DERIVATIVE INSTRUMENTS

Our policy prohibits the use of derivative instruments for trading purposes, and we have procedures in place to monitor and control their use. Our current use of derivative instruments is primarily limited to interest rate swaps and collars and commodity futures contracts.

Interest rate swaps and collars are entered into with the objective of reducing the volatility in borrowing costs. In 1998 and 1997, we entered into interest rate swaps to effectively convert a portion of our variable rate bank debt to fixed rate. Payment dates and the floating rates indices and reset dates on the swaps match those of our underlying bank debt. At December 26, 1998, our payables under the related swaps aggregated $1.6 million.

Interest rate collars are entered into with the objective of reducing the impact of variable interest rate changes in our bank debt thereby reducing volatility in borrowing costs. In 1998, we entered into interest rate collars to guarantee an upper (cap) and lower (floor) level of interest rates associated with a portion of bank debt. Collar reset dates and indices match those of our underlying bank debt. We make payments when interest rates fall below the floor level. We receive payments when interest rates rise above the cap. At December 26, 1998, our payables under the related collars were immaterial, and there were no related receivables.

Our credit risk related to these derivatives is dependent upon both the movement in interest rates and the possibility of non-payment by counterparties. We mitigate credit risk by entering into the agreements only with high credit-quality counterparties, netting payments within each contract and netting exposures upon default across all contracts with a given counterparty. However, we believe the risk of default is minimal.

Commodity futures contracts traded on national exchanges are entered into with the objective of reducing food costs. While this hedging activity has historically been limited, hedging activity could increase in the future if we believe it would result in lower total costs. Open contracts, deferred gains and losses and realized gains and losses were not significant for all years presented.

MARKET RISK OF FINANCIAL INSTRUMENTS

Our primary market risk exposure with regard to financial instruments is to changes in interest rates, principally in the United States. In addition, less than 2% of our debt is denominated in foreign currencies which exposes us to market risk associated with exchange rate movements. Historically, we have not used derivative financial instruments to manage our exposure to foreign currency rate fluctuations since the market risk associated with our foreign currency denominated debt was not considered significant.

At December 26, 1998, a hypothetical 100 basis point increase in short-term interest rates would result in a reduction of approximately $15 million in annual pre-tax earnings. The estimated reduction is based upon the unhedged portion of our variable rate debt and assumes no change in the volume or composition of debt at December 26, 1998.

 

In addition, a hypothetical 100 basis point increase in short-term rates at December 26, 1998 would increase the fair value of our interest rate derivative contracts approximately $23 million and, the fair value of our Unsecured Notes would decrease approximately $34 million. Fair value was estimated by discounting the projected interest rate cash flows.

See Notes to the Consolidated Financial Statements for discussion of new accounting pronouncements.

From time to time, in both written reports and oral statements, we present "Forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The statements include those identified by such words as "may," "will," "expect," "believe," "plan" and other similar terminology. These "forward-looking statements" reflect our current expectations and are based upon data available at the time of the statements. Actual results involve risks and uncertainties, including both those specific to the Company and those specific to the industry, and could differ materially from expectations.

Company risks and uncertainties include, but are not limited to, the limited experience of our management group in operating the Company as an independent, publicly owned business; potentially substantial tax contingencies related to the Spin-off, which, if they occur, require us to indemnify PepsiCo; our substantial debt leverage and the attendant potential restriction on our ability to borrow in the future, as well as the substantial interest expense and principal repayment obligations; potential unfavorable variances between estimated and actual liabilities including accruals for wage and hour litigation and the liabilities related to the sale of the Non-core Businesses; our failure or the failure of critical business partners to achieve timely, effective Year 2000 remediation; our ability to complete our conversion plans or the ability of our key suppliers to be Euro-compliant; and the potential inability to identify qualified franchisees to purchase the 408 Company units remaining from the fourth quarter 1997 charge as well as other units at prices we consider appropriate under our strategy to reduce the percentage of system units we operate.

Industry risks and uncertainties include, but are not limited to, global and local business and economic and political conditions; legislation and governmental regulation; competition; success of operating initiatives and advertising and promotional efforts; volatility of commodity costs and increases in minimum wage and other operating costs; availability and cost of land and construction; adoption of new or changes in accounting policies and practices; consumer preferences, spending patterns and demographic trends; political or economic instability in local markets; and currency exchange rates.