Sidenav for 1998 Annual Report
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Financial Review

Management's Discussion and Analysis

INTRODUCTION

Management's Discussion and Analysis is presented in four sections. The Introductory section discusses Pending Transactions/Events, Acquisitions, Market Risk (including the EURO conversion), Year 2000, Impairment and Other Items Affecting Comparability of Results and a New Accounting Standard (pages 13-16). The second section analyzes the Results of Operations, first on a consolidated basis and then for each of our business segments (pages 16-20). The final two sections address our Consolidated Cash Flows and Liquidity and Capital Resources (pages 20 and 21).

Cautionary Statements
From time to time, in written reports (including the Chairman's letter accompanying this annual report) and in oral statements, we discuss expectations regarding our future performance, Year 2000 risks, pending transactions/events, the impact of the EURO conversion and the impact of current global macro-economic issues. These "forward-looking statements" are based on currently available competitive, financial and economic data and our operating plans. They are inherently uncertain, and investors must recognize that events could turn out to be significantly different from expectations.

Pending Transactions/Events
In November 1998, our Board of Directors approved a plan for the separation from PepsiCo of certain wholly-owned bottling businesses located in the United States, Canada, Spain, Greece and Russia, referred to as The Pepsi Bottling Group. Pursuant to this plan, PBG intends to sell shares of its common stock in an initial public offering and PepsiCo intends to retain a noncontrolling ownership interest in PBG. A registration statement relating to the Offering has been filed on Form S-1 with the Securities and Exchange Commission. The transaction is expected to be consummated in the second quarter of 1999, subject to market conditions and regulatory approval. If consummated, the transaction is expected to result in a gain to PepsiCo, net of related costs. These related costs will include a charge for the early vesting of PepsiCo stock options held by PBG employees, which will be based on the price of our stock at the date of the Offering. See Management's Discussion and Analysis -Liquidity and Capital Resources on page 21 regarding PBG related financing and expected use of proceeds.

In January 1999, we announced an agreement with the Whitman Corporation to realign bottling territories. Subject to approval by the Whitman shareholders and various regulatory authorities, we plan to combine certain of our bottling operations in the mid-western United States and Central Europe with most of Whitman's existing bottling businesses to create new Whitman. Under the agreement, our current equity interest of 20% in General Bottlers, the principal operating company of Whitman, will also be transferred to new Whitman. Whitman transferred its existing bottling operations in Marion, Virginia; Princeton, West Virginia; and St. Petersburg, Russia to PBG. It is planned for new Whitman to assume certain indebtedness associated with our transferred U.S. operations with net proceeds to us of $300 million. Upon completion of the transaction, we will receive 54 million shares of new Whitman common stock. Whitman has undertaken a share repurchase program and it is anticipated that upon completion of the transaction and the repurchase program, our noncontrolling ownership interest will be approximately 40%. If approved, this transaction is expected to be completed in the second quarter of 1999 and result in a net gain to PepsiCo.

The Frito-Lay program to improve productivity, discussed in Management's Discussion and Analysis -Impairment and Other Items Affecting Comparability of Results on page 15, also includes consolidating U.S. production in our most modern and efficient plants and streamlining logistics and transportation systems. This program is expected to result in additional asset impairment and restructuring charges of approximately $65 million to be recorded in the first quarter of 1999.

Acquisitions
At the end of the third quarter 1998, we completed the acquisitions of Tropicana Products, Inc. from the Seagram Company Ltd. for $3.3 billion in cash and The Smith's Snackfoods Company (TSSC) in Australia from United Biscuits Holdings plc for $270 million in cash. In addition, acquisitions and investments in unconsolidated affiliates included the purchases of the remaining ownership interest in various bottlers and purchases of other international salty snack food businesses. Acquisitions for the year aggregated $4.5 billion in cash. The results of operations of all acquisitions are generally included in the consolidated financial statements from their respective dates of acquisition.

Market Risk
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:

  • interest rates on our debt and short-term investment portfolios,
  • foreign exchange rates and other international market risks, and
  • commodity prices, affecting the cost of our raw materials.

Interest Rates
PepsiCo centrally manages its debt and investment portfolios balancing investment opportunities and risks, tax consequences and overall financing strategies.

We use interest rate and currency swaps to effectively modify 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 that 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 fully offset by the opposite market impact on the related debt.

Our investment portfolios consist of cash equivalents and short-term marketable securities. The carrying amounts approximate market value because of the short-term maturity of these portfolios. It is our practice to hold these investments to maturity.

Assuming year-end 1998 variable rate debt and investment levels, a one-point change in interest rates would impact net interest expense by $64 million. This sensitivity analysis does not take into account existing interest rate swaps and the possibility that rates on debt and investments can move in opposite directions and that gains from one category may or may not be offset by losses from another category.

Foreign Exchange and Other International Market Risks
Operating in international markets involves exposure to movements in currency exchange rates. Currency exchange rate movements typically affect economic growth, inflation, interest rates, governmental actions and other factors. These changes, if material, can cause us to adjust our financing and operating strategies. The discussion of changes in currency below does not incorporate these other important economic factors. The sensitivity analysis presented below does not take into account 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.

International operations constitute about 15% of our 1998 consolidated operating profit, excluding unusual impairment and other 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 approximately $45 million. This was estimated using 10% of the international segment operating profit after adjusting for unusual impairment and other 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. There were net foreign exchange losses of $53 million in 1998, $16 million in 1997 and $1 million in 1996.

During the year, macro-economic conditions in Brazil, Mexico, Russia and across Asia Pacific have adversely impacted our results (see Russia discussion below). We are taking actions in these markets to respond to these conditions, such as prudent pricing aimed at sustaining volume, renegotiating terms with suppliers and securing local currency supply alternatives. However, we expect that the macro-economic conditions, particularly in Brazil, will continue to adversely impact our results in the near term.

The economic turmoil in Russia which accompanied the August 1998 devaluation of the ruble had an adverse impact on our operations. Consequently in our fourth quarter, we experienced a significant drop in demand, resulting in lower net sales and increased operating losses. Also, since net bottling sales in Russia are denominated in rubles, whereas a substantial portion of our related costs and expenses are denominated in U.S. dollars, bottling operating margins were further eroded. In response to these conditions, we have reduced our cost structure primarily through closing facilities, renegotiating manufacturing contracts and reducing the number of employees. We also wrote down our long-lived bottling assets to give effect to the resulting impairment. See Management's Discussion and Analysis - Impairment and Other Items Affecting Comparability of Results on page 15.

On January 1, 1999, eleven of fifteen member countries of the European Union fixed conversion rates between their existing currencies ("legacy currencies") and one common currency -the EURO. The EURO trades on currency exchanges and may be used in business transactions. Conversion to the EURO eliminated currency exchange rate risk between the member countries. Beginning in January 2002, new EURO-denominated bills and coins will be issued, and legacy currencies will be withdrawn from circulation. Our operating subsidiaries affected by the EURO conversion have established plans to address the issues raised by the EURO currency conversion. These issues include, among others, the need to adapt computer and financial systems, business processes and equipment, such as vending machines, to accommodate EURO-denominated transactions and the impact of one common currency on pricing. Since financial systems and processes currently accommodate multiple currencies, the plans contemplate conversion by the middle of 2001 if not already addressed in conjunction with Year 2000 remediation. We do not expect the system and equipment conversion costs to be material. Due to numerous uncertainties, we cannot reasonably estimate the long-term effects one common currency will have on pricing and the resulting impact, if any, on financial condition or results of operations.

Commodities
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.

Year 2000
Each of PepsiCo's business segments and corporate headquarters has established teams to identify and address Year 2000 compliance issues. Information technology systems with non-compliant code are expected to be modified or replaced with systems that are Year 2000 compliant. Similar actions are being taken with respect to non-IT systems, primarily systems embedded in manufacturing and other facilities. The teams are also charged with investigating the Year 2000 readiness of suppliers, customers, franchisees, financial institutions and other third parties and with developing contingency plans where necessary.

Key information technology systems have been inventoried and assessed for compliance, and detailed plans have been established for required system modifications or replacements. Remediation and testing activities are in process with work on approximately 70% of the systems already completed and the systems back in operation. This percentage is expected to increase to approximately 85% and 98% by the end of the first and second quarters of 1999, respectively. PepsiCo systems are expected to be compliant by the fourth quarter of 1999. Inventories and assessments of non-IT systems have been completed and remediation activities are under way with a mid-year 1999 target completion date.

Independent consultants have monitored progress of remediation programs at selected businesses and performed testing at certain key locations. In addition, other experts performed independent verification and validation audits of a sample of remediated systems with satisfactory results. Other independent consultants also performed a high-level review of our Year 2000 efforts and concluded that there were no significant deficiencies in our process, provided that resources are maintained at their current level and schedules are met. Progress is also monitored by senior management, and periodically reported to PepsiCo's Board of Directors.

We have identified critical suppliers, customers, financial institutions, and other third parties and have surveyed their Year 2000 remediation programs. We have completed on-site meetings with many of the third parties identified as presenting the greatest impact if not compliant. Risk assessments and contingency plans, where necessary, will be finalized in the first half of 1999 and tested where feasible in the second half of 1999. In addition, independent consultants have completed a survey of the state of readiness of our significant bottling franchisees. Such surveys have identified readiness issues and, therefore, potential risk to us. As a result, the franchisees' remediation programs are being accelerated to minimize the risk. We are also providing assistance to the franchisees with processes and with certain manufacturing equipment compliance data.

Incremental costs directly related to Year 2000 issues are estimated to be $141 million from 1998 to 2000, of which $64 million or 45% has been spent to date. Approximately 35% of the total estimated spending represents costs to repair systems while approximately 50% represents costs to replace and rewrite software. This estimate assumes that we will not incur significant Year 2000 related costs on behalf of our suppliers, customers, franchisees, financial institutions or other third parties. Costs incurred prior to 1998 were immaterial. Excluded from the estimated incremental costs are approximately $55 million of internal recurring costs related to our Year 2000 efforts.

Contingency plans for Year 2000 related interruptions are being developed and will include, but not be limited to, the development of emergency backup and recovery procedures, the staffing of a centralized team to react to unforeseen events, remediation of existing systems parallel with installation of new systems, replacing electronic applications with manual processes, identification of alternate suppliers and increasing raw material and finished goods inventory levels. The potential failure of a power grid or public telecommunication system, particularly internationally, will be considered in our contingency planning. All plans are expected to be completed by the end of the second quarter in 1999.

Our most likely worst case scenarios are the temporary inability of bottling franchisees to manufacture or bottle some products in certain locations, of suppliers to provide raw materials on a timely basis and of some customers to order and pay on a timely basis.

Our Year 2000 efforts are ongoing and our overall plan, including our contingency plans, will continue to evolve as new information becomes available. While we anticipate no major interruption of our business activities, that will be dependent in part upon the ability of third parties, particularly bottling franchisees, to be Year 2000 compliant. Although we have implemented the actions described above to address third party issues, we are not able to require the compliance actions by such parties. Accordingly, while we believe our actions in this regard should have the effect of mitigating Year 2000 risks, we are unable to eliminate them or to estimate the ultimate effect Year 2000 risks will have on our operating results.

Impairment and Other Items Affecting Comparability of Results
Asset Impairment and Restructuring Charges
Asset impairment and restructuring charges were $288 million ($261 million after-tax or $0.17 per share) in 1998, $290 million ($239 million after-tax or $0.15 per share) in 1997 and $576 million ($527 million after-tax or $0.33 per share) in 1996.

The 1998 asset impairment and restructuring charges of $288 million are comprised of the following:

  • A fourth quarter charge of $218 million for asset impairment of $200 million and restructuring charges of $18 million resulting from the adverse impact of market conditions of our Russian bottling operations described in Management's Discussion and Analysis -Market Risks on pages 13 and 14. The impairment evaluation was triggered by the reduction in utilization of assets caused by the lower demand, the adverse change in the business climate and the expected continuation of operating losses and cash deficits in that market. The impairment charge reduced the net book value of the assets to their estimated fair market value, based primarily on values recently paid for similar assets in that marketplace. Of the total $218 million charge, $212 million relates to bottling operations that will be part of PBG.
  • An impairment charge of $54 million relating to manufacturing equipment at Frito-Lay North America. In the fourth quarter, as part of our annual assessment of marketing plans and related capacity requirements at Frito-Lay North America and the development of a program to improve manufacturing productivity, we determined that certain product specific equipment would not be utilized and certain capital projects would be terminated to avoid production redundancies. The charge primarily reflects the write off of the net book value of the equipment and related projects.
  • A fourth quarter charge of $16 million for employee related costs resulting from the separation of Pepsi-Cola North America's concentrate and bottling organizations to more effectively serve retail customers in light of the expected conversion of PBG to public ownership. Of this amount, $10 million relates to bottling operations that will be part of PBG.

Most of the 1998 restructuring related amounts have been or will be paid in 1999.

In 1997 and 1996, asset impairment and restructuring charges of $290 million and $576 million reflected strategic decisions to realign the international bottling system, improve Frito-Lay International operating productivity and exit certain businesses. In 1997, restructuring charges included proceeds of $87 million associated with a settlement related to a previous Venezuelan bottler agreement, partially offset by related costs.

Income Tax Benefit
In 1998 we reported a tax benefit, included in the provision for income taxes, of $494 million (or $0.32 per share) as a result of reaching a final agreement with the Internal Revenue Service to settle substantially all remaining aspects of a tax case relating to our concentrate operations in Puerto Rico.

New Accounting Standard
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS 133 is effective for our fiscal year beginning 2000. This statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that we recognize all derivative instruments as either assets or liabilities in the balance sheet and measure those instruments at fair value. We are currently assessing the effects of adopting SFAS 133, and have not yet made a determination of the impact adoption will have on our consolidated financial statements.

[Results of Operations]

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