(FORTUNE Magazine) - One evening this past November, Pepsi CEO Steve Reinemund laid out a smorgasbord of snacks for his board of directors to munch on. This was not gentlemanly hospitality; it was pure business. These snacks represented Pepsi's future: a line of products aimed at cashing in on consumers' continuing obsession with healthy food. If all goes well, the line will bring in billions for the company. According to one board member, the treats were "delightful." But more than just the future of Pepsi, this spread in many ways represents everything the company has done right for nearly a decade: finding new ways into people's stomachs--and wallets--and pulling off one of the great turnarounds in American business.

In October 1996, the cover of this magazine ridiculed Pepsi. The image: then-CEO Roger Enrico trapped inside a Coke bottle. The headline on the story: HOW COKE IS KICKING PEPSI'S CAN. Our theme was that PepsiCo had lost the cola wars, and the proof was everywhere. The company's profits trailed those of its rival in Atlanta by 47%. Its value in the stock market was less than half of Coca-Cola's. Coke's CEO at the time, Roberto Goizueta, was so sure of his company's dominance that he practically dismissed Pepsi, telling FORTUNE, "As they've become less relevant, I don't need to look at them very much anymore."

How wrong we all were. In December, for the first time in this 108-year rivalry, Pepsi beat Coke, surpassing Warren Buffett's darling in market capitalization. Since our cover ran, Pepsi's operating margins have climbed from 16% to 23%, its net margins from 6% to 14%. Profits, effectively flat through the late 1990s, have climbed more than 100% since 2000, on track to reach $4.5 billion on $32 billion in sales this year. "Pepsi's been on fire," notes Robert van Brugge, beverage analyst with Sanford Bernstein. Over the past five years its stock has risen more than a third to a recent $57 a share, while Coke's has sunk 30%.

So what did FORTUNE miss? Everything--and nothing. The great irony of Pepsi's rise is this: It has never sold more soda than Coke, even today. What we failed to appreciate in 1996 was the power of its plan for resurgence, which was already beginning to take root. PepsiCo turned its cola Waterloo into an opportunity to retrench, regroup, and ultimately outflank its old foe.

Pepsi today is one of best-run companies in the country. In the food and beverage business, there are no game-changing innovations--no iPods or Xboxes. It is a detail-driven industry, a long hard slog where gains are measured in fractions of a percent and a single percentage point in market share or margins is a big deal. This is a game Pepsi has mastered--thanks in part to the rigor and competitiveness of CEO Reinemund. "Steve's an ex-Marine, and everything you would associate with that pertains," says Ken Harris, a consultant with Cannondale Associates who has worked with Reinemund at PepsiCo. "You'll leave a meeting knowing exactly what's expected of you and the time frame in which it should be done." Reinemund has put together one of the strongest management teams around, including president and CFO Indra Nooyi, and is a hands-on manager who's been known to personally make sales calls to help Pepsi win a contract. One Christmas Eve a few years back, while on vacation with his family, he found himself at a convenience store just as a Frito-Lay delivery arrived to replenish the shelves; he put aside his purchases and helped pack chips. A devout Presbyterian, he told Theology Today in 2003 that his primary goal is "to glorify God and to serve him in the way I am called to do. I think in the business world the manifestation of that is in actions, not in preaching." (Reinemund declined to be interviewed for this article.)

Reinemund certainly owes some of his company's success to stumbles by Coke, which has been plagued by CEO turnover (four in nine years) and management snafus (epitomized by a bungled attempt to buy Quaker Oats in late 2000 that allowed Pepsi to swoop in and make the deal). But Pepsi's resurgence is no accident. A decade ago Coke offered investors a compelling story: a recession-resistant product inexpensive enough that consumers would buy it in good times and bad, but valued enough that they would willingly pay an extra nickel or so above what no-name brands charged. What Coke investors didn't envision was that an emerging preference for other soft beverages--water, sports drinks--would fracture demand. Nor did they (or FORTUNE) see that the business strengths that once applied to cola would take hold across a broadened soft-drink and snack-food market--a market that Pepsi, and not Coke, dominated.

Losing the cola wars, it turns out, was the best thing that ever happened to Pepsi. It prompted Pepsi's leaders to look outside the confines of their battle with Coke. "They were the first to recognize that the consumer was moving to noncarbonated products, and they innovated aggressively," observes Gary Hemphill of Beverage Marketing. PepsiCo embraced bottled water and sports drinks much earlier than its rival. Pepsi's Aquafina is the No. 1 water brand, with Coke's Dasani trailing; in sports drinks, Pepsi's Gatorade owns 80% of the market while Coke's Powerade has 15%. Throughout the past five years under Reinemund, the company has deftly moved with every shift in consumer tastes. "He's thinking about what the products should look like in the future," says Victor Dzau, a director of PepsiCo. For example, as COO in 2000, Reinemund had a hand in Pepsi's acquisition of Sobe, buying the company a critical foothold in an emerging category of New Age drinks--the business now pulls in an estimated $200 million a year. Through a partnership with Starbucks, PepsiCo now dominates the bottled-coffee market; this year it will sell over $300 million of Frappuccinos.

But Pepsi's strongest business lies outside drinks altogether. Over the past ten years, the Frito-Lay division--which seems like it sells practically every chip in every store in the country--has become a powerhouse, controlling 60% of the U.S. snack-food market. So strong is Pepsi in this arena, in fact, that many investors no longer judge it by how it stacks up against Coke. "Most people think of Pepsi and Coke fighting it out," observes Eric Schoenstein, an analyst at Jensen Investment Management, which owns shares of both. "But we don't see it that way. Pepsi isn't really a beverage company anymore: It's a food company that also sells beverages." John Carey, manager of the Pioneer fund, which has 1.6 million PepsiCo shares, says he bought the stock because of Frito-Lay: "There's no Coca-Cola in that business."

That's a step up in the corporate pecking order for Pepsi's food di- vision. For most of the 40 years it has been a part of the company, Frito-Lay has taken a back seat to the high-profile cola business. "It was the unsung hero," says Mark Dollins, a company spokesman. Now the food brands dominate Pepsi's financial results: Selling Tostitos, Ruffles, and the like--as well as innovative product extensions like Wavy Lays, Limon Cheetos, and 3-D Doritos--now brings in more revenue in North America than beverages do. The news is the same when it comes to operating profit: Frito-Lay North America and Quaker Oats combined deliver 47% of PepsiCo's total, compared with 31% for North American beverages. The rest of the pie--some $1.3 billion in operating profit this year--comes from overseas, where PepsiCo's reach is huge and growing. The company operates across the globe, from Europe (where PepsiCo recently acquired Sara Lee's nuts business in Belgium, the Netherlands, and France, and a Polish snack-foods company) to China (where it owns several potato fields to help keep the chips flowing locally).

The company's big push now is getting all its different fiefdoms to work together, especially in sales and marketing campaigns. As this year's Super Bowl looms, supermarket shoppers will see in-store displays that tout watching the game while munching Lays chips and slurping on a Diet Pepsi. This is part of an initiative dubbed the "Power of One," designed to push the company's businesses to approach the marketplace more cohesively. "Our Power of One really speaks to our ability to use all of PepsiCo's products, services, and talents," Reinemund explained in last year's annual report. "We view this as a key strategic growth driver."

Right now PepsiCo needs that growth as it faces a toughening economic climate. The high price of energy is putting pressure on the company's margins, and nearly every aspect of its business--its suppliers, its fleet of delivery trucks, its manufactur- ing plants--is feeling the cost squeeze. The result: PepsiCo announced that this quarter it will be taking a restructuring charge of $65 million to $85 million. And barring a miraculous drop in energy prices, the coming year will bring continuing cost pressures.

Nonetheless, over the past five years Pepsi has demonstrated an ability to ride out business cycles and sustain its results: Net profits have climbed 50%, sales are up 33%. Since 2002, sales and earnings per share have grown every quarter year-on-year. The company now boasts 16 brands that bring in more than $1 billion each a year in revenue. Over the next five years, operating profits are expected to rise by 7.5% per year, compared with 5% for the rest of the industry and 6.5% for Coke, according to Sanford Bernstein.

The irony of Pepsi's success is that despite how far it has come out of the cola trenches, inside the company the primary competitive driver is still Coke. Ask any employee who the enemy is and the answer comes quick: "Every one of them will say Coke," says consultant Ken Harris, who's worked closely with Pepsi. Coke may no longer be the real competition, but for the soldiers of Pepsi, it's still a very useful enemy.

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