guidance for 2007 to at least $3.35 per share, which translates to 12% growth for the year.

Now, since our acquisition of Quaker Oats Company, we have growth EPS at a double-digit rate every year. Our strength is not just in EPS alone. Focusing just in the last three years, we have generated $17 billion in cumulative operating cash flow, reinvested $6 billion in our business, returned $11 billion through dividends and share repurchases and delivered a return on invested capital averaging in the high 20s. All of this while still delivering a revenue compound annual growth rate of 10%. I must say, this a performance that all of us at PepsiCo are very proud of.

Before I turn it over to Mike and John to discuss the business results, I'd like to highlight a few key themes in our overall performance. First, our well-balanced portfolio continues to deliver on both the top and bottom line. Volume growth was led by strong performance in both our international business and Frito-Lay North America. Beverage volume in North America was in line with our expectations, reflecting the very strong growth we were cycling from the second quarter of last year. Our revenue was also strong, which led to share gains versus our principal liquid refreshment beverage competitor.

Second, our portfolio transformation continues with activities in three areas: continued innovation in our Fun For You products while also making them healthier, stepped up innovation in our Better For You and Good For You products; and bolstering our marketplace presence and scale with tuck-in acquisitions.

Let me speak to these briefly. As you know, we are transforming our core Fun For You brands through steady and significant reformulations and new launches designed to meet the demand that consumers have for healthier and more nutritious products. In the U.S., all our Frito-Lay salty snack products are free of trans fats. In addition, we're moving our products to heart healthy oils.

We are embarking on this change in our international business as well. For example, our Walkers business has moved to a higher league sunflower oil which significantly reduced the saturated fat content of our products in the UK. Gradually we will make a similar switch in all our markets globally when the oils are available in the quantities we require.

Our innovation of Better For You and Good For You products continues. By adding Better For You and Good For You ingredients such as fruit, vegetables and fiber to our lineup, we are in fact developing a terrific lineup of healthy, nutritious products.

Let me share a couple of examples with you. On the snack side, Flat Herbs at Frito-Lay North America continues to build strong consumer acceptance and better than expected purchase repeat. By year end 2007, it will likely be one of the top ten food product introductions of this year.

In beverages, the introduction of white tea to the Lipton line has helped fuel tea volume growth of over 30% in Q2 and extended our tea leadership.

Similarly in our international business, the successful rollout of 7-Up H20, our lightly carbonated flavored water with no sugar or calories was a key force driving 16% growth in the 7-Up trademark. With strong base business performance across Europe and recent expansion into the Middle East and Asia, the Tropicana business also posted outstanding 16% growth in Q2.

On snacks, Baked Lay's continues to show great promise in the UK and Netherlands where it was recently launched. We'll hear more about these businesses from John and Mike when they discuss our North American international business performance in more detail.

Turning now to M&A The strategy we discussed during our Q1 call is being executed as planned; strategically and with rigorous financial discipline -- nothing has changed. As I've stated in Q1, the acquisition pipeline is robust. A $5 million to $2 billion pipeline focused on our core snack and beverage space. We're looking at deals that extend our core business and are aligned with our fundamental PepsiCo strength. Based on the companies we're looking at, as I mentioned to you in Q1, we expect the hit rate to be better this year than ever before. The acquisitions are intended to fill white spaces, add scale in existing markets and obtain new capability.

Deals we've executed recently, as you well know, are IZZE Sparkling Beverages and Naked Juice in the U.S; the Bluebird line of snacks in New Zealand. and the recently announced Sandora juice business in the Ukraine via a JV with Pepsi America.

That is our M&A strategy. It's just as I detailed in Q1. Our objective is to complete transactions that create tremendous shareholder value and we're in the process of executing against that goal.

Finally, underlying our strong financial performance is our continued commitment to corporate social responsibility, which we at PepsiCo call performance with purpose. We deliver on this commitment by focusing on three areas: our products, providing greater choice to consumers in the area of healthier foods and beverages. You've been hearing a lot about this over the past year as well as in my comments this morning.

Our environment, improving the relationship we maintained between our business, the communities in which we live and work and the natural environment. We've made enormous progress here and have received several accolades worldwide for our initiatives.

And then our people; doing even more to find, develop, reward, and retain the best talent.

Performance with purpose is a commitment we are making to our consumers and customers, suppliers and employees, our shareholders and the communities and the environment we all share. Ultimately, it's a commitment to the future. We will continue to refine and globalize our efforts to deliver our performance with purpose. Over the next quarters, I'll update you of our progress in these areas.

Now John and Mike will provide more details on their businesses and Richard will review the overall financials. We will then turn to Q&A after their remarks.

Let me turn the call over to John Compton to discuss our North American business in more detail. Before John begins, let me just express how proud I am of our performance in North America. John, your business is driving strong top line growth, you're transforming the portfolio and most impressively, you have share gains in savory snacks and you have gained share in liquid refreshment beverages against the principal competitor. I think that's just terrific performance. With that resounding endorsement, over to you.

John Compton

Thank you, Indra. We are all very pleased with our second quarter results across all of our North American businesses. We are equally optimistic about the back half of the year. I'll give you three thoughts for you to think about relative to our performance and our balance of year outlook.

First, in the second quarter our collective snack, food, and beverage businesses had 5% revenue growth and 5% profit growth. Our teams have judicially balanced price, mix and productivity to offset record raw material inflation.

Second, these financial results were achieved as our share position grew in both savory snacks and the liquid refreshment beverage category versus our primary competitors. In fact, in the beverage business we have grown faster than our primary competitor for the past three years.

Third, given that we have now successfully lapped the strong overall North American performance from last year, I believe we have the opportunity to accelerate our total North American growth in the next couple of quarters. Our innovation pipeline is in good shape and we'll be introducing exciting news in the fourth quarter.

Let me speak about each of our businesses, starting with our largest domestic business Frito-Lay. Frito-Lay had an excellent quarter posting 3% volume growth and 6% net revenue growth. Operating profits increased 8% and operating profit margin expanded by almost 40 basis points. We grew our A&M investment double-digits. Importantly, our measured channel share performance increased by half a point in the broader savory snack market. Net, a very strong quarter delivered by the Frito-Lay team.

Growth in the quarter was led by continued momentum behind Doritos which delivered double-digit volume and sales growth. The brand continues to connect with consumers as we roll out flavor extensions like Blazin' Buffalo Ranch and as we launch consumer programs like Fight for the Flavor where we put consumers in control by enabling them to select the next Doritos flavor.

Frito-Lay also continues to be successful in providing consumers with solutions as they can seek convenient choices in individual serving sizes. Our multi-pack business was up 20% and our single-serve business grew faster than the average of our total business.

Our products that meet new consumer needs and create new snack occasions are also fueling growth. Tostitos growth benefited from our new Tostitos flour chips and complementing these new businesses, our dip brands posted outstanding results with net sales growing 14% primarily driven by innovation like Tostitos all natural picante sauce, Tostitos new Southwestern Ranch and Tostitos creamy spinach dips.

Healthy snacking growth was once again led by SunChips. SunChips delivered another outstanding quarter posting net sales growth of 28%. We added a new line in Topeka, Kansas during the second quarter and immediately sold out that new capacity. Another new line will be up and running by the end of the year.

Additionally, our Stacy's Pita Chip business delivered strong volume growth and has extended the Frito-Lay portfolio into wholesome snackable bread into a different part of the store, the deli section.

Finally, our Quaker Rice Snacks business continues to be a home run with our Quakes brand up double-digits.

Now, our Lay's potato chip business, however, is behind our expectations and the team is taking corrective actions over the balance of year. New packaging will be hitting the stores in the fourth quarter, and we've just recently added capacity to the fastest-growing segment of potato chips, Kettle chips. This will enable us to accelerate growth over the balance of the year in both our Lay's Kettle and Miss Vickie's brands.

Now looking at the P&L, the overall health of the Frito-Lay algorithm reflects strong net revenue growth coupled with productivity gains and cost control. Frito-Lay drove both price and mix in the quarter and effectively managed input costs. Manufacturing productivity improved by almost 2 points in the quarter. Improved safety performance drove both a casualty insurance adjustment in the quarter and an ongoing rate reduction. This productivity helped Frito-Lay to deliver operating profit growth of 8% while investing in our brands with double-digit A&M increases. Net overall, just another terrific performance from the Frito-Lay team, and we expect that these same performance drivers -- our core brand strength, our innovation, and our relentless focus on execution and productivity -- will enable Frito-Lay to deliver solid performance in the second half of the year.

At Quaker foods, operating profit increased 2% driven by net revenue increases of 4%. Volume declined slightly and was in line with expectations as we took price increases to cover grain inflation and cycled prior year innovation.

Now let me turn to PB&A. I am very pleased that our domestic beverage business delivered solid results in the quarter. Net revenues grew a healthy 5% on volume declines of less than 1%. We were lapping an 8% volume increase from the prior year, driven largely by 29% growth on Gatorade. Operating profit grew a solid 4% despite a tough overlap of 13% in the prior year.

Please keep in mind that while we're benefiting from lower amortization expenses this year, we did have a favorable insurance settlement in last year's base. So excluding the net of these two items, that increases this quarter's operating profit growth by 2 full points.

Now as you know, the beverage business is an enormous category. In fact, it's the largest in consumer packaged goods. The category continues to grow as new products are introduced to create new segments in the marketplace. We think of these segments in three broad areas: first, enjoyment and invigoration; second, hydration; and third, nutrition. Let me talk about our performance and outlook in the context of these consumer needs states.

Enjoyment invigoration brands are about 55% of the category and this segment is dominated by carbonated soft drinks, but it also includes growth segments like energy drinks, coffee, and ready-to-drink teas. In the quarter, our total CSD volumes declined mid single digits, in line with our expectations in light of the higher level of retail pricing in the market. To drive profitable CSD growth and to meet consumers' desires for a low calorie boost during the day, we launched Diet Pepsi Max at the end of the quarter. Max is off to a terrific start, having recently achieved a 1 share.

Complementing Max will be a new in and out flavor extension on Mountain Dew. Dew has partnered with Microsoft Xbox on their gaming franchise Halo 3 for a limited time only beverage that will be called Mountain Dew Game Fuel. Game Fuel will launch in early Q4.

Our energy drink business grew in excess of 20% driven by our primary brand Amp, which had over 100% growth so far this year. We're committed to becoming a much bigger player in the energy drink segment led by the Amp brand. Watch for an announcement soon in the coming months behind Amp.

Finally, our Lipton tea business continued to extend its leadership, growing in excess of 30% while gaining over 4 share points in the tea category. Trademark Lipton delivered over 30 million growth cases in the first half alone. Much of our growth this year is driven by our ability to scale innovation in the tea category. As an example, Lipton White Tea is off to a terrific start.

Importantly, the Lipton brand is sourcing volume across the full spectrum of liquid refreshment beverages. In the quarter, Lipton added more growth cases to the enjoyment invigoration segment than any other brand. In fact, our Lipton brand delivered more case growth in the total measured channel than any other brand across the total liquid refreshment beverage marketplace.

The second segment in beverages is hydration. Hydration represents about 30% of LRB volume and our brands have leading positions in the key segments of unflavored water, isotonics, and enhanced waters and a strong relative market share versus our primary LRB competitor.

Across the water segments we had strong growth in trademark Aquafina; Propel grew double-digits, and we saw continued momentum in our new brand Lifewater. Gatorade declined modestly, in line with expectations, especially given the 29% overlap. Our estimate of measured and unmeasured all channel retail Gatorade movement was up mid single-digits on a year-to-date basis. Over the balance of the year, Gatorade will gain modest momentum in Q3 and then accelerate in Q4. We believe that this business has the opportunity to grow high single-digits on an ongoing basis.

In Gatorade, we've built a mega brand by hydrating athletes when they are active on the field of play. With only a 12% share of these active first occasions Gatorade still has tremendous growth potential in its core usage. However, there are obviously significant untapped opportunities to hydrate athletes when they are off the field. So for the first time since introducing Propel, Gatorade will introduce a low-calorie electrolytic beverage to help our athletes hydrate when they are not on the field of play. It's our biggest news on Gatorade in over a decade, so watch for more details in early Q4.

You'll also see news on our enhanced water portfolio during the balance of this year. We expect Propel will continue with successful fit positioning and grow as consumers favor fitness water. Propel line extensions will reach consumers, asking for water that offers functional nourishment. Like our new Gatorade product, our Propel news will launch in Q4 as well.

To complete the portfolio, we will be relaunching Lifewater, we will be making product and packaging changes in the fourth quarter. So taken together, we believe our hydration brands are poised for strong growth in the back half of the year. We continue to explore the most effective means to go to market and we'll be utilizing both our warehouse and bottling networks to optimize the customer experience.

Finally, in the nutrition segment, our Tropicana business continues to benefit from a careful balance of net price and mix management, and cost control to offset raw material inflation. The hard work and focus on realigning the economics of Tropicana is paying dividends and our recently acquired Naked Juice business is off to a very strong start.

So in total, our collective businesses in North America delivered over 5% revenue and 5% profit growth and performed in line with our expectations. Importantly, we gained share in each of our key segments and looking forward, our innovation pipeline is primed for a strong second half. Additionally, we will be making selective investments in the balance of the year to accelerate our growth and marketplace positions even further across both snacks and beverages.

Now, before I turn the call over to my colleague here, Mike White, to talk about the international business, let me assure that you while we report our businesses as North America and international, our teams work together across the globe in search of new products and opportunity for growth.

So here's Mike.

Mike White

Thanks, John. Good morning, everyone. PepsiCo International delivered, I think, another terrific quarter. Strong, balanced volume growth across both snacks and beverages enabled to us deliver strong profit growth across our geographies.

As reported, our operating profit for Q2 was up 18%. In that, we were successful in offsetting the impact of higher input costs, particularly in vegetable oils and corn through sound mix management, excellent productivity gains, procurement savings, and some selective pricing. We forecast further commodity cost pressures certainly in the balance of the year, but I'm confident in our ability to manage these pressures within our overall algorithm.

While we managed the impact of higher commodity costs, however, our reported operating margins were flat for the quarter. I thought I'd point out there were two main drivers negatively impacting those operating margins by about 40 basis points. First, we're now fully consolidating two bottlers in China. In the past we accounted for these investments under the equity method in our line of business. With our increased ownership position, we now consolidate their performance in our P&L, particularly their revenue performance.

Now this together with the acquisition of the remaining interest of another joint venture, Snacks America Latina in June, is going to continue to have some impact on our operating margins in the second half. Second, as you know in Q1, we implemented a recall of our ready-to-drink flavored milk, Toddynho in Brazil following negative consumer taste perceptions resulting from some recent formula changes. That had a significant impact as well in Q2.

Clearly, however, our overall fundamental performance remains very strong both in the quarter and in particular for the first half as a whole with our year-to-date revenues up 18% and our operating profits up 22%.

Turning first to our snacks business, there we delivered another strong quarter with volume up 9% in Q2 and 11% year-to-date. Our snacks growth was broad based across our portfolio and was fueled by excellent innovation. In fact, more than 15 countries delivered double-digit volume growth including key emerging markets like Venezuela, Argentina, Columbia, Romania, Turkey, and South Africa.

I was particularly pleased, however, with the growth in our Russia and India markets. In Russia, our Lay's business grew more than 30% on innovation based around local flavors like our recently launched Lay's White Mushroom. In India, our growth was fueled by new marketing promotions behind Lay's as well as innovation behind our lentil-based snacks product. [Quaker complemented] our big three snacks business performances with double digit volume growth behind terrific innovation like [inaudible] Grand Cereal, and Oat Cookies.

In our Sabritas snacks business, both revenue and profits grew mid-single-digits, volume was down 1% as expected as we took pricing at the end of 2006 and the start of 2007 to cover input cost inflation.

On the Walkers side, I'm very happy with the success of our potato chip renovation efforts and the introduction of Baked Walkers. Walkers did face some net pricing pressure in the quarter as they fought for market share. I fully expect to see improvements over the balance of the year behind rolling out new products like SunChips, leveraging our North American experience and continuing to refine our trade investment process and promotional calendar as well.

Turning to beverages there, our volume showed continued momentum up 8%. Our growth was well balanced across the portfolio with carbonated soft drinks growing 7% and our non-carbonated drinks growing 16%. Again, we had strong double-digit growth in key markets like Russia, Argentina, Brazil, Pakistan, the United Kingdom, China, Venezuela, and the Philippines. Innovation and the expansion of our global brands into existing markets also continued to fuel growth.

For instance, our 7-Up brand, as Indra mentioned, grew 16% on the strength of the launch of 7-Up H20. 7-Up H20 continues to do extremely well in Latin America where it was launched in 2005 in Argentina. We launched it this year in Brazil and it's now the number one no sugar CSD in San Paolo. The brand has also posted early successes in both Vietnam and Ireland, another strong 7-Up market.

Pepsi Max also had a terrific quarter with growth of over 30%. We continue to gain share in the UK and Pepsi Max is now being rolled out in the Middle East. Lipton grew more than 60% in the quarter with green tea now accounting for more than 35% of our Lipton mix in Russia and green mint being launched in several new markets as well. Mountain Dew and Tropicana juices also posted strong double-digit growth while we had modest growth from Pepsi in the quarter.

Innovation will continue to be a critical driver of growth for all of us in all of our businesses in PI. In fact, I was really, really pleased; we recently held a major innovation expo across our snacks and beverages businesses. We had more than 500 of our managers in sales, marketing and R&D from around the world in attendance. Now, this isn't something new for us, we've been doing it for the last six or seven years since I was running Europe. I have to say that all of us that attended were incredibly impressed and excited about the health of our innovation pipeline for next year and years to come beyond that.

One of the illustrations I think of the great way that our snacks and beverage teams now work together and leverage the power of one is our upcoming Black Eyed Peas Pepsi Doritos promotion for the summer. This is our first global joint snacks and beverage integrated communications campaign. By the way, it's also our first global music-based Doritos campaign. I'm confident it's going to help us build on the terrific momentum of the brand which grew double-digit in second quarter.

I'm also pleased with the performance of all of our recent tuck-in acquisitions, Duyvis in Europe, Sakata in Australia, and Bluebird in New Zealand. Overall, they're all performing on or ahead of our expectations. As Indra mentioned in her opening remarks, we continue to look for good tuck-in acquisitions that are complementary to our business or get us into new geography.

Finally, we continue to deliver our results while building our organizational capability. For instance, on June 6, our Mexico team successfully launched the first release of SAP under PIs global business transformation project which is an integral part of PepsiCo's broader project.

So in summary, the international business continues to deliver solid results for PepsiCo. Our performance was broad based across our geographies as well as both snacks and beverages. Our business teams around the world are executing incredibly well and are managing tough input cost headwinds, and our recent tuck-in acquisitions are well on track while we continue to look for new opportunities.

So with that, let me turn the call over to Richard Goodman.

Richard Goodman

Thanks, Mike. Good morning, everyone. As Indra, John, and Mike indicated, we delivered another strong quarter, with revenue up 10%, division operating profit up 9%, and EPS growth of 15%. The results showed the portfolio at work as every segment contributed to profit growth.

In the quarter, the overall division operating profit margin was down very modestly, about 20 basis points, primarily as a result of an overall mix shift in the portfolio to PI which has lower inherent margins than the domestic businesses. Company gross profits increased 9%, but our gross margin declined 90 basis points. This was also driven by PI, partially as Mike explained from bottler consolidations in China and a product recall in Brazil; and partly from interest cost inflation internationally.

Looking at our domestic businesses, we're forecasting that input cost inflation for all of 2007 will be largely in line with the guidance we provided to you at the beginning of the year. We had slightly better than expected costs so far but we anticipate that reversing in the second half. For the portfolio as a whole, we're continuing to look to a combination of innovation, selective price increases, and productivity to offset this inflation. So it's enabling us to be sensitive regarding the consumer value equation while still delivering on the bottom line.

In the quarter, below the line items and the tax rate provided 4 points of leverage from division operating profit to net income, with more than 3 percentage points coming from a 220 basis point reduction in the tax rate. Let me take you through the significant below the line items for the quarter and then turn to our guidance for the year.

The increase in corporate expenses for the quarter that you saw in the financial appendices to our press release related primarily to a $19 million increase in our reported deferred compensation costs. While we hedged almost all of that exposure, the favorable impact of those hedges is reported as a credit to net to interest income. Net deferred compensation expenses in the quarter increased by only $2 million.

All of the other pluses and minuses versus last year in corporate expenses netted to about zero in the quarter. However, I do want to point out that those results included a mark-to-market benefit on the commodity contracts reported at the corporate level. That gain, which contributed about 0.5 percentage point to our second quarter operating profit growth, will largely reverse during the balance of the year as the underlying contracts unwind.

Bottler equity income was up $12 million in total. This includes gains on PBG share sales which were about the same as last year.

Let me turn to our tax rate. As all of you know the implementation of FIN 48 will lead to greater variability in quarterly tax rates, and we saw the impact of just that in Q2. During the quarter, we settled the state audit for taxable years prior to 1998.

In prior years, we would have booked this ratably across Q2, Q3 and Q4, but the new rules required us to put the entire amount in Q2. That resulted in our reported 26.5% tax rate for the quarter significantly below last year's 28.7% and also below the 27.7% rate that had been our guidance for the year. I'll come back in a moment to what we're now forecasting as our effective tax rate for the full year.

The last element in our below the line leverage was the 1.4% decrease in our weighted average diluted share count. That's higher leverage than in the past because of our expanded share repurchase program. As we announced in May, we're expecting to increase share repurchases from $3 billion last year to $4.3 billion this year. We gained some additional net leverage in the quarter from repurchasing more than 5 million incremental shares, partially offset by the increased interest expense on the debt we took on to buy back those shares.

Moving on to cash flow, year-to-date cash provided by operating activities was $2 billion, which compares to $1.8 billion of cash flow year-to-date in 2006. This is consistent with our guidance which is to generate about $7 billion in cash from operating activities for the full year.

We returned $3 billion to shareholders year-to-date; $1 billion in dividends and $2 billion in share repurchases. As a reminder, in May we increase our dividend to an annualized $1.50 per share. The first of our dividend payments at the higher rate went out on June 29, and will be part of our third quarter cash flow results.

Let me turn now to our balance of the year outlook. As Indra mentioned in her opening remarks, given the strong first half performance and our confidence in the business, we are raising our full year earnings guidance to at least $3.35 per share. I know this is about where most of your forecasts are currently, so let me give you some context.

Our outlook for growth in our business remains very positive. We expect a strong first half division operating performance to continue into the second half. However, we will also see the impact of the quarterly variability in our net income from FIN 48 and from mark-to-market accounting. In the first half of the year, our tax rate 230 basis points below prior year coupled with net mark to market gains delivered about 5 points of positive leverage from division operating profits to net income. In the second half, it's likely that we will experience deleverage from division operating profit to net income driven by the flip side of these same factors.

Let me cover each of these in turn. First, our revised guidance assumes a full year tax rate of 27.3%. This includes a $17 million favorable adjustment which is a follow-on to the large one-time 2006 U.S. audit settlement that we reported last year. Without this benefit, our comparable rate would be 27.5%. As you saw, the reported tax rate for the first half of the year was a relatively low 26.1%. We're expecting the second half rate to be a couple of percentage points higher than that, which would also make it higher than the prior year's rates for both Q3 and Q4.

Second, as I indicated earlier, we expect a portion of the mark-to-market gains we recorded on certain corporate commodity hedges in the first half to reverse in the second half.

Finally, we will invest in our businesses through the balance of the year to drive growth. At the corporate level, we will accelerate our investments in long-term R&D initiatives. Separately, we will also be making selective investments in both our domestic and our international businesses to sustain our performance going forward. Again, a great outlook for 2007 as Indra noted, it is consistent with our strong EPS track record.

Let me turn it back now to Indra.

Indra Nooyi

Thanks, Richard. Let me just sum it up briefly. We are pleased with the company's performance of the second quarter and the first half. Our strategy of organic growth complemented by tuck-in acquisitions remains consistent, with tuck-ins ranging from a few million dollars to about $2 billion. We have momentum going into the second half and we have a portfolio that delivers results. Most importantly, we are in an enviable position of being able to both reinvest for growth and take up our full year guidance by $0.05 a share versus the start of the year. Last but not least, we have the absolute best and proven management team and associates to deliver for our shareholders.

We will now turn the line over for questions.

Question-and-Answer Session


(Operator Instructions) Your first question is from Robert van Brugge - Sanford Bernstein.

Robert van Brugge - Sanford Bernstein

It seems like the price increases on Gatorade are at least partially responsible for the recent deceleration. After this year's round of price increases, do you perceive going back to your previous strategy of holding pricing more or less steady for extended periods of time?

John Compton

If you look at the all channel measure share there, you can see our prices are up in the 2% to 3% range. As you know, that's the first price increase we've taken on Gatorade, basically since we acquired the business back in 2001. So no, going forward, pricing is something that we look at occasionally. Right now, we think we have the business priced for the long term.


Thank you. Your next question is from Bonnie Herzog - Citigroup.

Bonnie Herzog - Citigroup

Mike, I have a question for you regarding your business in China. So far I believe your priority has really been the CSD market in China and my understanding is that approximately two-thirds of that business, the beverage business in China is comprised of CSD so obviously that makes sense.

I was hoping you could talk about the possibility that you will increase your focus on the non-carb segment in the future. If so how you hope to increase your presence in non-carbs in China? Would it be through acquisitions, organically, or possibly a balance of both?

Mike White

Thanks, Bonnie. I think I'll save the mailing of my strategy to our friends in Atlanta if you don't mind, but let me try and comment on your question. Certainly first, I think we've been very clear that we absolutely see non-carbs as a strategic priority for PepsiCo and certainly for PI as well. I think I have talked about it at a number of our investor meetings and certainly as well, we see the priority for China and other key emerging markets. So you are absolutely right. We are ramping up our focus on non-carbs in a number of markets around the world.

In China, in particular, we just launched a product called [Sobidi], which is a refreshing soy drink, we're very excited about it, in three flavors. It's off to a great start in China. We're also seeing excellent growth out of Gatorade in China which we've gone national with this year. Of course, we're looking at all of the other segments of the business in China as well. I think I've been clear that we've got wonderful assets in North America in our portfolio there that we've yet to take advantage of in a number of markets as well.

As for acquisitions versus organic, I think it's going to be both, Bonnie. I think that it's clear to us we've got some terrific brands and products that we think we can leverage in other markets when we tailor them to the local market and so I do expect us to be ramping up our organic strategy in China as well as in other key emerging markets with a particular focus on juice, juice drinks, as well as sports drinks like Gatorade and other areas as well.

At the same time, we obviously are very actively scanning the horizon for acquisition opportunities or even joint venture opportunities. China is certainly a priority from that standpoint and we've actually been actively looking at the horizon for the last three years for NCB opportunities globally and we'll continue to do so. I certainly expect China would be a priority in that regard as well.

Indra Nooyi

If I may just add to what Mike said, the market for non-carbs is so fragmented in China, there's tremendous opportunity for growth. The question is, are you going to do it through an acquisition or through organic development?


Thank you, your next question is from Bill Pecoriello - Morgan Stanley.

Bill Pecoriello - Morgan Stanley

It seems that your announcement of the hydration segment is showing that Gatorade was losing share in the non-sweat occasions where it expanded to, and now you've announced an innovation pipeline to address that. So on the low calorie Gatorade, is that going to use artificial sweeteners? How is the line extension going to be positioned versus Propel and the relaunch of Lifewater in terms of your overall hydration strategy?

John Compton

That's a great question because the Gatorade business today is appropriately positioned to rehydrate athletes when they're active. Propel was introduced as a much broader fitness water for people who are walking, occasionally may be taking a run or even if you're just sitting down. It wasn't targeted specifically to athletes.

The product that we're going to introduce in the fourth quarter is specifically for athletes in the non-active occasion. I don't want to give the formula details right now. That will come forward as we get closer to the announcement of exactly when we launch it, but it will be coming in the back half of the fourth quarter. It's something that we have consistently been asked for by customers and consumers alike in terms of having a low calorie Gatorade offering and the team is excited about the launch. I think you'll see it marketed in a way that you have come to expect from the Gatorade marketing team.

Bill Pecoriello - Morgan Stanley

On the Lifewater relaunch that you're doing, do you see broadening that beyond, into additional flavors but also additional occasions you are going after there.

John Compton

I do and Dawn Hudson is here and I'll ask Dawn just to comment just for a second because that's in the PC&A line of business.

Dawn Hudson

Bill, Lifewater's really still in its infancy as it's growing so we have some additional news to continue trial, we're really after trial. Lifewater really is a broad hydration beverage with the ability to serve consumer needs across multiple occasions. We'll continue that strategy with the relaunch.

Indra Nooyi

Bill, the only other thing I'd add is with consumers being faced with a tremendous number of choices for products, some of the big brands we have in hydration seem to be cutting through the clutter very, very well. Taken together, our brands in hydration do have a leadership position and we are gaining share.


Your next question is from Marc Greenberg - Deutsche Bank.

Marc Greenberg - Deutsche Bank

I was hoping we might spend a little time talking about the elephant in the corner of the room. Last week's Journal reported discussions with Nestle; that's a little bit bigger than $2 billion. In light of the credible source, would you please comment on how that type of transaction is obviously very different from your strategy and how we should think about something transformational as opposed to bolt-on in the future? Thanks, Indra.

Indra Nooyi

Marc, you know that we never comment on rumors of that kind and we never comment on anything to do with M&A. All I can tell you is that our strategy's unchanged. I told you this on October 23 when we had our analyst meeting in New York that our strategy was tuck-in acquisitions. I reiterated that in our Q1 call and I reiterated it again on the call today.

You talked about a credible source -- what is this credible source?

Marc Greenberg - Deutsche Bank

The Wall Street Journal. I'd be careful. Be nice to them, Indra.

Indra Nooyi

Marc, I didn't say anything negative. Please, I like them a lot and it is a great paper. I was just wondering whether you knew more than I did.

Marc Greenberg - Deutsche Bank

No. I just read the paper.

Indra Nooyi

So do I.

Marc Greenberg - Deutsche Bank

Just as a follow-up there, can we talk as far as criteria for deals, be they big or small, maybe now might be an appropriate time to review that. Does anything change in terms of your objective criteria if deals got larger? Any consideration of higher interest costs or the dollar being weak, do those factor in?

Indra Nooyi

Marc, it's difficult to just give you every one of our criteria. All I will tell you is that we look primarily to fill in white spaces, to go into the deals where it adds scale to existing businesses or to add on new capabilities especially in the area of Better For You, Good For You snacks and beverages. That's been our traditional approach.

Internationally, clearly we would like more deals because we would like to build up the international part of our portfolio. As you well know, Marc, we've been extremely disciplined in the way we do deals. We try our best to see if it can't be EPS accretive in the first 12 months after the deal is done.

We also make sure that we can handle the post-merger integration and not have a problem when we put the two companies together. So contrary to these rumors, we are a very, very conservative and careful company when it comes to deal making.


Your next question is from Lauren Torres - HSBC.

Lauren Torres - HSBC

I was hoping you could talk a bit more about your plans for accelerated second half investments. First, if you could talk about the magnitude of these increased investments and second, where do you intend to direct these investments, be it domestic, international, or snacks and/or beverages?

Indra Nooyi

Clearly we cannot give you all of the details, Lauren, but I tell you that both John and Mike have plans to reinvest in their markets to accelerate growth. As Richard mentioned in the script, even at the corporate level, we are stepping up our investments in R&D in terms of big bet long-term investments. I think I discussed at the October 23 analyst meeting we had in New York that we intend to visibly step up our R&D spending and consistent with that, we began in Q2 and we are going to continue in Q3 and Q4.

Lauren Torres - HSBC

With that in mind it does seem though that there is more room internationally. That's where the weight of that investment will go?

Indra Nooyi

It's going to be both International and North American. I can't give you the details but it's going to be across all of our businesses.


Your next question is from Judy Hong - Goldman Sachs.

Judy Hong - Goldman Sachs

Just looking at the margin behavior at PI in the second quarter, just wondering if you can quantify some of the factors that depress the operating margin in the second quarter, be it the raw material costs or the product recall costs, et cetera and then how you envision those factors affecting the second half margins?

Secondly, your expectations for the outlook on the Walkers and Sabritas in the second half of the year.

Mike White

Happy to, Judy. Good morning. First of all, let's keep in mind that the overall goal for PI as I think we've consistently said, is to grow our profits at a mid-teens rate and certainly when I took over international and our margins were down in the low double-digits, I certainly felt there was significant expansion potential in our margins. We've delivered on that the last number of years.

Over the next three years first of all, let me be clear. I continue to expect us to see 25 to 50 basis point expansion which is consistent with what I've said before. Having said that, let me just comment on both Q2 and the balance of this year. On Q2, I probably couldn't break out the commodity cost piece of it that easily, although we certainly have significant pressure on the gross margin line.

But the recall was about $10 million. I think it was about $9 million in costs and there's probably a couple million dollars in lost sales. So it's probably more around $12 million, $13 million that did hit the quarter. That certainly had an impact on the margins.

The other factor, as I mentioned, is that we had a couple of joint ventures and a good example going forward in Q3 and Q4 is the joint venture that we had in Latin America on snacks where we historically consolidated the profits but not the revenues. So when you complete an acquisition, that's buying out our joint venture partner of a joint venture, we'll pick up the revenues, pick up their share of the profits but we're picking up 100% of the revenues. So you are going to see some pressure balance of the year out of these joint venture pickups between that and also the China bottlers.

That, coupled with the reinvestment I would say balance of year, I expect will still have very healthy mid-teens margins but we probably wouldn't be necessarily consistent with the longer-term guidance that I would expect to see over the next three years.

Some conscious decisions on reinvestments, for instance, the launch of SunChips in the UK which will be going in September with a big media bang is certainly one of the investments that we're going to be making.

Judy Hong - Goldman Sachs

Then just your expectation on Walkers and Sabritas?

Mike White

On Walkers, first of all, we are expecting to see a secular improvement in the second half around three priorities. One as I just mentioned is the launch of SunChips. The second is a relaunch of basic Walkers where they feature British potatoes. The third is really tuning up our promotional frequency in store.

I think the good news about the UK is we actually had category growth. In Q2, the category grew about 2%. It took us a little while to get our promotional frequency back in line. It was in line by the end of the quarter, but earlier in the quarter, we were probably missing a couple of promotional windows.

Now, weather aside and the impact weather may or may not have on the business, I certainly fully expect Walkers to have a solid second half in terms of the top line performance.

Sabritas is performing really right in line with the expectations that we have had for the year. Which is we took about a 6% price increase and based on all our elasticity models that suggested that we would have flattish, to maybe down 1 in terms of growth and we've been running right in line with that. Actually, our like-for-like comparison of our snacks business in local currency is up better than mid single-digits in both revenue and profits. That's right where I would expect a business of that size and magnitude.

We've got some promotions balance of year, a new flavor on Doritos. The Black Eyed Peas promotion will be a big hit in Mexico as well. I think the Sabritas team continues to really do an outstanding job on execution. We're gaining share there. I expect we'll continue to do that in the balance of the year.


Your next question is from Kaumil Gajrawala - UBS.

Kaumil Gajrawala - UBS

I know you can't provide us with what you're focusing on for R&D but could you help us a little bit with if anything has changed in the marketplace which is causing you to accelerate your R&D in some of your end market investing?

Indra Nooyi

No change, Kaumil. Remember when we were in the investor meeting in October, we talked about the fact that we've been focusing a lot on the D part of R&D and less on the R. There's tremendous opportunity to develop premium products with increased efficacy by focusing on R; not like the pharmaceutical companies do but through connecting with other people, figuring out how to take inventions in other industries and bringing it to the food industry. We're putting our money in some of those areas and some of them are looking pretty promising. We'll come back and talk to you when they come to fruition.

Kaumil Gajrawala - UBS

Also if I could ask about productivity a bit at Frito-Lay and as SAP rolls out, should we expect that to accelerate?

Indra Nooyi

First of all, SAP is still rolling out in Quaker, Tropicana, Gatorade and then it comes to PepsiCo in North America Frito-Lay is down the pike. John, why don't you talk about SAP rollout and Frito-Lay productivity?

John Compton

Yes. Let me start with SAP. I'm pleased at the Quaker business, that's the first that we rolled out across North America. We are about halfway through that rollout. To date, everything has gone exactly as we had planned. Frito-Lay will be further down the pike in terms of the expectation of when we roll out SAP to that business.

As it relates to your question about Frito-Lay productivity and the impact that had on margins in the quarter, we both got good leverage on the costs of goods sold and in S&D, so both areas; the selling system, the overall supply chain contributed about four-tenths of a point and then we spent back, as I said, in A&M overall, but overall our margin has expanded in the Frito-Lay business about 40 basis points.

As you know, that business has historically had strong manufacturing supply chain productivity. That is continuing today. The transformational agenda that we're underway on that business is very exciting. The team is in place and working against the initiatives that we've outlined. The selling organization, I think, is dong a terrific job and we're getting good leverage in our selling expenses.


Your next question is from John Faucher – JP Morgan.

John Faucher - JP Morgan

Following up on that last question, it seems going back a couple of years you guys have taken the opportunity to maybe take advantage of the operating profit growth on international to ramp up the investment in marketing on Frito-Lay North America and we're still seeing that in this quarter despite the margin expansion.

How much more reinvestment do you think you need to do? Is it core reinvestment at this point or is it more opportunistic? If that slows a little bit the level of reinvestment, do we continue to see more of the upside flowing through?

Indra Nooyi

John, I think the level of profit growth in Frito-Lay that you saw this quarter was pretty spectacular first of all.

Second, we are going into new categories, new parts of the store, new eating occasions. As we talk about our salty snack expansion, we said we're moving out of core salty snack and inching out of the core. If you inch out of the core and get into new areas of the store, clearly you have got to invest behind marketing programs, promotional activities to develop businesses in those parts of the store as you establish beach head.

So I think the Frito-Lay business has tremendous top line growth opportunities and to keep fueling that growth, we have to keep investing.

John Faucher - JP Morgan

So we should expect the level of investment then to probably continue to rise as a percentage of sales?

Indra Nooyi

Well, let's look at it this way. You will see continued growth in the top line and significant profit growth in Frito-Lay's bottom line as you have been seeing over the past few quarters.


Your next question is from Christine Farkas - Merrill Lynch.

Christine Farkas - Merrill Lynch

Just a couple of clarifications if I could, from Richard. I just want to understand higher R&D spend, would that fall into your corporate expense line then, rather than the segment line?

Richard Goodman

Yes, in this case it would because it is for corporate wide initiatives spanning all of the segments of our business. So yes, it would be below the division operating profit lines.

Christine Farkas - Merrill Lynch

Richard, can you confirm currency? Did it boost revenue and profit by about 150 basis points? Did I do the math right?

Richard Goodman

I'm sorry?

Christine Farkas - Merrill Lynch

Currency in your top line, the consolidated top line and profit growth?

Richard Goodman

Yes, it increased; on the division profits it was about, it was just about 1.5%, that's correct.

Christine Farkas - Merrill Lynch

Great. Based on your comments with the tax rate this year of 27.3% and the one-time benefit this year, we can perhaps estimate that going into '08 that should trend back up into the upper 27?

Richard Goodman

Yes. I think it would be the mid 27s is probably about right.

Christine Farkas - Merrill Lynch

Final question for Dawn if I could. The press release suggested noncarbonated volume in North America up 3%, I think that included Gatorade and Tropicana. Can you comment a bit on the bottler volume with some comments on Aquafina? The 9% growth, is that where we're comfortable or is this reflecting some tough comps in basic water? Thank you.

Dawn Hudson

First of all, we're very pleased with our noncarbonated portfolio increase; we are lapping 23% from a year ago and we continue to see strong growth. As we commented, it was driven by our tea portfolio with 30% growth. We're also pleased with the Aquafina growth at 8% and that's on a total portfolio basis as we expand Aquafina into other enhanced water occasions. What was your third question?

Christine Farkas - Merrill Lynch

I just want to confirm the noncarbonated growth, I read the press release to include the growth of 3% to include the slight weakness in Gatorade and Tropicana.

Dawn Hudson

That's correct.

Christine Farkas - Merrill Lynch

If we were to pull out those volumes and look at your teas and energy and water, typically, is that a number that you'd normally give us?

Dawn Hudson

No, we don't normally break it out, but it would be very healthy; significant double-digit growth.

Richard Goodman

Christine, just to clarify on the tax rates, for the second half of the year, as I mentioned in the prepared remarks, our tax rate will be a couple of percentage points higher than it was in the first half of the year. I assumed your question meant on an ongoing basis after that as you look forward to 2008, it would probably be mid-27s which is about the effective rate that we have this year.

Christine Farkas - Merrill Lynch

That's exactly what I meant. Thanks so much.


Your next question is from Matthew Riley - Morningstar.

Matthew Riley - Morningstar

I just had a quick question on Tropicana. I wanted to get your read on how you feel it's performed over the past few months? Then looking out into the future, is there any sort of light at the end of the tunnel given the really tough commodity cost situation we all know you have faced for so long?

John Compton

Matthew, thanks for the question. The Tropicana business is performing in line with our expectations given the pricing that we had to take to cover the significant raw material inflation that hit both us and every other competitor who is in this business. Based on what we've seen to date, on the scan volume in the measured channel and in the non-measured channels it is performing in line with where we thought it would be.

It's hard to predict this business going forward. The futures market is fairly volatile. As we sit here right now, we are expecting it to subside from the levels that we are incurring right now. Like we commented on Gatorade and Propel, and the rest of our beverage brands there's exciting news and innovation coming behind the Tropicana business in the first quarter of next year.


Your final question is from Eric Katzman - Deutsche Bank.

Eric Katzman - Deutsche Bank

I want to follow up a little bit in terms of what Marc had asked before. When you highlighted the October analyst meeting, one of the things that some investors noted to me and one of the things that I noticed was that historically on your slides, you have kind of had more of a laser focus on snacks. But on those slides, you had more of a focus on food. You talked about Quaker being a health brand you could move in white spaces. So from an M&A perspective, is it unreasonable for shareholders to think that food on a more generic basis is an area of target as opposed to just snacks?

Indra Nooyi

Eric, it's very hard for me to get that specific. I'll just tell you one thing. We're in the business of convenience; convenient snacks and beverages. We have some food businesses which came from the Quaker Oats acquisitions. We've been quite successful at sustaining the growth of those food businesses but more importantly, if I can coin a word, snackifying some of those foods. We've taken some of the Quaker products and actually made very interesting snacks out of them. So our core business is snacks and beverages. In some geographies does it make sense to get into food in the short term? Yes, for example in Mexico we are in the food businesses; in Brazil, we own a sardines business. That's a food business. Sometimes you get into the food business because it helps get the scale, drive your snacks business and then downstream if the food business doesn't fit with you, you can do something else with it like we did in Poland several years ago. Right now, our goal is not to get into food in a big way. We're still in the snacks business. That's really our ongoing strategy. No change.

It appears there are no more questions. Thank you for all your time and attention today. We appreciate your interest in PepsiCo and look forward to speaking with you soon. Thank you.

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