Vast and powerful direct store delivery (DSD) systems are at the heart of that network. Through these systems we take snacks and drinks directly to tens of thousands of distribution outlets, from the tiniest convenience store to the largest warehouse outlet. We and our bottlers actually take products into the store and set them on the shelves. That helps to ensure that our products are fresh and that fragile items like potato chips are handled with care. It also allows us to merchandise our brands for maximum visibility and appeal.

Our systems can move new products into national distribution very quickly, sometimes as fast as a week. And because we call on retail customers so frequently, we know very quickly how a new product is selling.

At the same time, DSD provides big financial benefits to retailers. Since we handle the products and do the merchandising, retailers save on labor. And because our products typically are sold and restocked every few days, while retailers pay for them on 30-day cycles, we add a lot to a store's cash flow.

Take, for example, big U.S. retailers. PepsiCo contributes more than any other manufacturer to their revenue growth, profit growth and cash flow. That's a powerful incentive to sell more of our brands.

In international markets we sometimes adapt our distribution to reap many benefits of traditional DSD — particularly the merchandising capabilities and the reach into many retail outlets — without the costs that would burden a young or subscale business.

For some of our products, traditional broker-warehouse distribution is as effective and more economical than DSD. Under this system, third-party distributors move our products to stores, and store employees stock the shelves. That generally works best for products that are less fragile (than potato chips, for example), less perishable and less likely to be "impulse" purchases, products like Gatorade, Quaker Oats, Tropicana Twister or Cap'n Crunch cereal.

The merger dramatically expanded our broker-warehouse distribution capability by adding the very large and efficient warehouse system used for Quaker and Gatorade products. To leverage that strength, we've combined that system with Tropicana's. We're also using the Quaker-Gatorade system very selectively for certain Frito-Lay snacks that are better suited to warehouse distribution.

Every year consumers buy more snacks and beverages from vending machines and the "foodservice" companies that serve stadiums, office buildings, colleges and similar places. We see this as a big opportunity. By combining capabilities of Frito-Lay, Tropicana and Quaker, we created one of the biggest vending and foodservice sales forces in North America, a 600-person team that already generates well over $1 billion in annual sales.

Exceptional Innovation Capabilities

Without question, innovation is the single greatest driver of growth for PepsiCo and our product categories. After years of making innovation a high priority, PepsiCo has experience and capabilities unrivaled in our industry.

Frito-Lay has by far the world's greatest institutional knowledge of snacks and snack consumption. Pepsi-Cola, a longtime leader in new products and packaging, recently added the creative resources of SoBe. And the combination of the Gatorade Sports Science Institute and the Tropicana Nutrition Center gives us unmatched expertise in the growing segment of "functional" beverages that offer nutrition or other health benefits consumers value.

The beauty of innovation is the way it differentiates our products in the marketplace. New products and packages — or changes to existing ones — give consumers exciting new reasons to buy our brands. Equally important, innovation gives retailers a great new reason to feature them prominently.

That's a big competitive advantage. So we grab every opportunity to differentiate our products through innovation.

It starts, literally, on the farm. To find the perfect "chipping" potato for every climate and agricultural condition, Frito-Lay has developed thousands of proprietary potato seed varieties not available to other manufacturers. Similarly, Tropicana has exclusive use of patented fruit varieties that allow it to produce not-from-concentrate juices with superior flavor, color and aroma throughout the year.

Differentiation also occurs in manufacturing. Frito-Lay patented a new process to produce more intense flavors in its Ruffles Flavor Rush snacks by coating the entire chip, front and back. For Tostitos Scoops, Frito-Lay developed technology to make tortilla chips, typically flat, in a three-dimensional spoonlike shape suited to scooping salsa or dip. Sounds easy. It's not.

New, more convenient packages also help us stand out from the competition. Tropicana's new 14-ounce plastic orange juice bottle is elegantly contoured to fit easily in the hand and the automobile cup holder. Similar thinking inspired Frito-Lay to create Go Snacks. These smaller versions of our traditional brands come in a plastic canister that also fits easily in hand and cup holder. On-the-go consumers can "pour" the snacks directly into their mouths. In one more example of innovative packaging, the Gatorade E.D.G.E. bottle is ergonomically designed for optimal thirst quenching.

In a business where consumers demand great taste, innovative flavors also make our products distinctive. For example, Mountain Dew Code Red, a new version of Mountain Dew "with a rush of cherry flavor," hit the market in 2001 and became one of the most successful new soft drinks ever.

Chairman's Letter continued -->