Pepsi 2006 Annual Report Download - page 37

Our open commodity derivative con-
tracts that do not qualify for hedge
accounting had a face value of
$196 million at December 30, 2006 and
$129 million at December 31, 2005. The
open derivative contracts that do not
qualify for hedge accounting resulted in
net losses of $28 million in 2006 and
$3 million in 2005. We estimate that a
10% decline in commodity prices would
have increased our net losses on open
contracts to $31 million in 2006 and
$4 million in 2005.
We expect to be able to continue to
reduce the impact of increases in our
raw material and energy costs through
our hedging strategies and ongoing
productivity initiatives.
Foreign Exchange
Financial statements of foreign
subsidiaries are translated into U.S. dol-
lars using period-end exchange rates for
assets and liabilities and weighted-aver-
age exchange rates for revenues and
expenses. Adjustments resulting from
translating net assets are reported as a
separate component of accumulated
other comprehensive loss within share-
holders’ equity under the caption
currency translation adjustment.
Our operations outside of the U.S.
generate approximately 40% of our net
revenue, with Mexico, the United
Kingdom and Canada comprising
approximately 20% of our net revenue.
As a result, we are exposed to foreign
currency risks, including unforeseen
economic changes and political unrest.
During 2006, net favorable foreign cur-
rency, primarily due to appreciation in
the Canadian dollar and Brazilian real,
contributed almost 1 percentage point
to net revenue growth. Currency
declines which are not offset could
adversely impact our future results.
Exchange rate gains or losses related
to foreign currency transactions are rec-
ognized as transaction gains or losses in
our income statement as incurred. We
may enter into derivatives to manage
our exposure to foreign currency trans-
action risk. Our foreign currency
derivatives had a total face value of
$1.0 billion at December 30, 2006 and
$1.1 billion at December 31, 2005. The
contracts that qualify for hedge
accounting resulted in net unrealized
losses of $6 million at December 30,
2006 and $9 million at December 31,
2005. We estimate that an unfavorable
10% change in the exchange rates
would have resulted in unrealized losses
of $86 million in 2006 and $81 million in
2005. The contracts not meeting the
criteria for hedge accounting resulted
in net losses of $10 million in 2006 and
net gains of $14 million in 2005. All
losses and gains were offset by changes
in the underlying hedged items, result-
ing in no net impact on earnings.
Interest Rates
We centrally manage our debt and
investment portfolios considering
investment opportunities and risks, tax
consequences and overall financing
strategies. We may use interest rate and
cross currency interest rate swaps to
manage our overall interest expense
and foreign exchange risk. These instru-
ments 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 2006 and 2005
variable rate debt and investment lev-
els, a 1-percentage-point increase in
interest rates would have decreased net
interest expense by $10 million in 2006
and $8 million in 2005.
Stock Prices
A portion of our deferred compensa-
tion liability is tied to certain market
indices and our stock price. We manage
these market risks with mutual fund
investments and prepaid forward con-
tracts for the purchase of our stock. The
combined gains or losses on these
investments are substantially offset by
changes in our deferred compensation
liability.
Our Approach to Managing Risks
The achievement of our strategic and
operating objectives will necessarily
involve taking risks. Our risk manage-
ment process is intended to ensure that
risks are taken knowingly and purpose-
fully. As such, we leverage an
integrated risk management
framework to identify, assess, prioritize,
manage, monitor and communicate
risks across the Company. This frame-
work includes:
• the PepsiCo Executive Risk Council
(PERC), comprised of a cross-
functional, geographically diverse,
senior management group which
identifies, assesses, prioritizes and
addresses strategic and reputational
risks;
• Division Risk Committees (DRCs),
comprised of cross-functional senior
management teams which meet reg-
ularly each year to identify, assess,
prioritize and address division-specific
operating risks;
• PepsiCo’s Risk Management Office,
which manages the overall risk man-
agement process, provides ongoing
guidance, tools and analytical support
to the PERC and the DRCs, identifies
and assesses potential risks, and facili-
tates ongoing communication
between the parties, as well as to
PepsiCo’s Audit Committee and Board
of Directors; and
• PepsiCo Corporate Audit, which con-
firms the ongoing effectiveness of the
risk management framework through
periodic audit and review procedures.
In 2006, we continued to focus our
mitigation efforts where it was deter-
mined that actions were necessary and
appropriate to further reduce PepsiCo’s
exposure to risks, integrating those
efforts in our businesses’ operating
plans and budgets, where accountabil-
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We do not use derivative
instruments for trading or
speculative purposes.
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