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Executives

Ilene Gordon - Chairman, Chief Executive Officer and President

Aaron Hoffman - Vice President of Investor Relations & Corporate Communications

Cheryl Beebe - Chief Financial Officer and Executive Vice President

Analysts

Vincent Andrews - Morgan Stanley

Christina McGlone - Deutsche Bank AG

Adam Josephson - KeyBanc Capital Markets Inc.

Heather Jones - BB&T Capital Markets

Christine McCracken - Cleveland Research Company

Kenneth Zaslow - BMO Capital Markets U.S.

David Driscoll - Citigroup Inc

Corn Products International (CPO) Q2 2011 Earnings Call July 28, 2011 9:00 AM ET

Operator

Good morning, everyone, and welcome to the Corn Products International 2011 Second Quarter Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Aaron Hoffman. Please go ahead.

Aaron Hoffman

Thanks, Corinne. Good morning, and welcome to Corn Products Second Quarter 2011 Earnings Call. Joining me on the call this morning are Ilene Gordon, our Chairman and CEO; and Cheryl Beebe, our Chief Financial Officer.

Our results were issued this morning in a press release that can be found on our website, cornproducts.com. The slides accompanying this presentation can also be found on the website and were posted about an hour ago for your convenience. As a reminder, our comments within this presentation may contain forward-looking statements. These statements are subject to various risks and uncertainties. Actual results could differ materially from those predicted in those forward-looking statements, and Corn Products International is under no obligation to update them in the future as or if circumstances change.

Additional information concerning factors that could cause actual results to differ materially from those discussed during today's conference call or in this morning's press release can be found in the company's most recently filed annual report on Form 10-K and subsequent reports on Form 10-Q and 8-K.

With that out of the way, I'll turn the call over to Ilene.

Ilene Gordon

Thanks, Aaron, and let me add my welcome to everyone joining us today. We appreciate your time and interest.

We continue to see strong performance across the entire business, driven by a number of factors. First, we were able to pass through pricing at a sufficient level to cover rising input costs. Second, our mix improved behind a focus on selling more value-added ingredients. With the National Starch acquisition, we continue to move toward higher margin, more functional ingredients that help our customers improve their products and, at times, reduce costs.

We also benefited from continued cost savings. We saw manufacturing optimization savings flow through in the first half, and expect that to continue throughout the year. Beyond that, we realized $12 million of acquisition integration benefits in the first half, primarily from procurement and employee-related initiatives.

All of these items contributed to top and bottom line growth in each of our 4 regions and reflect the overall strength of the business model we've developed.

We continue to manage on a local basis with a global perspective. And underpinning our business model is adherence to a prudent but appropriate risk management practice. With a strong second quarter and first 6 months, we are well-positioned to achieve our guidance.

As we discussed on our last earnings call, we expect the first half of the year to be stronger than the second half, particularly in North America. This is largely a result of the upward movement in corn prices. With a good 2011 in view, we continue to invest for the long term as well. We expect incremental capital spending in South America, as we continue to participate in those growing economies. At the same time, we are investing in Europe to better deliver against key food trends like convenience and healthier items.

Let's now shift from a broad view of the first half to some thoughts about how the business performed in the quarter. I'll take this from a fairly high-level, and Cheryl will fill in the financial results.

Let's start with North America. As we discussed last quarter, in May, we shut down our largest facility for a large maintenance project. The work was done essentially on plan, and the facility was back online in 12 days. We estimate that this initiative had a $0.12 per share impact on the quarter. It also limited our ability to increase sales, as we had less capacity available than normal.

During the quarter, we also negotiated a new labor agreement at this location, and the largest facility acquired with National Starch. We are grateful for the constructive and positive interactions with our union employees that led to new agreements with no downtime.

We continue to make progress integrating National Starch. In the U.S., our plans for network optimization are going well. Network optimization entails moving production to the most appropriate facility to reduce costs and improve quality.

Finally, we are experiencing an early start to contracting for 2012. As most of you know, in North America, the vast majority of contracts are done on an annual basis and, traditionally, are signed in the fourth quarter for the upcoming year. Some customers have reached out to us to begin this process a bit early, in order to gain visibility to their input costs next year. We won't comment about specific customers or volumes of business at this time.

Moving to South America. We continue to see strong results in spite of difficult comparisons to last year, which included the World Cup. In particular, we are doing well in the brewing and soft drink markets. We also completed the integration of National Starch's Brazilian operations during the quarter.

Looking at our Asia Pacific region. In general, we're seeing balanced demand and strong sales. We are pleased to note that, thus far, the tapioca root infestation issues we were concerned about are easing as a result of favorable weather conditions and preventative measures taken by the growers to address this issue.

Finally, in our Europe, Middle East, Africa or EMEA region, sales and volume have been strong. In Europe, we continue to see margins recover behind higher utilization rates and good price management.

I'll wrap up my opening comments with a short update on the integration of National Starch. As a reminder for those who may be new to our story, National Starch is a recognized innovator in specialty starches for food products, which has been a priority market for Corn Products as well. Underpinning this reputation is a core competency of research and development. This capability allows us to develop a variety of unique value-added products. As an example, we have applications for yogurts, soups and sauces that provide specific textures.

As a result of this value-added approach, the National Starch portfolio generally carries a higher gross profit margin than what Corn Products has historically reported, giving us meaningful mix improvements.

Turning to the quarter and a status update, we remain on plan to complete the integration by the end of 2012. We realized $12 million in recurring synergy savings in the first half and expect to see about $20 million for the full year, and likely more than that on a run-rate basis. We remain thoughtful but aggressive in pursuing additional benefits. But for now, we remain comfortable with a run rate of $50 million by the end of 2012.

The National Starch acquisition continues to have a meaningful financial impact. In the first half, it delivered approximately $701 million in sales and an estimated $104 million of operating income.

In summary, we are very pleased about the strong start to the year for our entire business and our good outlook for the year. Now I'll turn the time over to Cheryl to take you through some of our financial results. Cheryl?

Cheryl Beebe

Thanks, Ilene. Let me add my welcome to everyone on the call and webcast this morning. Before we get into the second quarter results, let me give you a short financial overview.

As we have discussed on previous calls, we anticipate fairly stable volumes for the full year, and the second quarter was in line with that expectation. Given the microeconomic turbulence in many countries, we view relatively stable volumes as a positive and are pleased that we can maintain these levels this year. I would also point out that the volume recovery last year was quite strong. In the second quarter of 2010, volume was up $143 million.

This quarter was similar to the first quarter, with significant pricing actions across the business. These have been focused on passing through higher input costs, particularly corn. Historically our business, both in North America and the rest of the world, has had a strong track record of pricing against rising commodity costs. Given our risk management approach and our historical ability to deal with input cost volatility, on a short-term basis, changes in corn prices generally have a nominal impact on the business.

That leads us to the co-product values, which partially offset higher gross corn costs, but resulted in no incremental benefit to our operating results on a consolidated basis. As in the first quarter, North America benefited from improving pricing on oil, feed and meal, which was partially offset by the higher gross corn costs in the rest of the world. Foreign exchange rates were positive in a number of our larger markets.

And now, let's move on to the financial highlights for the quarter. You'll likely recall this chart from our previous earning calls. It provides a good summary of the strong second quarter performance that Ilene mentioned.

First, you'll notice that in addition to the reported numbers, we have a couple of lines that show adjusted figures. Our definition of adjusted is again very straightforward. It excludes items that we do not believe are indicative of ongoing operating performance. By looking at operating income and EPS without these items, we believe you gain a clearer view of the underlying performance of our business.

Items being excluded for the quarter are charges related to the integration and the acquisition of National Starch. You may recall that we provided an estimated EPS impact from National Starch for the past 2 quarters. At this point in the integration, we no longer have sufficient comfort or visibility to appropriately delineate the income and the allocated costs. We will continue to do our best to help you understand the financial impact of the acquisition, though this may be the last quarter we are able to provide a look at its impact on operating income.

With that said, let's take a look at the results, starting with a 58% increase in net sales for the quarter. This bridge provides a good look at the drivers of that increase. I'll start with the largest figure on the page and point out that the National Starch acquisition contributed approximately $353 million worth of sales or about 60% of the growth. As a reminder, we are treating all of the incremental National Starch sales as volume.

The other significant change was an incremental $205 million of price/mix driven by both pricing pass-through and mix improvement. The impact of foreign exchange was $40 million, and organic volume was down $16 million or basically flat.

Looking at sales variance by region, the largest single factor is the 35% incremental volume from National Starch. Beyond that, price/mix is up 20%, reflecting both pass-through of higher commodity costs and ongoing mix improvement. Organic volume was down 1% for the total company, largely as a result of the decline in North America. Again, this represents only $16 million.

As Ilene pointed out, our largest facility was down for nearly 2 weeks. As a result, we had tight management over sales and supply chain to ensure that we met customer expectations. North America sales also reflect a strong 17% increase in price/mix.

South America's volume was flat, and price/mix was up 27%. The flat volume is a bit surprising at first blush. The year-ago quarter included substantial incremental sales from the World Cup. In fact, in the second quarter of 2010, South America sales rose 26%, and about 60% of that increase came from volume.

Moving on, Asia Pacific's organic volume was down 6%, as we are lapping a onetime liquid dextrose opportunity. To put the 6% in context, that's $2 million. Acquisition volume was up 115%. Price/mix was up 16% in this region.

And in EMEA, the strong volume growth of 171% was largely driven by the acquisition of National Starch of 166%, and the organic growth was 5%. Price/mix was quite positive, offsetting the minor currency devaluation.

Moving down the slide, you can see the jump in both gross profit dollars and margin. Good results from both the acquired and organic businesses contributed to the performance. At the same time, the margin is being mathematically compressed by higher pricing driven by pass-through of input costs. Given that, it's all the more impressive to see the gross profit percentage rise 90 basis points.

We expect the first half will have the lowest net corn costs for the year. As we have previously pointed out, the net corn cost is not evenly distributed throughout the year. Later quarters have higher corn costs. We had a 13% increase in net corn costs between the first and second quarters of this year and expect this trend to continue throughout the year.

Our business outside of North America will reflect current market prices in the second half of the year. We continue to expect the gross margin to be around 18% this year. Reported operating income rose $58 million compared to an increase of $46 million on an adjusted basis. The increases are primarily a result of the incremental income from National Starch. The legacy business reflects the $13 million impact of the large maintenance project.

Looking at regional contributions to operating income, you can see that we had growth in all 4 geographies. Income grew in North America, primarily due to the acquired business; and in South America, largely as a result of mix improvement and cost reductions. In Asia Pacific, growth came from both National Starch and the organic business. In EMEA, the improvement came from incremental income from National Starch.

Corporate costs were up slightly. And then we'll finish up the chart by backing out the restructuring and integration charges.

Let's move to a discussion of earnings per share. We saw our EPS rise 110% to $1.01 on a reported basis, and 47% to $1.10 on an adjusted basis.

The next slide gives us a good snapshot of where our EPS performance came from. We start with a reported EPS for the first quarter of 2010 of $0.48, and add back $0.27 of charges related to the Chilean earthquake and acquisition costs to get to the adjusted figure of $0.75. From there, we have $0.40 of improvement in our operations, largely driven by $0.44 of volume growth, which includes the incremental impact from National Starch.

Synergy savings contributed $0.05 per share, and the FX benefit accounted for another $0.03 of improvement. Margins came down $0.11, primarily due to $0.12 of costs incurred as part of the maintenance project we have mentioned several times.

From a nonoperational standpoint, we had a $0.05 negative variance. We had a lower tax rate this year, it contributed $0.08, offset by higher financing costs of $0.10 per share, and some modest dilution from share issuances of $0.03.

That takes us down to $1.10 of adjusted EPS, and we back out $0.09 per share of integration charges to reconcile back to the reported EPS of $1.01. In all, another good quarter on top and bottom line growth that sets up the year to achieve our guidance.

Moving to look at the first half, you'll see some of the financial highlights are quite similar, again, to what we discussed for the second quarter. We show stable volumes, significant pricing to manage through rising input costs and favorable foreign exchange rates. While the value of co-products increased year-over-year, as well as compared to the first quarter, it was not sufficient to cover the increase in gross corn costs. Thus, again, there was no incremental benefit to our operating results.

In the first quarter, we received a tax repayment of $58.4 million from the Government of Mexico that resulted from a NAFTA settlement. That payment is worth $0.75 per share of earnings, though we back that out of operating income and EPS when we do our adjusted calculations, as you'll see in a moment.

Financing costs increased by $34 million, largely as a result of the additional debt to finance the National Starch acquisition. Capital expenditures were $89 million, mostly to fund investments in North and South America.

Finally, we invested $266 million in trade working capital, as a result of higher inventory values due to rising commodity costs, as well as the increased sales.

Let's quickly run through the first half results using the same format we used to look at the second quarter, starting with sales. Revenues rose 57%, primarily a result of the acquired volume from National Starch and higher price/mix to cover rising input costs. Gross profit rose by $263 million or 86%, again behind the acquisition of National Starch, mix improvement, cost savings initiatives and integration synergies. Gross profit margin also grew substantially for the same reason and puts us in a good position to end the year at about 18%.

Moving down the chart to operating income on both a reported and adjusted basis, we saw significant increases. Reported operating income increased 144%, while adjusted was up 83%. As you expect, given the strong gross profit and operating income performance, EPS rose considerably as well.

On this slide, we can look at the underlying components of that EPS increase. We start with $1.05 of reported EPS for the first half of 2010, back out the $0.33 of restructuring and acquisition charges. That leaves us with an adjusted EPS of $1.38. Looking at the operations, we saw $1.26 of improvement, largely driven by $0.90 of volume. Keeping in mind that, that income associated with National Starch is in this line. We also saw a $0.21 of margin improvement, $0.10 of synergy savings and $0.06 of favorable FX. Nonoperational items resulted in a negative $0.27 per share impact. $0.09 of tax rate favorability was more than offset by 30% of higher financing costs related to buying National Starch and 6% of dilution from share issuance. That leaves us with $2.37 of adjusted EPS for the first half of 2011. To bridge back to the reported EPS of $2.97, we add back the $0.75 from the NAFTA settlement and back out $0.15 of integration charges.

Again, from a P&L standpoint, we really had a nice start to the year, and we are pleased with how the business is performing.

We can conclude our look at the results with a view of the cash flow statement that you can see on this slide. I'll point out a couple of items. First, we generated $102 million of cash from operations. Net income and depreciation and amortization covered the working capital increase of $266 million. As you'd expect, higher sales combined with the increase in raw material prices had a significant impact. CapEx was $89 million, though we have some significant spending left to do in the remaining 6 months.

Now let's turn to the guidance for the full year. We are not changing our sales or EPS forecasts for the year. We continue to expect EPS to be in the range of $4.85 to $5.15. I'll remind you that our guidance includes approximately $20 million of anticipated synergies from the integration of National Starch that we expect will be offset by about $30 million of integration costs. As you've seen in the first half, we already realized $12 million of the acquisition integration benefits and incurred about $18 million of integration charges.

We continue to believe that the first half of the year will be stronger than the second half. As we have said before, this is largely based on the anticipated upward movement of corn costs. We expect sales to exceed $6 billion in 2011, as we price through higher input costs. The expected tax rate is expected to be between 31% and 32% for the full year. Capital expenditures to be in the range of $280 million to $300 million, much of which is to support growth initiatives, particularly in South America and Europe, as we have discussed earlier. Included in this range is $50 million of capital related to the integration of National Starch.

Now I'll turn the call back to Ilene.

Ilene Gordon

Thanks, Cheryl. As I've done in previous calls, I'll wrap up with our strategic blueprint, which continues to guide our decision-making and strategic choices, with an emphasis on value-added ingredients for our customers.

With half of 2011 behind us and 9 months of owning National Starch, we're seeing our business model and our strategy continue to work well and evolve. We have delivered strong performance in spite of some difficult economic situations around the world. This is a testament to our prudent, thoughtful approach to managing risk, building our business and the talent of our dedicated employees. At the same time, our strategic acquisition of National Starch continues to provide a catalyst to accelerate Corn Product's already impressive track record. Looking at the back half of the year, while there's always risk in the potential for volatility, we remain confident in our ability to execute well and deliver our anticipated results.

And now we're glad to take your questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] And first, we'll go to Ken Zaslow with BMO Capital Markets.

Kenneth Zaslow - BMO Capital Markets U.S.

I have just a housekeeping question and then one bigger-picture question. If I look at $0.12 from the maintenance, does that include any missed opportunities on the sales growth line? And if so -- if not, how much would you attribute to the sales growth that we might be able to recapture over the next 6 to 9 months?

Ilene Gordon

The $0.12 does not include the missed sales opportunities. Clearly, there were some, because we didn't have extra volume and wanted to satisfy the customer commitments, but we have not quantified what that is. But clearly, there were opportunities that we couldn't fulfill because of the maintenance.

Kenneth Zaslow - BMO Capital Markets U.S.

Okay. My bigger-picture question is, I know you're not providing 2012 guidance, but your long-term growth is 10%. Besides the absence of obviously the maintenance issues next year, are there any factors that we should be aware of for 2012? Or said differently, is there anything that would prevent CPO from achieving at least that 10% growth level in 2012?

Cheryl Beebe

Ken, it's Cheryl. I would say that we fully expect, and this is a forward-looking statement, to have our long-term growth of 10% or better. If I think about next year, assuming there's no change in the corn costs, so we don't have a disruption in the crop, and that the pricing model holds, then we should have the benefits from the integration, so the savings coming from combining the 2 organizations, and we should have the benefit coming from the manufacturing optimization going on in our U.S. business. And I would expect that coming into 2012, that hopefully the economic situation on a global basis eases up a bit, and that would give us some more volume.

Kenneth Zaslow - BMO Capital Markets U.S.

The $30 million increment earnings from 2012, will that all flow to the bottom line?

Cheryl Beebe

It should. The only thing that doesn't flow to the bottom line is the fact that you still have to factor in inflation, and whether or not it all comes in, in the timing in the first, second, third and fourth quarter, offset by perhaps some chemical costs increase. But at this point in time, the $30 million from our visibility looks good, right down to the bottom line.

Kenneth Zaslow - BMO Capital Markets U.S.

And what about any return on capital projects in 2012? Is there something that we could think about? How much will be coming on line from just your capital spending on new projects that are coming on line?

Cheryl Beebe

Most of the capital spending won't hit until we're out in the later years, 2013, 2014. There are some expansion projects that are smaller, that should start to hit the numbers. But again, they're just startups. So I think, really, at the end of the day, the numbers next year is manufacturing optimization savings, the synergy savings of $30 million and some volume.

Kenneth Zaslow - BMO Capital Markets U.S.

And what about pricing? Are you done taking pricing in South America?

Cheryl Beebe

No, I think -- well, if corn prices stay at the rate they are today, then we're done having to take pricing action. The pricing action that has to occur is in the North American market next year.

Operator

And next we'll go to Christina McGlone with Deutsche Bank.

Christina McGlone - Deutsche Bank AG

Cheryl, I just wanted to understand the North American margin commentary a bit more. When you talk about the second half being weaker than the first half, are you pulling out the Argo maintenance charges and the accelerated depreciation to make that comparison? Or are you doing it kind of as reported?

Cheryl Beebe

I'm doing it as reported. And the other piece that is prevalent in the North American numbers is, again, we had a very strong first quarter. So if I look at second quarter, where basically the legacy business is down in total, driven by the Argo maintenance project, but the first quarter, the legacy business was up. And that carries through the year. So it really is the layout of the corn costs quarter-to-quarter. Lowest in the first quarter, up 13% second quarter versus the first quarter, and it will continue to rise as we go through the third and the fourth.

Christina McGlone - Deutsche Bank AG

Okay, so in as-reported, you had 10.5% operating margins in North America. And you're saying second half will be lower because of that pattern of corn, even though you don't have the Argo charge?

Cheryl Beebe

That's correct.

Christina McGlone - Deutsche Bank AG

And was there any -- if we look at Argo being down, [indiscernible] and that's your largest plant, I mean, what about fixed cost utilization? How much did that knock off things? And why wouldn't that come back in the second half?

Cheryl Beebe

That will come back in the second half, all right, but the $0.12 is a combination of lower yield, higher absorption costs and actual maintenance spending. So it's the combination of the 3.

Christina McGlone - Deutsche Bank AG

Okay. And then when you talk about -- can you just review, in Asia Pacific, why were volumes down 6%? I missed that.

Cheryl Beebe

Asia Pacific, we had made a comment at the year-end call, that we were going to be down in Asia Pacific. And, again, to put context in, we have realigned the countries, so this is Korea and Southeast Asia in the legacy CPO business. We had onetime liquid dextrose sales. So on the volume number, it skews it. But on the OI, we expect to be up year-over-year. And if I look at the second quarter, again, taking into account that the volume was down, but the legacy CPO is estimated to be up almost double. And net volume was about -- from a net sales standpoint, about worth $2 million.

Christina McGlone - Deutsche Bank AG

And just going back to North American margins, if we think about next year, with pricing starting earlier, I think that's a good sign that pricing will be firm and should offset, maybe more than offset net corn costs. Are we -- could we -- when can we start -- how can we think about margins going forward? What would drive margin expansion from this point? Basically, excluding synergies, but if we think about just the core business, if you have this tight utilization and pricing starting this early, shouldn't we see price increases on the legacy business leading to margin expansion?

Ilene Gordon

Well, of course, what we work on with our customers is passing through corn costs. And of course, the environment is tight. So we expect to have a good environment for that. But of course, it's on top of the year, where this year, we had to pass on quite a few corn costs. So of course our -- the consumer is being faced with these price increases and our customers are dealing with that. But we expect in this environment that we should be able to pass through those corn costs. Now of course, you talk about the -- putting aside the synergy, but as we move our different products around the different facilities, we are getting better utilization of our facilities and, therefore, our throughput improves. And therefore, we're getting that benefit. You can call that a synergy benefit, but in a way, it affects the whole system.

Operator

Next we'll go to David Driscoll with Citi Investment Research.

David Driscoll - Citigroup Inc

I just wanted to follow up on the second quarter a little bit. So the second quarter came in a bit light versus consensus estimates. You guys don't provide the quarterly forecasts. Can you tell us how the second quarter came in versus your internal forecast?

Ilene Gordon

It was right as we expected. We planned that maintenance project very well, moment by moment, and it basically came off the way we thought it would. And the quarter basically was what we expected. So we felt good that we got through that and negotiated labor contracts and kept our customers very happy.

David Driscoll - Citigroup Inc

On the co-product piece, you basically -- I think you made today the same comments that you made in the first quarter, that there was no real net benefit because South American co-products kind of come in a little bit below their historical averages on a relative basis, versus the experienced gross corn costs. Can you talk about why that's happening? I guess, I'm sure a lot of folks out there were thinking that this would have been a favorable benefit, this quarter and perhaps for the rest of the year, but it certainly doesn't sound like that's happening.

Cheryl Beebe

No. And David, let me see if I can take a stab at this. When I look at, clearly, the co-product credit, on a global basis, is up from whether we're comparing first quarter 2011 to first quarter 2010, or we're doing the second quarter the same comparison. And if I do sequential quarters from the first quarter of 2011 to the second quarter, the co-product credit is up. It's just that it's not moving at the same rate that the gross corn cost is moving. So if we look at the market data, gross corn costs, year-over-year, are up 100%. And so, even though there is improved co-product values, it's not enough to offset the increase in the gross corn cost on a global basis. And again, all of our international operations, or x North America, are pricing based upon current corn costs. So I think that's really from a market standpoint, I think where the most difficult comparison is. That's the one that tends to cause some disconnects.

David Driscoll - Citigroup Inc

Okay. I understand the mechanism here, but perhaps I don't understand why it's working this way. So I mean these co-product values, historically, corn feed, corn meal and corn oil, they usually have a good relationship between the spot price of corn. And as they rise on a percentage basis, there's an established relationship. It's working correctly in the United States, but it doesn't seem to be working in the same way in these international markets. Again, do you have any sense as to why? And does this change in the back half? I mean, is there any sense that these situations or this situation will improve?

Ilene Gordon

I think, Dave, the difference is the fact that in the North American market, we're doing annual contracting. 50% roughly is grain-related, in which case then there is no benefit at all to the company relative to a change in co-product values. And the other 50% is improvement, it helps to offset the higher corn costs. And so, that's why the North American market gets the benefit, but the rest of the world doesn't. And the rest of the world is dealing with having -- they don't have a hedged portfolio because we expect them to be able to reprice.

Operator

[Operator Instructions] Next, we'll go to Heather Jones with BB&T Capital Markets.

Heather Jones - BB&T Capital Markets

I wanted to follow up on a couple of questions. Going back to the Argo lost volumes issue. I want to make sure I understand that when you put out there the $13 million hit, that includes the maintenance expense, but you're also saying it includes the fact that there was underabsorption of fixed costs?

Cheryl Beebe

That's correct.

Heather Jones - BB&T Capital Markets

So I understand you're not going to give a number, but when we're -- if we try to estimate the impact of that lost volume, should we assume a higher contribution margin? Or do you -- would you suggest we use a margin in line with the quarter average?

Cheryl Beebe

I don't know how to answer that one, Heather. Let me think about it.

Heather Jones - BB&T Capital Markets

Okay. And going to the second half, you mentioned that in Q2, legacy North American profitability is down year-on-year because of Argo. I understand that North America is going -- legacy North America can be weaker than Q1, but do you expect it to be down year-on-year?

Cheryl Beebe

The North American operating income year-over-year will be up.

Heather Jones - BB&T Capital Markets

The legacy business.

Cheryl Beebe

Legacy business. That's correct.

Heather Jones - BB&T Capital Markets

And going back to the contracting discussion. Some of your peers have noted that they anticipate margin-enhancing price increases, due to tight capacity, due to high sugar prices. Is that a comment you feel comfortable with? Or do you think it's premature to commit to that?

Cheryl Beebe

We don't really comment on the margin side. Our expectation is to pass corn prices on and work with our customers through this. But we don't really comment on the margin expectations.

Heather Jones - BB&T Capital Markets

Okay. And then finally, on the by-product, the co-product issue, you mentioned that it wasn't a for the quarter, but was it actually a detriment when you consider the rest of the world, year-on-year, with the, basically, by-product values not keeping up?

Cheryl Beebe

Let's kind of do a run around the CPO world. So if I look at Asia Pacific, Korea and Thailand, Korea had no benefit, it actually was a negative, because they have the issue of hoof and mouth disease, which is impacting the grain prices. Then when you look at Thailand, we do tapioca. So really, no benefit, actually a negative relative to the co-product in Asia Pacific. EMEA, it's not large enough and, again, the dynamics are different than the North American and South American markets. And in South America, it's the fact that we're pricing year-over-year 100% and the co-product values have not kept up the same way they have in the North American market.

Heather Jones - BB&T Capital Markets

So net-net, it sounds like it might be a negative for the company?

Cheryl Beebe

I wouldn't say it's a negative. I think it's neutral. There was no incremental benefit. If I look at, and we've been asked a number of times on recovery ratios, and you look at it as what's your co-product values as a percent of your gross corn costs. All right, we're basically, if I look at the second quarter versus the first quarter, that recovery ratio was down. And if I look at it versus a year ago, it's basically flat. So not a -- I wouldn't call it a hurt, and I wouldn't call it a help.

Heather Jones - BB&T Capital Markets

Okay. And finally, on SG&A, you've given us some color on what you expect for the gross margin. But could you give us a sense of what you're expecting the SG&A run rate to be quarter-to-quarter? Should it be in the mid-120s range? Or should we be looking to something higher?

Cheryl Beebe

I think that we're not too far off the run rate that we had this quarter, maybe a little bit less. But if you look at the first quarter, we're about $131 million, this quarter $137 million. So, you know, $130 million, $135 million, I think, is a reasonable level to guide to.

Operator

We'll now go to Vincent Andrews with Morgan Stanley.

Vincent Andrews - Morgan Stanley

Couple of questions from me. The first is, Cheryl, the basis, the corn basis is kind of reversed in the U.S. I just want to make sure -- I know you guys hedge in the U.S. But my understanding is you can't hedge basis. Has there been any impact from the change in basis to your business?

Cheryl Beebe

Not that it's material, quarter-to-quarter, you see some swings. But full year, I think we're fine.

Vincent Andrews - Morgan Stanley

Okay. And then my second question is just on the -- on your inventory level coming out of 1Q, was it below normal?

Cheryl Beebe

No, it was actually higher. And so, taking out the higher corn costs on the valuation of your inventory, which is probably about 65% of the change, we actually did build inventory; one, to improve the service levels in the Modified Starch business, a.k.a. the acquired National Starch. We also built some inventory on raw material side, to try to get ahead of the rising corn prices.

Vincent Andrews - Morgan Stanley

Okay. I'm just trying to square up. I would have thought that, if you were going to bring Argo down, you would have tried to -- I just want to understand. Maybe you would have tried to have inventory at a higher level for that, and maybe you just couldn't because the demand environment is so strong?

Cheryl Beebe

It's a combination of both. Yes, we did build some inventory to cover the outage. But there's a limited amount of storage capacity. So again, that's why the sales group and the supply chain were so well synced to make sure that we didn't overpromise and underdeliver.

Vincent Andrews - Morgan Stanley

Okay. None of it was a function of you just did much better in 1Q than you thought, and that borrowed a little bit from Q2? I'm sorry. I'll say it again. There was no -- it wasn't a case where you just did much better in 1Q and borrowed a little bit from 2Q?

Cheryl Beebe

No, it was not.

Operator

The following question comes from Christine McCracken with Cleveland Research.

Christine McCracken - Cleveland Research Company

I just wanted to follow up on the contracting question. Ilene, you mentioned that about 50% of your contracts are done on tooling. I'm wondering if you've seen any change going into this year, given some of the volatility in commodity costs we've seen?

Ilene Gordon

No. I think we expect our book of business to still be about 50% grain-related. Some customers feel that they want to take that risk and get the upside or downside of co-products and have their own corn hedging programs. And others leave it to us and want more of a fixed price. And so, I think the ratio is about the same.

Christine McCracken - Cleveland Research Company

All right. Just wondering, too, you mentioned some of the benefit on pricing tied to the tightness in the North American business after you shut down your plant. I'm wondering if you've seen overall tightness in the industry helping pricing? And whether or not you can comment on kind of where the industry sits on a relative basis here in North America?

Ilene Gordon

Sure. We haven't mentioned the word Mexico yet. And I think that, as we've talked about in other calls, and what's been published on the demand in Mexico for high-fructose corn syrup, and so that continues to be a strength for the industry. And therefore, the utilization rate that we've talked about and the tightening up has really come from the growth in Mexico. And that continues to be a positive as Mexico's local demand grows, and we've been able, as an industry, to supply from the U.S. So I think that balance, though, is where -- where it is, is where it's going to be. And that we expect for next year for that to be similar. And of course, this is all driven by the benefit of the NAFTA agreement allowing for that shipment. But that continues to be I think a positive for our industry.

Christine McCracken - Cleveland Research Company

And just one last question on brewing. You mentioned the tough comparison versus a year ago. We've heard recently that, that market has picked up quite a bit, sequentially. Just wondering if you're expecting to see kind of better volumes there, as you move through the balance of the year? And if that's factored into your guidance?

Ilene Gordon

Yes, well, it is factored into our guidance. And we would expect it to pick up. Plus, we're coming out of the winter season in Brazil and Argentina. And so, as we go more towards summer, I think that will pick up again. And we are seeing the brewers are -- they're expecting to order a lot of material and to grow their business.

Operator

And we'll now go to Heather Jones with BB&T Capital Markets.

Heather Jones - BB&T Capital Markets

Just going back to the growth capital projects. My understanding has been there -- that there had been some of these expansion projects last year then some this year. And just wondering when you expect those to start flowing through -- the returns from those to start flowing into earnings? So not National Starch, specifically, but more the legacy CPO business?

Ilene Gordon

Well, I was about to say, that we had talked about some National Starch investments, especially in Europe, that we've been making to address the growing trend of clean label and ready meals. And we have some capacity that is coming on in the fourth quarter that will be in our guidance, but it will be helpful for our customers. And so, certainly something like that. I think that we've had other capacity in the legacy coming on and some of the specialty products, but it's still a small number in terms of it. So I think that where you're going to see the benefit in the legacy capital projects really is in what we call the synergy number and the optimization of moving some of the specs around between the different facilities. And so, that's reflected in this $20 million run rate that we talk about, $20 million this year and part of what's in next year. So it really would be from those type of projects for legacy, but more in the specialty side in Europe, as in for example, for the National Starch side.

Heather Jones - BB&T Capital Markets

And like the expansion you've been doing in Brazil, and I can't remember specific timeframes, but I remember there being an ongoing expansion in Brazil for the legacy business. Is that already in the numbers? Or is that more -- something we should see later this year or in 2012?

Ilene Gordon

We should see it in 2012. The expansions that we have talked about at Mogi, at Cabo, which is in the Northeast, those should hit the 2012 numbers.

Heather Jones - BB&T Capital Markets

And are those the ones that you're talking about are fairly small? Or are those more meaningful?

Ilene Gordon

I think they're well -- in respect to the total pie, I think it's relatively small.

Aaron Hoffman

I think we will take one final question.

Operator

We'll go to Adam Josephson with KeyBanc Capital Markets.

Adam Josephson - KeyBanc Capital Markets Inc.

How much longer do you expect U.S. capacity utilization to stay as high as it is? Do you think these levels of utilization represent the new norm for the industry? Or that the industry will revert to levels that more closely approximate the historical average?

Ilene Gordon

I think that as I talked about Mexico, we continue to expect the Mexico demand to be part of the situation. And as we both talked about in the past, a lot of that is driven by sugar prices being high and high-fructose corn syrup being in the mix. So the expectation or what we've factored in is that, that will continue, and that's helped create some of the tightness in the North America. So certainly in the foreseeable future, as far as we're looking ahead, we think that should remain and don't see any major disconnects to that. But of course, there's lots of things that can happen in the world. Consumer demand, it seems to be okay, certainly for the soft drink side. Certainly in Mexico, it's been robust. And if you look at some of the numbers from people like Coke, Mexico was up 10% for soft drinks this quarter. And in fact, the Coke brand in Mexico, they published, was up 7%. So that part remains robust. Some of the other soft drink numbers in the U.S. are a little less in competing with some other beverages. But generally, we would expect the demand for high-fructose corn syrup to be what it's been in the last year.

Adam Josephson - KeyBanc Capital Markets Inc.

Great. And just one other one on National Starch. National Starch's EBIT margins have fluctuated substantially over the past couple of years. They were 11% in '08, 9% in '09 and they've been 15% thus far in 2011. What would you say is the normal margin for that business? I know it's hard, given that you're integrating it into the rest of your business now, but any light you can shed on that issue would be terrific.

Cheryl Beebe

I would say that on the gross profit level, it tends to be in the 21% to 23% would be the expected average norm. And then the operating expenses run higher than the legacy CPO business. The legacy CPO business would have been in the average of 6% to 7%. NS/legacy, probably 10%.

Adam Josephson - KeyBanc Capital Markets Inc.

This is on operating expense numbers? Just to be clear.

Cheryl Beebe

Operating expenses. So when we get down to the OI level, there's not too much differential between the 2 businesses. And when we actually finish the integration and the harmonization, then there should be, in the combined business, from the historical averages, a couple of percentage point increase.

Ilene Gordon

So this is Ilene. So just, before we sign off, let me just make a few final comments. We continue to feel optimistic about our future and the anticipated opportunities in front of us. We've had strong results in recent quarters, and we continue to believe that we've really built a business model that can deliver growth for the long term. So to name just a few of those drivers, we believe that there is still more synergy savings to come, as we've said, what those numbers are. We have good visibility on our input costs, and we have an excellent track record of appropriately passing through these input costs. So I think this year shows that. And we're actively working to improve our product mix by selling more higher-margin, value-added ingredients, which is really our strategy of being an ingredient provider.

And that brings our second quarter 2011 earnings call to a close. So again, we'd like to thank you for your time today and look forward to future conversations. Thank you.

Operator

Once again, this concludes today's conference. Thank you, all, for participating [ph].

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