On August 2, 2001, we completed a merger transaction, which resulted in The Quaker Oats Company (Quaker) becoming a wholly-owned subsidiary of PepsiCo. As a result, we restated all prior periods presented to reflect the combined results of operations, financial position and cash flows of both companies as if they had always been merged. For further detail see "Merger of PepsiCo and The Quaker Oats Company."

Tabular dollars are in millions, except per share amounts. All per share amounts reflect common per share amounts, assume dilution unless noted, and are based on unrounded amounts. Percentage changes are based on unrounded amounts.

Management's Discussion and Analysis is presented in four sections. The first section discusses critical accounting policies, transactions with related and other parties, items affecting comparability, new accounting standards and market and other risk factors. The second section analyzes the results of operations, first on a consolidated basis and then for each of our business segments. The final two sections address consolidated cash flows and liquidity and capital resources.

Cautionary Statements
From time to time, in written reports and in oral statements, we discuss expectations regarding our future performance including synergies from the merger, the impact of the euro conversion and the impact of global macroeconomic 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 our expectations.

Principles of consolidation - The financial statements include the consolidated accounts of PepsiCo, Inc. and its controlled affiliates. Investments in unconsolidated affiliates over which we exercise significant influence, but not control, are accounted for by the equity method. Our definition of control for majority owned affiliates considers the exercisability of the minority interest rights, and consolidation would be precluded to the extent that the minority interest holds substantive participating rights. Our share of the net income or loss of unconsolidated affiliates accounted for by the equity method is included in our consolidated net income. As a result of changes in the operations of our European snack joint venture, we have determined that, effective in 2002, consolidation is required.

Revenue recognition - We recognize revenue when products are delivered to customers consistent with sales terms. Sales terms generally do not allow a right of return.

Derivative instruments and hedging - We manage risks associated with commodity prices, foreign exchange rates, interest rates and our stock price and may use derivative instruments to hedge these risks. As a matter of policy, we do not use derivative instruments unless there is an underlying exposure and, therefore, we do not use derivative instruments for trading or speculative purposes. The evaluation of hedge effectiveness is subject to assumptions based on the terms and timing of the underlying exposures. All derivative instruments are recognized in our Consolidated Balance Sheet at fair value. The fair value of our derivative instruments is generally based on quoted market prices.

Asset impairment - All long-lived assets, including goodwill, investments in unconsolidated affiliates and other identifiable intangibles, are evaluated for impairment on the basis of undiscounted cash flows whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An impaired asset is written down to its estimated fair market value based on the best information available. Estimated fair market value is generally measured by discounting estimated future cash flows. Considerable management judgment is necessary to estimate discounted future cash flows. Assumptions used in these cash flows are consistent with internal forecasts.

Income taxes - Our effective tax rate and the tax bases of our assets and liabilities reflect our best estimate of the ultimate outcome of tax audits. Valuation allowances are established where expected future taxable income does not support the realization of the deferred tax assets.

Commitments and contingencies - We are subject to various claims and contingencies related to lawsuits, taxes and environmental matters, as well as commitments under contractual and other commercial obligations. We recognize liabilities for contingencies and commitments when a loss is probable and estimable. Our contractual and other commercial obligations primarily relate to the procurement of goods and services in the normal course of business and to guarantees related to our equity investees.

Refer to Note 1 to the consolidated financial statements for additional information on our accounting policies.

Certain members of our Board of Directors also serve on the boards of certain vendors and customers. Our transactions with these vendors and customers are in the normal course of business and consistent with terms negotiated with other vendors and customers. Those Board members do not participate in vendor selection and negotiations nor in customer negotiations. In addition, certain officers serve on the boards of our anchor bottlers and other equity investees and may receive compensation from such entities consistent with that of other members serving on those boards.

Fifty-third Week in 2000
Comparisons of 2000 to 2001 and 1999 are affected by an additional week of results in the 2000 reporting year. Because our fiscal year ends on the last Saturday in December, a fifty-third week is added every five or six years. The fifty-third week increased 2000 net sales by an estimated $294 million, operating profit by an estimated $62 million and net income by an estimated $44 million or $0.02 per share.

Merger of PepsiCo and The Quaker Oats Company
Under the Quaker merger agreement dated December 2, 2000, Quaker shareholders received 2.3 shares of PepsiCo common stock in exchange for each share of Quaker common stock, including a cash payment for fractional shares. We issued approximately 306 million shares of our common stock in exchange for all the outstanding common stock of Quaker.

In connection with the merger transaction, we sold the global rights in our All Sport beverage brand to The Monarch Company, Inc. of Atlanta. As part of the terms of the sale, we agreed that, for 10 years after the Quaker transaction closing date, we would not distribute Gatorade sports drink through our bottling system in the United States and would not include Gatorade with Pepsi-Cola products in certain marketing or promotional arrangements covering specific distribution channels.

The merger was accounted for as a tax-free transaction and as a pooling-of-interests. As a result, all prior period consolidated financial statements presented have been restated to include the results of operations, financial position and cash flows of both companies as if they had always been combined. Certain reclassifications were made to conform the presentation of the financial statements, and the fiscal calendar and certain interim reporting policies were also conformed. There were no material transactions between pre-merger PepsiCo and Quaker.

The results of operations of the separate companies and the combined company for the most recent interim period prior to the merger and for the years presented in the consolidated financial statements are as follows:

During 2001, we recognized costs of $356 million associated with our merger with Quaker. The components of these merger-related costs were as follows:

Transaction costs were incurred to complete the merger and consist primarily of fees and expenses for investment bankers, attorneys and accountants, SEC filing fees, stock exchange listing fees and financial printing and other related charges.

Integration costs represent incremental one-time merger- related costs. Such costs include consulting fees and expenses, expenses for accelerated vesting under change-in-control provisions, information system integration costs and employee-related costs.

The restructuring charges primarily reflect termination costs for approximately 580 corporate, sales, distribution, manufacturing, research and marketing employees. Employee termination costs include retirement benefit costs, severance costs and expenses associated with change-in-control provisions of pre-merger employment contracts. As of December 29, 2001, approximately 380 of the terminations have occurred. The terminations are expected to be completed during 2002.

Additional merger-related actions are expected to bring the total integration costs and restructuring charges to between $450 million and $550 million. Ongoing merger-related cost savings and revenue enhancement opportunities are expected to reach $400 million a year by 2005. We expect to achieve up to $175 million of the synergies by the end of 2002.

Other Impairment and Restructuring Charges

2001 and 2000
The 2001 and 2000 other impairment and restructuring charges relate to a three-year supply chain reconfiguration project announced in 1999 to upgrade and optimize Quaker's manufacturing and distribution capabilities across all of its North American businesses.

The asset impairment charges primarily reflect the reduction in the carrying value of the land, buildings and production machinery and equipment to their estimated fair market value based on analyses of the liquidation values of similar assets. The restructuring charges primarily included severance and termination benefits for approximately 1,000 employees and other shutdown costs. No future charges are expected on this project.

1999
The 1999 other impairment and restructuring charges of $73 million were comprised of the following:

• A charge of $65 million, for asset impairment of $37 million and restructuring charges of $28 million, related to the closure of three plants and impairment of equipment at Frito-Lay North America. The asset impairment charges primarily reflected the reduction in the carrying value of the land and buildings to their estimated fair market value based on selling prices for comparable real estate, less costs to sell, and the write off of the net book value of equipment which could not be redeployed. The plant closures were completed during 1999. The majority of these assets were either disposed of or abandoned in 1999. The restructuring charges of $28 million primarily included severance costs and plant closing costs.
• A charge of $8 million, for asset impairment of $5 million and restructuring charges of $3 million, related to the previously discussed Quaker supply chain reconfiguration project. The charge included costs to consolidate several cereal manufacturing lines and employee-related costs.

Total restructuring reserves of $100 million, including merger-related reserves, at December 29, 2001, are included in accounts payable and other current liabilities in the Consolidated Balance Sheet.

Bottling Transactions
During 1999, we completed a series of transactions creating our anchor bottlers. In April 1999, certain wholly-owned bottling businesses, referred to as The Pepsi Bottling Group (PBG), completed an initial public offering with PepsiCo retaining a direct noncontrolling ownership interest of 35.5%. In May, we combined certain other bottling operations with Whitman Corporation retaining a noncontrolling ownership interest of approximately 38%. In July, we combined certain other bottling operations with PepCom Industries, Inc. retaining a noncontrolling interest of 35% in the combined entity renamed Pepsi Bottling Ventures, LLC. In October, we formed a business venture with Pohlad Companies, a Pepsi-Cola franchisee, retaining a noncontrolling ownership interest of approximately 24% in the venture's principal operating subsidiary, PepsiAmericas, Inc.

Our financial statements include the results of our bottling operations on a consolidated basis through the transaction dates above, and our proportionate share of income under the equity method subsequent to those dates.

In December 2000, Whitman merged with PepsiAmericas. We now own approximately 37% of the combined company, which has since changed its name to PepsiAmericas. As part of the merger, we participate in an earn-out option whereby we may receive additional shares when certain performance targets are met.

Our three anchor bottlers distribute approximately three-fourths of our beverage products in North America.

Tax Item
In 1999, Quaker adjusted its tax accruals and tax assets to reflect developments and information received during the year. The net effect of these adjustments reduced the income tax provision by $59 million or $0.03 per share.

During 2000 and 2001, the Financial Accounting Standards Board's (FASB) Emerging Issues Task Force (EITF) addressed various issues related to the income statement classification of certain promotional payments, including consideration from a vendor to a reseller or another party that purchases the vendor's products. EITF 01-9, Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor's Products, was issued in November 2001 and codified earlier pronouncements. Primarily effective for 2002, adoption of EITF 01-9 will reduce our net sales by $3.4 billion in 2001, $3.1 billion in 2000 and $2.9 billion in 1999, with selling, general and administrative expenses reduced by the same amounts.

In July 2001, the FASB issued SFAS 141, Business Combinations. SFAS 141 eliminates the pooling-of-interests method of accounting for business combinations and modifies the application of the purchase accounting method. The elimination of the pooling-of-interests method is effective for transactions initiated after June 30, 2001. The remaining provisions of SFAS 141 are effective for transactions accounted for using the purchase method that are completed after June 30, 2001. Since our merger with Quaker (see Note 2 to the consolidated financial statements) was initiated in December 2000 and our acquisition of South Beach Beverage Company, LLC (see Note 4 to the consolidated financial statements) was completed in January 2001, adoption of this statement does not have an impact on our consolidated financial statements.

In July 2001, the FASB also issued SFAS 142, Goodwill and Intangibles. SFAS 142 eliminates the current requirement to amortize goodwill and indefinite-lived intangible assets, addresses the amortization of intangible assets with finite lives and addresses impairment testing and recognition for goodwill and intangible assets. SFAS 142 applies to existing goodwill and intangible assets, as well as to transactions completed after the statement's effective date. SFAS 142 is effective for 2002. Adoption of SFAS 142 will increase income before taxes by approximately $87 million in 2002 reflecting the cessation of goodwill amortization and changes in the lives of other intangibles. The required transition impairment evaluations are not expected to result in impairment charges.

In June 2001, the FASB issued SFAS 143, Accounting for Asset Retirement Obligations. SFAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. It requires that we recognize the fair value of a liability for an asset retirement obligation in the period in which it is incurred if a reasonable estimate of fair value can be made. We are currently assessing SFAS 143 and the impact that adoption, in 2003, will have on our consolidated financial statements.

In August 2001, the FASB issued SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS 144 establishes a single model for the impairment of long-lived assets and broadens the presentation of discontinued operations to include more disposal transactions. SFAS 144 is effective for 2002. Adoption will not have a material impact on our consolidated financial statements.

Market Risks
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:

• commodity prices, affecting the cost of our raw materials and fuel;
• foreign exchange risks;
• interest rates on our debt and short-term investment portfolios; and
• our stock price.

Our hedging transactions include, but are not limited to, the use of various derivative instruments. As a matter of policy, we do not use derivative instruments unless there is an underlying exposure and, therefore, we do not use derivative instruments for trading or speculative purposes. Any change in the value of our derivative instruments would be substantially offset by an opposite change in the value of the underlying hedged items.

Commodity Prices
We are subject to market risk with respect to the cost of commodities because our ability to recover increased costs through higher pricing may be limited by the competitive environment in which we operate. We manage this risk primarily through the use of fixed-price purchase orders, pricing agreements, geographic diversity and derivative instruments. Derivative instruments, including futures, options and swaps, are used to hedge fluctuations in prices of a portion of anticipated commodity purchases, primarily corn, oats, natural gas, heating oil, vegetable oil and packaging materials. Our use of derivative instruments is not significant to our commodity purchases.

Our commodity derivative positions were $252 million at December 29, 2001 and $52 million at December 30, 2000. Our commodity derivative positions resulted in a net unrealized loss of $16 million at December 29, 2001 and a net unrealized gain of $3 million at December 30, 2000. We estimate that a 10% decline in commodity prices would have increased the loss by $18 million in 2001 and reduced the gain by $6 million resulting in a loss in 2000.

Foreign Exchange
International operations constitute about one-fifth of our annual business segment operating profit. Operating in international markets involves exposure to movements in foreign exchange rates, primarily the Mexican peso, British pound, Canadian dollar, euro and Brazilian real, which principally impacts the translation of our international operating profit into U.S. dollars. On occasion, we may enter into derivative instruments, as necessary, to reduce the effect of foreign exchange rate changes. We manage the use of foreign exchange derivatives centrally.

Our foreign currency derivative positions had an aggregate notional value of $355 million, with $223 million relating to contracts to exchange British pounds for U.S. dollars, at December 29, 2001 and $344 million, with $336 million relating to contracts to exchange British pounds to U.S. dollars, at December 30, 2000. These forward contracts had a net gain of $4 million at December 29, 2001 and losses of $9 million at December 30, 2000. We estimate that an unfavorable 10% change in the exchange rates would have decreased the 2001 gain by $35 million resulting in a loss and increased the 2000 losses by $35 million.

Interest Rates
We centrally manage our 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 entered into concurrently with the issuance of the debt that they are intended to modify. The notional amount, interest payment and maturity date of the swaps match the principal, interest payment and maturity date of the related debt. Our credit risk related to interest rate and currency swaps is considered low because such swaps are entered into only with strong creditworthy counterparties, are generally settled on a net basis and are of relatively short duration.

Assuming year-end 2001 and 2000 variable rate debt and investment levels, a one-point increase in interest rates would have increased net interest expense by $3 million in 2001 and $7 million in 2000. The change in this impact from 2000 resulted from decreased variable debt levels and increased investment levels at year-end 2001. This sensitivity analysis includes the impact of existing interest rate and currency swaps.

Stock Price
The portion of our deferred compensation liability which is based on our stock price is subject to market risk. Prepaid forward contracts with financial institutions with an aggregate notional amount of $52 million at year-end 2001 were used to hedge this risk and are accounted for as natural hedges. The change in fair value of these equity derivative contracts resulted in $1 million of expense in 2001, $19 million of income in 2000 and $6 million of expense in 1999. We estimate that a 10% unfavorable change in the year-end stock price would have increased the 2001 loss by $6 million and reduced the 2000 gain by $7 million.

Euro Conversion
Our operating subsidiaries affected by the euro conversion successfully addressed the issues raised by the euro currency conversion including, among others, adapting computer and financial systems, business processes and equipment, such as vending machines, to accommodate euro-denominated transactions and took actions to reduce the impact of one common currency on cross-border pricing. We have experienced no business interruption as a result of the issuance and circulation of euro-denominated bills and coins and the withdrawal of legacy currencies. The system and equipment conversion costs were not material. Due to numerous uncertainties, we cannot reasonably estimate the long-term effects one common currency may have on pricing and the resulting impact, if any, on financial condition or results of operations.

Management's Discussion and Analysis continued -->