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Executives

Edward White – Senior Vice President, CFO

Albert Stroucker – Chairman, CEO

Analysts

George Staphos – Banc of America

Ghansham Panjabi – Wachovia

Mark Wilde – Deutsche Bank

Timothy Thein – Citigroup

Claudia Hueston – J. P. Morgan

Richard Skidmore – Goldman Sachs

Joe Stivaletti – Goldman Sachs

Christopher Manuel – Keybanc Capital Markets

Alton Stump – Longview Research

Joseph Naya – UBS

Owens-Illinois Inc. (OI) Q3 2008 Earnings Call October 30, 2008 8:30 AM ET

Operator

I would like to welcome everyone to the OI third quarter 2008 conference call. (Operator Instructions) I would now like to turn the call over to Mr. Ed. White, Senior Vice President and Chief Financial Officer.

Edward White

Good mornings from Perrysburg, Ohio. We're here today to discuss the third quarter 2008 results, talk about the current business environment and answer any questions you may have. With us on the call today is our Chairman and CEO, Al Stroucken and our Vice President of Investor Relations Paul Butts. Several other members of the senior management team are as well.

We have a lot to talk about today, but before I go into detail let me turn the call over to Paul to review the company's position on forward-looking statements. When he is finished, I will discuss the results and then Al will offer his perspective on the quarter and review the performance of our global business unit. Afterwards, we'll be glad to take your questions.

Paul Butts

We'd like to remind you that in discussion the company's performance today, members of management may make forward-looking statements within the meaning of the Section 21E of the Securities Exchange Act of 1934, Section 27A of the Securities Act of 1933. Such statements relates to expectations of both known and unknown risks and uncertainties. The company's actual results or developments may differ materially from those projected in the forward-looking statements. For a summary of the specific risk factors that could affect these results, please refer to the company's most recent filings with the SEC. The company does not assume any obligation to update or supplement any particular forward-looking statements made during this call.

Also during the call members of management may refer to certain non-GAAP financial measures. Information regarding those non-GAAP measures as well as the reconciliation to GAAP measures is available on the OI web site.

Yesterday after the market closed, the company released its third quarter results. The earnings release stated that additional information has been posted on our web site. Ed White will refer to those slides to help illustrate and reconcile results with prior years. If you have not already accessed these charts, you can go to our web site, www.o-i.com, click on the investor relations tab and look for the charts under events and presentations. The chart number is on the lower right hand corner.

Edward White

It's been a tumultuous time for the world's financial markets and global economy in the twelve weeks since our last earnings call. Despite all of the uncertainty and volatility, I'm pleased to say that OI is in a very solid position. The strategy that we put into place nearly two years ago has succeeded in building an enterprise that can weather the storm, even this storm.

We outlined our plan for you. We have followed through and we remain committed to our strategy. We continue to track on our expectations even in this uncertain economy. We have restored lost margins through price adjustments that favor price over volume. We said we expected to lose some volume during this process and we have.

There haven't been any surprises in that regard, and even in a soft economy, there will always be demand for beverages and food packed in pure, safe, and earth friendly glass. Our fundamentals remain strong and our results today attest to that.

We also said we would use Lien Six Sigma to accelerate our continuous improvement efforts which are focused on increasing operational efficiencies and creating more manufacturing flexibility to adapt quickly to changing markets. We have done that and we will continue to do so. Lien Six Sigma tools have also been instrumental have also been instrumental in our global footprint review.

We are reducing fixed costs by shutting down less efficient furnaces and machine lines, closing high cost factories and moving business to production lines and plants with surplus capacity which has been created by our productivity improvement. This allows us to continue serving our customers while improving returns on a smaller and more efficient asset base.

All of these steps have contributed to our continued earnings growth. In fact, through the first three quarters of this year, our underlying EPS of $3.34 has already exceeded $2.93 full year EPS we earned in 2007. Naturally, we have felt the impact of the worsening economy like everyone else. But we are will positioned with our diversified global presence, our annual earnings growth, our record level cash flows supported by the strongest capital structure that we have had in more than 20 years.

If you'll turn now to our first web site chart, you can see more clearly how we are benefiting from the significant key leveraging we've undertaken. Our total debt has been reduced from $5.5 billion in 2007 to $3.5 billion today resulting in annual interest expense savings of more than $160 million.

As of September 30, our bank revolver availability was $745 million and we have no long term debt that we need to refinance this year or next. We are in an excellent financial position in terms of liquidity, cost of debt and debt maturity.

Let's look now at the second chart, free cash flow. We generated $195 million in free cash flow during the third quarter and almost $300 million for the first nine months. This number is in line with 2007 year to date results and we expect to meet or exceed full year 2007 free cash flow by the end of 2008 which is consistent with the revised outlook we issued in September.

Chart 3 breaks out year to date tax performance over the past nine months. The green bars show increases in cash compared to the same period last year. You can clearly see that most of this improvement was attributable to segment operating profit which brought in an extra $252 million. This certainly validates our price strategy.

Also on the plus side, was lower spending for the settlement of asbestos related claims as we returned to more normal spending patterns? Offsetting these positive cash flow factors is the red bar, for higher working capital, more spending on capital projects, cash spending related to plant restructuring and other operating cash flow items defined in the footnote at the bottom of the chart.

The most significant variance for the use of cash was working capital. It was a $209 million larger use than through the first nine months of last year. Working capital would normally be lower at this point in time because we would have converted more inventory into receivables and then into cash through the summer sales season.

However, the slowdown experienced in many economies in the third quarter, especially in Europe triggered unplanned inventory adjustments by our customers and impacted our own working capital management plan. Consequently, working capital in this year's third quarter was only a $61 million source compared to a source of $206 million in the last year's third quarter.

This sets up the fourth quarter as a period for us to bring inventories down and for working capital to be the most significant source of cash. This is the purpose of our temporary production line stoppages as we curtail output, to match seasonal demand and to reduce working capital.

The next largest variance for cash was the $74 million year over year in capital spending and is consistent with what we've said previously, that capital spending in 2008 would be higher than prior year and would be in the range of 80% to 85% of depreciation and amortization. However, while the $239 million year to date spending is higher than prior year, it is only running at 65%.

Given the current economic environment, we now expect our full year CapEx to be less than 80% of D&A. This is simply a matter of being prudent.

The final cash variance I want to discuss is the $23 million spent year to date for restructuring and modernizing our footprint. It is typical to have a three to six month lag between the plant closing announcement date and the actual use of cash. So in the fourth quarter, we will see the cash impact of the three plant closures announced in the third quarter. Therefore, you should expect the total cash used for this year for restructuring to be in the range of $80 million.

We include Chart 4 to give you an understanding and overview of the impact of foreign currency exchange rates when translating results into U.S. dollars. We operate each of our international businesses in their local currencies with revenues and costs largely matched in that currency. As a result, exchange rates have minimal impact on local business.

You can see from Chart 4 that foreign exchange has been a tail wind in dollars for sales, segment operating profit and EPS in each quarter of 2007 and 2008. If the strengthening of the U.S. dollar remains at the October 28 level, the fourth quarter comparison this year will become a head wind of about $25 million to $30 million after you let the translation impact on segment operating profit with the benefit on the interest line from our debt denominated foreign currency.

Let me turn to our sales reconciliation chart, Chart 5, and begin with volume. Our sales volume this quarter declined $146 million or 7.6% year over year. Two factors contributed about equally to the decline. Number one, being the leader means going first. We've lost some business because we would not accept price levels that we believe were below appropriate values of those products.

On an inflation adjusted basis, last container price levels are still below what customers were paying five or six years ago, but we have been culling low margin business to restore profitability to the levels that existed in the industry at the beginning of this decade. Whether the business we have released, stays with the competition in the long run, remains to be seen but we are confident this was the correct choice for OI.

Factor number two; we could not have foreseen this rapid economic downturn. Historically, glass volume decline 1% to 2% annually during a recession. However, the combined effectors of customer inventory corrections, consumers having less purchasing power and the repercussion of the current financial crisis on consumer confidence, have created sharp quarterly declines.

We see no indication of any change in long term consumption trends and expect this volume loss to return when the economy regains its footing and markets are back to prices that are more reflective of higher input costs. The reality for the entire packaging sector is that our end markets are not cyclical and people will continue to eat and drink.

Now I'd like you to note the second line on our sales reconciliation chart, price and product mix. Improvements in price mix contributed $149 million to sales in the third quarter offsetting the decline in volume we experienced. Price mix showed a 7.8% increase over prior year which was about the same as the second quarter of this year, and that level of improvement should continue through the fourth quarter.

The third factor impacting our sales reconciliation is of course, foreign currency translation. I've already talked about FX so let's recap Chart 5. Segment sales were up 4.5% for the quarter. Price mix provided a positive contribution although volumes were down. Foreign currency translation helped out although not as much as it has in the past.

So how did this translate into EBIT? Let's turn now to segment operating profit reconciliation which is Chart 6. Here you see that our segment operating profit for the quarter at $287 million was down $12 million or 4% from the third quarter 2007. However, year to date segment operating profit is $1 billion which is 24% higher than the first nine months of 2007.

The relationship to this profit reconciliation are all tracking consistently with what we discussed in prior quarters. Sales unit volume impact on profit was only about $1.00 for each $4.00 decline in sales. Price and product mix benefit translated almost dollar for dollar from the sales reconciliation to the segment profit reconciliation.

As we forecasted in our last earnings call, inflation in the third quarter was higher than any of the other quarters this year. Manufacturing and delivery expense increased by $144 million in 3Q 2008 over prior year and it was close in magnitude to the entire first half of 2008 versus prior. This pattern reflects the increasing inflation impact we've been seeing throughout 2008. Inflation represented approximately $120 million of the $144 million.

Energy has been the chief culprit as it accounted for almost one-half of this inflationary increase over prior year. Additionally, third quarter energy inflation was almost double what it was in the third quarter of 2007. At first glance this may seem counter-intuitive since the market has seen dramatic reduction in the quoted prices for oil and natural gas over the past three months, but as we've discussed previously, much of our European energy costs lag the market by three to six months.

And, approximately half of our U.S. and European energy buy is fixed during the year to hedges or annual contract. As a result of our hedging strategy we did not experience the full impact of the energy run up and likewise, we will not experience the full impact of the pull back.

What were the other costs that made up the difference between the $144 million and the $120 million for inflation? They were the unabsorbed fixed costs of extended Labor Day shut downs in the U.S. and similar production reductions in Europe which more than offset the favorable productivity gain achieved through the Lien Six Sigma project.

Let's move on to earnings per share reconciliation, Chart 7. Overall, we achieved an EPS of $0.90 for the quarter which was $0.12 higher than third quarter last year. Operational pluses and minuses largely offset each other in the quarter leaving the $0.09 reduction in that interest expense and the $0.08 reduction in retained corporate costs as the main contributor.

We include Charts 8 and 9 as reference to show reconciliation from GAAP to non-GAAP earnings for the quarter and year to date. Chart 10 is also for reference and shows 2007 quarterly segment results by region which were not included in prior 10-Q's because we reported only total glass and plastic segments at that time.

Let me talk a little bit about the path going forward. In the first quarter call this year I spoke about operating in unchartered territory. The global economic markets and the events of the last 12 weeks have given new definition to the term uncharted territory. Nevertheless, I would like to reiterate a couple of items we have shared with you on earlier conference calls.

First and foremost, due to the line stoppages, the fourth quarter manufacturing and delivery reconciling line will be about 25% higher than the $144 million year over year variance reported in the quarter just ended. However, a cash benefit from the temporary curtailments of production to reduce inventory is much greater than the earnings penalty from the unabsorbed fixed cost associated with these line stoppages.

Next, favorable accounting adjustments we took in the fourth quarter 2007 for the ramp up of our European SAP implementation will not repeat this year. And finally, when talking about fourth quarter results, a reminder that we benefited from an unusually lower effective tax rate in the fourth quarter 2007 which also will not repeat.

For all of the issues that impact our fourth quarter results are ones we've discussed before and I want to make clear that none of these items reflect a change in our business fundamentals or our strategy. In fact, the benefits we'll receive from price improvement in the fourth quarter will still exceed the combined impact of volume inflation.

No one knows what the next months will bring, but we do know that we are on solid financial footing and that is a powerful weapon to have in your arsenal. We are sensitive to the impact of the temporary and permanent cut backs are having on OI employees, their families and the communities where they live, but we are confident that the strategies we have in place and the steps we are taking to adjust to this rapidly shifting environment will ensure the long term viability of our company and the long term future of glass.

With that, I'll turn it over to Al.

Albert Stroucker

Ed has given you a lot of details about our performance in the third quarter. Now I would like to offer some perspective on that performance. To begin with, we are indeed very proud of the strong financial position we are currently in, especially considering the uncertain global economic environment.

To reiterate what Ed said, we are in this position because we have adhered to a sound strategy. Since the beginning of last year, we have been saying that we will focus on margin recovery and recapturing the profitability that OI had at the beginning of this decade. We have made tremendous progress towards this goal.

In fact, the profitability of our business in the first three quarters of this year has already exceeded the total profit of 2007 despite a clearly more difficult environment is a remarkable achievement. The point I will make today is that even when you talk and take all of the economic changes into consideration, the situation we face now is fundamentally the same one we faced a year and a half ago. And now that we've created a stronger, more agile company, we see many opportunities to expand our business going forward.

You will recall that earlier this year we pointed out that the strength of the U.S. dollar and initial margin improvements make for an easy year over year comparison. We also said that the quarterly comparison was going to become more complex, and it has.

Of course, at that time, we could not have foreseen the dramatic economic changes that lay ahead. We could not have foreseen that the inflation rate in 2008 would significantly exceed our expectations or that the U.S. dollar's value would rise precipitously against major foreign currencies in a very sort period of time. Nor could we have predicted the dramatic slowdown in economic activity we have all witnessed over the last two months.

Yet when it became evident in the third quarter that several of the underlying assumptions were changing, we reacted fairly quickly. We took steps that allowed us to adjust to the changing market conditions without impacting our underlying value proposition of recovering the impact of inflation while maintaining our cash flow focus. Both of these are geared toward our long term strategy.

Having experienced a period of tight supply and demand in 2007, we along with many others in the industry entered 2008 with high production rates. We wanted to ensure sufficient supply for our customers in the peak summer season. When that season went out with a whimper, it was quite evident that there was too much inventory.

Concurrent with that realization came the recognition by our customers that their sales projections and production had over shot the mark as well. This set the industry and our customers' operations into inventory control mode which of course impacted us at the beginning of the supply pipeline.

Fortunately, we had already been evaluating our overall footprint and could quickly adjust. We saw that permanent adjustments in our installed asset base were possible and that the economics for making those adjustments were quite attractive with a very short pay back period. So it was only logical to pull those permanent closure considerations forward in an environment where we had to quickly adjust our inventories and were entering a period in which it was traditionally curtailed volume due to seasonal demand.

Both the production curtailment and the accelerated cash spending for permanent closures impacted projected cash flows which is why we modified our free cash flow projection for 2008 in September.

Now, let me address inflation. As Ed said, inflation continues to be a considerable head wind and is likely to remain a significant cost driver as we go forward. The high rate of inflation we have witnessed over the course of this year has put considerable pressure on the margins we achieved after we had to reset our prices in January.

Despite the recent pull back and the price per barrel of oil, our average cost for energy this year is significantly higher than last year's average. In addition, the supply of one of our core raw materials, soda ash, is still very tight. Present predictions indicate a price inflation well beyond anything we have seen so far.

So going forward, depending on the country where we are doing business, we are looking at inflation levels for our consumable cost items in the high single, well into the double digit territory as we enter 2009. So it is of utmost importance that we obtain price increases to recover those costs over the course of the next couple of months.

Under normal circumstances, softer demand would make it more difficult to achieve such increases, but I believe that since all glass producers are coping with strong underlying inflation, the trade price for volume is not an economically sustainable alternative. All of this makes it clear that production adjustments and inflation recovery are co-dependent and we have to manage both of them proactively in this environment. As the global leader in this industry, we have certain capabilities that others do not.

Let me turn back now to foreign exchange. As I mentioned earlier, foreign currencies dropped precipitously against the U.S. dollar during the third quarter and even further in October. Due to the extent of our global operations, the translation of our business results in Europe, South America and Asia Pacific is impacted immediately by these changes.

Since most of our cost base is also based on these same foreign currencies our margins are not negatively affected by the exchange rate. We do however; expect to see a gradual inflationary impact on global quoted commodities like energy and soda ash in those countries whose currencies have dropped versus the U.S. dollar.

So what this all boils down to, as I said earlier, is that fundamentally the situation we're facing forward is no different than that which we faced a year and a half ago, to preserve and improve our margins, we have to pass through past and present inflation. That has required trade offs, meaning that we had to let go of volume that did not meet our profit objectives.

I do believe however, that the majority of volume loss is behind us, but the pricing story is far from over. To support our value over volume strategy we have been willing and able to adjust our asset base. We're going to do that aggressively, yet with great care. First and foremost as I've said, we are acutely aware of the impact these type of changes have on our employees and their families.

Secondly, we must clearly differentiate between volume that has slowed due to general economic conditions and volume that we let go during the process of trying to negotiate a more acceptable price line. We are finding that it is much easier to make the necessary adjustments in an economically attractive manner than we had predicted when we embarked upon this strategy.

We are still looking at pay back periods of less than two years for those footprint adjustments.

In addition, we are making solid headway with productivity improvements in virtually all of our facilities. The Lien Six Sigma tools that we are integrating into the organization are aiding this effort. Together, these improvements have helped us react much more proactively to changing customer requirements than we could have a short time ago.

One of the intended outcomes of having a cash focus strategy is that it gives us options and flexibility. We have discussed this in the past and in terms of cash use, we remain committed to pursuing acquisition opportunities and buying back shares through the buy back program. But, given the current uncertainty in the global markets, we will of course proceed with caution.

We are however, already strengthening our internal capabilities and structure. We are investing in our marketing, new product development and our R&D capabilities to better meet the needs of our customers.

Now, let me move on to our global businesses, beginning with North America. Here we have had to take the most aggressive steps to balance our footprint with reduced demand. We have lost some volume to our competitors but most of that happened early in 2008 and our margins for those volumes were extremely low.

As part of our footprint alignment, we have shut down eight furnaces in North America this year and half of those can be attributed to our plan to improve asset utilization and in all cases we addressed our most expensive manufacturing locations. Our financial results in North America are still heavily influenced by legacy contracts, most of which will be up for negotiation in 2009 to take effect in 2010. They are a stark reminder of what happens when inflation can not be recovered in a timely and complete fashion.

We will get some relief early next year when we address our prices for 2009 based on 2008 inflation rates and the following year, we have the opportunity to reset the North American contracts to restore margins to levels closer to those we currently have in Europe.

Europe is the region that has seen the most dramatic change in the third quarter. Currency exchange rates dropped significantly over the three month period. Inflation continued unabated and volumes were considerably below those of 2007. Dismal summer sales, a reduction in consumer disposable income and inventory corrections along the supply chain required us to think fast and decisive action with our own production schedule.

Several major European countries are now considered to be in recession. Unemployment and bankruptcies are on the rise and in addition, inflation expectations for the next 12 months remain high. The favorable impact of dropping oil prices in U.S. dollars will work its way through the cost structures next year but it's likely to be muted by the concurrent lower conversion rate of the British Pound, Euro and many other currencies.

Over the course of the fourth quarter, we will be negotiating the prices in Europe for 2009. The unrecovered inflation for this year as well as the inflation projections for next year will drive the required price adjustments in the high single digit to double digit range depending on the markets and segments.

The volume impact we saw in Europe this summer required us to rapidly adjust our inventory level by a temporary production line stoppages and those actions are underway. We also see the opportunity to adjust our manufacturing footprint in Europe to achieve an optimized cost base for our new business model. Following the necessary discussions with various the various works councils, we will likely be able to offer more specifics about these steps during our next conference call.

Our business in South America performed well in the third quarter and has not yet been seriously impacted by the global economic situation. Demand is still solid in the region even though some growth projections are being toned down. Currencies in Columbia are better than Brazil have seen strong devaluations due to capital flowing back to Europe and the U.S.

This has also impacted the prices of imported alternative packaging materials such as aluminum, metal and plastics in that region. Fortunately, we have a proven ability to adjust our prices in South America on an ongoing basis to offset the normal course of inflation we see in the region.

In Asia Pacific, we have seen some signs of the global economic down turn but results remain strong. We have seen wine sales for export markets particularly to the U.S. negatively impacted early in the year by the high exchange rate of the Australian dollar. The drop in value of the Australian dollar from being on par with the U.S. dollar at the end of June to being below %0.65 earlier this week is likely to correct some of that impact going forward.

Indonesia and New Zealand are growing at a solid pace and the situation in China remains extremely competitive. There are many small local manufacturers in China and high energy inflation during the quarter has made it difficult to get prices to an acceptable level in the large volume market sector.

So in light of these steps, and these results, what are our next steps? As we move into the fourth quarter and near year end, we will reduce our inventory to a level that's roughly equivalent to the position we held at the end of 2007. You heard from Ed that production curtailments are going to be impacted in the fourth quarter cost structure, but it will allow us to manage our cash flow and have a lean inventory position at the beginning of next year.

We are expecting a sales volume impact during the quarter which is likely similar to that experienced in the third quarter. This will be primarily attributable to weaker volumes in Europe and North America due to demand and inventory corrections. We also expect to spend quite a bit of time on price negotiations for the coming year and contractual price adjustments formula reset for 2009. In these negotiations, we will ensure that unrecovered inflation for 2008 and projected costs for 2009 are appropriately covered.

Despite the many unforeseen and significant changes we have all experienced over the last couple of months, our results show that our strategy is working and the actions we are taking will enable us to maintain a solid base not only for the remainder of this year, but also for years to come.

We have many plans to strengthen our role as the global leader in glass and we are committed to strengthening shareholder value as we walk down that path. We see plenty of opportunities for improvement along the way. We're investing in our own capabilities and we continue to scout for openings in new and expanded markets.

But our fundamental is very much intact. We know that our future and the future on glass remains strong.

Thank you everyone and we will now open the call to questions and answers.

Question-and-Answer Session

Operator

(Operator Instructions) Your first call comes from George Staphos – Banc of America.

George Staphos – Banc of America

As we look to the fourth quarter to try to make sure that we're all on the same playing field, you enumerated foreign exchange; you enumerated the effect of the production reduction, the down time in terms of a sequential further negative. Are there any other things that we need to be mindful of as we try to calibrate our fourth quarter forecasts to the likely reality?

Albert Stroucker

In line with what we have been discussing and the general comments and what we have been talking about in September when we made our adjustment, I think those are the two major variables and we've tried to put them into perspective today.

George Staphos – Banc of America

As we look out to next year, presuming that most of the volume impact from your pricing actions is over and assuming that pricing as of this year offsets inflation, would you anticipate that any of the regions given what you see right now, do you see any regions that would be down either in dollars or percentage margins in 2009 versus 2008. If you could share some color on that, that would be great.

Albert Stroucker

It's very difficult of course to make predictions for 2009, and in fact because of the uncertainty, we've pushed back our budgeting process for next year to a bit later in this quarter to get a better perspective. I think it's very easy to become influenced by all the hyper-ventilation that's going on about what's going to happen to the economy next year.

We still, as we look back long term at our business and how this business has behaved, and typical economic down turns, we have seen volume impacts that have generally been fairly mild. Between 2%, 2 1/2%, 1 1/2% depending on the region and I don't think that on an ongoing basis this recession is going to be much different from that. So I think as far as a bottom is concerned of overall consumption patterns, I think we're still in pretty good shape.

I'm very confident with the productivity improvements that we're working on and that we're getting through the operation that that too, will help us in maintaining the margins that we have been achieving in the course of this year and we of course will take great caution as we go into the next year to make sure that we preserve what we have achieved and try to go forward.

Operator

Your next question comes from Ghansham Panjabi – Wachovia.

Ghansham Panjabi – Wachovia

Given the end market weakness you're seeing at this point and the volume loss that you've incurred as you raise prices, is it going to be enough to keep volumes at the end of the fourth quarter flat with the fourth quarter of '07 or should we expect further destocking into 2009?

Albert Stroucker

You have to keep in mind as well, this is still a cyclical business and we when we go into the summer months we have an obligation to make sure that we have sufficient inventory for our customers. We may then perhaps in the first half of the year should demand show to be a bit slower, then to be a little bit more descriptive in how much we're going to produce in the beginning of next year. But I think as a starting point for our inventory, this is the right level.

Ghansham Panjabi – Wachovia

In terms of adjusting your strategy I think it's pretty obvious that you moved pretty fast in terms of cutting capacity, but it does seem like you're doing a disproportionate amount of the heavy lifting as it relates to the industry. Can you share some perspective there?

Albert Stroucker

I hear that. I hear that internally and I think certainly sometimes it feels that way, and it most probably is a true reflection. But if we are, and we have been holding the umbrella a little bit in the last year or so for the rest of the industry, we will not continue to let this go out of hand. I expect that we see also other eventually make some adjustments. Because if I look at some of these statistics, there is a considerable inventory run up at least in the statistics available in North America in our competitors' inventories, then they have to take some steps pretty soon, in my view.

Edward White

We also have two things going on here. While we've done some adjustment in terms of business we've been culling, we've also been going after in our strategic footprint review, the capacity we've created through productivity, if you don't do something about that, then it just becomes fixed cost overhead. So there's two pieces going on here.

Not everything that we're doing has to do with volume; it has to do with our strategic footprint review.

Operator

Your next question comes from Mark Wilde – Deutsche Bank.

Mark Wilde – Deutsche Bank

Is it possible to get a little more color on how these contract negotiations in North America are likely to roll over the next four or five quarters?

Albert Stroucker

Any contract negotiations depends on two partners, so I can try to give you an idealized version but that's not going to help very much. What we've been trying to do is, we've been trying to pull some of these discussions forward. We have not been very successful in doing that because there really was not a lot of upside to the other side to do this.

I think we're making a little bit of progress because we're now really only virtually 12 months away from when we need to have clarity around this. The change in the consolidations that are taking place are affecting some of the timelines as well, and that I think is going to be an important factor we have to keep in mind.

I have heard, I do not know exactly, but I have heard that apparently one of our larger competitors has had some renegotiations already this year because their contract has become due earlier and from what we have seen and their reporting, it apparently was successful.

Mark Wilde – Deutsche Bank

A lot of us have watched commodity volumes into China vapor lock over the last two or three months. Do you have any insight on what's going on over there?

Albert Stroucker

I think there was a lot of inventory build up; I would assume and of course a lot of infrastructure investments. I think for us the scenario is a bit different. We're much more focused on the area of consumables. The Chinese economy is still projected to grow quite considerably in the area of consumables in particular given the increasing overall level of income that we're going to see.

I think therefore, you have to differentiate a little bit between the economic numbers driven by infrastructure build and the economic numbers driven by consumption. I think consumption levels are still fairly solid. Beer consumption in China is still growing at a double digit rate and consequently will continue to do so for a long period of time.

Operator

Your next question comes from Timothy Thein – Citigroup.

Timothy Thein – Citigroup

As you look ahead at '09 in terms of the contracts that are based on this year's inflation, how much is it the percentage of the total? I know it's a high percentage in North America but the percentage of your total contracts that will triggered off some kind of PAF? And then as you look to Western Europe, what's your sense, two of the top five or six producers, one of which has a footprint that closely matches yours have come out and reported volumes that were flat to slightly up for the third quarter, and my guess is given your volume number for the quarter and that coupled with your commentary, I'm guessing that your volumes were down. I realize you'll take a disproportionate hit from that but do you think at the end of the day, the market in Western Europe is, what would you put as a growth rate there in the third quarter.

Albert Stroucken

I would say number one, as far as overall contract renewals are concerned, the Europe, and the typical fashion of about 75% of the volume in Europe will be renegotiated in this quarter going into next year. In the United States that number is significantly lower. We've typically talked about a 20% range. We touched a lot of these things last year. What we could pull forward, we pulled forward.

The percentage that is subject to the PAF is most probably well over 80% in North America. And then in Asia Pacific, it's perhaps 60% is PAF based, and Latin America is at a fairly high percentage to be renegotiated. So as far as what is really up for renewal and what is just more a formal adjustment.

With regards to the information that has been submitted by some of our competitors in Europe, of course it has our attention because it gives us some perspective due to the fact that we really do not have a lot of details, statistical information available from the market until later. What you have to keep in mind is that we do very often, even though we are in the same industry, have our emphasis on different components of the industry.

For instance, we have a significant larger component of beer than perhaps one of our competitors would have. Another competitor may have a higher component in food. What we saw really happening was that particularly, the beer industry in Europe was affected by a dismal summer and also, since they tend to be very large enterprises that they apparently are vey quick on the cash flow corrections, so they took the steps very early in this process, and that was really in August.

If I look on a global base, of our total volume short fall in the third quarter, two-thirds of that occurred in August. So that really shows you that there was a singular event that was just not a normal pattern of consumption. And I would assume though that going forward this year, since I suspect there is some volume build up in inventories, that we are going to see also in the course of this quarter still some inventory corrections both within our industry, but also within our customers' industries.

Operator

Your next question comes from Claudia Hueston – J. P. Morgan.

Claudia Hueston – J. P. Morgan

Could you talk a little bit about the corporate costs which has come down a lot year over year and what's driven the decline and how to think about that going forward?

Albert Stroucker

Some of this is costs that we have reallocated to some of the businesses so the performance of the regions is not a direct like for like comparison because some of those costs are now carried by the region.

Edward White

It picks up equity earnings so some of our equity investments have done better than forecasted and are definitely are doing better than prior year. It also has our non-cash pension income that we pushed through there. That has been more favorable this year than last year. When you start looking at the future, where we have an issue, until we know on the pension side what's going to happen to our assets are sitting at year end and rates of return, that number could move around a little bit.

That number we think on a normalized basis ought to be like $40 million a year, $10 million a quarter. We keep telling you the next quarter will be $10 million, and then when the forecast comes in, but it's also lumpy because it has all the other stuff that runs through it.

Claudia Hueston – J. P. Morgan

If you could comment on the stock buy back where you acted in the quarter and how are you thinking about repurchases versus that pay down and acquisitions?

Albert Stroucker

We have not been active because we've been in a black out period so we couldn't really act and I would say as we move forward and as we indicated in our comments, we're going to have to be very judicious about where we're going to spend our cash and certainly given the situation at this point in time, that requires some reflection and some trade off with other needs that we may have for cash.

I'd say if it is an economically attractive investment for our money, we will certainly proceed along the lines we described when we announced the buy back program.

Operator

Your next question comes from Richard Skidmore – Goldman Sachs.

Richard Skidmore – Goldman Sachs

Can you elaborate a little bit more on how you see the timing of the reduced energy prices rolling through the business? You mentioned energy was about 50% of that manufacturing cost line which is a pretty big number for '08 and would we expect to see some of that reverse for 2009, and if so, how does that play out?

Edward White

You're going to have a lot of moving parts on that energy because what will reverse, let me just use North America as an example. Our hedge position in 2009, will probably be $1.50 higher than it was this year, 50% of our buy. In '08 we were living off '07 hedges that were layered in through the year so now we will have an '09 layered in '08 hedges.

You can take half of our buy and say it's going to be $1.50 more expensive in '09 than it is this year. It's a counter intuitive discussion we're having. If natural gas goes up for 50% of our melting in North American next year, the other 50%, you're going to say should be down if natural gas stays where it is, and I think that's the outlook now as you look at the forward strip.

Energy in North America year over year could be flat between the two years because you've got the hedge which helps us take out the volatility. Our hedges were a $40 million asset in the second quarter and they're now a slight liability into the fourth quarter. So the hedges work in the right strategy but it mutes everything going up and down.

For Europe, a lot of those annual contracts were set early in '08, so when you reset them in early '09, especially in the electricity arena, we would expect our electric costs to be higher next year because there will be, when we set the dates. The gas piece, sometimes it's set by the government, which we know governments aren't necessarily market, so I'm going to give you a cloudy picture for energy next year.

It's obviously not going to be the major culprit as Al mentioned. The soda ash guys are rumbling more than the energy piece.

Albert Stroucker

I think the situation in Europe, we're not the only ones. I've been listening to some conference calls in the last couple of weeks and what I'm hearing there is also that they see an impact of about 60% of the inflation in the second half of the year versus 40% in the first half of the year. That is not dissimilar to what we're seeing.

In Europe you also have some individual components like for instance, Poland is talking about deregulating this entire utility sector which would most probably have a significant inflationary impact. It's all at this point in time still fairly uncertain. What's clear is that the overall demand is going for energy is going down and that will eventually have an impact and we will benefit from that impact. It will just not be as quickly as some people think when they see the price of a barrel of oil go up.

Richard Skidmore – Goldman Sachs

As you look to 2009 are you going to continue to employ the hedging strategy in North America?

Albert Stroucker

We're discussing that, and that ties in with the question I had earlier about the contract negotiations and the contract discussions. Fundamentally, if we're going to be successful in our negotiations, to go to a more timely adjustment of our energy prices, then it would not really make a lot of sense for us to hedging anymore because I think that would run counter to the way sell our product and we market our product.

It may very well be that we will be asked by some of our customers who hedge, but that is a different proposal.

Operator

Your next question comes from Joe Stivaletti – Goldman Sachs.

Joe Stivaletti – Goldman Sachs

Can you summarize the expected benefits from lower working capital between the end of the third and the end of the fourth quarter? Can you summarize that?

Albert Stroucker

Working capital should be the largest source of cash in the fourth quarter and if been a use through the year. Right now at September 30, it's at $227 million use of cash and we would like to get the largest portion of that back.

One reason why the range in our free cash flow is so broad is our ability to reduce inventories also depends on the ability of our customers to forecast what they're going to fill next week, and we threw out a rolling 30 day forecast a long time ago. We're just looking at what they're telling us weekly.

To give you a fourth quarter working capital is more aspirational depending on what our customers are doing, but it should clearly be well north of $100 million, $150 million.

Joe Stivaletti – Goldman Sachs

When you look at that manufacturing and delivery line which has been year to date $296 million negative on your operating profit, as you think about that more broadly for the full year '09, do you think it's going to be a positive or a negative?

Albert Stroucker

We're not really talking about '09 today. I think that's a little too granular at this point in time. I think it's also a little bit uncertain. As we said, there are two significant impacts. One is energy and energy is not going to be abruptly turned. I think it's going to gradually turn, but it's coming from a fairly high position and still the second half of this year. If you then go into next year, from that high level and it gradually goes down in comparison then the first half of next year is going to be higher than the first half of this year. But that's one thing you have to keep in mind.

The other part is that soda ash, given the fact that there are a limited range of suppliers only available in soda ash, the demand for the product is extremely high. Alternative products like caustic soda are very scarce right now because chlorine production is down and as a result caustic is down, so we're not going to get a lot of help from alternatives there. So caustic is still going to be a very significant cost driver.

Those are the two more significant impact drivers. I would expect to see a little bit immediate impact and benefit from transportation costs because that has worked its way to the gas stations, and that is going to help the diesel costs for our transportation.

Operator

Your next question comes from Christopher Manuel – Keybanc Capital Markets.

Christopher Manuel – Keybanc Capital Markets

My impression was that when you were working through the value pricing mechanism in Europe that you were also employing some escalators or openers or things of that nature in the contracts to help even on an annual basis make those more current. But as we look through potentially what's happened in the back half of this year and into the beginning of next year it isn't as apparent. Can you us understand how those mechanisms work?

Albert Stroucker

In the large contracts we're going more and more towards a quarterly price adjustment. That will only gradually through to the overall mix. One of the things I've talked about in the past is what we found particularly in Europe where there are many small and medium sized customers, that themselves do not really have a lot of pricing power in their markets, we have been asked during that period of price negotiations to rather set a somewhat higher price and make that price stable rather than to allow variability because they did not see a possibility to go back to their customer base in the course of the year.

With more than 10,000 or so vendors in Europe, you can imagine that's a fairly big customer base and there really isn't a lot of power. I think that has impacted somewhat the fact that we saw a fairly significant margin expansion in the first part of the year which then gradually got eaten away by the inflation.

Christopher Manuel – Keybanc Capital Markets

As you sit here today with credit markets still in a state of disarray and having no maturities for a period of time, how do you balance the certainty of being able to acquire OI through purchases versus acquisitions with the use of cash? Does it make more sense to let some of these acquisitions fester for a bit as their end markets remain challenged for cash? How do you balance that?

Albert Stroucker

It's a permanent dilemma just because right now with our multiple below four times EBITDA, it's very difficult to make an economic case and say it makes economic sense to make an acquisition for five times or five and a half times or six times. I think we all realize that this is not a normal environment and valuations are not particularly normal, so we've got to look at this from a longer term perspective and what is eventually going to be the contribution that a potential acquisition has on the overall position and earning power of the company versus an investment in stock that has an immediate payback but is basically a one time payback.

So those are things that we've got to look at. It is also quite obvious that in times of economic stress, availability of potential candidates becomes greater. So that creates an additional dilemma on top of that. I certainly think that we will find the right way of coming to conclusions that allow us to do what's right for the business and do what's right for the investors at the same time.

Christopher Manuel – Keybanc Capital Markets

Is it your sense that some of these potential acquisitions have multiples that have adjusted in the market downward, that their expectation is adjusted downward. Are they still at six times like they were six months, eight months ago?

Albert Stroucker

I think there's a ritual to this. I think first, in economic down turns, the availability becomes greater not necessarily their own perception of value. That takes a little bit longer to work its way through. I think availability may increase but I think the expectation of valuations will take a little bit longer to be adjusted.

Operator

Your next question comes from Alton Stump – Longview Research.

Alton Stump – Longview Research

You said you had high single, low double digit price increase heading into '09. How much of that do you think is simple pass through at this point with costs where they are right now versus actual margin opportunity heading into '09?

Albert Stroucker

I think right now we're really focusing on costs because we feel that with some of the productivity steps we've taken we will get the margin expansion opportunity as well if we're successful with the cost pass through. The range is so broad because we are talking about different countries with different currencies, different economic situations and so that's why it's a little broader in range than you would like.

I believe if we are able to recover part of the unrecovered part of the inflation this year, and what we see is going to happen next year, we will be doing very well next year because you should keep in mind that if you look at the numbers for the third quarter, a significant component of our margin is impacted by the temporary capacity curtailments that we have made.

So our overall margin is holding strong in this business for the ongoing underlying business. I think if we are able to recover inflation that we have not yet recovered this year and be successful with what we think is going to happen next year, we will be doing very well.

Alton Stump – Longview Research

You mentioned that expected a $25 million to $30 million hit in the fourth quarter from FX? Is that right?

Edward White

Yes.

Operator

Your next call comes from Joseph Naya – UBS.

Joseph Naya – UBS

Can you offer any more color in terms of visibility you have into what's going on with demand and what's happening with your customers at this point?

Albert Stroucker

I think you are seeing some of these statistic results from our competitors and non glass businesses, you see that non-alcoholic beverages is down significantly. I saw something that said shipments were down 3%. We're seeing in Europe, something similar. What we very often hear, and it's still a little bit difficult for us to really get perspective is that some of our large volume customers also have a significant component of bottled water, and bottled water seems to be severely affected by a reduced purchasing pattern because people just go to what's in their faucet.

So it's really difficult to really get clarity about what's happening in the individual components but I'd say that with regards to predictability, if we look into the past it's mostly going to give us a much better answer than anything that right now in this transition phase would be thrown at us.

So I'm still of the opinion that consumption may be impacted by %2 to 3% overall as demand is concerned, and that of course may vary a bit from industry to industry. We may see beer doing a bit better than non-alcoholic beverages but it's very difficult to really put a number on it.

Joseph Naya – UBS

Looking at the quarter, margins were down a little bit in North America and Europe, up a little bit in South America. Were there any big drivers there that we should be aware of and how do you see that playing out as we move forward?

Albert Stroucker

Our margins overall were affected a little bit by the reduced manufacturing to control our inventory, and that may have had some impact in some of the variation that you see. But also in North America, we have been suffering the entire year with the legacy contracts that were based on inflation that we saw last year and then went through the experience of much higher inflation this year. So that's really the main driver of the variation.

Joseph Naya – UBS

On the inflation side in North America, you probably don't get much relief there until you are able to post your prices for 2009.

Albert Stroucker

We reset the price in January based on the price adjustment for '09 so that's a natural reset.

Thank you everyone. Before concluding today's call, I'd like to let everyone know that Paul Butts has chosen to take a new assignment as Vice President and Sales Category Director with North American Glass Container team. He'll be transitioning out of his IR role over the next three months.

During the time, we'll have support from Jason Bissell, one of our current Lien Six Sigma black belts and the former Assistant Controller for American Glass. Jason is joining the IR team during this period so that Paul's transition is seamless from our perspective. We've begun a national search to find Paul's replacement. We'll update you as soon as that replacement has been named.

Let me end by thanking Paul for his hard work and dedication and the value he has brought to the position over the past two years. While we're sorry to lose him on the IR side, we know he will contribute greatly to OI in his new role.

With that, Paul and everyone, thank you for joining us and we look forward to speaking with you again when we report our full year 2008 results on Thursday, January 29, 2009.

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