Back to GetFilings.com

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS

PURSUANT TO SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

(Mark One)

For the fiscal year ended December 25, 2004

OR

For the transition period from                      to                     

Commission file number 1-1183

PEPSICO, INC.

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s telephone number, including area code 914-253-2000

Securities registered pursuant to Section 12(b) of the Securities Exchange Act of 1934:

Securities registered pursuant to Section 12(g) of the Securities Exchange Act of 1934: None

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2) . Yes x  No ¨

The number of shares of PepsiCo Common Stock outstanding as of February 18, 2005 was 1,678,172,035. The aggregate market value of PepsiCo Common Stock held by nonaffiliates of PepsiCo as of June 12, 2004, the last day of business of our most recently completed second fiscal quarter, was $93,273,528,587.

PepsiCo, Inc.

Form 10-K Annual Report

For the Fiscal Year Ended December 25, 2004

Table of Contents

ii

PART I

PepsiCo, Inc. was incorporated in Delaware in 1919 and was reincorporated in North Carolina in 1986. When used in this report, the terms “we,” “us,” “our” and the “Company” mean PepsiCo and its divisions and subsidiaries.

Our Divisions

We are a leading, global snack and beverage company. We manufacture, market and sell a variety of salty, convenient, sweet and grain-based snacks, carbonated and noncarbonated beverages and foods. We are organized in four divisions:

Our North American divisions operate in the United States and Canada. Our international divisions operate in over 200 countries, with our largest operations in Mexico and the United Kingdom. Financial information concerning our divisions and geographic areas is presented in Note 1 to our consolidated financial statements and additional information concerning our division operations, customers and distribution network is presented under the heading “ Our Business” contained in “ Item 7. Management’s Discussion and Analysis.”

Frito-Lay North America

Frito-Lay North America (FLNA) manufactures or uses contract manufacturers, markets, sells and distributes branded snacks. These snacks include Lay’s potato chips, Doritos flavored tortilla chips, Tostitos tortilla chips, Cheetos cheese flavored snacks, Fritos corn chips, Ruffles potato chips, branded dips, Rold Gold pretzels, Quaker Chewy granola bars, Sun Chips multigrain snacks, Munchies snack mix, Grandma’s cookies, Lay’s Stax potato crisps, Quaker Fruit & Oatmeal bars, Quaker Quakes corn and rice snacks, Cracker Jack candy coated popcorn, and Go Snacks. FLNA branded products are sold to independent distributors and retailers. FLNA’s net revenue was $9.6 billion in 2004, $9.1 billion in 2003 and $8.6 billion in 2002 and approximated 33% of our total division net revenue in 2004 and 34% of our total division net revenue in each of 2003 and 2002.

1

PepsiCo Beverages North America

PepsiCo Beverages North America (PBNA) manufactures or uses contract manufacturers, markets and sells beverage concentrates, fountain syrups and finished goods, under various beverage brands, including Pepsi, Mountain Dew, Gatorade, Tropicana Pure Premium, Sierra Mist, Mug, Tropicana Juice Drinks, Propel, SoBe, Slice, Dole, Tropicana Twister, and Tropicana Season’s Best. PBNA also manufactures, markets and sells ready-to-drink tea and coffee products through joint ventures with Lipton and Starbucks. In addition, PBNA licenses the Aquafina water brand to its bottlers and markets this brand. PBNA sells concentrate and finished goods for some of these brands to bottlers licensed by us, and some of these branded products are sold directly by us to independent distributors and retailers. The franchise bottlers sell our brands as finished goods to independent distributors and retailers. PBNA’s net revenue was $8.3 billion in 2004, $7.7 billion in 2003 and $7.2 billion in 2002 and approximated 28% of our total division net revenue in 2004 and 29% of our total division net revenue in each of 2003 and 2002.

PepsiCo International

PepsiCo International (PI) manufactures through consolidated businesses as well as through noncontrolled affiliates, a number of leading salty and sweet snack brands including Gamesa and Sabritas in Mexico, Walkers in the United Kingdom, and Smith’s in Australia. Further, PI manufactures or uses contract manufacturers, markets and sells many Quaker brand snacks. PI also manufactures, markets and sells beverage concentrates, fountain syrups and finished goods under the brands Pepsi, 7UP, Mirinda, Mountain Dew, Gatorade and Tropicana. These brands are sold to franchise bottlers, independent distributors and retailers. However, in certain markets, PI operates its own bottling plants and distribution facilities. PI also licenses the Aquafina water brand to certain of its franchise bottlers. PI’s net revenue was $9.9 billion in 2004, $8.7 billion in 2003 and $7.7 billion in 2002 and approximated 34% of our total division net revenue in 2004 and 32% of our total division net revenue in each of 2003 and 2002.

Quaker Foods North America

Quaker Foods North America (QFNA) manufactures or uses contract manufacturers, markets and sells cereals, rice, pasta and other branded products. QFNA’s products include Quaker oatmeal, Aunt Jemima mixes and syrups, Quaker grits, Cap’n Crunch and Life ready-to-eat cereals, Rice-A-Roni, Pasta Roni and Near East side dishes. These branded products are sold to independent distributors and retailers. QFNA’s net revenue was $1.5 billion in 2004, 2003 and 2002 and approximated 5% of our total division net revenue in each of those years.

Our Distribution Network

Our products are brought to market through direct-store-delivery, broker-warehouse and food service and vending distribution networks. The distribution system used depends on

2

customer needs, product characteristics, and local trade practices. These distribution systems are described under the heading “ Our Business” contained in “ Item 7. Management’s Discussion and Analysis.”

Ingredients and Other Supplies

The principal ingredients we use in our food and beverage businesses are almonds, aspartame, cocoa, corn, corn sweeteners, flavorings, flour, juice and juice concentrates, oats, oranges, grapefruits and other fruits, potatoes, rice, seasonings, sugar, vegetable and essential oils and wheat. Our key packaging materials include P.E.T. resin used for plastic bottles, film packaging used for snack foods and cardboard. Fuel and natural gas are also important commodities due to their use in our plants and in the trucks delivering our products. These products are purchased mainly in the open market. We employ specialists to secure adequate supplies of many of these items and have not experienced any significant continuous shortages. The prices we pay for such items are subject to fluctuation. When prices increase, we may or may not pass on such increases to our customers. When we have decided to pass along price increases in the past, we have done so successfully. However, there is no assurance that we will be able to do so in the future.

Our Brands

We own numerous valuable trademarks which are essential to our worldwide businesses, including Alegro, AMP, Aquafina, Aunt Jemima, Cap’n Crunch, Cheetos, Cracker Jack, Diet Pepsi, Doritos, Frito-Lay, Fritos, Gamesa, Gatorade, Golden Grain, Grandma’s, Lay’s, Life, Mirinda, Mountain Dew, Mountain Dew Code Red, Mug, Near East, Pasta Roni, Pepsi, Pepsi Max, Pepsi One, Pepsi Twist, Pepsi-Cola, Propel, Quaker, Quaker Chewy, Quaker Quakes, Rice-A-Roni, Rold Gold, Ruffles, Sabritas, 7UP and Diet 7UP (outside the United States), Sierra Mist, Slice, Smith’s, Snack a Jacks, SoBe, Sun Chips, Tostitos, Tropicana, Tropicana Pure Premium, Tropicana Season’s Best, Tropicana Twister, Walkers, Wild Cherry Pepsi and Wotsits. Trademarks remain valid so long as they are used properly for identification purposes, and we emphasize correct use of our trademarks. We have authorized, through licensing arrangements, the use of many of our trademarks in such contexts as snack food joint ventures and beverage bottling appointments. In addition, we license the use of our trademarks on promotional items for the primary purpose of enhancing brand awareness.

We either own or have licenses to use a number of patents which relate to some of our products, their packaging, the processes for their production and the design and operation of various equipment used in our businesses. Some of these patents are licensed to others.

Seasonality

Our beverage and food divisions are subject to seasonal variations. Our beverage sales are higher during the warmer months and certain food sales are higher in the cooler months. Weekly sales are generally highest in the third quarter due to seasonal and

3

holiday-related patterns. However, taken as a whole, seasonality does not have a material impact on our business.

Our Customers

Our customers include franchise bottlers and independent distributors and retailers. We normally grant our bottlers exclusive contracts to sell and manufacture certain beverage products bearing our trademarks within a specific geographic area. These arrangements specify the amount to be paid by our bottlers for concentrate and full goods and for Aquafina royalties, as well as the manufacturing process required for product quality.

Sales to Wal-Mart Stores, Inc. represent approximately 11% of our total net revenue. Retail consolidation has increased the importance of major customers and further consolidation is expected. Our top five retail customers currently represent approximately 27% of our 2004 North American net revenue, with Wal-Mart representing approximately 14%. In addition, sales to The Pepsi Bottling Group (PBG) represent approximately 10% of our total net revenue. See Note 8 to our consolidated financial statements for more information on our anchor bottlers.

Our Competition

Our businesses operate in highly competitive markets. We compete against global, regional and private label manufacturers on the basis of price, quality, product variety and effective distribution. Success in this competitive environment is primarily achieved through effective promotion of existing products and the introduction of new products. We believe that the strength of our brands, innovation and marketing, coupled with the quality of our products and flexibility of our distribution network, allow us to compete effectively.

Frito-Lay holds a significant leadership market position in the snack industry worldwide and faces local and regional competitors as well as national and global snack competitors on issues related to price, quality, variety and distribution. In the beverage industry, The Coca-Cola Company is our primary competitor. In the United States, The Coca-Cola Company has a slightly larger share of carbonated soft drink consumption, while we have a larger share for chilled juices and isotonics. We also face many local value brand competitors in the United States. Internationally, The Coca-Cola Company has a significant market share advantage for carbonated beverages. In addition, internationally we compete with strong local carbonated beverage brands in many countries. We believe that the strength of our brands, innovation and marketing coupled with the quality of our products and flexibility of our distribution network, enable us to compete effectively.

4

Regulatory Environment

The conduct of our businesses, and the production, distribution, sale, advertising, labeling, safety, transportation and use of many of our products, are subject to various laws and regulations administered by federal, state and local governmental agencies in the United States, as well as to foreign laws and regulations administered by government entities and agencies in markets where we operate. It is our policy to follow the laws and regulations around the world that apply to our businesses.

In the United States, we are required to comply with federal laws, such as the Food, Drug and Cosmetic Act, the Occupational Safety and Health Act, the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, the Federal Motor Carrier Safety Act, laws governing equal employment opportunity and various other federal, state and local statutes and regulations.

In many jurisdictions, compliance with competition laws is of special importance to us due to our competitive position in those jurisdictions.

We rely on legal, operational and environmental compliance programs, as well as local in-house and outside counsel, to guide our businesses in complying with applicable laws and regulations of the countries in which we do business. The cost of compliance with foreign laws does not have a material financial impact on our international operations.

5

Employees

As of December 25, 2004, we employed, subject to seasonal variations, approximately 153,000 people worldwide, including approximately 60,000 people employed within the United States. We believe that relations with our employees are generally good.

Available Information

Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, proxy statements and amendments to those reports, are available free of charge on our internet website at http://www.pepsico.com as soon as reasonably practicable after such reports are electronically filed with or furnished to the Securities and Exchange Commission.

Item 2. Properties

We own our corporate headquarters building in Purchase, New York. Leases of plants in North America generally are on a long-term basis, expiring at various times, with options to renew for additional periods. Most international plants are leased for varying and usually shorter periods, with or without renewal options. We believe that our properties are in good operating condition and are suitable for the purposes for which they are being used.

Frito-Lay North America

Frito-Lay North America (FLNA) owns or leases approximately 50 food manufacturing and processing plants and approximately 1,700 warehouses, distribution centers and offices, including its headquarters building and a research facility in Plano, Texas.

PepsiCo Beverages North America

PepsiCo Beverages North America (PBNA) owns or leases approximately 44 plants and production processing facilities and approximately 43 warehouses, distribution centers and offices, including its headquarters building in downtown Chicago, Illinois. Licensed bottlers in which we have an ownership interest own or lease approximately 70 bottling plants.

PepsiCo International

PepsiCo International (PI) owns or leases approximately 175 plants and approximately 1,500 warehouses, distribution centers and offices. PI is headquartered in the corporate facility in Purchase, NY.

6

Quaker Foods North America

Quaker Foods North America (QFNA) owns or leases approximately 20 manufacturing plants and 1 warehouse in North America. QFNA is headquartered in the same facility with PBNA in downtown Chicago, Illinois.

Shared Properties

Frito-Lay North America and Quaker Foods North America share approximately 7 plants and 4 distribution centers, warehouses and officers. FLNA, PBNA and QFNA share approximately 7 plants and 14 distribution centers, warehouses and offices in North America, including a research and development laboratory in Barrington, Illinois.

Item 3. Legal Proceedings

We are party to a variety of legal proceedings arising in the normal course of business, including the matters discussed below. While the results of proceedings cannot be predicted with certainty, management believes that the final outcome of these proceedings will not have a material adverse effect on our consolidated financial statements, results of operations or cash flows.

On April 30, 2004, we announced that Frito-Lay and Pepsi-Cola Company received notification from the Securities and Exchange Commission (the “SEC”) indicating that the SEC staff was proposing to recommend that the SEC bring a civil action alleging that a non-executive employee at Pepsi-Cola and another at Frito-Lay signed documents in early 2001 prepared by Kmart acknowledging payments in the amount of $3 million from Pepsi-Cola and $2.8 million from Frito-Lay. Kmart allegedly used these documents to prematurely recognize the $3 million and $2.8 million in revenue. Frito-Lay and Pepsi-Cola have cooperated fully with this investigation and provided written responses to the SEC staff notices setting forth the factual and legal bases for their belief that no enforcement actions should be brought against Frito-Lay or Pepsi-Cola.

On November 5, 2003, we announced that Frito-Lay received notification from the SEC staff indicating that the staff was considering recommending that the SEC bring a civil injunctive action against Frito-Lay and one of its non-executive sales employees who signed documents requested by The Fleming Companies in 2001-2002 involving payments of $400,000, which Fleming allegedly used to accelerate its revenue recognition. On December 28, 2004, the SEC staff notified Frito-Lay that it does not intend to recommend an enforcement action against Frito-Lay in connection with the Fleming matter.

Based on an internal review of the Kmart and Fleming matters, no officers of PepsiCo, Pepsi-Cola or Frito-Lay are involved. None of these matters involves any allegations regarding PepsiCo’s accounting for its transactions with Kmart or The Fleming Companies or PepsiCo’s financial statements.

7

Item 4. Submission of Matters to a Vote of Security Holders

Not applicable.

Our Executive Officers

The following is a list of names, ages and background of our current executive officers:

Steven S Reinemund, 56, has been PepsiCo’s Chairman and Chief Executive Officer since May 2001. He was elected a director of PepsiCo in 1996 and before assuming his current position, served as President and Chief Operating Officer from September 1999 until May 2001. Mr. Reinemund began his career with PepsiCo in 1984 as a senior operating officer of Pizza Hut, Inc. He became President and Chief Executive Officer of Pizza Hut in 1986, and President and Chief Executive Officer of Pizza Hut Worldwide in 1991. In 1992, Mr. Reinemund became President and Chief Executive Officer of Frito-Lay, Inc., and Chairman and Chief Executive Officer of the Frito-Lay Company in 1996. Mr. Reinemund is also a director of Johnson & Johnson.

Peter A. Bridgman, 52, has been our Senior Vice President and Controller since August 2000. Mr. Bridgman began his career with PepsiCo at Pepsi-Cola International in 1985 and became Chief Financial Officer for Central Europe in 1990. He became Senior Vice President and Controller for Pepsi-Cola North America in 1992 and Senior Vice President and Controller for The Pepsi Bottling Group, Inc. in 1999.

Matthew M. McKenna, 54, has been our Senior Vice President of Finance since August 2001. Mr. McKenna began his career at PepsiCo as Vice President, Taxes in 1993. In 1998, he became Senior Vice President, Taxes and served as Senior Vice President and Treasurer from 1998 until 2001. Prior to joining PepsiCo, he was a partner with the law firm of Winthrop, Stimson, Putnam & Roberts in New York. Mr. McKenna is also a director of PepsiAmericas, Inc. and a member of the Management Committee of Pepsi Bottling Ventures LLC.

Margaret D. Moore, 57, is our Senior Vice President, Human Resources, a position she assumed at the end of 1999. From November 1998 to December 1999, she was Senior Vice President and Treasurer of The Pepsi Bottling Group, Inc. (PBG). Prior to joining PBG, Ms. Moore spent 25 years with PepsiCo in a number of senior financial and human resources positions. Ms. Moore is also a director of PBG.

Indra K. Nooyi, 49, was elected to PepsiCo’s Board and became President and Chief Financial Officer in May 2001, after serving as Senior Vice President and Chief Financial Officer since February 2000. Ms. Nooyi also served as Senior Vice President, Strategic Planning and Senior Vice President, Corporate Strategy and Development from 1994 until 2000. Prior to joining PepsiCo, Ms. Nooyi spent four years as Senior Vice President of Strategy, Planning and Strategic Marketing for Asea Brown Boveri, Inc. She was also Vice President and Director of Corporate Strategy and Planning at Motorola, Inc. Ms. Nooyi is also a director of Motorola, Inc.

8

Lionel L. Nowell III, 50, has been our Senior Vice President and Treasurer since August 2001. Mr. Nowell joined PepsiCo as Senior Vice President and Controller in 1999 and then became Senior Vice President and Chief Financial Officer of The Pepsi Bottling Group. Prior to joining PepsiCo, he was Senior Vice President, Strategy and Business Development for RJR Nabisco, Inc. From 1991 to 1998, he served as Chief Financial Officer of Pillsbury North America, and its Pillsbury Foodservice and Haagen Dazs units, serving as Vice President and Controller of the Pillsbury Company, Vice President of Food and International Retailing Audit, and Director of Internal Audit.

Gary M. Rodkin, 52, was appointed Chairman and Chief Executive Officer of PepsiCo Beverages and Foods North America in February 2003. Mr. Rodkin became President and Chief Executive Officer of PepsiCo Beverages and Foods North America in 2002. He served as President and Chief Executive Officer of Pepsi-Cola North America from 1999 to 2002. Mr. Rodkin was President of Tropicana North America from 1995 to 1998, and became President and Chief Executive Officer of Tropicana when PepsiCo acquired it in 1998.

Irene B. Rosenfeld, 51, was appointed Chairman and Chief Executive Officer of Frito-Lay, Inc. in September 2004. Prior to joining PepsiCo, Ms. Rosenfeld served as President of Kraft Foods North American Businesses. During her career at Kraft, she also served as Group Vice President responsible for Kraft’s North American manufacturing, distribution, procurement, R&D and information systems and also served as President of Kraft Canada and Kraft Mexico. Prior to that, Ms. Rosenfeld served in various senior management positions with Kraft since joining in 1981.

Larry D. Thompson, 59, became PepsiCo’s Senior Vice President, Government Affairs, General Counsel and Secretary in November 2004. Prior to joining PepsiCo, Mr. Thompson served as a Senior Fellow with the Brookings Institution in Washington, D.C. and served as Deputy Attorney General in the U.S. Department of Justice. In 2002, he was named to lead the National Security Coordination Council and was also named by President Bush to head the Corporate Fraud Task Force. In April 2000, Mr. Thompson was selected by Congress to chair the bipartisan Judicial Review Commission on Foreign Asset Control. Prior to his government career, he was a partner in the law firm of King & Spalding, a position he held from 1986 to 2001.

Michael D. White, 53, was appointed Chairman and Chief Executive Officer of PepsiCo International in February 2003, after serving as President and Chief Executive Officer of Frito-Lay’s Europe/Africa/Middle East division since 2000. From 1998 to 2000, Mr. White was Senior Vice President and Chief Financial Officer of PepsiCo. Mr. White has also served as Executive Vice President and Chief Financial Officer of PepsiCo Foods International and Chief Financial Officer of Frito-Lay North America. He joined Frito-Lay in 1990 as Vice President of Planning.

Executive officers are elected by our Board of Directors, and their terms of office continue until the next annual meeting of the Board or until their successors are elected and have qualified. There are no family relationships among our executive officers.

9

PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Stock Trading Symbol – PEP

Stock Exchange Listings – The New York Stock Exchange is the principal market for our Common Stock, which is also listed on the Amsterdam, Chicago, Swiss and Tokyo Stock Exchanges.

Shareholders – At December 25, 2004, there were approximately 209,000 shareholders of record.

Dividends – We target an annual dividend payout of approximately 45% of prior year’s net income from continuing operations. Dividends are usually declared in January, May, July and November and paid at the end of March, June and September and the beginning of January. The dividend record dates for these payments are, subject to approval of the Board of Directors, expected to be March 11, June 10, September 9, and December 9, 2005. We have paid quarterly cash dividends since 1965. The quarterly dividends declared in 2004 and 2003 are contained in our Selected Financial Data.

Stock Prices – The composite quarterly high, low and closing prices for PepsiCo Common Stock for each fiscal quarter of 2004 and 2003 are contained in our Selected Financial Data.

10

A summary of our repurchases (in millions, except average price per share) during the fourth quarter under the $7 billion repurchase program authorized by our Board of Directors and publicly announced on March 29, 2004, and expiring on March 31, 2007, is as follows:

Item 6. Selected Financial Data

Selected Financial Data is included on page 88.

11

Item 7. Management’s Discussion and Analysis

12

13

Our discussion and analysis is an integral part of understanding our financial results. Definitions of key terms can be found in the glossary on page 91. Tabular dollars are presented 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.

OUR BUSINESS

Our Operations

We are a leading, global snack and beverage company. We manufacture, market and sell a variety of salty, convenient, sweet and grain-based snacks, carbonated and non-carbonated beverages and foods. We are organized in four divisions:

Net revenue and operating profit contributions to growth from each of our divisions in 2004 are as follows:

Our North American divisions operate in the United States (U.S.) and Canada. Our international divisions operate in over 200 countries, with our largest operations in Mexico and the United Kingdom. Additional information concerning our divisions and geographic areas is presented in Note 1.

Frito-Lay North America

Frito-Lay North America (FLNA) manufactures or uses contract manufacturers, markets, sells and distributes branded snacks. These snacks include Lay’s potato chips, Doritos flavored tortilla chips, Tostitos tortilla chips, Cheetos cheese flavored snacks, Fritos corn chips, Ruffles potato chips, branded dips, Rold Gold pretzels, Quaker Chewy granola bars, Sun Chips multigrain snacks, Munchies snack mix, Grandma’s cookies, Lay’s Stax potato crisps, Quaker Fruit & Oatmeal bars, Quaker Quakes corn and rice snacks, Cracker Jack candy coated popcorn, and Go Snacks. FLNA branded products are sold to independent distributors and retailers.

14

PepsiCo Beverages North America

PepsiCo Beverages North America (PBNA) manufactures or uses contract manufacturers, markets and sells beverage concentrates, fountain syrups and finished goods, under various beverage brands including Pepsi, Mountain Dew, Gatorade, Tropicana Pure Premium, Sierra Mist, Mug, Tropicana juice drinks, Propel, SoBe, Slice, Dole, Tropicana Twister and Tropicana Season’s Best. PBNA also manufactures, markets and sells ready-to-drink tea and coffee products through joint ventures with Lipton and Starbucks. In addition, PBNA licenses the Aquafina water brand to its bottlers and markets this brand. PBNA sells concentrate and finished goods for some of these brands to bottlers licensed by us, and some of these branded products are sold directly by us to independent distributors and retailers. The franchise bottlers sell our brands as finished goods to independent distributors and retailers. PBNA’s volume reflects sales to its independent distributors and retailers, and the sales of beverages bearing our trademarks that franchise bottlers have reported as sold to independent distributors and retailers.

PepsiCo International

PepsiCo International (PI) manufactures through consolidated businesses as well as through noncontrolled affiliates, a number of leading salty and sweet snack brands including Gamesa and Sabritas in Mexico, Walkers in the United Kingdom, and Smith’s in Australia. Further, PI manufactures or uses contract manufacturers, markets and sells many Quaker brand snacks. PI also manufactures, markets and sells beverage concentrates, fountain syrups and finished goods under the brands Pepsi, 7UP, Mirinda, Gatorade, Mountain Dew and Tropicana. These brands are sold to franchise bottlers, independent distributors and retailers. However, in certain markets, PI operates its own bottling plants and distribution facilities. PI also licenses the Aquafina water brand to certain of its franchise bottlers. PI reports two measures of volume. Snack volume is reported on a system-wide basis, which includes our own volume and the volume sold by our noncontrolled affiliates. Beverage volume reflects company-owned and franchise bottler sales of beverages bearing our trademarks to independent distributors and retailers.

Quaker Foods North America

Quaker Foods North America (QFNA) manufactures or uses contract manufacturers, markets and sells cereals, rice, pasta and other branded products. QFNA’s products include Quaker oatmeal, Aunt Jemima mixes and syrups, Quaker grits, Cap’n Crunch and Life ready-to-eat cereals, Rice-A-Roni, Pasta Roni and Near East side dishes. These branded products are sold to independent distributors and retailers.

15

Our Chairman and CEO Perspective

The questions below reflect those commonly asked by our shareholders, and are followed by answers from our Chairman and CEO, Steve Reinemund.

How will you sustain growth?

By taking our competitive strengths, and investing in them to create longer-term value. That may sound a bit simplistic, but here’s what I mean.

PepsiCo has three key advantages:

1. big, muscular brands,

2. the proven ability to innovate and create differentiated products, and

3. powerful go-to-market systems.

What makes this all work are the extraordinarily talented, dedicated people at PepsiCo.

When we take those competitive advantages, and invest in them with dollars generated from top-line growth and cost saving initiatives, we sustain a value cycle for our shareholders.

In essence, investing in innovation fuels the building of our brands; this in turn drives top-line growth. Dollars from that top-line growth are strategically reinvested back into new products and other innovation, along with cost savings projects, and thus the cycle continues.

Your cycle of reinvestment relies on your ability to grow brands.  Are PepsiCo’s brands up to the challenge?

Yes. With 16 brands that each generate over a billion dollars of retail sales annually, and many more moving in that direction, we have big “global icon” brands that sit squarely in the sweet spot of convenience. We constantly differentiate those brands in the marketplace by what we do with ingredients and nutrition science, product packaging and processing. And, we create points of difference with marketplace solutions in our retail environment, exciting the consumers who ultimately buy our products.

We have more of these icon brands than any other food and beverage company in the world, and we continue to add new products to the portfolio through internal innovations combined with smaller, tuck-in acquisitions with our international businesses.

How do you invest in, and differentiate, PepsiCo’s brands?

We invest in many ways, including advertising and merchandising. I’d say innovation is the most impactful option. Innovation lives at the core of any successful consumer products company. Our organization is structured to capture consumer insights, and customer – or retailer – insights as well. Strategically, we look at innovation in three

16

ways, or types. “Type A” innovation is what we call “close-in” – ideas like new flavors of existing products.

“Type B” innovation is represented in new products delivering additional benefits or meeting specific consumer preferences, but generally within existing brands. For example, Tostitos Scoops tortilla chips, Lay’s Stax potato crisps or Tropicana Light ‘n Healthy beverages are products more incremental to the business than Type A.

“Type C” innovation is focused on new platforms, like delivering chilled products directly to the store; or entirely new products, like new Quaker Milk Chillers and Tropicana Fruit Integrity, which delivers a fruit serving in a new, fun snack format. These products are mostly incremental, and we’ve centralized our research and development for this kind of innovation so we can put our resources into developing really big ideas.

Our goal is to incorporate more Type B and Type C innovation into our pipeline. In this way, we may have fewer new products every year, but more of our new product revenues will be incremental. This has already been happening at Frito-Lay, with products like Lay’s Stax potato crisps.

On the beverage side, we are finding that “in-and-out” products – those with limited time availability – can create a lot of excitement and incremental volume over a set time period. These products are relatively easy to develop, and we work closely with our bottling partners on the right timing. For example, in 2004, we introduced Mountain Dew Pitch Black just as Mountain Dew LiveWire was winding down. Then, we introduced Pepsi Holiday Spice for the year-end holiday season. These all contribute to differentiating our brands.

You talked about innovation in terms of brands.  Are you innovating in other ways?

We’re innovating in ways that go beyond traditional brand ideas. For example, we look at health and wellness as an opportunity to be an active part of the solution. We’ve improved the healthfulness of our existing products by taking important steps like eliminating trans fats in our Frito-Lay chips, reducing saturated fats in Walkers crisps and reducing sugar in some food and beverage products in the United States and other markets. We’ve also developed new products that deliver more powerful health benefits, like Quaker Take Heart Oatmeal, which can help reduce cholesterol and help maintain healthy blood pressure – two important factors for heart health. The Tropicana Pure Premium line of fortified orange juices is another great example. And we strengthened the Quaker snack line with products like new soy crisps, and new or improved bar products.

In 2005, we’ll grow our beverage portfolio with innovation in diet carbonated soft drinks. We’ll also add a new line of Gatorade Endurance Formula and Aquafina flavored waters in carbonated and non-carbonated varieties. With snacks, we’re relaunching Light versions of our chips with reduced calories and fat.

17

As an umbrella logo that applies to more than 100 products in our portfolio, we’ve developed a new Smart Spot trademark in the United States and Canada. The Smart Spot symbol helps consumers find our products that can contribute to healthier lifestyles. The Smart Spot program is based on authoritative statements from the U.S. Food and Drug Administration (FDA) and the National Academy of Sciences (NAS).

Smart Spot products are the fastest growing part of our North American product portfolio, with revenue growth approximately double that of our fun-for-you products. This strategic marketplace solution exists at the intersection of public interest and business interests, and we intend to continue capturing growth through health and wellness solutions that address energy balance.

You’ve said PepsiCo’s health and wellness initiatives are based on the concept of “energy balance.” What do you mean by this?

Energy balance challenges consumers to look at calories consumed, as well as calories burned, through physical activity and exercise. We’re investing in solutions that address both. We’ve committed to achieving more than half of our new product revenues from Smart Spot products in North America, and our projections show we’ll significantly surpass that goal. We’re also stepping up efforts in our new product pipeline to capture this opportunity in markets around the world.

On the physical activity front, we believe we can be part of the solution as well. For example, we’re the national presenting sponsor for America on the Move, a national initiative designed to help Americans achieve energy balance by taking 2,000 more steps a day and reducing calories by 100 each day. It’s been proven to work, and can help almost anyone get started making simple changes to achieve a healthier lifestyle. We’re also funding other efforts that range from activity-based initiatives with the YMCA, to research-based programming, like the partnership Gatorade has with the University of North Carolina’s School of Public Health to understand what can help prevent childhood obesity.

With the emphasis on Smart Spot, how will you balance investments in the larger, fun-for-you portfolio?

Our goal is to offer a balanced and broad PepsiCo portfolio with a range of great-tasting product choices. While our better-for-you product portfolio is growing at an impressive clip, we also know that it’s critical to drive growth in our flagship, heritage brands that comprise our fun-for-you portfolio. For example, within Frito-Lay’s core salty portfolio, we focused on Tostitos with an entirely new logo and packaging, and an aggressive “on-shelf” strategy to drive visibility and growth for this venerable billion-dollar brand. We’re improving Doritos Nacho Cheesier tortilla chips and making Doritos Black Pepper Jack tortilla chips a permanent addition to our line. On the beverage side of the business, we have aggressive plans for our trademark Pepsi, Mountain Dew and Sierra Mist brands that demonstrate we remain committed to growing these larger, legacy businesses as well.

18

In the past, you’ve talked about the power of Frito-Lay’s direct-store-delivery (DSD) system differentiating Frito-Lay in the marketplace. Now, you seem to be taking a new approach with a 50% increase in media spending that is being partially funded by the plant consolidations. Is there a change in strategy?

Frito-Lay’s well-known brands feature great taste and really appeal to consumers. The power of the company’s virtually unrivaled distribution system has enabled us to differentiate these products in the marketplace, and rely to a lesser extent on high-impact marketing and advertising.

With an explosion of convenient foods choices in the categories where Frito-Lay competes, we need to communicate even more aggressively to strengthen our bond with consumers and highlight our choices for snacking occasions in order to continue growing our top line.

Historically, there has been a focus on your North America business. How does the international market figure into your growth targets?

The growth and expansion of our international businesses are vital. PepsiCo International became our largest division – by revenues – in 2004. While the year was extraordinary, for the longer term we believe that we can grow our international business at about twice the rate of growth for the United States into the foreseeable future.

We’re confident because we have clear leadership of the global snack category, and significantly lower per capita consumption outside the United States. Our volumes are increasing in every region, and we’re demonstrating we can capture opportunities by customizing our snack products to meet local tastes and packaging preferences. For example, in Thailand, we’ve introduced Nori Seaweed Lay’s potato chips, and in China, we’ve captured new “office snacking” opportunities through a new pull-out tray with Lay’s Stax potato crisps.

On the beverage side, we have a disciplined, focused growth strategy that includes carbonated and non-carbonated brands. We’ve introduced flavor innovations tailored to our markets, new consumer-friendly packaging, and enjoyed great success with high-impact advertising and music and sports marketing.

Overlaying our flexible portfolio, we have global productivity programs in ever increasing scale, and a diverse, talented and experienced team from the front line to senior management. All these elements combine to give us great confidence in our international business and its ability to fire on all cylinders.

Returning to the question about sustainable growth, you included powerful go-to-market systems as a competitive advantage. What do you mean?

PepsiCo arguably has the most diverse set of distribution systems of any consumer product company, including direct store delivery (DSD) at Frito-Lay and our bottling partners, warehouse delivery for Quaker products, and warehouse delivery and chilled DSD at Tropicana.

19

The reach and scale of these systems provide considerable cost efficiency and system effectiveness in driving value.

Our systems deliver product freshness and quality for the consumer, generate cash flow for our retail customers, and provide economic value for PepsiCo. Our products respond very well to merchandising, and need to be replenished often because they sell so quickly. By having our DSD associates deliver products and stock the shelves themselves, we save retailers money by doing this labor for them, and help make sure our products are fresh, available and displayed to our advantage.

You’ve referenced PepsiCo’s Power of One as a competitive capability. Can you provide some examples of the advantages that Power of One offers retailers?

Our Power of One really speaks to our ability to use all of PepsiCo’s products, services and talents for the advantage of our retail partners. Whether it’s a joint promotion between Pepsi and Frito-Lay for Super Bowl Sunday, a “breakfast bundling” opportunity with Quaker and Tropicana brands, creating a shared service unit to support our businesses in Mexico or combining our products that contribute to healthier lifestyles under the Smart Spot banner, the idea is to combine the strength of our brands and businesses to develop customized solutions for customers. This, in turn, drives incremental growth for them, and for us.

We view this as a key strategic growth driver, and will continue to invest in such things as integrated customer teams, research into consumer insights, and creating customized retail solutions to drive growth.

Retail volume growth seems to be slowing in some channels, such as supermarkets, and accelerating in large-format and discount channels. How is that trend affecting PepsiCo?

It’s obviously important for us to be well-represented in all channels. Like all consumer product companies, we have benefited from the growth of mass merchandisers, clubs and dollar stores. At the same time, we’re just as committed to working closely with our supermarket partners to help them grow.

The consolidation of retailers has made our Power of One initiative increasingly important. We can approach these retailers as a powerful partner in supporting their growth objectives. Ultimately, we need to ensure that we have the right products, package sizes, and price points in each channel so that we can maximize growth in each.

Pricing is a key element of our mix. Consumers demand value, which especially means low prices, so we can’t depend on price increases for revenue growth. That’s why our focus on innovation, commitment to improving product mix, and the priority on delivering customized retail solutions are key to the growth of PepsiCo and our retail customers.

20

How do you ensure you can deliver on all the priorities required by brand and product investment, and go-to-market systems?

In a word, it’s about people – our ultimate and truest source of competitive advantage. We continue to invest in our people as well.

One of the strengths Wall Street has noticed about PepsiCo is our ability to grow talent from within the company – particularly bench strength for our most senior team. I think this reflects a number of our “people priorities.”

For starters, we’re passionate about developing leaders. That’s why we provide the training, tools and experiences that give us many options when it comes to preparing leaders for tomorrow. But developing this kind of bench strength demands a comprehensive view of people.

That’s why we have a focus on diversity and inclusion as a strategic lever to drive the business. As a leading consumer products company, we strive to recruit a diverse workforce to assist us in serving our diverse consumer base. That’s diversity. Equally important, we must ensure we’re creating and sustaining an environment that allows everyone to contribute at his or her maximum potential in order for the best ideas to come forward – and that’s inclusion.

We hold our leaders accountable – and reward them – on their ability to create and sustain a diverse and inclusive workforce at PepsiCo. We’re seeing progress. In the last two years, we’ve put 11,000 associates through a first level of diversity and inclusion training and more than 6,000 associates through a second level of inclusion training. Our ongoing internal measurement of how associates observe diverse and inclusive behavior in management shows we’re moving the dial as well.

I know that our 2004 growth benefited from our diversity and inclusion efforts. Product flavor ideas, promotions and advertising benefited from the views of the entire spectrum of our associates. Our successes reinforce that we are on the right track, and we remain committed to this strategic priority as a key growth driver. We know that diversity and inclusion is a journey – in fact, a marathon – and we’ll continue investing in the journey to reap its utmost benefits.

With your focus on diversity and inclusion, brand building, and go-to-market capabilities, how will you fund everything?

Some of the investment comes from top-line growth, and some of it comes from productivity initiatives around the world. Whether in supply chain manufacturing, procurement of goods and services, or more efficient trade and media spending, at any given time PepsiCo has hundreds of productivity programs under way.

21

We view these efforts to control costs as critical fuel for brand building and innovation work, which leads to top-line growth that we can use to fund further productivity projects. That’s the value creation cycle I mentioned earlier, and it provides flexibility for us to meet our stated double-digit earnings goals. At the same time, it allows us to return cash to shareholders through our share buyback program and dividend payments, which PepsiCo’s Board of Directors increased by 44% in 2004.

What is “Business Process Transformation” (BPT) and how does it contribute to the business?

Business Process Transformation (BPT) is the comprehensive effort to drive efficiencies at PepsiCo, and fuel our future growth. It includes efforts to physically consolidate, or hardwire, key business functions to take advantage of our scale. It also includes moving to a common set of processes that underlie our key activities, and supporting these activities with common technology applications. And finally, it’s about linking our systems so that data will flow seamlessly from system to system. Our SAP installation – the computer system that will link all of PepsiCo’s systems and processes – is the linchpin for these efforts. A special project team has started implementing this multi-year BPT effort.

While obviously requiring funding, this is exactly the kind of initiative which is designed to yield efficiencies that we can reinvest back into our business for many years to come.

Once BPT is fully implemented, we’ll have flexibility in everything we do. We’ll be able to more easily change any product through better control of our supply chain. We’ll have even greater accuracy in our operations, removing the need for checking and rechecking. We’ll also achieve efficiencies and consistency by delivering lower costs through common processes and expanded IT capabilities, delivered through one face to the customer. We’ll have end-to-end, real-time visibility to data that allows us to use information as a true strategic tool. And finally, with a common IT platform, we’ll be able to more quickly expand to take on new businesses seamlessly.

PepsiCo has a lot to accomplish. How do you balance current and future needs without compromising anything?

Here again, it ultimately comes down to people and the values they hold. In last year’s annual report, our theme was “Growth and Trust.” We emphasized the importance of growth in the right way – as a responsible corporate citizen. Our focus remains centered on behaving in this way.

For example, we continue to make progress with our efforts in environmental management and sustainability. I encourage shareholders, once again, to read the Corporate Social Responsibility Report in this publication. But it’s also important to understand that we continue to spend a considerable amount of time and energy reinforcing the PepsiCo Values that will get us growth the right way for our future. We

22

remain steadfast in our commitment to sustained growth, through empowered people, acting with responsibility and building trust.

When you think about it, we’re lining up what we do best and investing in those capabilities to drive value today and into our future. And we’re doing it in a responsible way. Our shareholders demand this kind of responsible growth and should expect nothing less, just like all of us at PepsiCo.

Our Customers

Our customers include franchise bottlers and independent distributors and retailers. We grant our bottlers exclusive contracts to sell and manufacture certain beverage products bearing our trademarks within a specific geographic area. These arrangements specify the amount to be paid by our bottlers for concentrate and full goods and for Aquafina royalties, as well as the manufacturing process required for product quality.

Since we do not sell directly to the consumer, we rely on and provide financial incentives to our customers to assist in the distribution and promotion of our products. For our independent distributors and retailers, these incentives include volume-based rebates, product placement fees, promotions and displays. For our bottlers, these incentives are referred to as bottler funding and are negotiated annually with each bottler to support a variety of trade and consumer programs, such as consumer incentives, advertising support, new product support, and vending and cooler equipment placement. Consumer incentives include coupons, pricing discounts and promotions, such as sweepstakes and other promotional offers. Advertising support is directed at advertising programs and supporting bottler media. New product support includes targeted consumer and retailer incentives and direct marketplace support, such as point-of-purchase materials, product placement fees, media and advertising. Vending and cooler equipment placement programs support the acquisition and placement of vending machines and cooler equipment. The nature and type of programs vary annually. The level of bottler funding is at our discretion because these incentives are not required by the terms of our bottling contracts.

Sales to Wal-Mart Stores, Inc. represent approximately 11% of our total net revenue. Retail consolidation has increased the importance of major customers and further consolidation is expected. Our top five retail customers currently represent approximately 27% of our 2004 North American net revenue, with Wal-Mart representing approximately 14%. In addition, sales to The Pepsi Bottling Group (PBG) represent approximately 10% of our total net revenue. See “ Our Related Party Bottlers” and Note 8 for more information on our anchor bottlers.

Our Related Party Bottlers

We have ownership interests in certain of our bottlers. Our ownership is less than 50% and since we do not control these bottlers, we do not consolidate their results. We include our share of their net income based on our percentage of economic ownership in our income statement as bottling equity income. We have designated three related

23

party bottlers, PBG, PepsiAmericas, Inc. (PAS) and Pepsi Bottling Ventures LLC (PBV), as our anchor bottlers. Our anchor bottlers distribute approximately 65% of our North American beverage volume and approximately 20% of our international beverage volume. Our anchor bottlers participate in the bottler funding programs described above. Approximately 12% of our total 2004 sales incentives related to these bottlers. See Note 8 for additional information on these related parties and related party commitments and guarantees.

Our Distribution Network

Our products are brought to market through direct-store-delivery, broker-warehouse and food service and vending distribution networks. The distribution system used depends on customer needs, product characteristics, and local trade practices.

Direct-Store-Delivery

We and our bottlers operate direct-store-delivery systems that deliver snacks and beverages directly to retail stores where the products are merchandised by our employees or our bottlers. Direct-store-delivery enables us to merchandise with maximum visibility and appeal. Direct-store-delivery is especially well-suited to products that are restocked often and respond to in-store promotion and merchandising.

Broker-Warehouse

Some of our products are delivered from our warehouses to customer warehouses and retail stores. These less costly systems generally work best for products that are less fragile and perishable, have lower turnover, and are less likely to be impulse purchases.

Foodservice and Vending

Our foodservice and vending sales force distributes snacks, foods and beverages to third-party foodservice and vending distributors and operators, and for certain beverages, distributes through our bottlers. This distribution system supplies our products to schools, businesses, stadiums, restaurants and similar locations.

Our Competition

Our businesses operate in highly competitive markets. We compete against global, regional and private label manufacturers on the basis of price, quality, product variety and effective distribution. Our chief beverage competitor, The Coca-Cola Company, has a slightly larger share of CSD consumption in the United States, while we have a larger share of chilled juices and isotonics. In addition, The Coca-Cola Company maintains a significant CSD share advantage in many markets outside North America. Further, our snack brands hold significant leadership positions in the snack industry worldwide and face local and regional competitors, as well as national and global snack competitors, on issues related to price, quality, variety and distribution. Success in this competitive environment is dependent on effective promotion of existing products and the

24

introduction of new products. We believe that the strength of our brands, innovation and marketing, coupled with the quality of our products and flexibility of our distribution network, allow us to compete effectively.

Other Relationships

Certain members of our Board of Directors also serve on the boards of certain vendors and customers. Those Board members do not participate in our vendor selection and negotiations nor in our customer negotiations. Our transactions with these vendors and customers are in the normal course of business and are consistent with terms negotiated with other vendors and customers. In addition, certain of our employees serve on the boards of our anchor bottlers and other affiliated companies and do not receive incremental compensation for their Board services.

Our Business Risks

Our Approach to Managing Risks

We are subject to risks in the normal course of business due to adverse developments affecting:

We manage these and other risks through an integrated risk management framework. This framework includes:

Also see “ Market Risks” below for a discussion on how we manage specific market risks.

25

Our Reputation

We have a longstanding history of maintaining a good reputation globally which is critical to selling our branded products. If we fail to maintain high standards for product quality and integrity, our reputation could be jeopardized. In addition, we must protect our reputation by maintaining high ethical, social and environmental standards for all of our operations and activities. Damage to our reputation might result in rejection of our products by consumers and a loss of brand equity, as well as require additional resources to rebuild our reputation.

Information Technology

Information technology is becoming increasingly important as an enabler to operating efficiently and interfacing with customers, as well as maintaining financial accuracy and efficiency. If we do not allocate, and effectively manage, the resources necessary to build and sustain the proper technology infrastructure, we could be subject to transaction errors, processing inefficiencies, the loss of customers, business disruptions, or the loss of or damage to intellectual property through security breach.

As discussed by our chairman, we have embarked on our multiyear BPT initiative that includes the delivery of an SAP enterprise resource planning application, as well as the migration to common business processes across our North American operations. The inability to deliver our goals may impact our ability to (1) process transactions accurately and efficiently, and (2) remain in step with the changing needs of the trade, which could result in the loss of customers. In addition, the failure to either deliver the application on time, or anticipate the necessary readiness and training needs, could lead to business disruption.

Product Demand and Retail Consolidation

We are a consumer products company operating in highly competitive markets and rely on continued demand for our products. To generate revenues and profits, we must sell products that appeal to our customers and to consumers. As our chairman notes, our continued success is dependent on our product innovation, including maintaining a strong pipeline of new products, effective sales incentives, appropriate advertising campaigns and marketing programs, and the ability to secure adequate shelf space at our retailers. In addition, our success depends on our responses to consumer trends, such as low carbohydrate diets, consumer health concerns, including obesity and the consumption of certain ingredients, and changes in product category consumption and consumer demographics, including the aging of the general population. Seasonal weather conditions, particularly for sports drinks and hot cereals, can also impact demand. Our top five retail customers now represent approximately 27% of our North American net revenue reflecting the continuing consolidation of the retail trade. In this environment, there continue to be competitive product and pricing pressures, as well as challenges in maintaining profit margins. We must maintain mutually beneficial relationships with our key customers, including our retailers and anchor bottlers, to effectively compete.

26

Global Economic and Environmental Conditions

Unforeseen global economic and environmental changes and political unrest may result in business interruption, supply constraints, foreign currency devaluation, inflation, deflation or decreased demand. Economic conditions in North America could also adversely impact growth. For example, rising fuel costs may impact the sales of our products in convenience stores where our products are generally sold in higher margin single serve packages.

Regulatory Environment

Changes in laws, regulations and the related interpretations may alter the environment in which we do business and, therefore, impact our results or increase our liabilities. Such regulatory environment changes include changes in food and drug laws, laws related to advertising and deceptive marketing practices, accounting standards, taxation requirements, competition laws and environmental laws, including the regulation of water consumption and treatment.

Workforce Retention

Our continued growth requires us to develop our leadership bench and to implement programs, such as our long-term incentive program, designed to retain talent. We also compete to hire new employees, and then must train them and develop their skills and competencies. We have in place human resource programs, including our diversity and inclusion focus mentioned by our chairman, aimed at hiring, developing and retaining our talented and motivated workforce which provides us with competitive advantage. However, unplanned turnover could deplete our institutional knowledge base and erode our competitive advantage.

Market Risks

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

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 of meaningful cost saving opportunities or efficiencies and effective implementation. Our global purchasing programs include fixed-price purchase orders and pricing agreements. Our hedging strategies involve the use of derivatives designated as cash flow and fair value hedges. The fair value of our hedges fluctuates based on market rates and prices. The sensitivity

27

of our hedges to these market fluctuations is discussed below. See Note 10 for further discussion of these hedges 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 stock prices and discount rates.

Inflationary, deflationary and recessionary conditions impacting these market risks also impact the demand for and pricing of our products. See “ Product Demand and Retail Consolidation” and “ Global Economic Conditions” above for further discussion.

Commodity Prices

Our open commodity derivative contracts designated as hedges had a face value of $155 million at December 25, 2004 and $43 million at December 27, 2003. These derivatives resulted in a net unrealized loss of $1 million at December 25, 2004 and $4 million at December 27, 2003. We estimate that a 10% decline in commodity prices would have resulted in an unrealized loss of $16 million in 2004 and $1 million in 2003.

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, called currency translation adjustment.

Our operations outside of the U.S. generate over a third of our net revenue of which Mexico, the United Kingdom and Canada comprise nearly 20%. As a result, we are exposed to foreign currency risks, including unforeseen economic changes and political unrest. During 2004, the impact of the favorable euro and British pound was partially offset by the unfavorable Mexican peso resulting in a contribution of almost 2 percentage points to revenue growth. If declines in the Mexican peso continue and are not offset, our future results will be adversely impacted.

Exchange rate gains or losses related to foreign currency transactions are recognized as transaction gains or losses in the income statement as incurred. We may enter into derivatives to manage our exposure to foreign currency transaction risk. Our foreign currency derivatives had a total face value of $908 million at December 25, 2004 and $484 million at December 27, 2003. These contracts had net unrealized losses of $27 million at December 25, 2004 and $30 million at December 27, 2003, respectively. We estimate that an unfavorable 10% change in the exchange rates would have resulted in an unrealized loss of $123 million in 2004 and $50 million in 2003, respectively.

28

Interest Rates

We centrally manage our debt and investment portfolios considering investment opportunities and risks, tax consequences and overall financing strategies. We may use interest rate and cross currency interest rate swaps to manage our overall interest expense and foreign exchange risk. These instruments effectively change the interest rate and currency of specific debt issuances. 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 counterparty credit risk is considered low because these 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 2004 and 2003 variable rate debt and investment levels, a one point increase in interest rates would have decreased net interest expense by $11 million in 2004 and $10 million in 2003.

Stock Prices

A portion of our deferred compensation liability is tied to certain market indices and our stock price. We manage these market risks with mutual fund investments and prepaid forward contracts for the purchase of our stock. The combined gains or losses on these investments are offset by changes in our deferred compensation liability, which are included in corporate selling, general and administrative expenses.

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 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. The preceding discussion of risks is by no means all inclusive but is designed to highlight what we believe are important factors to consider when evaluating our trends and future results.

OUR CRITICAL ACCOUNTING POLICIES

An appreciation of our critical accounting policies is necessary to understand our financial results. These policies may require management to make difficult and subjective judgments regarding uncertainties, and as a result, such estimates may significantly impact our financial results. The precision of these estimates and the likelihood of future changes depend on a number of underlying variables and a range of possible outcomes. Other than our accounting for stock-based compensation and certain allocation methodologies for pension and retiree medical, our critical accounting policies do not involve the choice between alternative methods of accounting. We applied our critical accounting policies and estimation methods consistently in all periods presented and have discussed these policies with our Audit Committee.

29

Our critical accounting policies arise in conjunction with the following:

Revenue Recognition

Our products are sold for cash or on credit terms. Our credit terms, which are established in accordance with local and industry practices, typically require payment within 30 days of delivery and may allow discounts for early payment. We recognize revenue upon shipment or delivery to our customers in accordance with written sales terms that do not allow for a right of return. However, our policy for DSD and chilled products is to remove and replace damaged and out-of-date products from store shelves to ensure that consumers receive the product quality and freshness they expect. Similarly, our policy for warehouse distributed products is to replace damaged and out-of-date products. Based on our historical experience with this practice, we have reserved for anticipated damaged and out-of-date products. Our bottlers have a similar replacement policy and are responsible for the products they distribute.

Our policy is to provide customers with product when needed. In fact, our commitment to freshness and product dating serves to regulate the quantity of product shipped or delivered. In addition, DSD products are placed on the shelf by our employees with customer shelf space limiting the quantity of product. For product delivered through our other distribution networks, customer inventory levels are monitored.

As discussed in “ Our Customers,” we offer sales incentives through various programs to customers and consumers. Sales incentives are accounted for as a reduction of sales and totaled $6.6 billion in 2004, $6.0 billion in 2003 and $5.5 billion in 2002. Sales incentives include payments to customers for performing merchandising activities on our behalf, such as payments for in-store displays, payments to gain distribution of new products, payments for shelf space, and discounts to promote lower retail prices. A number of our sales incentives, such as bottler funding and customer volume rebates, are based on annual targets, and accruals are established during the year for the expected payout. These accruals are based on our historical experience with similar programs and require management judgment with respect to estimating customer participation and performance levels. The terms of most of our incentive arrangements do not exceed a year, and therefore do not require highly uncertain long-term estimates. For interim reporting, we estimate total annual sales incentives and record a pro rata share in proportion to revenue. Certain arrangements, including fountain pouring rights, may extend up to 15 years. The costs incurred to obtain these arrangements are recognized over the life of the contract as a reduction of revenue, and the outstanding balances of $337 million at year-end 2004 and $359 million at year-end 2003 are included in other assets in our Consolidated Balance Sheet.

30

We estimate and reserve for our bad debt exposure based on our experience with past due accounts. Our method of determining the reserves has been consistent during the years presented in the consolidated financial statements. Bad debt expense is classified within selling, general and administrative expenses in our Consolidated Statement of Income.

Brand and Goodwill Valuations

We sell products under a number of brand names, many of which were developed by us. The brand development costs are expensed as incurred. We also purchase brands and goodwill in acquisitions. Upon acquisition, the purchase price is first allocated to identifiable assets and liabilities, including brands, based on estimated fair value, with any remaining purchase price recorded as goodwill.

We believe that a brand has an indefinite life if it has significant market share in a stable macroeconomic environment, and a history of strong revenue and cash flow performance that we expect to continue for the foreseeable future. If these perpetual brand criteria are not met, brands are amortized over their expected useful lives, which generally range from five to 20 years. Determining the expected life of a brand requires considerable management judgment and is based on an evaluation of a number of factors, including the competitive environment, market share, brand history and the macroeconomic environment of the countries in which the brand is sold.

Goodwill, including the goodwill that is part of our noncontrolled bottling investment balances, and perpetual brands are not amortized. Perpetual brands and goodwill are assessed for impairment at least annually to ensure that discounted future cash flows continue to exceed the related book value. A perpetual brand is impaired if its book value exceeds its fair value. Goodwill is evaluated for impairment if the book value of its reporting unit exceeds its fair value. A reporting unit can be a division or business within a division. If the fair value of an evaluated asset is less than its book value, the asset is written down to fair value based on its discounted future cash flows.

Amortizable brands are only evaluated for impairment upon a significant change in the operating or macroeconomic environment. If an evaluation of the undiscounted cash flows indicates impairment, the asset is written down to its estimated fair value, which is based on its discounted future cash flows.

Considerable management judgment is necessary to evaluate the impact of operating and macroeconomic changes and to estimate future cash flows. Assumptions used in our impairment evaluations, such as forecasted growth rates and our cost of capital, are consistent with our internal forecasts and operating plans. These assumptions could be adversely impacted by certain of the risks discussed in the “ Our Business Risks” section, including, but not limited to, operating risks, product demand and the competitive landscape.

We did not recognize any impairment charges for perpetual brands or goodwill during the years presented. As of December 25, 2004, we had $4.8 billion of perpetual brands and

31

goodwill, of which nearly 75% related to Tropicana and Walkers. In our most recent impairment evaluations for Tropicana and Walkers, no impairment charges would have resulted even if the fair market values resulting from our discounted cash flow analyses were assumed to be 5% lower.

Income Tax Expense and Accruals

In 2004, our annual tax rate for continuing operations was 24.7% compared to 28.5% in 2003 as discussed in “ Other Consolidated Results.” The tax rate in 2004 decreased 3.8 percentage points primarily as a result of the favorable resolution of certain open tax issues. For 2005, our annual tax rate is expected to be 29.4%, reflecting the absence of the favorable 2004 resolutions, and excluding any impact of the potential repatriation of certain undistributed international earnings discussed below and in Note 5.

Our annual tax rate is based on our income, statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we operate. Significant judgment is required in determining our annual tax rate and in evaluating our tax positions. We establish reserves when, despite our belief that our tax return positions are fully supportable, we believe that certain positions are subject to challenge and that we may not succeed. We adjust these reserves, as well as the related interest, in light of changing facts and circumstances, such as the progress of a tax audit. An estimated effective tax rate for a year is applied to our quarterly operating results. In the event there is a significant or unusual item recognized in our quarterly operating results, the tax attributable to that item is separately calculated and recorded at the same time as that item. We consider the tax benefits from the resolution of prior year tax matters to be such items.

Tax law requires items to be included in the tax return at different times than the items are reflected in the financial statements. As a result, our annual tax rate reflected in our financial statements is different than that reported in our tax return (our cash tax rate). Some of these differences are permanent, such as expenses that are not deductible in our tax return, and some differences reverse over time, such as depreciation expense. These temporary differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in our tax return in future years for which we have already recorded the tax benefit in our income statement. We establish valuation allowances for our deferred tax assets when we believe expected future taxable income is not likely to support the use of a deduction or credit in that tax jurisdiction. Deferred tax liabilities generally represent tax expense recognized in our financial statements for which payment has been deferred, or expense for which we have already taken a deduction in our tax return but we have not yet recognized as expense in our financial statements.

32

We have not recognized any U.S. tax expense on undistributed international earnings since we intend to reinvest the earnings outside the U.S. for the foreseeable future, subject to the opportunity afforded us as a result of the American Jobs Creation Act of 2004 (AJCA). Our undistributed earnings are approximately $11.9 billion at December 25, 2004, and $8.8 billion at December 27, 2003. We are currently contemplating taking advantage of the AJCA for up to $7.5 billion of our undistributed foreign earnings. See Note 5 for further discussion on the AJCA and its potential impact on our 2005 results.

A number of years may elapse before a particular matter, for which we have established a reserve, is audited and finally resolved. The number of years with open tax audits varies depending on the tax jurisdiction. During 2004, we recognized $266 million of tax benefits related to the favorable resolution of certain open tax issues. In addition, in 2004, we recognized a benefit of $38 million upon agreement with the U.S. Internal Revenue Service (IRS) on an open issue related to our discontinued restaurant operations. At the end of 2003, we entered into agreements with the IRS for open years through 1997. These agreements resulted in a tax benefit of $109 million in the fourth quarter of 2003. As part of these agreements, we also resolved the treatment of certain other issues related to future tax years.

The IRS has initiated their audits of our tax returns for the years 1998 through 2002. Our tax returns subsequent to 2002 have not yet been examined. While it is often difficult to predict the final outcome or the timing of resolution of any particular tax matter, we believe that our reserves reflect the probable outcome of known tax contingencies. Settlement of any particular issue would usually require the use of cash. Favorable resolution would be recognized as a reduction to our annual tax rate in the year of resolution. Our tax reserves, covering all federal, state and foreign jurisdictions, are presented in the balance sheet within other liabilities (see Note 14), except for any amounts relating to items we expect to pay in the coming year which are included in current income taxes payable. For more information on the impact of the resolution of open tax issues, see “ Other Consolidated Results” and “ Our Liquidity, Capital Resources and Financial Position.”

Stock-Based Compensation Expense

We believe that we will achieve our best results if our employees act and are rewarded as business owners. Therefore, we believe stock ownership and stock-based incentive awards are the best way to align the interests of employees with those of our shareholders. Historically, following competitive market practices, we have used stock option grants as our primary form of long-term incentive compensation. These grants are made at the current stock price, meaning each employee’s exercise price is equivalent to our stock price on the date of grant. Employees must generally provide three additional years of service to earn the grant, referred to as the vesting period. Our options generally have a 10-year term, which means our employees would have up to seven years after the vesting period to elect to pay the exercise price to purchase one share of our stock for each option exercised. Employees benefit from stock options to the extent our stock price appreciates above the exercise price after vesting and during the term of the grant.

33

There have been no reductions to the exercise price of previously issued awards, and any repricing of awards would require approval of our shareholders.

Our new executive compensation program, effective for 2004, strengthens the relationship between pay and individual performance through greater differentiation in the amount of base pay, bonus and stock-based compensation based on an employee’s responsibility and performance. The new program results in a shift of both cash and stock-based compensation to our top performing executives. In addition, our new program provides executives, who are awarded long-term incentives based on their performance, with a choice of stock options or restricted stock units (RSUs). RSUs generally vest after three years of service and each restricted stock unit can be settled in a share of our stock after the vesting period. Executives who elect RSUs receive one RSU for every four stock options that would have otherwise been granted. Senior officers do not have a choice and are granted 50% stock options and 50% RSUs. Vesting of RSU awards for senior officers is contingent upon the achievement of pre-established performance targets.

We also continued, as we have since 1989, to grant an annual award of stock options to all eligible employees, based on job level or classification under our broad-based stock option program, SharePower. As part of the new compensation program in 2004, the SharePower program grant was reduced by approximately 50% for employees in the U.S. and replaced with matching contributions of PepsiCo stock to our 401(k) savings plans. We did not reduce the SharePower award for international employees and continued using tenure as a base for delivering the award in addition to job level and classification. For additional information on our 401(k) savings plans, see Note 7.

Method of Accounting

We account for our employee stock options under the fair value method of accounting using a Black-Scholes valuation model to measure stock-based compensation expense at the date of grant. We do not expect Statement of Financial Accounting Standards (SFAS) 123R, Share-Based Payment, to materially impact our financial statements upon adoption no later than in the fourth quarter of 2005. Two of our anchor bottlers, PBG and PAS, will be adopting SFAS 123R in 2005. They are currently evaluating the impact of SFAS 123R which will consequently impact our bottling equity income.

Beginning in 2004, our divisions were held accountable for stock-based compensation expense and, therefore, this expense is allocated to our divisions as an incremental employee compensation cost. Prior year division results have been adjusted for comparability. The allocation of compensation expense is approximately 28% FLNA, 19% PBNA, 32% PI, 4% QFNA and 17% corporate unallocated. The expense allocated to our divisions excludes any impact of changes in our Black-Scholes assumptions which reflect market conditions over which division management has no control. Therefore, any variances between allocated expense and our actual expense are recognized in corporate unallocated expenses.

34

Our Assumptions

Our Black-Scholes model estimates the expected value our employees will receive from the options based on a number of assumptions, such as interest rates, employee exercises, our stock price and dividend yield. Our weighted-average fair value assumptions include:

The expected life is a significant assumption as it determines the period for which the risk free interest rate, volatility and dividend yield must be applied. The expected life is the period over which our employee groups are expected to hold their options. It is based on our historical experience with similar grants. The risk free interest rate is based on the expected U.S. Treasury rate over the expected life. Volatility reflects movements in our stock price over the most recent historical period equivalent to the expected life. Dividend yield is estimated over the expected life based on our stated dividend policy and forecasts of net income, share repurchases and stock price.

2005 Estimated Expense and Sensitivity of Assumptions

Our stock-based compensation expense, including RSUs, is as follows:

If we assumed a 100 basis point change in the following assumptions, our estimated 2005 stock-based compensation expense would increase/(decrease) as follows:

If the expected life were assumed to be one year longer, our estimated 2005 stock-based compensation expense would increase by $9 million. If the expected life were assumed to be one year shorter, our estimated 2005 stock-based compensation expense would decrease by $6 million. As noted, changing the assumed expected life impacts all of the Black-Scholes valuation assumptions as the risk free interest rate, expected volatility and expected dividend yield are estimated over the expected life.

35

Pension and Retiree Medical Plans

Our pension plans cover full-time employees in the U.S. and certain international employees. Benefits are determined based on either years of service or a combination of years of service and earnings. U.S. retirees are also eligible for medical and life insurance benefits (retiree medical) if they meet age and service requirements. Generally, our share of retiree medical costs is capped at specified dollar amounts, which vary based upon years of service, with retirees contributing the remainder up to the total cost.

Our Assumptions

The pension or retiree medical benefits expected to be paid are expensed over the employees’ expected service. We must make many assumptions to measure our annual pension and retiree medical expense, including:

The assumptions, assets and liabilities used to measure our annual pension and retiree medical expense are determined as of September 30 (measurement date) and all plan assets and liabilities are reported as of that date. Our assumptions reflect our historical experience and management’s best judgment regarding future expectations. Some of these assumptions require significant management judgment and could have a material impact on the measurement of our pension and retiree medical benefit expense and obligation. However, any impact from the changes in retiree medical assumptions would be mitigated by the cap on these benefits.

Since pension and retiree medical liabilities are measured on a discounted basis, the discount rate is a significant assumption. At each measurement date, the discount rate is based on interest rates for high-quality, long-term corporate debt securities with maturities comparable to our liabilities. The expected return on pension plan assets is based on our historical experience, our pension plan investment strategy, and our expectations for long-term rates of return. Our pension plan investment strategy is reviewed annually and is based upon plan liabilities, an evaluation of market conditions, tolerance for risk and cash requirements for benefit payments. We use a third-party consultant to assist us in determining our investment allocation and modeling our long-term rate assumptions. Our current investment allocation target for our U.S. plans is 60% equity securities, with the balance in fixed income securities. Our current assumed rate of return on plan assets is 7.8%, reflecting an estimated long-term return of 9.3% from equity securities and an estimated 5.8% from fixed income securities. As permitted by U.S. generally accepted accounting principles, plan assets used in determining the expected return component of annual pension expense reflect the difference between the actual and the expected return in any one year over five years. Therefore, it takes five years for the gain or loss from any one year to be fully included in the measurement of plan assets.

36

Other gains and losses resulting from actual experience differing from our assumptions are also determined at each measurement date. If this net accumulated gain or loss exceeds 10% of the greater of plan assets or liabilities, a portion of the net gain or loss is included in expense for the following year. The cost or benefit of plan changes, such as increasing or decreasing benefits for prior employee service, is included in expense on a straight-line basis over the average remaining service period of the employees expected to receive benefits.

Weighted-average assumptions for pension and retiree medical expense are the following:

Future Expense

Our 2005 pension expense is estimated to be approximately $310 million and retiree medical expense is estimated to be approximately $135 million. These estimates incorporate the 2005 assumptions, as well as the impact of the increased pension plan assets resulting from our discretionary contributions of $400 million in 2004, and the impact of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (Medicare Act) as discussed in Note 7. Changes in our 2005 assumptions include updates to our mortality tables, employee turnover assumptions, and retirement age assumptions. These changes result in an increase in our pension experience loss amortization for 2005 of $45 million. In addition, the increase in amortization for 2005 pension expense reflects the absence of asset gain amortization of approximately $50 million in 2004 in accordance with our methodology discussed above. An analysis of the estimated change in pension and retiree medical expense follows:

Pension service costs, including the impact of demographic assumption changes on service costs, are reflected in division results, with the impact of changes in discount and

37

asset return rates, gains and losses, and the impact of funding reflected in corporate unallocated. Under this policy, approximately $20 million of the increased pension and retiree medical expense in 2005 will be reflected in corporate unallocated expense.

Based on our current assumptions, which reflect our prior experience and current plan provisions, and assuming we are allowed to make annual discretionary contributions of approximately $400 million, we expect our pension expense to increase by approximately $15 million in 2006. In 2007, our pension expense would begin to decrease, with the expense dropping to approximately $220 million by 2010 as unrecognized asset losses are fully amortized. If our assumptions and our plan provisions for retiree medical remain unchanged and our experience mirrors these assumptions, we expect our annual retiree medical expense beyond 2005 to approximate $140 million.

Sensitivity of Assumptions

A decrease in the discount rate or a decrease in the expected rate of return on assets would increase pension expense. The estimated impact of a 25 basis point change in the discount rate on 2005 pension expense is a change of approximately $32 million. The estimated impact on 2005 pension expense of a 25 basis point change in the expected rate of return on assets is a change of approximately $13 million. See Note 7 regarding the sensitivity of our retiree medical cost assumptions.

Future Funding

We make contributions to pension trusts maintained to provide plan benefits for certain pension plans. These contributions are made in accordance with applicable tax regulations that provide for current tax deductions for our contributions, and taxation to the employee only upon receipt of plan benefits. Generally, we do not fund our pension plans when our contributions would not be currently deductible or when the employee would be taxed prior to receipt of benefit.

Our pension contributions for 2004 were $458 million of which $400 million was discretionary. In 2005, we expect contributions to be about the same with approximately $400 million expected to be discretionary and the remainder satisfying minimum requirements. Our cash payments for retiree medical are estimated to be $85 million in 2005. As our retiree medical plans are not subject to regulatory funding requirements, we fund these plans on a pay-as-you-go basis. For estimated future benefit payments, including our pay-as-you-go payments as well as those from trusts, see Note 7.

38

OUR FINANCIAL RESULTS

Items Affecting Comparability

The year-over-year comparisons of our financial results are affected by the following items:

For the items and accounting changes affecting our 2002 results, see Note 1 and our 2002 Annual Report.

Impairment and Restructuring Charges and Merger-Related Costs

In the fourth quarter of 2004, we incurred restructuring and impairment charges of $150 million in conjunction with the consolidation of FLNA’s manufacturing network in connection with its ongoing productivity program. Savings from this productivity program have been and are expected to be used to offset increased marketplace spending.

In the fourth quarter of 2003, we incurred a restructuring charge of $147 million in conjunction with the streamlining of our North American divisions and PepsiCo International. Also, during 2003 and in 2002, we incurred costs associated with our merger with The Quaker Oats Company (Quaker).

For additional information, see Note 3.

Net Tax Benefits – Continuing Operations

In the fourth quarter of 2004, we recognized $45 million of tax benefits related to the completion of the IRS audit for pre-merger Quaker open tax years. In the third quarter of 2004, we recognized $221 million of tax benefits related to a reduction in foreign tax accruals following the resolution of certain open tax issues with foreign tax authorities, and a refund claim related to prior U.S. tax settlements.

39

At the end of 2003, we entered into agreements with the IRS for open tax years through 1997. These agreements resulted in a tax benefit of $109 million. As part of these agreements, we also resolved the treatment of certain other issues related to future tax years.

For additional information, see “ Our Critical Accounting Policies.”

Tax Benefit from Discontinued Operations

In the fourth quarter of 2004, we reached agreement with the IRS for an open issue related to our discontinued restaurant operations which resulted in a tax benefit of $38 million.

Results of Continuing Operations – Consolidated Review

In the discussions of net revenue and operating profit below, effective net pricing reflects the year-over-year impact of discrete pricing actions, sales incentive activities and mix resulting from selling varying products in different package sizes and in different countries.

Servings

Since our divisions each use different measures of physical unit volume (i.e., kilos, pounds and case sales), a common servings metric is necessary to reflect our consolidated physical unit volume. Our divisions’ physical volume measures are converted into servings based on U.S. Food and Drug Administration guidelines for single-serving sizes of our products.

Total servings increased 6% in 2004 compared to 2003 as servings for beverages worldwide grew 7% and servings for snacks worldwide grew over 5%. All of our divisions positively contributed to the total servings growth. Total servings increased 5% in 2003 compared to 2002 primarily due to contributions from PI, PBNA and FLNA.

40

Net Revenue and Operating Profit

2004

Division net revenue increased 8%, primarily due to strong volume gains across all divisions, favorable product mix, primarily at PBNA and PI, and net favorable foreign currency movements. The volume gains contributed over 4 percentage points, the favorable mix contributed almost 2 percentage points, and the net favorable foreign currency contributed almost 2 percentage points to division net revenue growth.

Total operating profit increased 10% and margin increased 0.3 percentage points. Division operating profit increased 12% and division margin increased 0.5 percentage points. These gains reflect leverage from the revenue growth, partially offset by increased selling, general and administrative expenses, primarily corporate unallocated expenses. In addition, total operating profit growth reflects the absence of merger-related costs in 2004.

2003

Net revenue increased 7%. Division net revenue increased 8%, primarily due to the strong volume which contributed 4 percentage points of growth. Favorable product and country mix, as well as North American snack and concentrate price increases, contributed over 2 percentage points to the growth. Favorable foreign currency movements contributed nearly 1 percentage point to the net revenue growth.

41

Total operating profit increased 11% and margin increased 0.6 percentage points. Division operating profit increased 11% and division margin increased 0.5 percentage points. These gains were driven by the strong volume and higher effective net pricing. Cost of sales increased 8%, reflecting increased commodity costs, particularly corn oil and natural gas. Selling, general and administrative expenses increased 6% driven by higher selling costs primarily reflecting the increased volume and increased fuel costs. Unfavorable foreign currency reduced operating profit growth by nearly 1 percentage point. In addition, total operating profit reflects the benefit from lower merger-related costs, offset by the 2003 impairment and restructuring charges of $147 million.

Corporate Unallocated Expenses

Corporate unallocated expenses include the costs of our corporate headquarters, centrally managed initiatives such as our BPT initiative, unallocated insurance and benefit programs, foreign exchange transaction gains and losses, profit-in-inventory elimination adjustments for our noncontrolled bottling affiliates, and certain other items.

In 2004, corporate unallocated expenses increased 38%. Higher employee-related costs contributed 18 percentage points of the increase, an accrual recognized in the fourth quarter for the settlement of a contractual dispute with a former business partner represented 10 percentage points of the increase, and higher costs related to our BPT initiative contributed 4 percentage points of the increase. Corporate departmental expenses increased 2% compared to prior year.

In 2003, corporate unallocated expenses increased 14% primarily reflecting our 2003 investment in our BPT initiative. Higher employee-related costs, including deferred compensation, and corporate departmental costs also contributed to the increase. The increase in the deferred compensation costs is partially offset by the decrease in net interest expense. Corporate departmental expenses increased 3% reflecting staffing and other costs related to our health and wellness initiatives.

42

Bottling equity income includes our share of the net income or loss of our noncontrolled bottling affiliates as described in “ Our Customers.” Our interest in these bottling investments may change from time to time. Any gains or losses from these changes, as well as other transactions related to our bottling investments, are also included on a pre-tax basis. Over time, we expect to be selling shares of PBG stock to trim our ownership to the level at the time of PBG’s initial public offering. Our ownership has increased as a result of PBG’s share repurchase program. During 2005, we intend to sell up to 7.5 million shares of PBG stock. The resulting lower ownership percentage will reduce the equity income from PBG that we recognize.

2004

Bottling equity income increased 18%, primarily reflecting increased earnings from our anchor bottlers and favorable comparisons from international bottling investments, primarily as a result of the nationwide strike in Venezuela in early 2003.

Net interest expense declined 17% primarily due to favorable interest rates and higher average cash balances, partially offset by higher average debt balances and lower gains in the market value of investments used to economically hedge a portion of our deferred compensation liability. The offsetting increase in deferred compensation costs is reported in corporate unallocated expenses within selling, general and administrative expenses.

The annual tax rate decreased 3.8 percentage points compared to the prior year, primarily as a result of tax benefits from the resolution of open items with tax authorities in both years, as discussed in “Items Affecting Comparability.” The tax benefits reduced our tax rate by 2.6 percentage points. Increased benefit from concentrate operations and favorable changes arising from agreements with the Internal Revenue Service in the fourth quarter of 2003 also contributed to the decline in rate.

43

Net income from continuing operations increased 17% and the related net income per common share from continuing operations increased 18%. These increases primarily reflect the solid operating profit growth and our lower annual tax rate. The absence of merger-related costs in 2004 and increased bottling equity income also contributed to the growth.

2003

Bottling equity income increased 16%. This increase primarily reflects a favorable comparison to the impairment charge taken in 2002 on a Latin American bottling investment, and increased earnings from PBG and PAS in 2003.

Net interest expense declined 21% primarily due to a gain of $22 million on investments used to economically hedge a portion of our deferred compensation liability versus losses of $18 million in the prior year. This net gain was partially offset by lower investment rates.

The annual tax rate decreased 3.8 percentage points compared to the prior year. At the end of 2003, we entered into agreements with the IRS. These agreements resulted in a tax benefit of $109 million, reducing our tax rate by over 2 percentage points. Lower taxes on foreign results, including the impact of our new concentrate operations, also reduced our tax rate by nearly 2 percentage points. The impact of lower nondeductible merger-related costs contributed 0.9 percentage points to the decrease.

Net income increased 19% and the related net income per common share increased 22%. These increases primarily reflect the solid operating profit growth, our lower annual tax rate and increased bottling equity income. The benefit of lower merger-related costs was largely offset by the impairment and restructuring charges. Net income per common share also reflects the benefit of a reduction in average shares outstanding primarily as a result of share repurchase activity.

44

Results of Continuing Operations – Division Review

The results and discussions below are based on how our Chief Executive Officer monitors the performance of our divisions. Prior year amounts exclude the results of divested businesses. For additional information on these items and our divisions, see Note 1.

Frito-Lay North America

2004

Net revenue grew 5% reflecting volume growth of 3% and positive effective net pricing due to salty snack pricing actions and favorable mix. Pound volume grew primarily due to new products, single-digit growth in Lay’s Classic potato chips, strong double-digit growth in Variety Pack, and mid single-digit growth in Tostitos and Fried Cheetos. Lay’s Stax and Doritos Rollitos led the new product growth. These gains were partially offset by single-digit declines in Doritos and Fritos, and double-digit declines in Rold Gold and Quaker Toastables.

45

Operating profit grew nearly 7% reflecting the positive pricing actions and volume growth. Higher commodity costs, driven by corn oil and energy costs were largely offset by cost leverage generated from ongoing productivity initiatives.

On September 1, 2004, we introduced our new “Smart Spot” program which helps consumers identify products in our portfolio that can contribute to a healthier lifestyle. Products qualifying for our new Smart Spot program represented approximately 10% of 2004 FLNA net revenue. These products experienced high single-digit revenue growth and the balance of the portfolio had mid single-digit revenue growth. See our website at www.smartspot.com for additional information on our new Smart Spot program.

2003

Net revenue growth of 6% reflects volume growth of 4% and positive effective net pricing. Pound volume grew primarily due to new products, double-digit growth in Cheetos, Munchies snack mix and Quaker Chewy Granola bars, and single-digit growth in branded dips and Doritos. Quaker Toastables, Lay’s Stax and the Natural snack line led the new product growth. These gains were partially offset by double-digit declines in Rold Gold, Lay’s Bistro, and Go Snacks. Modest pricing actions on certain salty snacks and favorable mix led the positive effective net pricing. These gains were partially offset by higher trade spending on product innovation.

Operating profit growth of 8% reflects the volume growth and positive effective net pricing. These gains were partially offset by increased commodity costs, particularly corn oil and natural gas. Increased commodity costs reduced operating profit growth by 3 percentage points, more than offsetting the cost leverage generated from productivity initiatives.

Pe psiCo Beverages North America

2004

Net revenue increased 7% and volume increased 3%. The volume increase reflects non-carbonated beverage growth of 10% and a slight increase in carbonated soft drinks (CSDs). The non-carbonated beverage growth was fueled by double-digit growth in Gatorade, Aquafina and Propel, as well as the introduction of bottler-distributed Tropicana juice drinks. Tropicana Pure Premium increased slightly for the year. The carbonated soft drink performance reflects a low single-digit increase in Trademark Mountain Dew and a slight increase in Trademark Sierra Mist, offset by a slight decline in Trademark Pepsi. Across the trademarks, high single-digit diet CSD growth was

46

substantially offset by a low single-digit decline in regular CSDs. The increase in Trademark Mountain Dew reflects growth in both Diet and regular Mountain Dew and the limited time only offering of Mountain Dew Pitch Black, substantially offset by declines in both Mountain Dew Code Red and LiveWire. The performance of Trademark Pepsi reflects declines in regular Pepsi, Pepsi Twist and Pepsi Blue, mostly offset by increases in Diet Pepsi and the introduction of Pepsi Edge. Favorable product mix contributed 3 percentage points to net revenue growth, primarily reflecting a migration to non-carbonated beverages. Additionally, concentrate and fountain price increases taken in the first quarter contributed 1 percentage point to net revenue growth.

Operating profit increased 13% reflecting the net revenue growth, partially offset by higher selling, general and administrative costs, as well as costs related to marketplace initiatives.

Products qualifying for our new Smart Spot program represented over 60% of net revenue. These products experienced high single-digit revenue growth, and the balance of the portfolio had mid single-digit revenue growth.

2003

Net revenue increased 7% on volume growth of 3%. The volume growth reflects non-carbonated growth of 8% and carbonated beverage growth of 1.5%. Double-digit growth in Gatorade, Aquafina and Propel drove the non-carbonated portfolio. Tropicana chilled products growth was low single-digit. The carbonated beverage performance reflects the national launch of Sierra Mist and high single-digit growth in diet carbonated beverages, primarily Diet Pepsi. Declines in trademark Pepsi, excluding diet, partially offset this carbonated beverage growth. Higher effective net pricing contributed 4 percentage points to the net revenue growth. The higher effective net pricing reflects a favorable product mix shift to the higher priced non-carbonated beverages, and fountain and concentrate price increases, partially offset by increased promotional spending. The price increases contributed 1 percentage point to the net revenue growth.

Operating profit increased 14 percentage points reflecting the higher effective net pricing, volume gains and purchasing efficiencies. These gains were partially offset by increased advertising and marketing expenses. The higher effective net pricing contributed 9 percentage points to the operating profit growth with product mix contributing 7 percentage points.

47

PepsiCo International

2004

International snacks volume grew 8%, comprised of 7% in our Latin America region, 8% in our Europe, Middle East & Africa region and 14% in our Asia Pacific region. These gains were driven by high single-digit growth at Sabritas in Mexico, strong double-digit growth in India, low single-digit growth at Gamesa in Mexico coupled with double-digit growth in Egypt, Venezuela, Turkey and Brazil.

Beverage volume grew 12%, comprised of 14% in our Europe, Middle East & Africa region, 15% in our Asia Pacific region and 8% in our Latin America region. Broad-based increases were led by double-digit growth in the Middle East and China, high single-digit growth in Mexico and double-digit growth in India, Germany, Russia and Venezuela. Favorable comparisons as a result of the 2003 national strike in Venezuela and the German deposit law impact contributed to the growth in Venezuela and Germany. Both carbonated soft drinks and non-carbonated beverages grew at double-digit rates.

Net revenue grew 14% driven by the broad-based volume growth and favorable mix. Foreign currency impact contributed 4 percentage points of growth driven by the favorable British pound and euro, partially offset by the unfavorable Mexican peso. Acquisitions contributed less than 1 percentage point.

Operating profit grew 25% driven largely by the volume and favorable mix. The favorable comparison of certain reserve actions taken in 2003 on potentially unrecoverable beverage assets contributed 2 percentage points of growth. Foreign currency impact contributed almost 3 percentage points of growth driven by the favorable British pound and euro, partially offset by the unfavorable Mexican peso.

2003

International snacks volume grew 6%, comprised of 3% in our Latin America region, 10% in our Europe, Middle East and Africa region and 16% in our Asia Pacific region. These gains were driven by double-digit growth from Walkers in the United Kingdom, India, Turkey and Russia, and low single-digit growth at Sabritas in Mexico. Mid single-digit sweet growth was led by Gamesa in Mexico.

Beverage volume grew 8%, comprised of 8% in our Latin America region, 6% in our Europe, Middle East and Africa region and 11% in our Asia Pacific region. Broad-based increases were led by double-digit growth in the Middle East, China, Brazil, India, Russia

48

and Thailand and mid single-digit growth in Mexico. Volume gains in India driven by competitive pricing actions were offset by double-digit declines in Germany due to the new one-way bottle deposit requirement imposed by the government.

Net revenue grew 12% driven by higher volume across most markets. Acquisitions contributed nearly 2 percentage points of growth and favorable foreign currency contributed 1 percentage point as the favorable euro and British pound substantially offset the unfavorable Mexican peso. These gains were partially offset by the impact of the German one-way beverage deposits and competitive beverage pricing actions in India.

Operating profit grew 17% largely due to the drivers of net revenue growth. Acquisitions contributed 2 percentage points of growth. Unfavorable foreign currency reduced operating profit by 6 percentage points due to the impact of the peso on our Mexican snack businesses. In addition, operating profits were reduced by 2 percentage points due to reserve actions taken on potentially unrecoverable beverage assets.

Quaker Foods North America

2004

Net revenue increased 4% and volume increased 3%. The volume increase reflects high single-digit growth in Oatmeal and double-digit growth in Life cereal, partially offset by a mid single-digit decline in Cap’n Crunch cereal. The Life cereal growth was led by the introduction of Honey Graham Life. Favorable product mix, reflecting growth in higher revenue per pound brands, was offset by promotional spending behind new products. Favorable Canadian exchange rates contributed 1 percentage point to net revenue growth.

Operating profit increased 1% reflecting the net revenue growth, substantially offset by an unfavorable cost of sales comparison and higher advertising and marketing costs. Products qualifying for our new Smart Spot program represented approximately half of net revenue and had high single-digit revenue growth. The balance of the portfolio was flat.

2003

Net revenue and volume were flat compared to prior year as the national launch of Breakfast Squares and Canadian Oatmeal to Go growth were offset by declines in Rice and Pasta Roni side dishes and in our hot cereal business. A favorable Canadian exchange rate, which contributed 1 percentage point to net revenue growth, and ready-to-eat

49

cereal price increases, were offset by unfavorable product mix and increased promotional spending related to the Breakfast Squares launch.

Operating profit grew 3% compared to prior year. Lower advertising and marketing spending contributed over 4 percentage points to operating profit growth, while favorable cost of sales contributed almost 5 percentage points. These gains were partially offset by an unfavorable product mix, which reduced operating profit growth by 7 percentage points. The unfavorable product mix reflects declines in higher margin products.

Our Liquidity, Capital Resources and Financial Position

Our strong cash-generating capability and financial condition give us ready access to capital markets throughout the world. Our principal source of liquidity is our operating cash flow. This cash-generating capability is one of our fundamental strengths and provides us with substantial financial flexibility in meeting operating, investing and financing needs. In addition, we have revolving credit facilities that are further discussed in Note 9. Our cash provided from operating activities is somewhat impacted by seasonality. Working capital needs are impacted by weekly sales, which are generally highest in the third quarter due to seasonal and holiday-related sales patterns, and generally lowest in the first quarter.

a) Operating activities     b) Short-term borrowings     c) Stock option exercises     d) Share repurchases     e) Capital spending     f) Dividends g) Short-term investments     h) Divestitures     i) Acquisitions     k) Long-term debt     m) Other, net

Operating Activities

In 2004, our operations provided $5.1 billion of cash, primarily reflecting our solid business results, partially offset by net tax payments of $1.8 billion and pension plan contributions of $458 million of which $400 million was discretionary. In 2003, our operations provided $4.3 billion of cash reflecting our solid business results, partially offset by net tax payments of $1.5 billion and pension plan contributions of $535 million of which $500 million was discretionary. The year-over-year increase in cash flows from operations is primarily attributable to our solid business results and effective working capital management, partially offset by the higher tax payments in 2004.

50

Investing Activities

In 2004, we used $2.3 billion for investing, primarily reflecting capital spending of $1.4 billion and short-term investments of almost $1.0 billion. In 2003, we used $2.3 billion for investing, primarily reflecting capital spending of $1.3 billion and short-term investments of nearly $1.0 billion.

We expect capital spending to continue at a rate of approximately 5% of net revenue in 2005. In December 2004, we announced that we would acquire General Mills, Inc.’s 40.5% ownership interest in Snack Ventures Europe (SVE) for $750 million. We expect the transaction to be completed in early 2005. This transaction will be funded with existing international cash. In addition, in 2005, we will generate cash from the expected sale of up to 7.5 million shares of PBG stock.

Financing Activities

In 2004, we used $2.3 billion for financing, primarily reflecting share repurchases at a cost of $3.0 billion and dividend payments of $1.3 billion, partially offset by net issuances of short-term borrowings of $1.1 billion and proceeds from exercises of stock options of nearly $1.0 billion. This compares to $2.9 billion used for financing in 2003, primarily reflecting share repurchases at a cost of $1.9 billion and dividend payments of $1.1 billion.

In the second quarter of 2004, our Board of Directors authorized a new $7.0 billion share repurchase program. Since inception of the new program, we have repurchased $2.1 billion of shares, leaving $4.9 billion of remaining authorization. We target an annual dividend payout of approximately 45% of prior year’s net income from continuing operations. Each spring we review our capital structure with our Board, including our dividend policy and share repurchase activity.

Management Operating Cash Flow

We focus on management operating cash flow as a key element in achieving maximum shareholder value, and it is the primary measure we use to monitor cash flow performance. However, it is not a measure provided by accounting principles generally accepted in the U.S. Since net capital spending is essential to our product innovation initiatives and maintaining our operational capabilities, we believe that it is a recurring and necessary use of cash. As such, we believe investors should also consider net capital spending when evaluating our cash from operating activities. The table below reconciles the net cash provided by operating activities as reflected in our Consolidated Statement of Cash Flows to our management operating cash flow.

51

Management operating cash flow was used primarily to repurchase shares and pay dividends. We expect management operating cash flow in 2005 to exceed $4.1 billion reflecting our underlying business growth. We expect to continue to return approximately all of our management operating cash flow to our shareholders through dividends and share repurchases, and expect our share repurchases to range from $2.5 billion to $3.0 billion in 2005. However, see “ Our Business Risks” for certain factors that may impact our operating cash flows.

Credit Ratings

Our debt ratings of Aa3 from Moody’s and A+ from Standard & Poor’s contribute to our ability to access global capital markets. We have maintained strong investment grade ratings for over a decade. Moody’s rating reflects an upgrade from A1 to Aa3 in 2004 due to the strength of our balance sheet and cash flows. Each rating is considered strong investment grade and is in the first quartile of their respective ranking systems. These ratings also reflect the impact of our anchor bottlers’ cash flows and debt.

As discussed in Note 5, we are evaluating our options with respect to repatriating undistributed international earnings under the AJCA. If we decide to repatriate funds in excess of available international cash, we would be required to borrow funds. We would not expect this activity to adversely impact our credit ratings.

Credit Facilities and Long-Term Contractual Commitments

See Note 9 for a description of our credit facilities and long-term contractual commitments.

Off-Balance Sheet Arrangements

It is not our business practice to enter into off-balance sheet arrangements, other than in the normal course of business, nor is it our policy to issue guarantees to our bottlers, noncontrolled affiliates or third parties. However, certain guarantees were necessary to facilitate the separation of our bottling and restaurant operations from us. As of year-end 2004, we believe it is remote that these guarantees would require any cash payment. See Note 9 for a description of our off-balance sheet arrangements.

52

Financial Position

Significant changes in our consolidated balance sheet from December 27, 2003 to December 25, 2004 not discussed above were as follows:

Future Outlook

Our long-term financial targets are mid single-digit volume and net revenue growth, and low double-digit EPS growth. The results of any one year may differ from our long-term targets. Our 2005 results will include the results of a 53^rd week.

53

OUR FINANCIAL RESULTS

Consolidated Statement of Income

PepsiCo, Inc. and Subsidiaries

Fiscal years ended December 25, 2004, December 27, 2003 and December 28, 2002