PepsiCo 2009 Annual Report

Failure to complete the PBG Merger and the PAS Merger may adversely affect our results of operations and prevent us from realizing the full extent of the benefits and cost savings expected from either or both of the PBG Merger and the PAS Merger.

The PBG Merger and the PAS Merger are each subject to the satisfaction or, to the extent permissible, waiver of certain conditions, including, but not limited to, receipt of the necessary consents and approvals. Although we expect to complete both of the Mergers, it is possible that either the PBG Merger or the PAS Merger may not be completed. Our relationship with PBG or PAS may suffer following a failure to complete the PBG Merger or the PAS Merger, as applicable, which could adversely affect our results of operations. Failure to complete either Merger will also prevent us from realizing the full extent of the benefits and cost savings that we expect to realize as a result of the completion of both Mergers. See also "The Mergers are subject to the receipt of certain required clearances or approvals from governmental entities that could prevent or delay their completion or impose conditions that could have a material adverse effect on us."

After completion of the Mergers, we may fail to realize the anticipated cost savings and other benefits expected therefrom, which could adversely affect the value of our common stock or other securities.

The success of the Mergers will depend, in part, on our ability to successfully combine our business with the businesses of PBG and PAS and realize the anticipated benefits and cost savings from such combination. While we believe that these cost savings estimates are achievable, it is possible that we will be unable to achieve these objectives within the anticipated time frame, or at all. Our cost savings estimates also depend on our ability to combine our business with the businesses of PBG and PAS in a manner that permits those cost savings to be realized. If these estimates turn out to be incorrect or we are not able to combine our business with the businesses of PBG and PAS successfully, the anticipated cost savings and other benefits, including expected synergies, resulting from the Mergers may not be realized fully or at all or may take longer to realize than expected, and the value of our common stock or other securities may be adversely affected.

Specifically, issues that must be addressed in integrating our operations with the operations of PBG and PAS in order to realize the anticipated benefits of the Mergers include, among other things:

• integrating the manufacturing, distribution, sales and administrative support activities and information technology systems among the companies;
• motivating, recruiting and retaining executives and key employees;
• conforming standards, controls, procedures and policies, business cultures and compensation structures among the companies;
• consolidating and streamlining corporate and administrative infrastructures;
• consolidating sales and marketing operations;
• retaining existing customers and attracting new customers;
• identifying and eliminating redundant and underperforming operations and assets;
• coordinating geographically dispersed organizations; and
• managing tax costs or inefficiencies associated with integrating our operations following completion of the Mergers.

Delays encountered in the process of integrating our business with the businesses of PBG and PAS could have an adverse effect on our revenues, expenses, operating results and financial condition after completion of the Mergers. Although significant benefits, such as increased cost savings, are expected to result from the Mergers, there can be no assurance that we will realize any of these anticipated benefits after completion of either or both of the Mergers.

Additionally, significant costs are expected to be incurred in connection with consummating the Mergers and integrating the operations of the companies, with a significant portion of such costs being incurred through the first year after completion of the Mergers. We continue to assess the magnitude of these costs and additional unanticipated costs may be incurred in the integration of our business with the businesses of PBG and PAS. Although we believe that the elimination of duplicative costs, as well as the realization of other efficiencies related to the integration of the businesses, will offset incremental transaction and merger-related costs over time, no assurances can be given that this net benefit will be achieved in the near term, or at all.

Furthermore, the Mergers, and the related integration efforts, could result in the departure of key employees or distract management and employees from delivering against base strategies and objectives, which could have a negative impact on our business, and, prior to the completion of the Mergers, the businesses of PBG or PAS.

The Mergers are subject to the receipt of certain required clearances or approvals from governmental entities that could prevent or delay their completion or impose conditions that could have a material adverse effect on us.

Completion of each of the Mergers is conditioned upon the receipt of certain governmental clearances or approvals, including, but not limited to, the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvement Act of 1976 (the HSR Act) with respect to such Merger. There can be no assurance that these clearances and approvals will be obtained, and, additionally, government authorities from which these clearances and approvals are required may impose conditions on the completion of the PBG Merger or the PAS Merger or require changes to their respective terms. While under the terms of the Merger Agreements, neither we nor PBG or PAS is required, in connection with the PBG Merger or the PAS Merger, as applicable, to enter into any agreement or other undertaking with any such governmental authority with respect to any of our respective or our respective material subsidiaries' material businesses, assets or properties, we, PBG and PAS have each agreed to use reasonable best efforts to obtain governmental clearances or approvals necessary to complete the applicable Merger. If, in order to obtain any clearances or approvals required to complete either the PBG Merger or the PAS Merger, we become subject to any material conditions after completion of the PBG Merger or PAS Merger, as applicable, our business and results of operations after completion of the PBG Merger or PAS Merger, as applicable, may be adversely affected. In addition, there can be no assurances that the Commissioners of the Federal Trade Commission (FTC) will approve the consent decree (Consent Decree) we signed that was proposed by the Staff of the FTC. If the Commissioners do not approve the Consent Decree, the Mergers could be prevented or delayed.

Following completion of the Mergers, a greater portion of our workforce will belong to unions. Failure to successfully renew collective bargaining agreements, or strikes or work stoppages could cause our business to suffer.

Over 25% of current PBG and PAS employees are covered by collective bargaining agreements. These agreements expire on various dates. Strikes or work stoppages and interruptions could occur if we are unable to renew these agreements on satisfactory terms, which could adversely impact our operating results. The terms and conditions of existing or renegotiated agreements could also increase our costs or otherwise affect our ability to fully implement future operational changes to enhance our efficiency after completion of the Mergers.

Any downgrade of our credit rating could increase our future borrowing costs.

Following the public announcement of the PBG Merger Agreement and the PAS Merger Agreement (as defined in "Acquisition of Common Stock of PBG and PAS"), Moody's Investors Service (Moody's) indicated that it was reviewing our ratings for possible downgrade. Moody's has noted that the additional debt involved in completing the Mergers and our consolidated level of indebtedness following completion of the Mergers could result in a rating lower than the current rating level. Also following the public announcement of the PBG Merger Agreement and the PAS Merger Agreement, Standard & Poor's Ratings Services (S&P) indicated that its outlook on PepsiCo was negative and it could lower our ratings. S&P has indicated that when additional information becomes available S&P will review whether, following completion of the PBG Merger and the PAS Merger, any of our senior unsecured debt will, in S&P's view, be structurally subordinated, which could result in a lower rating for PepsiCo's debt securities. A downgrade by either Moody's or S&P could increase our future borrowing costs.

Forward-Looking and Cautionary Statements

We discuss expectations regarding our future performance, such as our business outlook, in our annual and quarterly reports, press releases, and other written and oral statements. These "forward-looking statements" are based on currently available information, operating plans and projections about future events and trends. They inherently involve risks and uncertainties that could cause actual results to differ materially from those predicted in any such forward-looking statements. Investors are cautioned not to place undue reliance on any such forward-looking statements, which speak only as of the date they are made. We undertake no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise. The discussion of risks below and elsewhere in this report is by no means all inclusive but is designed to highlight what we believe are important factors to consider when evaluating our future performance.

Market Risks

We are exposed to market risks arising from adverse changes in:

• commodity prices, affecting the cost of our raw materials and energy,
• foreign exchange rates, and
• interest rates.

In the normal course of business, we manage these risks through a variety of strategies, including productivity initiatives, global purchasing programs and hedging strategies. Ongoing productivity initiatives involve the identification and effective implementation of meaningful cost saving opportunities or efficiencies. Our global purchasing programs include fixed-price purchase orders and pricing agreements. See Note 9 for further information on our non-cancelable purchasing commitments. Our hedging strategies include the use of derivatives. Certain derivatives are designated as either cash flow or fair value hedges and qualify for hedge accounting treatment, while others do not qualify and are marked to market through earnings. Cash flows from derivatives used to manage commodity, foreign exchange or interest risks are classified as operating activities. We do not use derivative instruments for trading or speculative purposes. We perform assessments of our counterparty credit risk regularly, including a review of credit ratings, credit default swap rates and potential nonperformance of the counterparty. Based on our most recent assessment of our counterparty credit risk, we consider this risk to be low. In addition, we enter into derivative contracts with a variety of financial institutions that we believe are creditworthy in order to reduce our concentration of credit risk and generally settle with these financial institutions on a net basis.

The fair value of our derivatives fluctuates based on market rates and prices. The sensitivity of our derivatives to these market fluctuations is discussed below. See Note 10 for further discussion of these derivatives and our hedging policies. See "Our Critical Accounting Policies" for a discussion of the exposure of our pension plan assets and pension and retiree medical liabilities to risks related to market fluctuations.

Inflationary, deflationary and recessionary conditions impacting these market risks also impact the demand for and pricing of our products.

Commodity Prices

We expect to be able to reduce the impact of volatility in our raw material and energy costs through our hedging strategies and ongoing sourcing initiatives.

Our open commodity derivative contracts that qualify for hedge accounting had a face value of $151 million as of December 26, 2009 and $303 million as of December 27, 2008. These contracts resulted in net unrealized losses of $29 million as of December 26, 2009 and $117 million as of December 27, 2008. At the end of 2009, the potential change in fair value of commodity derivative instruments, assuming a 10% decrease in the underlying commodity price, would have increased our net unrealized losses in 2009 by $13 million.

Our open commodity derivative contracts that do not qualify for hedge accounting had a face value of $231 million as of December 26, 2009 and $626 million as of December 27, 2008. These contracts resulted in net losses of $57 million in 2009 and $343 million in 2008. At the end of 2009, the potential change in fair value of commodity derivative instruments, assuming a 10% decrease in the underlying commodity price, would have increased our net losses in 2009 by $17 million.

Foreign Exchange

Financial statements of foreign subsidiaries are translated into U.S. dollars using period-end exchange rates for assets and liabilities and weighted-average exchange rates for revenues and expenses. Adjustments resulting from translating net assets are reported as a separate component of accumulated other comprehensive loss within shareholders' equity under the caption currency translation adjustment.

Our operations outside of the U.S. generate 48% of our net revenue, with Mexico, Canada and the United Kingdom comprising 16% of our net revenue. As a result, we are exposed to foreign currency risks. During 2009, net unfavorable foreign currency, primarily due to depreciation of the Mexican peso, British pound, euro and Russian ruble, reduced net revenue growth by 5 percentage points. Currency declines against the U.S. dollar which are not offset could adversely impact our future results.

In addition, we continue to use the official exchange rate to translate the financial statements of our snack and beverage businesses in Venezuela. We use the official rate as we currently intend to remit dividends solely through the government-operated Foreign Exchange Administration Board (CADIVI). As of the beginning of our 2010 fiscal year, the results of our Venezuelan businesses will be reported under hyperinflationary accounting. This determination was made based upon Venezuela's National Consumer Price Index (NCPI) which indicated cumulative inflation in Venezuela in excess of 100% for the three-year period ended November 30, 2009. Consequently, the functional currency of our Venezuelan entities will be changed from the bolivar fuerte (bolivar) to the U.S. dollar. Effective January 11, 2010, the Venezuelan government devalued the bolivar by resetting the official exchange rate from 2.15 bolivars per dollar to 4.3 bolivars per dollar; however, certain activities would be permitted to access an exchange rate of 2.6 bolivars per dollar. In 2010, we expect that the majority of our transactions will be conducted at the 4.3 exchange rate, and as a result of the change to hyperinflationary accounting and the devaluation of the bolivar, we expect to record a one-time charge of approximately $125 million in the first quarter of 2010. In 2009, our operations in Venezuela comprised 7% of our cash and cash equivalents balance and generated less than 2% of our net revenue.

Exchange rate gains or losses related to foreign currency transactions are recognized as transaction gains or losses in our income statement as incurred. We may enter into derivatives, primarily forward contracts with terms of no more than two years, to manage our exposure to foreign currency transaction risk. Our foreign currency derivatives had a total face value of $1.2 billion as of December 26, 2009 and $1.4 billion as of December 27, 2008. The contracts that qualify for hedge accounting resulted in net unrealized losses of $20 million as of December 26, 2009 and net unrealized gains of $111 million as of December 27, 2008. At the end of 2009, we estimate that an unfavorable 10% change in the exchange rates would have increased our net unrealized losses by $86 million. The contracts that do not qualify for hedge accounting resulted in net gains of $1 million in 2009 and net losses of $28 million in 2008. All losses and gains were offset by changes in the underlying hedged items, resulting in no net material impact on earnings.

Interest Rates

We centrally manage our debt and investment portfolios considering investment opportunities and risks, tax consequences and overall financing strategies. We use various interest rate derivative instruments including, but not limited to, interest rate swaps, cross currency interest rate swaps, Treasury locks and swap locks to manage our overall interest expense and foreign exchange risk. These instruments effectively change the interest rate and currency of specific debt issuances. Our interest rate and cross currency swaps are generally entered into concurrently with the issuance of the debt that they modified. The notional amount, interest payment and maturity date of the interest rate and cross currency swaps match the principal, interest payment and maturity date of the related debt. Our Treasury locks and swap locks are entered into to protect against unfavorable interest rate changes relating to forecasted debt transactions.

Assuming year-end 2009 variable rate debt and investment levels, a 1-percentage-point increase in interest rates would have increased net interest expense by $3 million in 2009.

Risk Management Framework

The achievement of our strategic and operating objectives will necessarily involve taking risks. Our risk management process is intended to ensure that risks are taken knowingly and purposefully. As such, we leverage an integrated risk management framework to identify, assess, prioritize, manage, monitor and communicate risks across the Company. This framework includes:

• The PepsiCo Risk Committee (PRC), comprised of a cross-functional, geographically diverse, senior management group which meets regularly to identify, assess, prioritize and address strategic and reputational risks;
• Division Risk Committees (DRCs), comprised of cross-functional senior management teams which meet regularly to identify, assess, prioritize and address division-specific operating risks;
• PepsiCo's Risk Management Office, which manages the overall risk management process, provides ongoing guidance, tools and analytical support to the PRC and the DRCs, identifies and assesses potential risks, and facilitates ongoing communication between the parties, as well as to PepsiCo's Audit Committee and Board of Directors;
• PepsiCo Corporate Audit, which evaluates the ongoing effectiveness of our key internal controls through periodic audit and review procedures; and
• PepsiCo's Compliance Department, which leads and coordinates our compliance policies and practices.