All per share information is computed using average shares outstanding, assuming dilution.
Management's Discussion and Analysis is presented in four sections. The introductory section discusses the 1997 Disposal of the Restaurants Segment and two pervasive issues impacting many companies, Market Risk and Year 2000 (pages 13-14). The second section analyzes the Results of Operations, first on a consolidated basis and then for each of our two industry segments (pages 14-19). The final two sections address our consolidated Cash Flows and Liquidity and Capital Resources (pages 19-20).
From time to time, in written reports, including the Chairman's Letter accompanying this annual report, and oral statements, we discuss our expectations regarding PepsiCo's future performance. These "forward-looking statements" are based on currently available competitive, financial and economic data and our operating plans. They are also inherently uncertain, and investors must recognize that events could turn out to be significantly different from what we expect.
Disposal of the Restaurants Segment
On August 14, 1997 we announced that our Board of Directors approved a formal plan to spin off our restaurant businesses to our shareholders. Under the plan, owners of PepsiCo capital stock as of September 19, 1997 received one share of common stock of the new restaurant company, TRICON Global Restaurants, Inc. (TRICON), for every ten shares of PepsiCo capital stock. The spin-off was completed on October 6, 1997 (Distribution Date). In 1997, we also sold PepsiCo Foods Systems (PFS), the restaurant distribution operation and all of the non-core U.S. restaurant businesses. As a result, the sales, costs and expenses, assets and liabilities, and cash flows of the Restaurants segment have been classified as discontinued operations in our financial statements. See Note 4. Accordingly, the discussions that follow focus on the continuing operations of our packaged goods businesses.
The principal market risks (i.e., the risk of loss arising from adverse
changes in market rates and prices) to which we are exposed are:
PepsiCo centrally manages its debt and investment portfolios considering investment opportunities and risks, tax consequences and overall financing strategies.
We use interest rate and currency swaps to effectively change the interest rate and currency of specific debt issuances with the objective of reducing our overall borrowing costs. These swaps are generally entered into concurrently with the issuance of the debt they are intended to modify. The notional amount, interest payment and maturity dates of the swaps match the principal, interest payment and maturity dates of the related debt. Accordingly, any market risk or opportunity associated with these swaps is offset by the opposite market impact on the related debt.
Our investment portfolios consist of cash equivalents and short-term marketable securities; accordingly, the carrying amounts approximate market value. It is our practice to hold these investments to maturity. Assuming year-end 1997 variable rate debt and investment levels, a one-point change in interest rates would impact net interest expense by $13 million.
Operating in international markets sometimes involves exposure to volatile movements in currency exchange rates. The economic impact of currency exchange rate movements on us is complex because such changes are often linked to variability in real growth, inflation, interest rates, governmental actions and other factors. These changes, if material, can cause us to adjust our financing and operating strategies. Consequently, isolating the effect of changes in currency does not incorporate these other important economic factors.
International operations constitute about 16% of our 1997 consolidated operating profit, excluding unusual items. As currency exchange rates change, translation of the income statements of our international businesses into U.S. dollars affects year-over-year comparability of operating results. We do not generally hedge translation risks because cash flows from international operations are generally reinvested locally. We do not enter into hedges to minimize volatility of reported earnings because we do not believe it is justified by the exposure or the cost.
Changes in currency exchange rates that would have the largest impact on translating our international operating profit include the Mexican peso, British pound, Canadian dollar and Brazilian real. We estimate that a 10% change in foreign exchange rates would impact reported operating profit by less than $50 million. This represents 10% of the international segment operating profit (disclosed on page 33) after adjusting for unusual items. We believe that this quantitative measure has inherent limitations because, as discussed in the first paragraph of this section, it does not take into account any governmental actions or changes in either customer purchasing patterns or our financing and operating strategies.
Foreign exchange gains and losses reflect transaction gains and losses and translation gains and losses arising from the remeasurement into U.S. dollars of the net monetary assets of businesses in highly inflationary countries. Transaction gains and losses arise from monetary assets and liabilities denominated in currencies other than a business unit's functional currency. Net foreign exchange gains and losses were not material to our earnings for the last three years.
The sensitivity analyses presented in the interest and foreign exchange discussions above disregard the possibility that rates can move in opposite directions and that gains from one category may or may not be offset by losses from another category and vice versa.
We are subject to market risk with respect to commodities because our ability to recover increased costs through higher pricing may be limited by the competitive environment in which we operate. We use futures contracts to hedge immaterial amounts of our commodity purchases.
The Year 2000 issue is the result of computer programs using two digits rather than four to define the applicable year. Computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in system failures or miscalculations leading to disruptions in a company's operations. If either we, our significant customers or suppliers fail to correct Year 2000 issues, such failure could have a significant impact on our ability to operate our businesses. However, the impact cannot be quantified at this time.
We are in the process of taking actions to address and complete the work associated with the Year 2000. Each of our business segments and Corporate have established teams to identify and correct Year 2000 issues. Internal software with non-compliant code is expected to be fixed or replaced with software that is Year 2000 compliant. Similar attention is being given to technology infrastructures, manufacturing plants and building facilities to achieve compliance in all these areas. The teams are also charged with investigating the Year 2000 capabilities of suppliers, customers and other external entities, and with developing contingency plans where necessary.
An inventory and assessment of all computer systems and application software have been completed, and plans for establishing compliance have been developed in the United States. These plans identify which non-compliant hardware and software will be corrected, upgraded or replaced; the timetable and resource requirements to achieve those objectives and estimated associated costs. Remediation and testing activities are under way at both Pepsi-Cola and Frito-Lay. Most of our larger international operations have made similar progress, while some of our smaller international operations, which are generally less automated, are still developing their strategies.
We do not expect Year 2000 spending to materially affect consolidated profitability or liquidity. This expectation assumes that our existing forecast of costs to be incurred contemplates all significant actions required and that we will not be obligated to incur significant Year 2000 related costs on behalf of our customers or suppliers. About 40% of the total estimated spending represents replacement systems that, in addition to being Year 2000 compliant, provide significantly enhanced capability which will benefit operations in future years.