(FORTUNE Magazine) – OUR GOAL is simply to be the best consumer products company in the world,'' says PepsiCo Chief Executive Wayne Calloway. Is he joking? Doesn't everybody know from the Coke vs. Pepsi battles that Calloway runs the world's most renowned also-ran? And what's this ''consumer products company'' stuff anyway? If that's your reaction, consider carefully the following: -- Coke may win on market share, but Pepsi is emerging as the profitability champ in the U.S. Defying expectations with cost cutting and productivity gains, Pepsi-Cola has increased operating earnings more than 15% annually for the past five years. -- The Frito-Lay division of PepsiCo is one of the world's most profitable businesses, with operating margins exceeding 20%. While Borden, Procter & Gamble, Anheuser-Busch, and other salty snack sellers get crunched in price wars, munchies like Ruffles and Doritos ring up year after year of record sales and earnings for Frito-Lay. -- The three restaurant companies PepsiCo owns -- Pizza Hut, Taco Bell, and Kentucky Fried Chicken -- are making McDonald's look muscle-bound. Their combined operating profits are rising more than 20% annually, vs. around 8% a year for fast food's longtime No. 1. ALL OF WHICH suggests that Calloway isn't dreaming: PepsiCo is on its way to becoming one of the world's best consumer products companies -- potentially even the best. Since 1980, sales have quadrupled to $17.8 billion, while operating profits have risen even faster. The pace really picked up after Calloway, 55, became CEO five years ago. Return on equity has averaged a bracing 25% since then. And if you had owned Pepsi stock since 1986 and reinvested the dividends, you would have earned an annual return of over 30%. In FORTUNE's recent survey of corporate reputations, PepsiCo ranked No. 5 among 306 large U.S. companies, two notches behind P&G but a step ahead of the famous Atlanta cola contender. What makes this performance especially impressive is that the company must sweat for success. Says analyst Jay Nelson of the brokerage firm Brown Brothers Harriman: ''PepsiCo doesn't participate in rapid-growth industries with favorable demographic trends. But managers there think it's their destiny to win.'' They're also driven by Calloway, a boss who believes that ''if the market you're in isn't growing, you'd better rethink it and find a way to grow.'' There's no secret to the Pepsi formula, insists Calloway. He identifies three main ingredients: ''Love change. Learn to dance. And leave J. Edgar Hoover behind.'' Sounds tough to bottle, but what exactly does he mean? Learning to dance is a Calloway colloquialism for dealing with customers in radically new ways. No longer is Pepsi merely a big-brand advertiser -- renowned for multimillion-dollar deals with Michael Jackson and Madonna. In recent years it has transformed itself into a nimble operating company. You may be surprised, for example, to learn that PepsiCo has more salespeople, making a greater number of daily contacts with customers, than any other company in the world. Leaving J. Edgar Hoover behind means managing those people in a hands-off way that the former FBI chief would have detested. But wait. We'll get back to J. Edgar later. The most important element in PepsiCo's success is its passion for change. Largely because it has been playing a scrappy No. 2 for a century or so, this is a company with an attitude. Says Calloway: ''Nothing focuses the mind better than the constant sight of a competitor who wants to wipe you off the map.'' The upshot: PepsiCo not only reacts to the other guy's every move, but often revamps operations, or marketing, or management when things look fine, simply to gain a step. ''The worst rule of management is 'If it ain't broke, don't fix it,' '' insists Calloway. ''In today's economy, if it ain't broke, you might as well break it yourself, because it soon will be.'' Love of change is propelling PepsiCo's success in the food business. In the most recent quarter, restaurants became the company's largest division, measured by revenues. With 15,000 units in the U.S., the company has more eateries than McDonald's. Sales in PepsiCo's U.S. restaurants were up an estimated 13% in 1990, vs. 6% for the industry and 2% for McDonald's. Though McDonald's per-store margins are higher, Pepsi is narrowing the gap. Says Calloway: ''For us the restaurant business is the most compelling action around.'' Pepsi-Cola was invented as a tonic to stimulate the appetite, but the company didn't enter the restaurant business until 1977, when it acquired Pizza Hut. Today one of its big advantages is that it sells the food people want to eat. Americans now devour 46% more pizza, 52% more Mexican food, and 13% more chicken outside the home than they did in 1984, but 6% less beef, according to the Chicago consulting firm NPD Crest. Under their previous owners, Pizza Hut, Taco Bell, and Kentucky Fried ) Chicken were lukewarm performers, content to remain leaders in their narrow markets. The folks from Purchase, New York, got the chains cooking by showing them who their real competition is: not just another pizza or taco joint down the block, but every alternative from grocery store delis to Mom's Sunday dinner to, most important, McDonald's. PepsiCo's biggest edge is better value. All three PepsiCo chains have been lowering menu prices, adjusted for inflation, for the past several years, while McDonald's has been consistently raising prices. Says Leslie Steppel, Prudential-Bache's restaurant analyst: ''PepsiCo's chains have been drawing in McDonald's customers because McDonald's is no longer price competitive.'' Nowhere have prices fallen further faster than at Taco Bell, where in two years the tab for an average meal has dropped 25% -- and customer traffic has risen 60%. Spurred by surveys of thousands of customers, Taco Bell President John Martin reorganized most of his menu last fall into three price tiers: 59 cents, 79 cents, and 99 cents. Now, while most of the industry toys with short-term discounts and later begs customers to pay full price, Martin promises everyday bargains. ''Radical thought, huh?'' he says, laughing. ''Low prices are what got our business started. The other guy has gotten away from it.'' Keeping costs down is key. While a new McDonald's costs $1.6 million to construct -- up 60% from five years ago -- one of PepsiCo's units, which tend to be smaller and simpler, gets built for an average $900,000. Also, McDonald's nonfood operating expenses have increased as it has added playgrounds, movie screens, and in one Wall Street restaurant a doorman, grand piano, and electronic stock market ticker tape. Says Martin: ''Do customers want this? Our research shows they don't.'' So although McDonald's recently reduced prices on several items, its high costs will likely prevent it from making strong profits at low prices for long. MARTIN'S RULE: Simplify, simplify, simplify. He has reduced labor costs and kitchen space by switching to ground beef that's cooked outside the store, tortillas that are already fried, and even diced onions that someone else cried over. He has refigured the menu to emphasize plain tacos and burritos, which take eight seconds to make, vs. over 20 seconds for Mexican pizza or a taco salad. At its busiest hour today, a new Taco Bell can handle $1,500 worth of business, more than twice the volume of five years ago -- with half the labor. As a result, profit margins have improved even as prices have dropped. Says Paine Webber analyst Emanuel Goldman: ''PepsiCo's strength is that they have the ability to manufacture and distribute billions of little things increasingly efficiently. That, not marketing, is the secret of their success.'' PepsiCo also leads the restaurant industry in coming up with new ways to distribute food. Says Calloway: ''We're not going to prosper if we just wait for busy people to come to our restaurants. We want to move toward the day when pizzas, chicken, and tacos are as convenient and readily available as a bag of Doritos is now.'' PepsiCo thrust Pizza Hut, a dinner chain, into the fast-food business by introducing five-minute service at lunch -- the waitress places a timer on your table to guarantee it. You can now buy Pizza Hut pies at football stadiums and basketball arenas, in grade-school cafeterias, from airport kiosks, and perhaps someday on airline flights. A pie-in-the-sky proposition? Not at all, says Pizza Hut President Steven Reinemund, who is coordinating the scheme with airline caterers, including his former employer, Marriott Corp. If plans pan out, Pizza Hut in five years will be selling in 20,000 locations, vs. 6,000 today. Reinemund says he views his business as a ''pizza distribution company.'' It began delivering pizzas in 1987 and now is building most units exclusively for delivery and carryout. Cheap to construct, at about $250,000, they earn returns on investment of more than 25% a year, twice the average of Pizza Hut's eat-in restaurants. Says George Rice, chairman of the food-service consulting firm GDR Enterprises: ''Since 1984 the entire growth in restaurant sales has been in takeout, delivery, and other consumption outside the stores. That makes Pizza Hut one of the industry's best-positioned companies.'' CALLOWAY forces change by moving managers back and forth among PepsiCo's divisions. In 1989 he sent John Cranor, the former chief of PepsiCo's eastern U.S. soft-drink business, to pluck the problems out of Kentucky Fried Chicken. Acquired five years ago, this has been PepsiCo's turkey: It serves cholesterol-coated grub, projects a dowdy image, and has a flock of franchisees who feistily resist change. Cranor has bought and remodeled hundreds of franchisees' restaurants, introduced new products like Lite & Crispy skinless fried chicken, and recruited several former Pizza Hut executives to teach him delivery % techniques. There's a new name (simply ''KFC''), a new slogan (''Nobody's cookin' like the new KFC''), and new packaging (without the Colonel). Per- store sales at KFC increased 5% last year, and profits rose 28% to a record $127 million on sales of $1.5 billion. It's one thing to change a business that needs a kick, like restaurants, but why interrupt the party at Frito-Lay? Despite slow population growth, a shrinking base of snacking teenagers, and a backlash against junk food, the U.S. salty-snack industry -- driven by Frito-Lay, which controls nearly half the market -- has expanded 3% annually. Frito-Lay's own volume has been rising 6% a year. Still, in January, Calloway sent Pepsi Worldwide Beverages chief Roger Enrico to run Frito and named Michael Jordan, the man Enrico replaced, head of a new division that combines snacks and soft drinks outside the U.S. Some company observers figure that Enrico, who suffered a mild heart attack while on a business trip in Turkey a year ago, moved to Frito-Lay to get away from the exhausting globe-trotting crucial to running Pepsi-Cola. He denies it. ''I was a good two-pack-a-day smoker,'' says Enrico, 46. ''Now that I've quit, my doctor tells me I'll live forever.'' Enrico's strength: big marketing ideas and what PepsiCo people call ''out- of-the-box thinking'' -- viewing a business unconventionally. He is fomenting change by focusing Frito-Lay more sharply on what customers want. Consumer testing has already persuaded the snackmaker to redesign its products. Ruffles are getting made with a new kind of potato to give them an extra dose of potato flavor. Doritos will be thinner and crispier. Says Calloway: ''I don't care if Doritos is the best-selling snack brand. The worst attitude is to say, 'I've got the best. I'd better not fool with it.' '' The folks in Frito-Lay's 39 production plants are thinking more like customers too. Until recently they relied on computers and sophisticated monitors to measure crunchiness, moisture, flavor, and a dozen other qualities. ''But no one actually put the product in his mouth,'' says Enrico. Now at least once every hour one of several manufacturing supervisors in each plant samples the munchies and compares them against gold-standard Frito-Lay products shipped from a special plant at the division's headquarters in Plano, Texas, near Dallas. BUT CONSUMERS can't sample a new goody unless stores make space for it. With computerized checkout scanners providing retailers instant analysis of what's moving fastest off their crowded shelves, winning the war in the stores requires more than simply offering the best quality or running flashy TV ads. That explains the importance of working closely with big retail customers -- what Calloway calls ''learning to dance.'' Frito-Lay does that with what may be the most sophisticated information system in the packaged-goods business. Its 10,000 salespeople all carry hand- held computers that zap data nightly to computers in Plano. Says Calloway: ''In 1980 I could have told you how Doritos were selling west of the Mississippi. Today I can tell you how they're selling not only in California, but also in Orange County, in the town of Irvine, in the local Von's, in the special promotion at the end of aisle four, on Thursday.'' These analyses get relayed back to the delivery people, who use them to advise retailers how to stock their shelves most profitably. Now when a rival brings out a hot new product in Seattle, Frito-Lay can respond with a promotion, or even a change in the product mix, in two weeks instead of three months. Pepsi-Cola too is beginning to trip the light fantastic with retailers. For decades the company focused on supplying syrup and concentrate to independent bottlers. It backed them with mountains of marketing money but rarely dealt directly with the stores. But by the early 1980s Pepsi decided that it could best satisfy retailers' rising demands by serving them itself. After spending several billion dollars to buy out franchisees, Pepsi-Cola today owns bottling and distribution operations that account for half the soda in its system, vs. just 21% ten years ago. Says Craig Weatherup, president of Pepsi-Cola North America: ''Now we're a selling company as opposed to a marketing company.'' That means 600,000 customers -- stores, restaurant chains, schools, stadiums -- instead of 600 before. Since last fall Weatherup has been sending his 70 most senior executives on field trips to observe and interview companies renowned for customer service -- among them, Federal Express, Nordstrom, Xerox, British Airways, and Walt Disney. These managers also are visiting retailers to find out what they think of Pepsi. Says Weatherup: ''We have rooms full of data on consumers, and yet we didn't have a piece of formal research showing how we were delivering against the expectations of our retail customers.'' In January, Weatherup, who now makes a point of calling at least four customers a day, even telephoned a senior McDonald's executive and promised that Pepsi ''could bring you an awful lot of value'' if given a chance. Largely because PepsiCo's restaurants are McDonald's worst nightmare, Coke has had a lock on that business. McDonald's response? ''They said, 'We'll keep talking.' '' LEARNING TO DANCE with customers is even more challenging for Michael Jordan, 54, the new international chief. Pepsi-Cola is a weakling outside the U.S., with an estimated 15% market share, vs. Coke's 46%, and the gap grows wider every year. Jordan's job is to hitch a ride for soft drinks on PepsiCo's rapidly expanding international snacks business. PepsiCo's 1989 acquisitions of Britain's leading snack companies, Smiths Crisps and Walkers Crisps, provide distribution strength on the Continent. Says Jordan: ''We'll do joint purchasing and marketing programs for snacks and soft drinks in European hypermarkets. Eventually we're looking for ways to put them together in the same vending machine.'' Calloway encourages innovation and flexibility by giving his managers a lot of running room. Which brings us back to J. Edgar Hoover. Calloway says that the FBI chief insisted on signing off on every decision, even going so far as to specify how many inches wide margins should be on agency memos. Says he: ''One day Hoover received one whose margins were too small. In big red letters he scrawled an angry warning across the top: 'Watch the borders!' The next morning his frightened assistants transferred 200 FBI agents to Canada and Mexico.'' By contrast, Calloway limits his job mainly to setting ambitious financial goals. ''Most of the time I see the advertising on TV when you do,'' he says. The catch: He is a relentless performance monitor. ''Don't let that country- boy charm fool you,'' says a former senior executive of his North Carolina- born ex-boss. ''Promise him 12% profit growth, and he'll say, 'Well, gee, I'd take another look at that plan, Tom. I sorta think you oughta be comin' up with a number in the high teens.' '' Then, after you ''work your ass off to make that target,'' this executive claims, ''guess what? Wayne wants 22% the next year.'' This relentless pressure can spark some real cost-cutting creativity. Weatherup has reduced Pepsi-Cola's total distribution expenses by $56 million -- some 20% -- over the past four years simply by not letting trucks run empty. Instead they may carry cartons of Frito-Lay snacks from Harrisburg, - Pennsylvania, to Baltimore, or even outsiders' products, such as Purina Dog Chow or Rubbermaid wastebaskets. Says Weatherup: ''We even tried hauling chickens for a while, but that got too messy.'' Inside the plants, mechanical adjustments that can, say, shorten bottle-size changeovers from 90 minutes to 20 minutes are quickly adopted and shared with other operators in the Pepsi system. Helped by hundreds of such small cost- cutting efforts, the soft-drink division has been achieving those 15%-plus profit gains on only 3% to 4% annual increases in sales volume. While PepsiCo's brass tout their company as a warm, caring place, the pace Calloway sets can be brutal. Three senior vice presidents of sales and marketing for soft drinks have fallen off the career ladder and left PepsiCo in the past six years. If you make it, though, you really make it. PepsiCo's top 250 executives, a group that includes division vice presidents, earn annual salaries and bonuses of more than $200,000. In addition, every two years they receive stock options that in the past have bumped their compensation up to an equivalent of over $400,000. Incentives also abound for those lower down the corporate ladder. In 1989 PepsiCo became the first FORTUNE 500 company to award stock options to all its full-time employees. And a new compensation system in restaurants allows a smart manager of a Taco Bell or Pizza Hut unit to earn $50,000 a year, even if she's as young as 22. Says a prominent restaurant industry executive: ''Ten years ago the average manager at PepsiCo wasn't as good as the average assistant manager at McDonald's, but the fact that PepsiCo is the hot company on the street has changed that.'' With all his businesses bubbling, Calloway claims his biggest worry is -- what else? -- complacency. But considering the quality of the No. 1 companies he's going after, that's not likely to be a big problem. For example, McDonald's could still rouse itself, reduce costs, and bust out of its box. If it did, Calloway would be the last to be surprised. Says he: ''Anybody predicting the death of McDonald's is way premature.'' That's the voice of experience. As Calloway knows, Coke also woke up, and Pepsi never did win the cola wars, which rage on and on. The real victor in PepsiCo's three-front battle for industry supremacy will be the consumer. That's because when marketing giants fight it out, you're bound to see lower prices, better products, and improved service amidst the fray.

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