Earnings Call: Q2 2012

Jul 25, 2012

Summary

Organic revenue grew 5% and results met expectations, while core constant-currency EPS fell 4% in Q2. Full-year EPS guidance remained a 5% decline, with pricing, productivity and shareholder returns supporting the outlook amid commodity, FX and structural pressures.

Good morning, and welcome to PepsiCo's second quarter 2012 earnings conference call. Your lines have been placed on a listen-only until the question and answer session. In order to ask a question or make a comment, please press star followed by one on your touch-tone phone at any time. You may remove yourself from the queue by pressing the pound key. Today's call is being recorded and will be archived at www.pepsico.com. It is now my pleasure to introduce Mr. Jamie Caulfield, Senior Vice President of Investor Relations. Mr. Caulfield, you may begin. Thank you, operator, and good morning, everyone. With me today are Indra Nooyi, PepsiCo's Chairman and CEO, and Hugh Johnston, PepsiCo's CFO, as well as a few of our operating executives. We'll lead off today's call with a review of our second quarter performance and our balance of year outlook, and then we'll move on to Q&A. Before we begin, please take note of our cautionary statement. This conference call includes forward-looking statements, including statements regarding 2012 guidance based on currently available information. Forward-looking statements inherently involve risks and uncertainties that could cause our actual results to differ materially from those predicted in such forward-looking statements. Statements made on this conference call should be considered together with the cautionary statements and other information contained in today's earnings release and in our most recent periodic reports filed with the SEC. Unless otherwise indicated, all references to revenue, EPS, and division and total operating profit growth are on a core basis. In addition, references to organic results in this call exclude the impact of acquisitions and divestitures, and beginning this quarter, foreign exchange translation. To find disclosures and reconciliations of non-GAAP measures we use when discussing PepsiCo's financial results, please refer to the glossary and other attachments to this morning's earnings release and to the investors section of PepsiCo's website under the investor presentations tab. Now it's my pleasure to introduce Indra Nooyi. Thanks, Jamie, and good morning, everyone. Our second quarter results came in right in line with our expectations. The major economies we do business in, consumer behavior, the competitive landscape, and commodities were all in line with our assumptions and expectations. Net revenue in the quarter grew 5% on an organic basis, supported by organic net revenue growth in each of our four business units. This is a solid result reflecting balanced revenue management, which led to a healthy price mix benefit. Our organic net revenue growth was 5% year to date, and we're on track to deliver organic revenue growth of mid-single digits for full year 2012. Our organic net revenue growth was ahead of our reported revenue growth owing to structural changes and to the negative impact of translating our international revenues with a strengthened dollar in Q2. The structural changes included re-franchising our bottling operations in Mexico in the fourth quarter of last year and in China with a transaction with Tingyi at the beginning of Q2. As a consequence of entering into new franchise agreements with our highly capable partners, we no longer report bottling revenues in these markets. From a strategic standpoint, these transactions strengthen our operations and are expected to improve our operating margins and key efficiency metrics, including revenue and EBIT per employee, improve our returns on capital, and reduce the capital intensity of PepsiCo's operations in these markets. Importantly, in addition to very solid organic top-line growth in the quarter, we continue to gain traction on the brand-building, innovation, execution, and productivity initiatives that are key elements of our 2012 plan. Before I discuss progress on these initiatives, though, let me quickly review the financial highlights for Q2. Our financial results are right in line with our expectations. Core EPS was $1.12. As I just mentioned, organic net revenue grew 5% and reflected strong price mix across all of our businesses. Globally, price mix was up 4%, and this pricing helped offset the impact of about $350 million of commodity cost inflation. We had growth in both global snack revenue and global beverage revenue on an organic basis. Emerging and developing markets revenue growth was particularly strong, up 9% on an organic basis, led by strong double-digit organic revenue growth in key emerging markets. Results were generally strong across our four business units, and each business unit posted organic revenue growth and achieved solid productivity gains to help offset inflation. Within PepsiCo Americas Foods, Frito-Lay North America executed very deliberate channel and revenue management strategies that drove very good net price realization revenue growth, especially in the C store and food service channels, and positive unit growth overall, while they delivered volume performance that was even with prior years. We could have employed different volume-oriented tactics, particularly in large format channels, but they would have been detrimental to our overall channel mix and net pricing objectives. We are comfortable with the channel, pricing, unit, and volume balance we achieved. PepsiCo Americas Beverages had another solid quarter of solid net price realization. We remain highly disciplined in the execution of our price pack and channel strategies. As a result, we are seeing very good performance in the immediate consumption packages, which led to strong net revenue growth in the C store channel. We are seeing good, stable every value share performance relative to our primary competitor in measured channels. Europe was a terrific story with strong performance, with organic net revenue up 3% and constant currency operating profit up 15%. Zane will comment on Europe in more detail in a few minutes. In AMEA, we had 10% organic net revenue growth and terrific operating profit performance, reflecting the strength of the top-line growth and our productivity progress. Overall, our Q2 results encourage us that we're making good progress, and we are on track to deliver our full-year financial targets. Let me now turn to the progress we are making on our key initiatives for the year. We remain focused on five big areas: brand building, innovation, execution, productivity, and driving cash returns. Let me talk to each of them. On brand building, we are on target to increase our investment in advertising and marketing to 5.7% of revenue this year, which is an increase of 50 basis points over our investment level last year. We have made good progress on increasing our consumer-facing A&M investment focused on our 12 global mega brands to drive greater scale and impact with our spending. Much of this is enabled by having much greater coordination among our operations globally, allowing us to leverage creative and production activities across multiple geographies, which gives us cost leverage and drives greater consistency in our brand messaging. We have significantly stepped up our media in key markets. For example, in the U.S. alone, our media spending was up over 40% in the second quarter and over 30% year-to-date. We are beginning to gain traction with these efforts. Brand equity scores for our major brands in our key markets are showing improvement in many cases and are stabilizing in the remainder. We will sustain our efforts in this area, and we are confident we will see higher brand equity scores translate into strong top-line growth with healthy price premiums. Our second focus area is innovation, where our goal is to consistently increase the contribution of new products to our total net revenue. Our innovation is targeted on specific channel, cohort, and occasion opportunities and with a balanced focus on Fun For You, Better For You, and Good For You products. For example, at Frito-Lay North America, innovation drove incremental sales all across the portfolio. Doritos had double-digit sales growth in the quarter behind innovations such as Doritos Jacked and Doritos Locos Tacos, which continues to drive strong growth at Taco Bell. Ruffles delivered mid-single-digit sales growth supported by incremental sales from Ruffles Ultimate, which continues to gain distribution during ramp-up with strong retail activation surrounding the launch. In our Frito-Lay Middle East and Africa business, which is focused on incubating new premium and value products, revenue grew 13% in the quarter, led by double-digit gains in Stacy's and our Smartfood platform. In North American beverages, Pepsi Next is off to a strong start, and we have just launched two new limited time only flavors, Pepsi Next Cherry Vanilla and Pepsi Next Paradise Mango, to satisfy the thirst of cola lovers looking for unique fruit flavor blends, both with 60% less sugar than regular colas. We are also driving growth across the Gatorade portfolio with additions to the G Series line and introduction of differentiated packaging. One of our most recent introductions is the Prime Chews. The Chews come in three flavors and contain 25 grams of carbohydrates as well as B vitamins to help your body break down carbs into fuel and helps you maintain your performance throughout your activity. At Quaker, we are driving organic sales growth and share gains with innovation like Quaker Real Medleys and Quaker Yogurt Bars. Interestingly, on both Quaker Real Medleys and the Gatorade Chews, we are selling all we have the capacity to make. Year-to-date, our innovation is off to a good start, and it provides a good base to build on. Let me turn to execution. We are measuring and driving execution across every element of the value chain to increase efficiency, quality, and service to best-in-class levels, and we are seeing good results across our functions and businesses. One example is how we have executed our price pack and channel mix strategies this year, driving strong revenue realization and positive mix. This is evident in North America, where our C-store growth remains very strong, with retail sales gaining 8% in both snacks and beverages in the second quarter, making us the number one contributor to growth in the channel. In fact, PepsiCo was the largest contributor to food and non-alcoholic beverage growth across all measured channels in the U.S. in the second quarter. Our businesses are executing well together. We launched our Rock Your Summer campaign, where consumers are encouraged to match, snap, and win. Match any Frito-Lay product with any Pepsi beverage product, then snap and submit a picture of the two products for a chance to win a variety of prizes. We featured the campaign in 46 of our top 50 retail accounts and increased our Power of One display in the grocery channel by 13% compared to last summer. Joint promotion merchandising is a key element of our Power of One programming, and it is driving coincidence of purchase of PepsiCo beverages and PepsiCo snacks at a rate well above our fair share. Our execution focus is especially evident in many of our emerging and developing markets. For example, we had strong double-digit organic revenue growth in beverages in India and Brazil and in snacks in Mexico and India. We are especially pleased with the progress we have made in Eastern Europe. I would like to ask Zane to give us a quick update on this business, which had very good results this quarter. Zane? Thank you, Indra, and good morning, everyone. Despite the well-known challenges in Europe, we continue to build momentum in our business, beginning with very solid performance in Q1, followed by strong results in Q2. We grew our organic net revenue by 3% and delivered 15% growth in our core constant currency net operating profit. We have done this through a disciplined approach to pricing and mix management, together with terrific execution against an aggressive productivity agenda. A particular highlight this quarter has been our acceleration in Eastern Europe, where our successful integration of Wimm-Bill-Dann and our Power of One initiatives drove outstanding results in Russia. Our success has really been enabled by the transformation we have made to our business over the last few years, with a strong focus on expanding in the faster-growing Eastern European markets, encompassing a broader set of categories to cater for more consumer needs and day-parts. A portfolio that is wonderfully balanced across Fun for You, Better for You, and Good for You, which is the best way to compete in this region. In 2008, less than 25% of Europe's revenue mix came from the East, and by last year, that figure had increased to well over 50%. This portfolio transformation is helping us weather the macroeconomic headwinds facing other parts of Europe. PepsiCo Europe's increasingly diverse category portfolio, about 40% of net revenue comes from snack, with the remainder well-balanced across non-carbonated beverages, CSDs, and dairy, has positioned us to respond to changing consumer preferences and to strengthen our mix. Central to these changes has been PepsiCo's journey in Russia, one we embarked upon some 50 years ago. Through our recent investments, we've built the largest food and beverage business in Russia, a powerhouse business primed for growth and positioned to capitalize on a market with lots of growth potential. PepsiCo Russia net revenues now represents some 40% of our total sector's revenue, and Russia is growing profit at the fastest rate in Europe. We have leading positions in multiple categories, savory snacks, juice, tea, water, energy, and dairy, with a portfolio of strong global and local brands. In fact, we now have 10 of the top 25 non-alcoholic food and beverage brands in Russia, each with retail sales of more than $250 million. Building on this strong base, PepsiCo Russia provides a gateway to more than 400 million consumers. It's our base for expanding successfully across Eastern and Central Europe, and we've started to see the benefits of this in the quarter with accelerated growth in Ukraine and other CIS markets. The integration of Wimm-Bill-Dann is progressing very well. Adding this to the Power of One business infrastructure we had already put into place across our Russian businesses, we've been able to drive significant synergies and productivity. We have a fully integrated and low-cost supply chain and back office, delivering substantial cost synergies. We have tremendous go-to-market advantage with unparalleled reach across the organized and traditional trade channels. We've created a single sales structure for our top eight national accounts, enabling us to capitalize on the benefits of scale to enhance customer engagement. We've integrated our food service teams in Moscow and St. Petersburg, now delivering dairy, juice, beverages, and snacks to on-premise and social channels. Top-line synergies have come in the form of convergence in brand building and go to market, such as the recent launch of oats products under Chudo branding and single-serve kefir or drinkable yogurt being distributed through the PepsiCo system. All this is helping us to deliver strong revenue realization through selective pricing, portfolio management, and strong, speedy innovation. We have very strong share positions across our strategic categories in Russia. Highlights include very favorable savory snack share with 1.9 percentage point value share gains year to date, and strong CSD share with 0.8 percentage point value share gains year to date. In short, we are pleased with our results in Europe overall, enabled by a well-architected geographic and product portfolio. With Russia and the balance of Eastern Europe well positioned to be a substantial growth engine, not only for the European sector, but for all of PepsiCo. Thank you, Zane, and that's a great report card on East Europe and Russia. Let me now turn to productivity. We're targeting more than $1 billion in productivity this year and $3 billion in total over the next three years, which includes the restructuring program we announced early this year and other productivity initiatives that are incremental to our ongoing productivity agenda. Our productivity programs for 2012 are locked in, and we are very confident to deliver those targeted savings. We made substantial progress against our productivity plans in the first half of the year. The financial benefits of the restructuring accelerated in Q2 and will continue to benefit financial performance as we move through the second half of the year. In addition to the restructuring programs, we've also accelerated other productivity initiatives. We're driving hard against reducing the capital intensity of our business and improving working capital efficiency, and we are already seeing good results. Finally, we're doing a better job leveraging global capability and know-how. By sharing best practices and implementing best-in-class processes, we're improving operating performance. We are encouraged by the pace and progress of our productivity plan. Finally, we're taking steps to drive higher returns on our invested capital and enhance cash returns to shareholders. We've reduced our net capital spending year to date by $338 million and reduced our net CapEx as a percentage of sales over the last four quarters by more than 100 basis points. We are achieving this both by driving high utilization of our assets and by reducing the cost of replacement and growth capacity through value engineering and through enhanced global procurement management. We remain committed to returning cash to our shareholders. In the first half, we returned $2.8 billion in cash to our shareholders through dividends and share repurchases. We expect to return more than $6 billion for the full year, an increase of approximately 12%. Our dividend increased again this June, making 2012 our 40th consecutive year of dividend per share increase. Based on yesterday's closing stock price, our current dividend represents a 3.1% annual dividend yield. To recap, we are focused on brand building, innovation, execution, productivity, and cash return. We are making good progress. We expect momentum to continue to build as the year progresses, and we are confident in achieving our 2012 goals in this area. Let me now turn the call over to Hugh Johnston. Hugh? Thanks, Indra, and good morning, everyone. I'd like to start by reviewing the scorecard we introduced at our investor meeting in February. At that time, we shared that we'd review with you on a semiannual basis our performance in eight key areas, and I'm pleased to share our initial results with you today and look forward to providing another update following Q4. Let me review the results briefly. We're focused on four key input metrics, brand strength, innovation, execution, and cost and capital spending, and then four key output metrics, value share, EPS, net return on invested capital, and operating cash flow. We're making good progress on each of these, and our results were right in line with where we expected to be at this point in the year. On brand strength, our objectives are to step up the level of investment in A&M and to improve the brand equity for our major brands in our key markets. At the end of Q2, our brand equity scores are stable or improving in 85% of our key brands in strategic markets, with sequential improvement from Q1 to Q2, and we're on track to achieve our targeted A&M investment level of 5.7% of sales for the full year. On innovation, our goal is to increase the contribution of innovation to our overall net sales. Year-to-date, our innovation is currently at 7% of net revenue and is on track with where we want to be. Our expectation is for this number to trend up as we launch products currently in the pipeline. Turning to execution, as a proxy for overall execution, we're providing share of inventory on display and coincidence of PepsiCo snack and beverage purchases in the U.S. Share of inventory on display increased in the second quarter for both snacks and carbonated soft drinks, and we continue to achieve above our fair share of co-purchases of salty snacks and CSDs, which improved from 2011 to 2012. From a market share perspective, we're gaining or holding LRB value share versus our primary competitor in a majority of our strategic markets. While our value share trends in savory are a bit more mixed, we've shown sequential improvement from Q1 to Q2, and we expect this to continue to improve. This is not an area where we expect to see results overnight, because it's partly an outcome of our brand-building efforts, which are just beginning to gain traction. We're staying focused on this and expect to continue to see sequential improvement. We feel good about our performance against our financial metrics. Cost and CapEx performance are both positive, with CapEx trending at 4.4% of net revenue over the last four quarters, and we're projecting to meet our targeted operating cost reduction of 75 basis points of net revenue. With respect to EPS, ROIC, and operating cash flow, as Indra mentioned earlier, we're on track to deliver our EPS and cash flow targets for 2012, and our capital investment in 2012 is in line with our target to begin to see ROIC improvement of 50 basis points per year beginning in 2013. Overall, we're pleased with the progress we're making on our scorecard, and we'll provide another update on our Q4 call. I'll wrap up now with a quick discussion of the numbers and our outlook, and then we'll turn to Q&A. As Indra mentioned, the quarter came in in line with what we expected. Organic net revenue increased 5%, while our reported net revenue declined, reflecting the structural changes, including Mexico and China, which reduced the reported number by approximately four points, and by negative currency translation, which was a three-point drag on the reported net revenue. We realized four percentage points of effective net pricing, with increases across each of our divisions. Core gross margins were down 64 basis points, driven by higher commodity costs in the quarter, which is a sequential improvement from the first quarter. Core division operating margins were down by 22 basis points, with productivity in SG&A helping to offset a substantial portion of the commodity inflation. All in, this resulted in a 1% decline in core division operating profit on a constant currency basis and a 3% decline in core division operating profit on a U.S. dollar basis, reflecting a nearly three-point drag from currency in line with our expectations. Core corporate unallocated expenses increased in the quarter, reflecting higher pension-related costs. Net interest expense was $208 million in the quarter, an increase of approximately $30 million over Q2 of 2011, which is a function of both lower net interest income and higher average debt balances. Our core tax rate for the quarter was 27.8%, which is 180 basis points higher than the rate in Q2 of 2011, driven by country mix and the favorable resolution of some tax items in Q2 of last year. Finally, our fully diluted share count was down 1.5% in the quarter compared to the prior year period, reflecting the impact of our share repurchase program. So in total, below-the-line items, mainly pension-related expenses we record at the corporate level, interest, and tax rate, offset somewhat by the benefit of the reduced share count, drove about 3 points of deleverage from our core constant currency division operating profit decline of 1% to our core constant currency EPS decline of 4%. Now turning to our outlook. We anticipate continued strong net effective pricing, which will contribute to net revenue growth, but expect continued impact from negative currency translation and from the deconsolidation of revenue related to structural changes. We expect continued commodity cost pressures. Our current outlook on commodities is consistent with our previous outlook at about $1.5 billion for the full year. As Indra mentioned, we are on track to deliver productivity of more than $1 billion this year, which represents a substantial increase versus our historical productivity target. The incremental productivity is largely driven by the restructuring program we announced earlier this year. A majority of the restructuring actions have already taken place, and we expect the remainder will take place over the course of this year, so the productivity benefits should accelerate as we move through the year. We are investing more in A&M this year to support our brands, and we are making incremental marketplace investments in routes and racks. We expect A&M as a percent of sales to increase by approximately 50 basis points on a full-year basis. We began to put more media in the market in the first half, but the increase in A&M expense as a percent of net revenue in the P&L will actually be more pronounced in the back half based on how the accounting curve of the expense works. In fact, we expect A&M as a percent of sales will increase by approximately 100 basis points year-on-year in the second half, so you should model this increase into your operating margin and operating profit growth assumptions with the impact heavier in Q3 than in Q4. Below the division operating profit line, we expect an increase in corporate unallocated expenses reflecting higher pension costs related to the change in the discount rate and investments in productivity capability, with Q3 corporate unallocated expected to be a bit higher than what we saw in Q2 based on the timing of expenses. Full-year net interest expense is expected to be higher, driven by higher debt balances and higher rates as we have termed out some of our debt during the year. We expect our core tax rate to be approximately 27% for the full year, but with some level of variability between the quarters. Based on current ForEx market consensus, currency translation would have approximately 3 points unfavorable impact on our full-year core EPS, with the Q3 impact on both net revenue and operating profit estimated at approximately 5 points. As you model out the second half, you should be mindful of 3 structural changes we have mentioned where we will no longer record the revenue. First, we refranchised our Mexican beverage business in early Q4 of 2011. We adjusted our ownership in our joint venture in Almarai such that we are now in the minority. Finally, we entered our alliance with Tingyi, which closed on March 31. We estimate the impact of these changes will be an approximately 5-point drag on our reported net revenue in Q3 and approximately 3 points in Q4. The impact abates somewhat in Q4 as we lap the Mexico refranchising that occurred in Q4 2011. From a cash flow standpoint, year-to-date reported cash generated by operating activities was $1.2 billion, which includes a $1 billion discretionary pension and retiree medical contribution we made in Q1. Reflecting our capital spending productivity initiatives, net CapEx is down $338 million year to date and down more than 100 basis points as a percentage of revenue on a rolling four quarters basis. In addition, our working capital also improved year to date, with net working capital on receivables, inventory, prepaids, and payables improving by more than $300 million year on year. Our management operating cash flow, excluding certain items, improved by $28 million to $1.4 billion year to date. We returned $2.8 billion to shareholders year to date through dividends of $1.6 billion and share repurchases of $1.2 billion. For the full year, we expect to generate more than $6 billion in management operating cash flow, excluding certain items, and return more than $6 billion in dividends and share repurchases, including our previously announced increase in our quarterly dividend that took effect with the June dividend payment. Finally, from an earnings perspective, consistent with our previous outlook, we expect our core constant currency EPS to decline 5% for the year. Now, I realize that the first half came in a bit ahead of the consensus estimate, but you should not flow that through to the bottom line as you model the full year. As I mentioned, A&M expense, based on how it was curved in last year and in this year, will result in a substantial reported increase in the back half. In addition, if we have upsides in areas like commodities, our intention is to reinvest those in the business to support and accelerate our brand-building, innovation, and productivity initiatives. Net, the quarter came in as we expected. The pricing picture was positive and our outlook for the year for earnings, cash flow, and cash returns is exactly and completely consistent with what we previously shared with you. Now we will open the lines for your questions. Thank you. Once again, in order to ask a question or make a comment, please press star, followed by one on your touchtone phone at any time. Our first question is coming from John Faucher with JPMorgan. Thanks. You talked about the convenience store business doing better generally, which would imply, I guess, that the large format store business is probably struggling a little bit. Can you talk a little bit about some of the challenges there? Is it just fundamentally a consumer spending issue, or what color can you give us on the large format store business? Thanks. John, I am going to toss this over to Brian Cornell, and then maybe Al will carry. Brian, do you want to take it from here? Yeah. John, I think as you have seen, there has been considerable weakness in the core grocery channel. But that is being offset by growth in other channels, food service, C store, and certainly club. As we look at our business, we are managing through those channel mixes and making sure we are making profitable investments to grow our business and sustain the volume in those channels. Al, did you want to add anything? I would just add one thing. I just mentioned earlier, it's The microphone the discounting for holidays does a disproportionate amount of the business, and we need to spread the value throughout the month rather than just during those holiday peak periods. I think we're doing some work on that right now that I have optimism for in the future. Hey, John, this is Hugh. The only thing I'd add to that is, one of the things that's important to us in large format is that we have consistency in our pricing across the channels, and that's been a real point of emphasis for us. So to the degree that has something of an impact on volumes, particularly in areas like bottled water, where we're not electing to go chase that type of volume. We don't view that as detrimental to the performance of the business, nor do we view it as value-creating by chasing those things. So from our standpoint, we're trying to maintain consistent levels of pricing discipline across large format channels. Okay, thanks. Your next question comes from the line of Dara Mohsenian with Morgan Stanley. Good morning. Morning, Darrin. I was hoping for more color on trends in the gas and convenience channel post quarter end over the last month or so here in the U.S. Have you seen any type of slowdown, or is the momentum continuing there? What are your thoughts around the sustainability of some of the year-to-date strength, just given we saw weather boost first half results? This is Brian Cornell. We're seeing very consistent performance trends in both the convenience and gas channels. Their traffic trends remain strong. They're seeing broad growth across regions, but very consistent traffic and revenue gains. So it's a channel that's performing very consistently across the country, with strong traffic and revenue gains. We have not seen a slowdown. We've not seen any signs of slowdown in the C&G channel. I'd add to that and say that some time ago, the convenience business was losing a fair amount of their volume to cigarettes, and they've done a pretty good job of offering food service that I think has picked up their business. Our trends are very solid in the convenience business. Go ahead, John. Dara, the other thing that the teams are doing is a more coordinated effort across Power of One snacks and beverages, and I think particularly in the convenience and gas channel, that's a benefit to PepsiCo. What is it? We have 11 of the 15 top-selling SKUs in C stores. Yeah, 11 of the 15 top-selling SKUs, and as Hugh and Dara both mentioned in their comments, we're far and away the largest contributor of growth to the C store channel. Our Mountain Dew and Gatorade business is very strong in the small format. I think if you have innovation and good execution, the DSD system, we're able to drive growth in this channel. Traffic still seems to be okay, Dara. Okay, that's helpful. Al, at the Deutsche Bank conference, you seem to be more focused on using mix to drive CSD pricing longer term than we've heard from Pepsi in the past. Is that an increased area of focus, and can you discuss how much tangible incremental benefit we could expect from that focus over the next few years? You also mentioned managing the highs and lows from a pricing standpoint in terms of everyday versus holiday pricing more over time, and mentioned it again here today. It sounds great in theory, but it's often hard to execute day-to-day. In your mind, is that also a significant opportunity or something which takes a long time to play out? Well, I think two areas that will help us improve in the future in this is balancing out the value across the month in the large format, and we're working on that, but it's tricky. It will take us a little bit of time to get there. The second thing is to offer flexible package opportunities in that channel as well, which we're putting capacity and capability in our system right now so that in 2013, you'll see us offer more flex packaging, different packages, that will be variety packs and those kinds of things in the marketplace. Okay. Thanks. Your next question comes from the line of Bryan Spillane of Bank of America. Good morning. Morning, Brian. Hey, Brian. Just two questions related to the Europe and AMEA segments, and profitability, specifically. First, in AMEA, just what effect did the implementation of the Tingyi relationship have on the profitability in the quarter? I guess what I'm trying to drive at is, was there a profit lift that we realized in the quarter because of the structural change? Second, in Europe, just in Russia, the margin expansion there, the profit growth there, how much of that is a function of your pricing and maybe some improvement in the consumer? And how much of it is still structural benefits, so integration benefits from Wimm-Bill-Dann? And just trying to understand how much more runway we have in terms of margin growth there. Yeah. Hey, Brian, it's Hugh. Regarding Tingyi, we haven't disclosed specifics on the bottom line on that. Suffice to say, in the context of our overall AMEA business, we clearly got a bit of a benefit, but it was not by any stretch of the imagination, the big driver. The big driver was the organic performance of the business. On- Russia. Brian, on Russia, I'd say the performance is just very balanced across top-line initiatives and management of cost through productivity initiatives. Clearly, as we put these businesses together, we have tremendous scale benefits, as we drive supply chain consolidation, and that obviously is helping margin expansion. But equally, we're able to drive now a much more positive mix as we drive our brands into the convenience channel. Also, we build out innovation that is highly accretive to the margin mix. So it's a very good balance across both. Has the nature of the competition in Russia changed at all? You've got so many more multinationals now operating in that market. Has that affected the competitive landscape at all? Clearly, Russia is an attractive market for all of the multinationals. But we enjoy considerable scale and considerable operating history in Russia. What it's allowed us to do is to build a talented management team and a capability across many years. Our sources of competitive advantage are both scale and the development of the capability of our business over time. Thank you. Your next question comes from the line of Kaumil Gajrawala with UBS. Hey, everybody. I know you maintained your guidance on COGS inflation and such, but I just want to ask, given the drought situation, if there's something we need to be thinking about, perhaps about next year or maybe even perhaps from a supply chain standpoint, maybe there's not enough supply. Hey, Kaumil, this is Hugh. I'll handle this one. From the perspective of 2012, because of the forward buying or the hedging program that we have in place, really nothing to discuss in that regard. Obviously, and I've talked about this in the past, we're out about nine months, so we were also starting to buy into 2013, given that it was already June before the drought situation really started to hit and before prices started to pop in the last couple of weeks. The thing I would tell you in that regard is, while grains are certainly up, remember that there is no individual commodity that accounts for even 10% of PepsiCo's overall commodity buy. Grains are up. Aluminum's obviously moved in the other direction. Oil and all of the things that flow out of energy move in the other direction. Really nothing to report in terms of 2013 at this point, because we're not going to get into that until we get into pricing and get into more of the details of 2013. I do, though, just want to remind you that our basket of commodities is pretty broad. I know corn's certainly been in the news, but we buy an awful lot of other commodities as well, and the commodities numbers are moving both up and down, depending on the individual commodity. Okay, got it. If I can ask you, and maybe this is a softer answer, is operationally, obviously, earnings were a little bit ahead of expectations. You'll be spending that back behind the business. Is that an incremental spend? Are you further stepping up how much you're going to be spending on marketing versus what your initial plan was? Or is this part of the original plan? Yeah. Yeah. Right now, Kaumil, we're still basically saying we're going to spend 5.7%, which was the number that we originally put out for the year. But we'll obviously continue as the year evolves to look at opportunities and as the overall margin mix of the business comes in to the degree that we do have upsides, we will look to invest it behind brand-building activities. But note, the 5.7 is still the number that we're talking to right now. The one thing to keep in mind in that regard, though, is there is marketing that we spend in the A&M line, which shows up through SG&A. There's also marketing in joint ventures that gets reported just in the consolidated joint venture line. And then there's marketing that comes in the form of bottler support, but it's bottler support that is clearly A&M, that occurs between gross and net revenue. When we talked about 5.2% to 5.7%, we were talking specifically about the SG&A, and that's the number that we're still saying is going to be consistent. But to the degree that we choose to do more marketing through bottlers, you could see some of those numbers change as well. We'll talk about that in Q4 as to where all of the numbers came out. But the one thing I want to emphasize is there's no change in the 5.7% number. That's the number that we are managing to, and that's the number we'll look to hit. As the business presents more opportunities, we'll evaluate what types of brand-building investment opportunities are before us at that time. Got it. Thank you. Your next question comes from the line of Judy Hong with Goldman Sachs. Thanks. Good morning. Good morning. I just wanted to drill into Frito-Lay a little bit. From a share perspective, I know you talked about sequentially maybe getting a little bit better, and it looks like the C stores and non-measured channel doing a little bit better, but just sort of taking a step back, if you can just tell us kind of what you're seeing from a competitive perspective and just what's sort of holding back Frito-Lay from getting better more quickly. Then on the profit side in the quarter, I'm just wondering how much of the margin decline was commodities sort of still not being fully offset by pricing, and then how much of that was marketing spending step-up? Go ahead, Brian. As Indra mentioned, we took a very disciplined approach to managing revenue and our channel mix during the quarter. We're really focused on investing in brand building, innovation, and continuing to deliver the productivity initiative to Frito-Lay. I expect that's going to serve us well as we go into Q3 and Q4, and you're starting to see evidence of that in our P4 share results, particularly during the important Fourth of July period, where we grew share at Frito-Lay. So I think we're well-positioned right now to continue to see performance improvement in Q3 and Q4. We're going to continue to focus on being very disciplined in our revenue management and channel management mix, and continuing to invest in our brands and innovation to make sure that we can continue to deliver sustainable growth at Frito-Lay. Judy, if you recall, I think it was at CAGNY when John Compton presented, talked about the Frito-Lay business growing at the two ends, the value and the premium side. We had a very strong position in the middle. The middle continues to grow. We were looking for the right model to compete against the value segment of the business and the premium segment. The premium segment, we started to compete with our growth ventures business, and that's doing very well. Again, off of a small base, but it's doing well, and that growth will continue. Our challenge is to figure out the right model to play against the value players without impacting the middle. We wanted to make sure we did it the right way and not take down the pricing level of the middle. And that is why when Brian talked about playing the channels and the portfolio very carefully, we want to make sure that we keep the pricing in place and do not take it down, because getting pricing back in the market is much harder than tweaking the product portfolio to go against specific consumer needs. So as the year goes on, you will see improvement in Frito-Lay because we are fine-tuning the model and doing better as the quarters go on. Okay. Hugh, when you put up the slide with the brand strength, the equity scorecard Yep I think you said 85% of your core brands are showing improvement up from 81%. Can you give us a little bit more color just in terms of what brands you are actually seeing, maybe a better improvement versus what are the 15% that is not showing improvement? Yeah. To talk to the ones that are doing better, Lay's was notably strong in the quarter. We really saw terrific results on Lay's. Gatorade, we also saw terrific results on. The Lemon Lime, still a little bit more work to do. That's the brand equity scores or the share scores? Those are the equity scores. Equity score. Okay, got it. Thank you. Your next question comes from the line of Caroline Levy with CLSA. Good morning, and thank you for the increased disclosure on brand equity health and so on. I think it is extremely helpful. I just wanted to follow up on Judy Hong's question on, if you could talk about brand Pepsi, which is the centerpiece of everything you are doing, just in terms of what we can look for, what you have seen so far. I know it is very early, but it is such a huge brand within the total company. I would like to also understand what we can look for as progress measures in the Tingyi JV going forward now. Al, you want to talk about brand Pepsi? Yeah. Brand Pepsi, the campaign began in about April, and it is very early to try to indicate whether or not we are seeing a result. But the thing that I like to look at is our single-serve business, which will be a first indicator, and that is usually not impacted by these holiday discounting and overlaps. So we see growth in brand Pepsi on single-serve for the first time in a very long time. Our brand equity scores have improved for the second quarter. So some improvement. We have Pepsi Next in the marketplace that is delivering about what we expected. Very happy with it. In the just recent few weeks, we have just launched a new TV campaign and also two new flavors of the product. So, let us stay cautiously optimistic on that brand. On China, Al, do you want to give some color to Yi? Yeah. Hi, Caroline. How are you? Hey. We really feel good about the progress of our transitioning our business in China to Tingyi. As you know, we got the approval at the end of March, and we've spent the months of April and May and big part of June transitioning our business into our partner. We've moved upwards of 20 plants and about 20,000 employees into that. Now I think the transition is complete. We're going to see sequential improvement into our volumes. Basically, there are three areas where we will see huge improvements as we go Q3, Q4, and for next year. One, new areas, wide areas we will have accessible to us that we would not have before. Two, we will have production availability for water and other products, such as Gatorade. Thirdly, we will benefit a huge deal from the distribution strength of Tingyi. We really feel good about that alliance, and we're going to start bearing the fruit Q3 and going forward. That's very helpful. Thank you. Can I also just clarify, I think you said you did raise your efficiency targets for the total company. Can you just remind us how much you've increased that now? Yeah. Caroline, this is Hugh. No, I am sorry. We did not raise the efficiency target. We said $1 billion plus this year, $3 billion over three years, and that is exactly where we are. No change on that at all. Okay. Thank you so much. Your next question comes from the line of Bill Schmitz with Deutsche Bank. Hi, good morning. Hi, Bill. I have a long question because I'm sort of confused on some of the numbers. I think you said U.S. media spend was up 40%, and then you look at sort of the year-over-year SG&A, and it was down. Then I think you said 100 basis points increase in that ad ratio in the back half of the year, which sort of implies that there was sort of flat advertising ratio on the front half. Then to kind of take it a step forward, I was looking at the PepsiCo Americas Beverages margins. Given that shift away from the center store and towards the C stores, you would've thought you would've seen a little bit bigger uptick in the margin structure. Can you sort of square this for me? I know it's a long question. Yeah. Bill, why don't I take a shot at that? Because that's a big cause of change you just laid out. First and foremost, the thing to keep in mind is the way we talk about media, that's publicly reported media data, okay? At the same time, when we talk about advertising and marketing expense, which is obviously inside of SG&A, that's curved over the volume curve during the course of the year. You have to consider those numbers from two perspectives. Number one, what's happening this year with the curve, and then number two, what's happened last year with the curve. The way our curve worked last year was you saw the A&M number fall off during the latter portion of the year. So we had, from an expense standpoint, more of the spending in the first half of the year, relatively speaking, compared to the 2012 timing of the spend. So it's almost impossible to connect the media number to the A&M expense in the P&L. I wouldn't spend a whole lot of time doing that. What I wanted to do when I gave you the A&M expense timing comments was not so much to tie to the media spend, but rather to connect the fact that the year-over-year impact in H1 versus the year-over-year impact in H2, it's much more substantial in H2. So hopefully that kind of addresses your A&M question. Regarding the bottling or the beverage PAB business and the impact on margins, there's two things to keep in mind there that are also important to balance out. On the one hand, the convenience store business performance was strong. On the other hand, the inflation that we have inside of PepsiCo, and particularly in beverages, is much more front-loaded than it is back-loaded. Those two are probably having something of an offsetting effect. Therefore, in the back half of the year, you should see the margin impacts start to improve really in the PAB business in the back half of the year due to the commodities overlap timing muting, while we certainly expect the C store business to continue to perform well. Great. Thanks. Just a quick follow-up. Did you see any benefit from the PET deflation? I think that's one of the few commodities you can't hedge out nine months, and I think a lot of your competitors have talked about some relief there. Yeah, Bill, we actually can hedge out PET pretty well, because of the nature of the relationships that our global procurement team has created. You're right in saying there's no market to do that. But through suppliers, we've been pretty successful in moving our PET buy further and further out over the last couple of years. So in terms of your question on any benefit, the answer is basically nope. From our perspective, the commodities for this year have been largely hedged out for a couple of months now, so not a whole lot of change going to be coming in the balance of the year on that. Great. Thank you very much. Yep. Your final question comes from the line of Ali Dibadj with Sanford C. Bernstein. Hey, guys. Hi, Ali. Hi. Wanted to follow up on a couple things and ask a third slightly different question. Just to follow up on Frito-Lay North America. in February, and I think since then, we've also heard you guys still expect flat volumes, flat margins. Now, that's a little bit better than what we've seen in the first half of the year, and it sounds like you're expecting an inflection as you go into the back half of the year for Frito to maintain that flat margin, flat volume expectation for the year. Is that the right way to interpret your comments today? Oli, it would be. I think we expect to see improved performance in the third and fourth quarter. The benefits of our investments in brand, the continued focus on innovation and productivity should show improvements in our third and fourth quarter results. Okay. Oli, we started the year across all of PepsiCo saying, "Don't chase volume for the sake of volume. Chase share in a very responsible way." We've tried to balance volume, pricing, revenue, and profit in a very balanced way through the first half of the year. Okay, so still sticking to flat margins, flat volume for the year for Frito. Yep. Okay. Then on PAB, the volumes, whether it be negative 1% or negative 1.4%, were I guess a little bit lower than what I'm hearing some folks had expected. Can you help us disaggregate that? I know you're going to do it in your Q, but disaggregate that between North America and the rest of PAB, Latin America, and then also between CSDs and stills, just to give us a sense of where the volumes were looking for each of those segments. Yeah, Ali, this is Hugh. From the standpoint of CSDs, again, our focus was first and foremost on let's make sure that we get the right pricing into the marketplace, and let's make sure we maintain the consistent funding behind the brands and behind the innovation that we've launched this year. As you know, because you've been around the consumer space for a while, when you're doing brand building and innovation types of build, it takes a bit longer for those things to get traction. But when they get traction, they're more advantaged than simply dropping price. That's the strategy that we've chosen to follow, and frankly, the expectations that we had for the volumes in the business are basically right on where we would've expected them to come out, both from a volume perspective and from a market share perspective in terms of the reported market share numbers that are out there. Regarding the other piece, the non-carbs in the overall volumes, I think the other factor that you have to consider is around this whole area of water and in particular case pack water. We're in the business, we promote it sufficiently to stay in the business, but we're not interested in chasing case pack water pricing down. We just don't think that's the right strategy for us. We do think it's an important part of the overall Aquafina business, but we promote it just enough to really maintain our relevance. On the other hand, the single-serve side of water is obviously a great business. It's a profitable business. We like that business quite a bit, but we're not interested in chasing volume just by promoting case pack water at the end of the quarter. Ali, the other thing too is we don't have as much of a tailwind from the distribution of energy drinks as anybody else might have. Second, our food service business is substantially different. As you know, our footprint is very different, and therefore, our food service volume uplift is overall lower than it might be for other people. So if you take into account these fundamental structural differences in our respective businesses between us and competition, you'd see that we held value share, which is what we are focused on in the measured channel business. On food service, we gained share, but from a very small base. The energy drink is a big wildcard and something we distribute, but we don't get as much tailwind as the market does. Okay. That makes sense from the spirit of the answer, but would you care to offer numbers on North America CSD volume growth, Latin America, still, et cetera? If you broke that down, would you care to offer those? I think a lot of that will be in your Q, but I am just trying to get a head start on that. Yeah. Basically, the way the numbers came in, North America volumes were down 2%. North America volumes on CSDs were down 4%, and non-carbs were up 1%. Okay, cool. Then there is the last thing, if you would indulge me. I guess we do appreciate, you have heard this from others as well. But we appreciate the change to how you are disclosing things like organic growth. For us at least, that has been very helpful in understanding how you actually are operating. If we could push for another potential change or at least some clarity is within SG&A. I think it might help answer some part of Bill Schmitz's question a little while ago as well. In your SG&A, obviously you put your JVs. So there is a bunch of income with no revenue attached to it, whether it be Lipton or Tingyi or Starbucks or Müller or Almarai, I am probably missing a few. So it is difficult for us, at least for me, and maybe I am just missing something, to figure out what your real SG&A productivity is or what your real level of improvement is at the overall company level, but also at the, perhaps even more importantly, at the operating segment level. Is there a consideration to split that out as you go forward, given that it has become a big chunk, number one? And number two is to the question part, can you help us understand what was the actual operating leverage on SG&A if you excluded those JV incomes that you report through that line item? Yeah. Olly, this is Hugh. I hear your feedback on that one. One of the things that we do every year is we both look at the disclosure to ensure that we're maintaining the right level of transparency without obviously giving away anything that would be competitively sensitive. SG&A would be less concerning in that regard, although I'm not crazy about the idea of breaking out JV profitability. Hear your feedback on that. We, at the same time, also look at other big multinationals, and we're trying to position ourselves where we're certainly at or better than most in terms of disclosure. At a certain point, it also makes sense to limit the amount of disclosure based on, frankly, not giving away competitive information. So I appreciate the perspective. We're going to take a look at it again during the course of the fall as we think about 2013. Perhaps we can talk offline a little bit more about some of the detailed thoughts that you have on that. Be helpful to get your point of view. Olly, I have to tell you one thing. When we look at productivity, we look at every item of the cost structure, including G&A. What's the corporate unallocated? What's the infrastructure running to the sectors? Are we actually making that bucket more and more efficient over time? From an internal management of the cost structure, believe me, we are maniacally focused on any sort of overhead structure to run this company. Based on all of our benchmarks, our core G&A to run the company is among the lowest of any multinational company. So we feel good about the way we are managing G&A. Okay, thanks very much. Let me just close by saying Q2 marks good progress against a clear focus game plan that is allowing us to compete effectively today while positioning us for sustainable long-term growth and shareholder value creation. You have my and our entire leadership team's commitment that we will continue to act with great urgency to deliver against our 2012 targets and our strategic objectives. Let me close by thanking you all for joining us and for the confidence you have placed in us with your investment. Have a great day. Thank you. This concludes today's PepsiCo second quarter 2012 earnings conference call. You may now disconnect.