Good morning and welcome to PepsiCo's Second Quarter 2017 Earnings Conference Call. Your lines have been placed on listen-only until the question-and-answer session. [Operator Instructions] 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. With me today are Indra Nooyi, PepsiCo's Chairman and CEO, and Hugh Johnston, PepsiCo's CFO. We'll lead off today's call with a review of our second quarter 2017 performance and full-year outlook, and then we'll move on to Q&A. We've kept our comments brief and intend to conclude the call by 8.30. Before we begin, please take note of our cautionary statement. This conference call includes forward-looking statements, including statements regarding 2017 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 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 EPS and operating profit growth are on a core constant currency basis. All references to free cash flow exclude certain items. In addition, references to organic revenue results in this call exclude the impact of acquisitions and divestitures, structural changes and foreign exchange translation. To find disclosures and reconciliations of non-GAAP measures that we use when discussing PepsiCo's financial results, you should refer to the Glossary and other attachments to this morning's earnings release and to the Investor section of PepsiCo's Web-site under the Events and Presentations tab. Now it's my pleasure to introduce Indra Nooyi.

Thank you, Jamie, and thank you all for joining us this morning. I am pleased to report that our second quarter results were very much in line with our expectations and that we remain on track to meet our full-year 2017 financial goals. For the quarter, while our reported results continue to be impacted by macro volatility and weak currencies, organic revenue was up more than 3% globally, a sequential acceleration from our growth rate in the first quarter. We generated organic revenue growth across both developed and developing and emerging markets, with developed markets up 2% and D&E markets growing 6%. The portfolio generated strong net price realization and core constant currency operating profit grew 7%. Core constant currency EPS grew 13%. Our results reflect the power and durability of our portfolio, its ability to deliver sustainable and well-balanced results, despite ongoing pockets of macro and geopolitical challenges in a number of our key markets around the globe, and in an increasingly dynamic retail and consumer environment. Let's briefly review the performance in the quarter across our sectors, starting with North America where organic revenue grew 2% and core constant currency operating profit was up 4%. Importantly, year to date through the second quarter, we have also generated more U.S. retail sales growth than all other $5 billion-plus manufacturers combined. Frito-Lay North America had another very strong quarter. Volume and organic revenue accelerated sequentially from Q1, as we expected, and results reflected a very good balance of volume growth, net price realization and margin expansion. We feel very good about the business, with innovation, pricing and execution, all on target. We are pleased to report that Frito-Lay alone was the number one contributor to total U.S. food and beverage retail growth by all $5 billion-plus manufacturers through the end…

Thank you, Indra, and good morning everyone. Let's move to our outlook for 2017. Looking ahead, and as we set out in the release, we continue to expect organic revenue growth of at least 3%, fueled by successful product innovation and strong marketplace execution but tempered by a cautious macro outlook. Based on current market consensus rates, foreign exchange is expected to negatively impact full-year reported net revenue by approximately 2 percentage points, consistent with our previous guidance, and negatively impact core EPS by approximately 2 percentage points, which is a 1 point improvement from our previous guidance. We intend to reinvest the Britvic share sale gain in the balance of the year, so I would encourage you not to flow through the impact of the gain in your full year models. Given the variety of macro issues we are facing around the globe, we think it is prudent to use this upside to strengthen the business. As a result of the improvement in foreign exchange outlook on earnings, we now expect core earnings of $5.13 per share. This reflects core constant currency EPS growth of 8%, offset by the 2 point Forex impact. In terms of other key considerations and assumptions embedded in our full-year outlook, we continue to expect raw material inflation driven by both an increase in our basket of commodities and additional pressure from transaction Forex. We continue to expect core operating margin expansion, fueled by our productivity programs, and we continue to expect our core effective tax rate to be approximately 24%. Turning to cash flow, we expect to continue to generate strong cash flow and to exercise discipline over capital allocation, with prudent reinvestment into the business and the majority of our free cash flow excluding certain items to be returned to shareholders through…

[Operator Instructions] Your first question comes from the line of Dara Mohsenian of Morgan Stanley.

So Indra, I was hoping you could give us some perspective on the U.S. CPG environment. Obviously it's been weak year to date, but also specifically in Q2 we have seen category weakness across the board, including in your segment. So, I was hoping for detail on what's driving the softness in your mind from a consumer standpoint across CPG, are you seeing any signs of improvement in Q3? I guess your comment on the tough top line comparison might indicate you are not so far. But any reason to think basically that consumer outlook may improve in the back half of the year? And then specifically on your business, the flat Frito-Lay North America volume results in Q2 were essentially flat. Do you think that will improve in the back half of the year, and how concerned are you also on the U.S. carbonated soft drink side by the year-over-year market share losses and plans to improve that going forward?

That was 10 questions, Dara. That was 10 questions very wonderfully rolled into one, but we're going to try to answer every one of those. Let me start by saying that I think you are beginning to see the limitations of the syndicated data, because as I mentioned in my script, the channels are beginning to blur between food service, retail, home delivery, restaurants, everything, the channels are beginning to blur. And when you have blurring channels, you now have a shopping occasion being replaced by home delivery or replaced by a meal delivery of kits. So what we have to do is rethink what is the real growth of the marketplace, the food and beverage marketplace, in a much more holistic way. There's no question that the syndicated data showed a slowdown in the overall market I'd say in the first half. Rather than talk about quarter to quarter, let's just talk about the first half. Slightly south of 2% is what we saw in the first half. But I think if you include a much broader definition of the market, I think you're going to see what the traditional growth is, which is population plus some, more in the range of somewhere between 2% and 2.5%. I think that's what you'll see as an overall growth rate. I think we all as manufacturers have to start to rethink how we serve this multiplicity of channels and how we should retool our business models to serve every one of these fragmenting channels. That's the challenge all of us have and we have been looking at that very, very carefully. Now let's talk a little bit about the category weakness. I think, on salty snacks in particular, let me speak to that. I have belief, and we watch volume, revenue…

Your next question comes from the line of Steve Powers of UBS.

Actually, I was hoping we could maybe just clean up a little bit on both those two topics, Frito-Lay and North America Beverages. On Frito-Lay, the 3.5 points of net pricing this quarter, is there a way to just frame how much of that was rate versus the channel or package mix premiumization that you called out, Indra, versus maybe some lingering sober effects? I'm just trying to figure out what's driving that price, because to the extent I think the concern is that the price gap gets too wide and that becomes problematic on volume. Just like to hear your explanation there. And then on North America Beverages, I was hoping you could also give more color, maybe a quantification on the favorable legal settlement, Hugh, and the promotional spending accruals that helped segment profit there this quarter? I think that's the second quarter in a row where we've had favorable promotional spending accruals, and I'd just love just to better understand the magnitude and the dynamics there. So thanks for both.

Happy to answer both of those, Steve. In terms of price versus mix in Frito, round numbers it was about 2 points price and about 1.5 points of mix. Mix, as Indra mentioned, is driven by premium products such as Lay's Poppables. So when you are selling a potato puff, you are obviously filling the bag with less weight than you would say with a bag of Fritos. So we think that's a good win for the consumer and it's obviously a good win for us as well.

And it's a great tasting product.

Fantastic tasting product. In terms of the legal settlement and the other items that you mentioned, it was in the teens in millions. So, it was not small number but not a gigantic number by any stretch of imagination.

Your next question comes from the line of Ali Dibadj of Bernstein.

Wanted to touch on two topics, if I could please? One, in your first answer this morning around changes of channels and shift that you mentioned in your prepared remarks as well, have you guys really figured out how to sell impulse online well, how do you get that cold icy package, or quick $0.89 or $0.99 bag of Lay's to really resonate online without the immediacy of that channel? It seems to be becoming a bigger and bigger deal, given just lower foot traffic in brick-and-mortar. So I'd love to hear your philosophy on that. The second topic, I want to dig a little bit deeper on, and a few folks mentioned early, Steve mentioned, secondly on operating margins more broadly, so just hoping if you could quantify operating margins, the impact of productivity, the impact of commodities, the impact of promotional spending accrual settlements, as well as the marketing spend? Because if I look at two of those in particular on productivity, and we've heard for many, many years now, we know doing all those cost savings on an annual basis, but we don't actually see your SG&A as a percentage of sales particularly low versus peers even with some adjustments given bottler structure, et cetera, and we are now starting to see core operating margins have difficulty expanding, in fact they were down 10 basis points this quarter. So, is it that the low hanging fruit is most difficult, is harder to get now, I mean the lowest hanging fruit I guess is gone and it's hard to show? So, I'd love some more detail after quantification on productivity. And on marketing spend, you did increase marketing spend in FLNA, QFNA, NAB, AMENA this quarter, it looks like year-to-date as well, and that's where you're seeing volume struggles. And on the one hand, you could say, one could say, well, that's causality, so no ad spend growth leads to challenged volume growth, or actually is it judicious decision-making because those markets aren't going to grow anyway? So I know there's a lot packed in there but it's really around the second part, the topic of operating margins please. Thanks.

So, I'm going to let Hugh get all the answers ready for the 10 questions you asked in operating margin, Ali. Let me talk about the changes in channels. We are all figuring it out as we go along. The good news is, our e-commerce business is growing brilliantly. We are doing very, very well. We are not yet ready to talk about it in any significant way. Maybe in the next couple of calls we will start focusing on that. But it's growing really, really nicely. But it's growing with our traditional products and our traditional packaging, if you want to call it that. There is clearly an opportunity for us to think about innovation for e-commerce, which is what we are all focused on. We want to make sure that our snacks are more shippable, not just in click and collect, but more also for delivery, so that the cube efficiency is there. And on beverages, I think there are two issues. One is the cold delivery of the beverages, if consumers so desire ice-cold beverages delivered to them, which I find it hard to believe, but you can never tell. And then how do we make sure that we address this whole delivery of water, because beverages is largely water. So we are looking at meaningful innovation, both in snacks and beverages, in order to address the exploding growth of e-commerce. And with our big brands, I think we are well-positioned. Now let me come to the impulse nature of our products. I think the whole e-commerce area is going to be impulse as you see it in a brick-and-mortar store, which then translates to e-commerce and then becomes part of a replenishment cycle. But then as people stop going to brick-and-mortar and start shopping only on e-commerce, which well could be the Gen-Z, the new I-generation, if you want to call it that, I think the new digital tools can easily afford you the ability to create the impulse experience online. We have seen so many virtual reality tools right now that can actually simulate grocery stores or whatever version of a grocery store you want online, and you can easily navigate the aisles and just with a click shop for whatever you want. So, I think in an interesting way there's infinite possibilities to create impulse all through technology online, and I think as this market matures and evolves, you're going to see a lot of that happening, and we are focused on developing all of these tools ourselves with our e-commerce partners to make sure that we are responsive to them when they so choose to go that way. So with that, let me turn it to Hugh to give you the [treaties] [ph] on operating margin. Go ahead, Hugh.

Sure, happy to. Ali, a couple of comments on that. First, as we pointed out at the beginning of the year, we expect to see operating margin improvement strengthen as we go from the front half to the back half. That's what you saw from Q1 going to Q2 and that's what you'll see as we head into the back half of the year as well. So, I think things generally are tracking to our expectations. Regarding advertising and marketing spend, we have said many times that we would invest further in A&M to the degree that we saw a return on investing further in A&M. As we move from 5.2% of sales to 5.7%, that was a move to get more competitive, as we have moved over the past four years from 5.7% to about 6.7% of sales. Those were all based on good ROI. So, I think you'll see the A&M change as we introduce new products or as we see opportunities to earn a good return. We're not going to blindly put money into A&M. Do I think you'll see A&M going backwards? No, I don't expect that to be the case in a meaningful way. It could go forward to the degree that we see good investment opportunities. More broadly on productivity, truthfully I think we have years of productivity still in front of us. The cost bucket that we evaluate productivity against, what we call OpEx, is about $28 billion. It's got a natural inflation rate of 3% to 4% per year. So as we continue to drive 4%-ish types of productivity, you see that bucket basically staying relatively flat. I do expect that we will, as we have guided in the past, continue to see steady margin improvement while we reinvest in growth. So, I think overall, the margin versus growth equation is one that hasn't changed much relative to where we have been in recent years.

And I think, Hugh, it's fair to say that with the changing marketplace, where there's blurring of retail channels, the consumer preferences changing, the marketing models changing, we have to invest in these new capabilities in order to generate the top line growth we are generating. So, we intend to continue to invest judiciously in these new areas, so we can sustain our top line growth globally.

Absolutely.

Your next question comes from the line of Bryan Spillane of Bank of America.

What are the questions that I guess or themes that have come up this year, specifically in North America, has been I think with all the changes in the retail environment, some concerns about pricing, and you have seen it especially in the food industry with the food stocks and how they have performed this year, and I think generally the concern is that there is going to be more sort of deflationary pressure at retail as retailers try to drive some traffic or keep customers, so can you kind of talk to how you're thinking about that, not so much for this year but over the next few years, do you think that there is going to be maybe a need to just maybe change the way you have thought about pricing philosophically, just given the changes in the channel?

We model out different channel shifts, what could be the pricing implications, we look at analogs from Europe when there were lots of retail disruptions, and then we look at what do we need to do to get innovation-driven pricing, mix-driven pricing, and then what do we need to offset the productivity, how do we need to go deeper on productivity programs. So Bryan, what we do do is model this out constantly, we look at multiple scenarios, and then we figure out how to get the best blend of top and bottom line growth in a changing retail environment. The good news is that as the retail environment shifts, we just have to retool our model for the retail environment shifts. The market is still growing, that's the good news, and these are huge categories. So, our goal is to capture the growth with a changing environment with our innovation and our big brands. That's why we focus so much on innovation because we believe innovation can actually create consumer demand and get us the price premium, and then we keep investing in our brands, both at the big brand level and the emerging brands like KeVita and Naked, so that we can grow our business on both ends of the spectrum.

Your next question comes from the line of Mark Swartzberg of Stifel.

In February, we came to an interesting point in history, it was the five-year anniversary of your rebasing earnings, and no doubt the environment remains and arguably has become more challenging, but this year we are at just shy of 3% organic revenue. If you look at 2012 through 2016, you were at 4s and 5s. And we spent time in this Q&A talking about the need to invest. So my question is simply, headwinds are always there, they are always changing, but when you think about your internal capacity to invest, and of course that relates to the resolve to cut costs and where you put that money, do you think, A, that the need to reinvest is getting greater, that you have to actually pick up the pace of investment because of the headwinds getting harder, and then B, if it is getting harder, do you think you have the resources, the ability to even up the productivity target to address that greater pressure?

I don't know about harder, they are different. I think it's different buckets, different areas, some areas that we are comfortable with, some areas where we have to develop new muscle, but that's part of life in our food and beverage industry. I've been in PepsiCo for 23 years and every five years or so there is a brand-new skill we have to develop. And this place is amazingly resilient, we develop the muscle, we hire from the outside when we have to, we retrain, and then we go on. So, I wouldn't say it's getting harder, I'd just say that it's different buckets and we have to put in the work to make sure that we can deliver growth in this new environment. As I said in response to an earlier question, we are looking at how much productivity we need to deliver to offset any price inflation if it happens because of retail disruption. So, we are constantly looking at how we need to balance top line and bottom line growth, and clearly productivity is a major factor in bottom line growth delivery. So we are looking at that. Hugh, did you want to add anything to that point?

No, I think you captured it effectively. I do think we are doing different than new skills but that's something to be expected. And as far as having the resources, I think we can continue to drive sufficient productivity to stay ahead of the wave.

And I think a lot of the new technologies actually allow us to deliver more productivity. We just need to – I think the key thing people have to take away is that in order to deliver productivity downstream, you have to invest upstream. So you have to invest today to get the benefits tomorrow. Benefits don't come out of thin air. And so, what we are doing is investing today to get more productivity downstream.

Your next question comes from the line of Pablo Zuanic of SIG.

Just a question on, maybe it's going back in time, but 15 years ago the industry went through significant consolidation with Quaker, Kraft/Nabisco, General Mills/Pillsbury, Kellogg/Keebler, and we are talking about the significant changes taking place in the retail channel, we have seen retail consolidation, consumer changes, e-commerce, do you think the industry needs to as you mentioned develop new muscles, and a way to do that, that we should see another consolidation wave in the industry? I mean, yes, I'm asking a little bit from an industry point of view but also from a Pepsi point of view, does size being bigger help to adapt to these new changes or what happened 15 years ago in hindsight was a wrong answer, that wave of consolidation? And just a quick follow-up, if Unilever were to change hands, I suppose that you could lose the Lipton agreement, right, you would be probably – there would be a penalty that you will need to be compensated, but I assume that that contract would be taken away, if you can expand on that? Thank you.

So, first of all, we don't lose the Lipton business even with change of hands. So I would rest assure that we are protected there. On this whole industry outlook, Pablo, I think you guys on the sell side are much more knowledgeable about industry and industry trends, because you've been following it for such a long time. We actually read your reports to get insights into where you think the industry is going. So I'd rather depend on your opinions here and we'll keep our opinions to ourselves on this one.

Your next question comes from the line of Lauren Lieberman of Barclays.

I just wanted to follow up again on the scanner conversation and just specifically relative to your business on North America Beverages, because the scanner data and your results have really been diverging 300, 400, now I think 450 basis points this quarter. So if you could just talk a little bit about where the sort of untracked data is coming from? And then the other piece was that at least in the scanner data, both Mountain Dew overall, and specifically Kickstart and Gatorade, slowed dramatically, both of those down double digits. So if you could just talk a little bit about that, with anything specific plans you may have where you are anticipating those to recover, at least to get in the tracked channel piece of it? Thanks.

Thanks Lauren for the question. First of all, we don't reconcile our data with the scanner data. We just keep running the business and just we keep selling, we keep making sure that our product is on the shelf. Remember, we are high velocity products. So, we know on a weekly basis exactly what we sell and what's being pulled by the consumer. So we have good data on what's happening in the marketplace. I have no idea why the scanner data diverges so much. It's been happening in many markets and I think it reflects some of the limitations of syndicated data and they need to go back and retool it, but we are very comfortable where we are and we are just going to keep running the business this way. So with that, let me thank you for your questions, and to summarize, we are pleased with our results for the first half, we remain on track to deliver our full-year financial targets, and we feel well-positioned to continue to perform well, even in the midst of change and disruption. Thank you very much for joining us this morning and for the confidence you've placed in us with your investment.

Thank you. That does conclude today's PepsiCo's Second Quarter 2017 Earnings Conference Call. You may now disconnect.