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Pepsico Inc. (NYSE:PEP)

Q2 2008 Earnings Call

July 23, 2008 11:00 am ET

Executives

Jane Nielsen - VP of IR

Indra Nooyi - Chairman and CEO

John Compton - CEO of PepsiCo Americas Food

Massimo D'Amore - CEO of PepsiCo Americas Beverages

Mike White - PepsiCo's Vice Chairman and CEO of PepsiCo International

Richard Goodman - PepsiCo's CFO

Analysts

Bill Pecoriello - Morgan Stanley

Mark Schwartzburg - Stifel Nicolaus

Jonathan Feeney - Wachovia

Judy Hong - Goldman Sachs

Bryan Spillane - Banc of America

Ann Gurkin - Davenport

Alec Patterson - RCM

Operator

Welcome to PepsiCo's Second Quarter 2008 Earnings Call. Your lines have been placed on listen-only until the question-and-answer session. Today’s call is being recorded and will be archived for 14 days. It is now my pleasure to introduce Ms. Jane Nielsen, Vice President of Investor Relations.

Jane Nielsen

Thank you. 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 statements. This conference call includes forward-looking statements based on currently available information, operating plans and projections about future events and trends. Our actual results could differ materially from those predicted in such forward-looking statements. We undertake no obligation to update any such statements, whether as a result of new information, future events, or otherwise. Please see our filings with the Securities and Exchange Commission, including our Annual Report on Form 10-K and subsequent reports on Form 10-Q and 8-K for a discussion of specific risks that may effect our performance.

You should refer to the Investor Section at the PepsiCo's website at www.pepsico.com under the heading PepsiCo Financial Press Releases to find disclosures and reconciliations of non-GAAP financial measures that may be used by management when discussing PepsiCo's financial results with investors and analysts.

Just one house-keeping item, during today's call, our references to EPS growth excludes the current and prior year mark-to-market gains or losses on commodity positions, included in corporate and allocated expenses.

This morning's prepared remarks will be made by Indra Nooyi PepsiCo’s Chairman and CEO; John Compton, CEO of PepsiCo Americas Food; Massimo D'Amore, CEO of PepsiCo Americas Beverages and Mike White, PepsiCo's Vice Chairman and CEO of PepsiCo International, who is joining us from Switzerland, and Richard Goodman, PepsiCo's CFO. After our prepared remarks, we'll move to Q&A. Now to Indra.

Indra Nooyi

Thank you. I appreciate the opportunity to discuss PepsiCo's second quarter performance and our outlook for full year 2008.

Now as you saw in this morning's release, we delivered strong second quarter results and I am proud of our performance for the first half of 2008. This quarter, with 4% snack and 5% beverage growth, 14% revenue and 11% EPS growth, our portfolio performed well, especially in the context of absorbing higher levels of commodity inflation and implementing pricing actions around the globe, all while driving against an aggressive productivity agenda.

I think this demonstrates our ability to successfully manage the challenges of the current environment, through the power of our portfolio, the breadth of our global footprint, but more importantly, the can-do spirit of our associates around the globe.

With strong overall results in the first half, we are on track to deliver earnings per share of at least $3.72 in 2008, excluding the net impact of mark-to-market gains and losses. Now, as you are all aware these are interesting times. Inflation has become a part of consumers' daily lives and economies are slowing in many developed markets. And these realities may be raising some key questions in your mind. For example, given the growth outlook for our international markets, can we manage escalating inflation and drive top and bottom line growth, and can our portfolio manage through the current weakness in the U.S. liquid refreshing beverage category.

Before I turn it over to John, Massimo, Mike and Richard, let me share a few thoughts on these questions with you. First and foremost, we have confidence in PepsiCo's outlook. Actions speak louder than words so today we are confirming our 2008 guidance and announcing an increase of at least an additional billion dollars in share repurchases over the balance of the year, bringing total repurchases to at least $5.3 billion during the year 2008.

Let’s look at the results and trends that are the basis for our confidence and help provide answers to your questions. First of all, our markets outside the United States remain vibrant. PepsiCo International delivered double-digit snack and beverage growth, both in the quarter and for the first half. Our focus on brand recognition and local relevance combined with convenience, quality and outstanding distribution has delivered steady growth, even as we have effectively executed our pricing strategies. Clearly, we are closely monitoring each of our markets for signs of changes in consumer behavior, and trying to separate the impacts of weather and other temporary factors from any longer-term indicators of change.

At the same time, we continue to see the fundamental long-term growth opportunities created by low per capita consumption, a growing middle class and share expansion, especially in micro snacks and non-carbs. We are embracing the challenges of successfully navigating amidst inflation and economic uncertainty. We know we won't drive performance to the business as usual attitude, so we've made changes in three key areas and we are very encouraged with the early results.

First, we have adjusted our approach to global procurement, to minimize commodity volatility and uncertainty while reducing costs. We are accomplishing this by hedging a higher percentage of our commodities and by taking longer positions. So in addition to having very extensive commodity coverage for the balance of the year, we also have significant positions for 2009.

Second, we are leveraging our pricing and revenue management capabilities around the world. In many cases, we are taking a lesson from our international teams who have managed structural inflation currency devaluations for years. Optimizing price pack architectures and trade investments across our product lines is critical in providing a great product at an attractive price point for our broad consumer base. This quarter, our team showed great revenue management expertise, as we worked with customers locally and in

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to implement pricing that delivered solid volume performance, demonstrating the pricing power of our brand and flowing through to the bottom line.

This is particularly evident in our Frito-Lay business in the U.S., our Walkers business in the United Kingdom and our Latin American foods business. Each had strong and balanced growth across the P&L in Q2. Pricing is largely in place to cover balance of year inflation.

Finally, we are raising the bar on productivity. As the divisions execute their continuous drive for efficiency, we are also looking at new ways to reduce manufacturing, logistics and go-to-market costs. We are laying the groundwork for another meaningful reduction in the cost base. Stay tuned for further information at the end of Q3 or early Q4. Right now, we are tightening our belts, while preserving our important growth investments in emerging markets, marketing to build our brand, R&D to fuel innovation, and IT to enhance our performance, management and decision-making.

Turning to snacks, in our snacks’ categories, consumers continue to make snacks an affordable treat in their daily lives. From the U.S., where our single-serve bag is 99cents, to India where a 32 gram single-serve bag is the equivalent of $0.24, our products offer great value across a broad base of consumers. Our local cost base and global scale allows us to deliver affordability while driving profitability. With this approach, we have seen stable demand across the channels. Even in the United States single-serve bags posted growth.

Turning to domestic beverages, our teams are managing through an unprecedented slowdown in the U.S. beverage market. This quarter was down more than 4% across measured channels, driven by softness in both the convenience channels, due to the economy, and also in unflavored water, as a result of consumer substitution. These two factors alone compressed category growth by about 2 to 3 points. Now, clearly our domestic beverage performance has not been immune to the slowdown and we are hard at work to restore long-term growth to the category and our business. All efforts are focused on exploiting our strengths. Our ongoing share gains in carbonated soft drinks, our number one position in hydration, with 150 index versus our next largest competitor, excellent health and wellness credentials for the Tropicana and Naked juice brand, and our leadership in tea and coffee.

These strengths our shaping our work to launch brand and package innovations targeted at incremental consumption, leveraging our unique power of one customer relationships to drive growth and profitability for us and our retailers, and work with our bottling partners to innovate and execute, to grow the total profit pool for all of us. I'll be the first to tell you that these are not one-quarter fixes. They require some rethinking and retooling in our portfolio, and willingness to initiate change. Rest assured we are actively engaged in these efforts. However, there are good efforts to reshapeone part of the PepsiCo portfolio without impacting our overall growth algorithm.

In summary, PepsiCo is a company that thrives on and drives growth. Our performance so far this year shows that during uncertain times, our portfolio, our strategies and our capabilities drive growth. Growth and profits, yes but also growth in market share, with continued focus on innovation, and growth in brand strength. When combined with the passion and commitment of our associates around the world, these elements, we are confident, will position PepsiCo for even stronger future performance as the environment stabilizes.

With that, let me turn the call over to John Compton, who will discuss Pepsi Americas foods.

John Compton

Thanks Indra. I'm pleased to take you through PepsiCo's Americas Food strong second quarter results. Our volume was up 2%, revenues were up 16% and operating profit grew 13%. I'm proud of the work the teams have done to successfully grow our top line, while managing through the ongoing commodity headwinds facing our businesses. All three of our businesses contributed to balanced growth.

So let me take you through the results of each. Frito-Lay's second quarter results with volume growth of 2% and revenue and operating profit each growing 8% were driven by solid volume growth, effective net pricing, and productivity. [Casually] interest true-up accounted for 1 point of the overall operating profit growth. Now, our volume growth was largely driven by strong increases for our core salty brands, like Cheetos, Ruffles and Fritos, and double-digit growth for our better for you brand like SunChips and Quaker Chewy Granola Bars.

Our

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pound volume declined in the quarter as a result of a combination of weight-outs and also a shift of promotional frequency to our corn-based products, which was necessary in light of a potato supply constraint as a result of flooding in some of our growing areas. As expected, the more significant driver of revenue growth in the quarter was effective net pricing across the majority of the portfolio, achieving overall high single-digit pricing. And after the actions taken in the marketplace during the second quarter, pricing is now fairly balanced between visual pricing and weight-outs.

I remain encouraged by what we've seen in the markets so far, we are monitoring price gaps very carefully relative to competing brands and other snack categories like Crackers. Our objective is to proactively manage our price gaps to mitigate the pricing impact, and this has enabled us to gain value share in both the salty and overall [savory] categories. And I think this speaks to the strength of the Frito-Lay trademarks, particularly in our core brands.

From retail perspective we grew revenue across each of our major channel segments, including convenience and gas. Our single-serve flex bag business grew volume 2% with high single-digit revenue growth. Our positive performance is due to both the strong consumer value of our single-serve offering and focused sales execution strategies. Also, in the food service channel, we have benefited from value menu offerings in our key customers.

Now, innovation played a significant role in the second quarter results, driving both top and bottom-line growth. New baked snacks, such as Lay's Cracker Crisps continue to gain distribution, consumer awareness, and trial. In our new nut line, True North is showing real consumer appeal, while commanding premium pricing in a new part of the store for Frito-Lay, the nut aisle.

Our product innovation within multi cultural focus also has great momentum. You’ll see this in brands like Flaming hot Funyuns, Doritos Collisions and Doritos Spicy Sweet Chili. On the packaging side our new product singles, our new multipack package of individual portions is off to a strong start, providing packages that offer portion control for smaller households.

And finally, on the availability front, Flat Earth, our baked fruit and vegetable snacks are now available at all subway stores, a great trial venue for a new health and wellness brand like Flat Earth.

Now in the quarter for Frito-Lay, our productivity accelerated. Manufacturing, Warehousing and sell-in expenses, all provided leverage to second quarter profit growth. Along with the revenue initiatives, Frito-Lay is stepping up productivity and is on target to deliver total savings to cover about 20% of its commodity inflation. Initiatives like capturing waste heat from our Doritos ovens for steam production and the installation of high-efficiency infrared burners on our baking ovens are delivering benefits.

So far this year, we have reduced water usage by 2%, electricity by 3%, and natural gas by 3%, all on a per-pound of product produced. This is impressive progress on top of a great track record. Since 1999, Frito-Lay has reduced its use of water by 38%, manufacturing fuels by 27% and electricity by 21%. These efforts have made a difference to the bottom line and equally important to the environment.

Now, looking to Frito-Lay's performance of the balance of the year, we remain confident in our ability to continue to produce solid top and bottom line results. I expect our most challenging cost of goods inflation to be in Q3, and we may see some impact to profit growth. But as I look over the balance of the year, we believe we have the right pricing in place to cover these challenges. And as is our normal practice, we will begin to execute our year-end pricing initiatives during Q4 to prepare for 2009. Additionally, we will also look for new ways to enhance productivity initiatives for next year.

I am very encouraged by the strong Q2 results and feel that we have the necessary plans in place over the second half of the year to deliver solid profit growth and importantly, market share gains.

Turning now to Quaker Foods, as you saw our Quaker Foods business in North America generated 2% volume growth, 4% revenue growth and 4% operating profit growth in the quarter. Results reflected volume growth from oatmeal and Rice-A-Roni coupled with pricing actions across the portfolio.

As we announced in mid June, the extensive flooding in the Midwest damaged our Cedar Rapids production facility at the end of the second quarter. This has caused temporary disruption to Quaker production and we have had to place our retail customers on product allocation. This will impact volume and revenue in the coming quarter.

Financially, we expect the insurance will both cover asset damage and business disruption, and we reserved against our insurance deductible in the second quarter. Most importantly, we restarted a portion of operations last week and we expect to be back in full production levels by mid-August. We are all extremely proud of the efforts of our Quaker employees, who have worked tirelessly to restore and restart this facility in a very short period of time.

Finally, let me offer some thoughts on the Latin America food business. In the quarter, our volume grew 4%. Net revenues grew 41%, and profits grew 38%. Excluding the impact of acquisitions in Forex, net revenues grew 10% and profits were up 21%. Now, as planned, we executed pricing actions in all three businesses, within Latin America Foods, Sabritas, Gamesa and South America. Each contributed significantly to revenue and profit growth.

At Sabritas wait-outs caused volumes to contract on a tonnage basis, but unit sales grew mid-single digits during the quarter, a very encouraging result that speaks of the strength of our Mexican South East snack business and the success of our innovation.

Gamesa held volume, despite very strong pricing in a double-digit overlap. The Quaker snacks portfolio continued to perform very well. In fact, to support the growth and potential, we see in the Quaker business, we have established separate health and wellness sales and delivery routes and merchandising racks in the marketplace.

In South America, Brazil continued to drive growth organically and with the Lucky acquisition. Our categories and our businesses are continuing to grow in the region, but we are staying close to the affordability metrics and looking for any signs of a possible slowdown. Beyond the macros, we are adding sales routes, increasing our market reach in Mexico, and continuing to expand our portfolio and distribution in Brazil. We are very encouraged by the top and bottom line growth in our Latin American businesses.

So to sum up for PepsiCo American foods, a very strong quarter. We continue to see opportunities for growth across our businesses and are driving against an aggressive productivity agenda. I expect continued strong growth for the balance of the year. With that, let me turn the call over to Massimo d'Amore.

Massimo d'Amore

Thank you. I’ll provide you an overview of PepsiCo Americas Beverage and our forward focus.

This quarter was a tale of two cities for our business. First, our Latin American markets performed well and we increased volume in mid-single digits. But in North America, our business was challenged. PB declined about a point versus the prior year and total operating profit decreased 7%. In fact, North American beverages faced a perfect storm. With declining category volumes, rising inflation, are shifting channel mix away from C-Stores and food service and the slowing growth in unflavored water.

Let me review now some of these factors. You know that the economic slowdown continues to pressure the LRB category. Consumers seek value and affordability, while the rising inflation requires pricing actions. This quarter, the total LRB category has declined almost four points in measured channels and about two points across old channels. We have not seen these kinds of declines since we started measuring this category. We saw a significant shift away from convenient channels.

Indeed, food traffic declined over 10% in Q2. As a result, C&G beverage volume declined and LRB scan data was down more than 5.5 points, about 8 points below its historic growth rate. As you know, food service is also experiencing a consumer pullback. We estimate that convenient channels put about two points of pressure on the overall LRB category, which had some downstream impacts as well.

Flavored water, which grew double digits over the last two years, had moderated growth across all channels and was flat this quarter. Consumers are eating more at home and increasing consumption of tap water as they look for ways to economize.

So, with that as a bit of context for the market, I'll take you through our results in North America. For CFDs this quarter, we gained volume and value share, although volume was down 2%. This share growth reflects our strong performance in our Mountain Dew and Sierra Mist trademarks.

Mountain Dew loyal user base showed their passion by posting over 200,000 online votes to determine the next new flavor. Our customers have fully embraced this Mountain Dew initiative, which is driving awareness, especially in C&G, with engaging point of purchase displays. Our new Sierra Mist line extension and their cover orange is driving consumer interest in trial, especially in the impulse channels. Finally for CFDs, although trademark Pepsi was down mid-single digit, growth in Pepsi Max is very encouraging.

Now, turning to non-carbs, Gatorade continued to gain volume and value share. And total, shipments grew slightly in the quarter, despite the weakness of the convenience channels, where Gatorade is highly developed. Importantly, Gatorade scans in the grocery, drug and mass channels with up about 5.5%, in line with our expectations.

We also showed progress on our shelf resale’s, adding four additional SKUs in large format and gained about half a share in the C&G cold wars. G2 continues to gain consumer acceptance and broaden the user demographic. As a result, our trail and repeat numbers in G2 continue to be stable. Tiger also continues to grow trial and repeat with its unique formula and the differentiated link to Tiger Woods.

Overall, Gatorade grew faster than the category and I expect it to continue to do so as we are investing in marketing and trial on G2 and Tiger and will focus our execution to give the entire Gatorade line-up the space it deserves to continue overall. Also in hydration, our SoBe Life Water brand continued strong growth, with volume up over 50% and very strong repeat rates. With three new flavors and a new very popular commercial, we expect SoBe Life Water to continue growing its user base.

Turning now to the energy category, our total energy portfolio was up 18%. Our Amp business is driving a lot of this increase and our association with Dale Earnhardt, Jr. as a result of the Amp Energy more than doubling its business in the quarter. You also know that consumers love tea. Lipton Tea is the undisputed market leader in tea across America. A large number of Lipton Iced Tea users consume it on the go and we will be leveraging our one liter package to offer a great value in [these] channels. You will also see great packaging news on Lipton, a new light weight bottle with 20% less plastic, which will save 20 million pounds of plastic each year. We're also expanding our offerings on Lipton PureLeaf, our best quality tea the gold standard. We have increased the amount of tea we offer in PureLeaf and added new consumer preferred varieties like red and white.

Our Tropicana juice business was down mid single digits, partially due to weight-out in our new 89-ounce picture, which is a packaging improvement offering easier pour and the new flip-top lid that feels easier. This is the start of our important efforts to re-engage Tropicana consumers with packaging, innovation and brand marketing to strengthen the health credentials and the naturalness of the Tropicana brand.

As Indra said, during these times we need to retool and retain. During this quarter we maintained our focus on affordability despite rising commodity costs and we continue to invest in A&M, IT distribution. Volume and profitability pressured performance in North America below our expectations. Going forward, our focus is on developing priced pack architectures and innovations, to meet the consumer need for affordability, while driving net revenue and profit for us and for our bottling partners

Stay tuned for news of our 2009 initiatives, which we'll unveil early in Quarter 4.

Now Latin American markets, beverage growth was broad-based, with mid single digit CSD growth and double-digit NCB growth. This growth was led by H20 with rollout across the region and with successful flavor extensions in Argentina and Brazil. Lipton was up over 70%, with excellent growth in Mexico and successful launches in Central America and Venezuela.

Finally, Gatorade also performed well, with growth across all key markets and continued strength in Mexico. In total, continued strong results in Latin America.

Now over to Mike.

Mike White

Thanks, Massimo. As you've all seen in our release, PepsiCo International turned in another strong quarter. Our revenues were up 25% and our operating profit up 18%, despite of lapping more than 30% profit growth in 2007.

Now to address rise in commodity inflation, we did continue to execute our plan to phase in price increases to optimize consumer acceptance while holding volume growth. This approach has worked very well, as evidenced by our strong, very balanced top line growth. Our performance allowed us to make incremental investments in marketing in China and India, as we continue to build important platforms for growth in those countries.

Overall, I'm very pleased with PI's second quarter results two fronts are particularly encouraging. First, we drove growth across our categories and products. Volumes were strong across our snacks products, up 10%. Our carbonated soft drinks were up over 6%, and our non-carb beverages were up strong double digits, led by Tropicana and Lipton. This growth in part reflects our consumer-driven innovation and the broad appeal of our marketing initiatives. Our growth was also geographically broad-based. Our developed markets grew steadily and our emerging markets accelerated our total growth significantly. In fact, PI's 10 largest snack and beverage markets posted organic volume growth of about 9% in the quarter, terrific performance.

A brief overview of our innovations and marketing follows, with market and brand performance by division. Our focused innovation in marketing capabilities produced strong growth. On beverages, the juice platform expansion which has been a major area of focus over the past several quarters, continues and is doing very well. Among other juice and juice drink initiatives, we launched a new package in India and we expanded our Tropicana Smoothies product from the UK to parts of Western Europe, with different fruit flavors, such as mango passion and fruit pineapple.

In China, we continued with the geographic rollout of Tropicana juice drinks, which is achieving impressive consumer acceptance. Regional rollouts of Pepsi Max and 7UP H2O continued to be strong. During our second quarter we launched Pepsi Max in Vietnam and Pakistan, and H20 in China, Lebanon and a few additional European markets. We've also added new flavors, citrus, apple and tangerine to our 7Up H2O line-up. In China, our Go China chain has been successful in engaging consumers in a unique Pepsi way with the two-thumbs up way to cheer on China's athletes in the games next month.

Our base snacks lines are also doing well in both Russia and Spain and we're borrowing a page from my friends in the United States, where consumers take control of their brand's new flavor innovation. For instance in India, we launched a fight for your flavor program where consumers will vote on their favorite lays flavor innovation and each flavor has its own celebrity sponsor. So together, innovation and marketing continue to fuel growth across our categories and our markets.

Turning now to our divisions, let me discuss first the UK and Europe and then the Middle East, Asia and Africa markets. In the UK, our developed snacks market grew very well with Walkers setting the pace as they continue to successfully implement pricing while also growing volume mid single digits.

Our [British] promotion was a successful way to add consumer value, while

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price. Advertising emphasized the local provenance of the great British potatoes used in Walkers crisps which further enhanced consumer perceptions. Snacks volume in Spain included the benefit of a purely the month calendar reporting change, which impacted our UK/EU region snacks volume by over a point.

Our emerging snack markets delivered excellent growth, led by Russia, up 20%, and very solid performance in Eastern Europe as well. Our UK, Europe beverage growth was driven by Tropicana in the UK, offset by somewhat sluggish growth in Russia. Unseasonably cold weather in the early summer, primarily in Russia, slowed down carbonated soft drink growth, but our non-carbs market continued to grow. Our reported results also reflect great performance from our recent acquisitions, Sandora in the Ukraine, as well as the expansion of our Lipton partnership.

Turning now to our Middle East, Africa, Asia region, our snacks volume was very strong in our key growth markets. China continued to grow in the 20% plus range, with double-digit volume growth in the Middle East, India, and South Africa. We continued to build our Doritos trademark in the region with distribution

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and flavor expansion like barbecue in Egypt and taco flavor in South Africa. In China, Cheetos shops had a new flavor like Japanese steak and mild cheese. And we introduced two new spicy flavors as a Lay's team China special pack, all locally tailored and targeted to the public in each of those countries.

Our beverages had terrific results in several high growth markets. China, India, and the Middle East all delivered double-digit growth, with strength in core brands and innovation. Our non-carbonated platform produced high double-digit growth in both India and Saudi Arabia. These results include marketing investments we’re making behind growth in our dynamic businesses in both China and India.

To look forward to the balance of the year, (inaudible) is a full calendar of innovation. Some of the highlights on the snack side are flavor extensions to Lay's stacks in China and expanding our better for you options like Baked Lay’s in additional European markets and new flavors in our bread snack product in Russia.

On on the marketing front, we'll continue engaging with consumers in the UK with a Do Us a Flavor campaign, where consumers design and vote on a new Walkers crisps flavor.

In beverages, we'll be launching a new Tropicana Twister flavor, Apple, in India, expanding the Pepsi Deluxe lineup in the Philippines and continuing our rollout of Pepsi Max. Also on our top line, we will continue to diligently implement our revenue management strategies with price pack architectures focused on driving rate, while maintaining affordability and minimizing volume impact.

Throughout the rest of the middle of the P&L, we're working very hard against productivity initiatives and cost control. I do expect continued growth in our developing and emerging markets, but we're diligently monitoring consumer trends and economic changes on a country-by-country basis. Importantly, I believe we have the initiatives in place to produce strong, ongoing results over the course of the year. With that, let me turn it over to Richard Goodman, our CFO.

Richard Goodman

Thanks, Mike. We are pleased with our overall operating results in Q2, with revenues up 14% and division operating profit up 7%. As you saw in the release, our reported EPS was $1.05 and excluding the net impact of mark-to-market gains in both years, it was up 11% to $1.03.

Our below the line leverage reflected mark-to-market gains of $61 million on commodities that do not receive hedge accounting. This mark-to-market gain compares to a $13 million gain in the previous year for a net change of $48 million. So the mark-to-market drove about two points of operating leverage and contributed $0.02 to our per share earnings.

Let me remind you that over the duration of our contracts, the mark-to-market impact on corporate costs, nets out to zero with hedges ultimately being reflected in division costs. We will focus our discussion and guidance on EPS and EPS growth, excluding the impact of mark-to-market gains and losses in both the current and prior year. We believe this provides a better perspective on our ongoing business performance.

So setting mark-to-market gains aside, lower employee related expenses helped drive other corporate, unallocated costs down $23 million in Q2, offsetting higher interest costs, lower equity income from bottling investments, and continued investments in our business process transformation and in R&D. Developmental costs were slightly down in the quarter. Our tax rate for the quarter was 26.7%, up 20 basis points versus last year. We returned $2 billion to shareholders, $600 million in dividends and $1.4 billion in share repurchases. As a result, our weighted average diluted share count declined by 3.1%.

Turning to our balance of the year outlook, we are taking advantage of the current market conditions to repurchase additional shares. As Indra indicated, we will increase our share repurchases to at least $5.3 billion for full year 2008, up by at least $1 billion from our prior guidance of $4.3 billion. Through the end of the second quarter, we spent $2.9 billion on share repurchases.

Our outlook is for continued strength in the second half. However, as we manage the company to deliver our performance commitments for the year, we expect stronger performance in Q4 than in Q3. Our commodity overlaps are most challenging in Q3 and as John noted earlier, the floods that damaged our Cedar Rapids facility in June, will impact Quaker Food's performance in Q3.

We have insurance coverage, but due to the timing of preparing and approving claims, some of the insurance recovery might not be recognized until Q4. Throughout the balance of the year, we will continue to drive against productivity and expense control. Overall, with our solid results in the second quarter, we are reiterating our EPS guidance for the full year, volume of 3% to 5%, low double-digit revenue growth, including acquisitions of Forex, and EPS, excluding the net impact of mark-to-market gains or losses of at least $3.72. Finally, there is no change to our cash flow or CapEx targets.

Back to Indra.

Indra Nooyi

Thanks, Richard and as I said to you at the top of the call today, I'm really proud of our business results and the strength and resiliency of our portfolio and the outstanding commitment and capability of our people really gives me confidence on the future outlook for our business.

Now, before I open it up for your questions, I just want to share something with you. This is Jane Nielsen, our Head of Investor Relations, her last call. And I’d like to thank her for her passion and commitment during her time on the road. Jane is staying in the PepsiCo system, but is moving with her family to the Boston area.

Taking Jane's place is Mike Nathanson, who until recently was Head of PepsiCo’s Financial Planning and Analysis team and since joining PepsiCo 13 years ago, Mike has held multiple leadership positions, including being the CFO for our Australian snack business. Mike is an incredible individual. I have great respect for Mike's capabilities and I'm confident he will serve our investors well. Mike, you have big shoes to fill, but I'm sure you'll do a great job. Both Jane and Mike have been working together over the past two months to make this transition seamless and will continue to do so through the summer.

So with that, let's open it up for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question is from Bill Pecoriello with Morgan Stanley. Please go ahead.

Bill Pecoriello - Morgan Stanley

Good morning, everybody.

Indra Nooyi

Good morning, Bill.

Bill Pecoriello - Morgan Stanley

My question is, you talked about putting on some coverage for ‘09. Can you give us an idea of what percentage of your input costs are now hedged for ‘09 and then given the lead time you have to think about another year of input cost inflation, can you provide any more color on the types and the magnitude of some of the productivity savings that you might see for ‘09?

Indra Nooyi

Bill, let me touch on the productivity savings and then toss it to Richard, who will give you some color on coverage. As I said in my script, in the end of Q3 or early Q4, we will announce our productivity program. So at this point, we are not ready to share with you the details, but just know that it is going to be meaningful and so with that, let me turn it to Richard.

Richard Goodman

Bill as you know, it is really still a little too early to give an estimate for 2009 and we typically do that on our call later in the year. However, obviously, there have been increases in grains and cooking oil and fuel, so there will be inflation next year. That said, as we have discussed, we really are taking the opportunity to decrease our volatility by expanding the amount of coverage that we take and the duration of the coverage we take. So clearly it is higher going into 2009 than it was going into 2008. However, I really do not want to talk about specific percentages at this point.

Bill Pecoriello - Morgan Stanley

Is it too early also to comment if you will be able to rely less on price into ‘09, given the coverage and the productivity programs?

Richard Goodman

Yes, it is a little too early because we are still formulating the productivity programs that we have and then when we have a very more complete understanding of the inflation environment as well as the productivity, then we will have a better sense of what amount of pricing that we will be need to be taking as well.

Indra Nooyi

Bill, we also talked about price back architecture. What we want to do is to make sure that we balance productivity, affordability, and competitive gaps in prices. We want to make sure we maintain a reasonable gap versus competition and not let that widen too much. So as Richard said, as the year progresses and as we complete all our price back work and look at the inflation trends and look at competitive pricing, we will then implement our pricing actions. Just rest assured that every one of our divisions has a maniacal focus on 2009 and what to do to make sure that we are ahead of the curve in 2009.

Bill Pecoriello - Morgan Stanley

Okay, thank you.

Operator

Thank you. Your next question is from Mark Schwartzburg with Stifel Nicolaus. Please go ahead.

Mark Schwartzburg - Stifel Nicolaus

Thanks. Good morning, everyone.

Indra Nooyi

Good morning, Mark.

Mark Schwartzburg - Stifel Nicolaus

Indra, division operating profit in the quarter ex-currency, I believe was up 4%. Can you talk a little bit about how you think that number compares to what is going to happen in the future and perhaps things like we just heard from Richard, the volatility and cost management, the improvements you expect there, might we consider that a trough number, incremental pricing, incremental productivity, for is a lot lower than we have seen historically. How do you think it is going to compare to the upcoming quarters next year?

Indra Nooyi

Mark, the first two quarters and going into the third quarter is when we have the extraordinary inflation hitting us and as we said in our Q1 call, the Frito-Lay pricing started going into effect in Q2. In fact, we did not have the benefit of the pricing the entire Q2. On top of that, as Massimo discussed on North American beverages, we were all balancing affordability and beverages and not taking up the pricing too much, when traffic was slowing down, especially in C stores for beverages and making sure we were driving some volume growth. The good news is we had four as tail winds that allowed us to reinvest in some pricing, keep our investments in A&M up at a fairly high level and keep investing in R&D and IT.

So as we managed the portfolio and looked at the overall EPS numbers, we felt like driving the top line revenue growth and getting the pricing in initially was more important than focusing then directly on line of business operating profits. So the portfolio in fact worked.

Going forward, Q3 is going to be an interesting quarter because the full impact of the commodity inflation hits us in Q3, but we will also get a full quarter of Frito-Lay pricing. I think the portfolio is still going to work well in the second half. I think sequentially as you go through the year, into Q4, our line of business operating profit improved and as you go into 2009, as we take all the pricing actions earlier, you start seeing sequential improvement. Richard, did you want to add anything on that?

Richard Goodman

Yes, I think we do manage, we manage it as a portfolio and as Indra said, it is really rather than looking at a specific line item expert or we trying to be able to balance all the things that we need to achieve over both the quarters and the year, and so I think, you know, part of the Forex impact was also seen in our cost of goods sold because inflation, part of the inflation was driven by the poor dollar. So it really is the ability to have the broad portfolio that allows us to achieve this sort of consistent results.

Indra Nooyi

Mark, given the tail winds on the Forex, we made a conscious decision to keep investing in A&M, R&D, IT. We said we are not backing off any of those expenses, because we really have an eye towards the long-term future of the company. So feel good about the top line. Feel good about revenue. Feel very good about overall EPS in returns.

Mark Schwartzburg - Stifel Nicolaus

Great. Thank you.

Operator

Thank you. Your next question is from Jonathan Feeney with Wachovia. Please go ahead.

Jonathan Feeney - Wachovia

Good morning, thank you.

Indra Nooyi

Hi, Jonathan.

Jonathan Feeney - Wachovia

Just one clarification. John told us about how convenience stores held up actually quite well with, on the Frito-Lay side, but in North America, but Massimo told us that it cost beverages 2 points of pressure. Why do you think the desperate performance inconvenient stores between the Frito-Lay portfolio and beverages, is there something specific to the beverage portfolio in that channel that you could elaborate on?

Indra Nooyi

John, do you want to take this?

John Compton

Jonathan, its John. Two things, one on the Frito-Lay side, the pricing that we took in that channel was largely through the weight-out. Some of our visual price points has been and remains at 0.99 cent package. That is largely what consumers see when they walk into the store. As we said in our comments, we also had a very deliberate execution focus against specific multicultural type products, flaming hot Cheetos, flaming hot Funyuns, new Doritos flavors to serve that segment.

The second part is, as the snack business is different from the beverage business and it is not as penetrated as beverages are. So beverages, if one business was going to slow down before the other, beverages would, because it is almost twice the size in convenience stores than salty snacks are.

Indra Nooyi

Tracks more closely to food traffic.

John Compton

Yes.

Indra Nooyi

However, I think there were more alternatives for beverages, as Massimo mentioned when unflavored water slowed down, people switched to tap water and, you know, applied their discretionary dollars against Frito-Lay salty snacks.

Jonathan Feeney - Wachovia

Okay. Well, thanks very much.

Operator

Thank you. You next question is from Judy Hong with Goldman Sachs. Please go ahead.

Judy Hong - Goldman Sachs

Good morning, everyone.

Indra Nooyi

Hi, Judy.

Judy Hong - Goldman Sachs

Just looking at North America beverages and recognizing that you have managed the business as a portfolio, but margin was pretty weak in the second quarter. I wanted to just walk through some of the key drivers of margin decline and then more broadly speaking, some of the new price pack architecture initiatives that you are talking about, if you could give us a little bit more details and the timing of when you can introduce these initiatives and how quickly can these initiatives really restore profitability in North America beverages?

Indra Nooyi

Massimo, do you want to take that?

Massimo D’Amore

Yes. So first of all, as we said, throughout the quarter we have continued to make sure our product remained affordable while investing in A&M, IT, and distribution capabilities. So the key reason for the margin decline is the increased cost of commodities in this environment. However, more importantly Judy, Indra said it very clearly that we are really working on unprecedented price pack architecture across all of our beverage brands and we are building on a lot of expertise available within the company, especially outside of North America, where we have been living with inflation for many years. We are really striking the right balance, I believe, between price points driving affordability and revenue management growth through these price pack architectures. So it would be put in place in the second half of the year and you will see its full impact really as of 2009. Because our objective here is to really lay the right foundations for 2009.

Judy Hong - Goldman Sachs

Massimo, if I can just follow up on the non-carb trend, beyond the economic pressure that we are seeing in North America, do you think the growth of non-carbs could go back to the growth that we had seen historically.

Indra Nooyi

Judy, I tell you something, that is a big mystery and we do not have the answers yet. As Massimo said, ever since we started tracking this category, yesterday we are joking about it saying going back 100 years, but really the last 30 years if we have tracked this category, the category has never been in such a decline as it is now. In the last 10 or 15 years, we haven’t had an economic slowdown of the kind we are seeing now. If you believe standard for capita measures and penetration into tap water and population growth and growth in GDP, you would expect the growth in the LRB category should come back to the 1% to 2% range. That is our long-term expectation for volume, 1% to 2% volume growth, but you know what, predicting the trough is always wrong. We have to wait and see what happens as the economy slowly recovers and then we can all look and see if the fundaments of the category are still there. At this point we feel optimistic about the category.

Judy Hong - Goldman Sachs

Okay. Thank you.

Operator

Thank you. Your next question is from Bryan Spillane with Banc of America. Please go ahead.

Bryan Spillane - Banc of America

Hi good morning.

Indra Nooyi

Good morning Bryan. Just a question on working capital, it was up pretty significantly in the quarter, so want just some of the drivers behind that and then the second question related, just as you hedge out or contract out raw materials further out than you have done in the past, will that also have an impact on working capital, will it cost you more to hold some of that raw material for a longer period of time and will that have an impact on free cash flow going forward?

Richard Goodman

So just on the first question, on working capital, and actually if you look at the fundamental cash conversion cycle that was actually, we were absolutely on track, I mean some of the numbers are higher because our revenue base was higher, but they were absolutely on track and some of the things that drove slightly worse working capital were one-time things, one-time timing things like BAT and stuff, so I feel, we feel very good about being on track from our working capital standpoint. On the contracting, yes, we do not actually make payments on things that we are contracting out in the future, so the amount of goods that we actually will store going forward is extremely, is extremely small and very and would be very localized, almost all of it is simply just locking in prices with suppliers going forward and then when those goods are delivered, that is when we are paying for it. So that it will not impact our working capital on a go-forward basis.

Bryan Spillane - Banc of America

Okay, great. Thanks.

Richard Goodman

Thanks.

Operator

Thank you. Your next question is from Ann Gurkin with Davenport. Please go ahead.

Ann Gurkin - Davenport

Good morning.

Indra Nooyi

Hi, Ann.

Ann Gurkin - Davenport

If I could just get some more detail on your outlook for the U.S. liquid refreshment beverage volume at this year and if you could break that down into CSD and non-CSD and how are you going to step up your pace of innovation in domestic beverages in the back half of ‘08 into ‘09? Then if I could pick up more detail on Gatorade reset, how much did that contribute to volume in the quarter and then Lay’s in the U.S., the decline, what was that decline? How much was due to allocation versus just the weight-out impact?

Indra Nooyi

That a lot hard, but Massimo do you want to take some part of that question, go ahead.

Massimo D’Amore

So, first of all, as we said, the performance of the category is equivalent and we would expect to see the category to decline.

Indra Nooyi

Massimo, I am sorry. You are far away.

Massimo D’Amore

Sorry. So as we said earlier, the decline in the category that we are seeing this year is really unprecedented, and we would expect the category to decline one to two points for the year, for 2008. However, going to next year, as Indra said, we will see how strong the economic recovery is going to be and we should see a better performance going forward.

Having said this, we are being very aggressive on developing the right innovation for 2009. We are going to disclose it during quarter four, but let me assure you that it is really focused on each one of our key brands and more importantly, we are really innovating, keeping in mind the needs and the trends of each one of the key channels. So you will see innovation that will be just tailored for the convenience channel versus innovation tailored for mass, for drag, or for the club channel. So we are really focusing on the consumer needs within the context of the economic context we are in and the dynamics of each channel.

Now, as far as Gatorade is concerned, and what we are seeing is just a slowdown of the Gatorade performance in the convenience channel, but this is a category issue. It is not a brand issue, because that is where the brand is gaining both volume and value share, and the reason why it is impacting Gatorade is because, as we said, it is well developed in the convenience channel.

Having said this, the innovation we have in place this year is right on G2 and Tiger are both performing very well, and let me assure you that we have a lot more innovation going forward into 2009. Therefore, Gatorade, we have continued to grow and we are investing at the same time on new marketing initiatives, as well as distribution plans.

Indra Nooyi

John, do you want to talk on Lays.

John Compton

On Lays, as I have said in my comments. Lays is the most price sensitive of the salty brands that we have, but most of the volume impact in the quarter was related to the shortage on the crop, because we lost the big part in the Missouri part of the country, where our potatoes were due to come out. It is the same storm that had the effect in Cedar Rapids on the flooding. So the majority of this was just shifting out of potato into our corn-based products as we prepared for the upcoming July 4th holiday.

Ann Gurkin - Davenport

How much was the Lays volume down in the quarter?

John Compton

It was down around 7%, I believe, in the quarter.

Ann Gurkin - Davenport

Okay, great.

John Compton

Again largely, that was just shifting our trade calendars from potato to corn.

Ann Gurkin - Davenport

All right. Thank you, all.

Indra Nooyi

The only thing I will tell you is that you asked for innovations balance of the year and going into 2009. We are already into July and so really should not be talking about any big new innovation balance of year. I have had the privilege of looking at the early 2009 innovation calendar and in Pepsi Beverages North America, what Massimo and the team have done, is probably among the strongest innovation that we have ever seen coming out of North American Beverages and it is very exciting, I must say. We are going to be unveiling a lot of that at the Morgan Stanley conference in November. So I think it is going to be quite exciting. Thank you, very good.

Ann Gurkin - Davenport

All right. Thank you.

Operator

Thank you. Your next question is from Alec Patterson of RCM. Please go ahead.

Alec Patterson - RCM

Yes, thank you. Two questions, one, Massimo, I may be a connoisseur to be obvious here, but what I am hearing about price pack architecture and the sensitivity to the value equation for consumers, especially in C&G, sounds a bit of a wait-out strategy on beverages. We have obviously heard about smaller bottle sizes and what have you, but in that context, is that an apt description of the pricing initiative that is going on?

Massimo D’Amore

Not exactly, Alec. Let me explain. What we really mean by price pack is that we want to have the right offering to heed the right price point from an un-affordability standpoint as well as the right value for manning for larger packs. So, whenever we look at resizing our offering, is keeping always in mind these two factors. So, if we think of downsizing at the same to heed a certain price point, at the same time we upsize, to maintain better value for money. So it is really acting on both fronts of the value equation.

Alec Patterson - RCM

Okay.

Indra Nooyi

So, that is our last question and I want to thank everybody for coming on to our call today and look forward to continuing this dialogue with you through the rest of the quarter. Thank you.

Operator

Thank you. This does conclude today’s PepsiCo second quarter 2008 earnings conference call. You may now disconnect your lines and have a wonderful day.

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Source: Pepsico Inc. Q2 2008 Earnings Call Transcript
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