Good morning. My name is Angela, and I will be your conference operator today. At this time, I would like to welcome everyone to the O-I Second Quarter Earnings Conference Call. [Operator Instructions] I would now like to turn the call over to Mr. John Haudrich, Vice President of Finance. Sir, you may begin your conference.
Thank you, Angela. Good morning, and welcome, everyone, to O-I's second quarter 2011 earnings conference call. I'm joined today by Al Stroucken, our Chairman and CEO; Ed White, our Chief Financial Officer; and several other members of our senior management team.
Today, we will discuss key business developments, review our financial results for the second quarter and discuss future trends affecting our business in 2011. Following our prepared remarks, we'll host a question-and-answer session. Presentation materials for this earnings call are also being simulcast on the company's website at o-i.com. Please review the Safe Harbor comments and the disclosure of our use of non-GAAP financial measures included in those materials.
Unless otherwise noted, the financial results we are presenting today relate to adjusted net earnings, which exclude certain items that management considers not representative of ongoing operations. A reconciliation of GAAP to non-GAAP earnings can be found in our earnings press release and in the appendix to this presentation.
I'll now turn the call over to Al, who will start on Chart 2.
Thank you, John, and good morning. Our second quarter 2011 adjusted earnings were $0.59 per share, down considerably from $0.84 last year. Clearly, we are disappointed with these results, and our performance was unacceptable. Heading into the second quarter, we expected our earnings would be in line with the prior year despite elevated cost inflation. However, we incurred significantly higher manufacturing costs, which more than offset the benefit of higher shipments on a global basis.
Market demand has started to rebound after several years of unfavorable trends in our business. Shipments in tonnes were up more than 6% in the second quarter, driven by recent acquisitions as well as organic growth. In fact, demand was up across all key end-use categories on a global basis. This should have been a very favorable environment for O-I, given our work in the past to create significant operating leverage from improving demand. However, we incurred much higher manufacturing costs due to elevated cost inflation, production issues in North America and market challenges in Australia and New Zealand. Cost inflation accounted for most of the additional manufacturing costs. While inflation was not a surprise, energy prices in Europe have increased faster and to a greater extent than we expected heading into the year. And we have discussed this trend in detail during previous earnings calls.
We have implemented an energy surcharge in Europe to help offset the impact of the most recent spike in energy pricing. The combination of our surcharge this year and expected higher selling prices next year should fully offset the impact of 2011 cost inflation on a global basis.
In North America, poor operating performance resulted in manufacturing inefficiencies and supply chain issues. As a result, we incurred higher production and logistics costs as well as additional expenses for product loss. Challenging market conditions in Australia and New Zealand resulted in sharply lower demand in those countries. And in response, we reduced our production to match supply with demand, which led to a higher unabsorbed fixed cost in Asia-Pacific.
As we respond with urgency to these issues, my leadership team and I are focusing on our core operations to restore high productivity level. We also need to significantly improve our ability to generate a more accurate business forecast. Serving our customers and maximizing our long-term earnings are our highest priority. Despite our disappointing operating performance, we can point to a number of positive developments this past quarter. Organic growth was 3%, excluding the impact of a much lower demand in Australia and New Zealand. We generated $97 million of free cash flow, and we acquired the remaining interest in our 7 Brazil operations from our minority partner. O-I will now fully benefit from future growth and profit improvement in the attractive Brazilian market. And finally, we refinanced debt to extend maturities and increase financial flexibility.
Looking to the third quarter, we expect shipments will be up in all regions and end uses on a year-over-year basis. As we focus on fully restoring our operating performance, we will still incur higher manufacturing costs during this transition period. And as a result, we expect third quarter adjusted earnings will improve from our second quarter results but likely lag the prior year. Looking to the full year, we have revised our 2011 free cash flow target for a number of reasons. In Australia, we are restructuring our footprint in response to changes in demand. This will result in additional capital spending and severance costs. In North America, we will rebuild inventory levels to avoid repeating significant supply chain disruptions as demand improves. And in Europe, we expect some restructuring costs as part of the purchase price for our recent VDL acquisition. And finally, we will invest in capacity expansion in South America to improve margins and support growth. As a result, our 2011 free cash flow target has been reduced from $300 million to between $200 million and $250 million.
Now I will review each of our segments, and I'll start with Europe, our largest region, on Chart #3. Europe performed as expected. Operating profit was $107 million compared with $104 million in the second quarter of 2010. The benefit of favorable currency translation and higher shipments offset elevated cost inflation. Shipments were up mid-single digits in Europe as demand grew across all key end-use segments. Selling prices were flat with the prior year, reflecting the annual contracts negotiated last year when supply demand conditions and inflation levels were much softer and those we are experiencing today. In response to the higher cost inflation, we have successfully negotiated energy surcharges of approximately $15 million to $20 million in the second half of the year. Overall, we expect to fully pass on the impact of 2011 cost inflation on Europe to our surcharge this year and higher prices next year. And in the future, we plan to include prospective inflation provisions into our annual customer agreements there.
Several days ago, we announced the acquisition of VDL, which operates a single glass plant in Vergeze, France, located near the Nestlé Waters' Perrier bottling facility. We have strengthened our strategic relationship with Nestlé and are now the leading glass container provider for both their Perrier and San Pellegrino brands in France and Italy, respectively.
Moving to Chart 4. Our South American operations also performed as expected and generated operating profit of $53 million in the second quarter, up from $49 million last year. Volumes were up more than 35% year-over-year. Our strategic acquisitions last year accounted for most of this growth. But the region also posted double-digit organic growth driven by Brazil, Argentina and Peru. But the benefit of higher shipments was mostly offset by higher costs. So segment operating -- sorry -- segment profit margin was about 18%, which was lower than we typically see in this region for a few reasons. First, we incurred additional cost inflation. While our second quarter prices were flat with the prior year, we expect to recapture cost inflation through higher prices beginning in the third quarter.
Second, our Brazilian operations were sold out, and we shipped glass from other countries in the region to meet growing Brazilian demand. These shipments had associated freight and importation penalties, that allowed us to meet growing demand before we commit more capital for expansion in the region. Throughout the glass [indiscernible] situation, we incurred some costs to realign machinery and increase capacity in Brazil. And to support continued growth, we will further debottleneck our operations there. We are also planning a Greenfield plant in South America to support our customers' long-term growth needs. And finally, as I mentioned already, we bought out our minority partner in our Southern Brazil operations, and we expect this transaction to be accretive in 2011.
Moving to North America on Chart #5. Heading into the second quarter, we had expected higher earnings compared to the prior year. We anticipated stronger shipments combined with footprint initiative sales. However, North American's operating profit was $56 million, down from $87 million in the prior year. Most of the decline was due to $26 million from production inefficiency, higher freight costs and product loss. Due to a number of operating issues, we were not able to meet all of our customers' needs. And as a result, shipments in North America were down slightly despite fundamental strength in all key end-use markets other than the mega beer brand.
We have always prided ourselves on our operational excellence and our ability to meet or exceed our customers' expectations. We failed to meet those standards in the second quarter, but we expect to significantly improve our service level in the back half of the year. The graph on Chart 5 depicts the chain of events that led to our issues in the region this quarter, and keep in mind that the last result [ph] does not represent specific data. The blue line represents our effective manufacturing capacity, while the yellow line illustrates seasonal demand pattern. We permanently closed 2 plants in North America in mid-2010 to realign capacity with lower demand, following the conclusions of contract renegotiations with key customers. Given soft demand last year, we were focused on efficient working capital levels, and we maintained tight inventories as we entered 2011. And the green dotted line represents inventory levels to show relative trend. But again, it's illustrative. Then as 2011 progressed, several things happened. First, demand started to pick up in North America, but the growth was in wine, spirits and craft beer and not in mega beer brand. This mix created additional complexities that we underestimated. For example, more SKUs result in shorter production runs, which require greater flexibility in our plant.
We struggled with a greater number of job changes at several plants and did not achieve the same production efficiency that we typically see with the mega beer brands. Second, we had a number of production interruptions that required downtime for repairs. As you can see, this downtime coincided with seasonally stronger demand. As a result, we did not achieve the productivity improvements that we expected in the second quarter.
And third, longer lead times on repair parts delayed the anticipated restart of 2 previously idle furnaces, so we did not get the much needed additional capacity as fast as we had expected. As a result of these issues, tight inventory became short inventory at several locations. And to serve our customers, we had to reallocate production to other facilities in North America. Now this in turn disrupted those plants' normal manufacturing patterns, which led to incremental costs. Since production sometimes occurred to plants hundreds of miles away from the customer, we also incurred significant higher freight cost, all of which unfortunately coincided with spiking diesel costs. You can see the domino affect that started with production issues early in the quarter. Now to address these issues, we have initiated a plan to both restore our inventories to sustainable levels and improve production efficiency over the course of the second half of the year.
First, we're taking immediate action to rebuild inventory. We restarted our 2 previously idle furnaces, and they were up and running by early July. This added approximately 5% more production capacity to the region. We are also leveraging our global footprint by shifting glass from other regions to increase North American inventories by about 5%. And finally, our North American plants will, of course, run at high operating rates through the end of the year.
As a result of these actions, we expect to rebuild North American inventories and reduce the risk of significant future supply chain complication. Over the next 6 months, we are focusing on returning to operational excellence in North America. Most of our inefficiencies during the second quarter was tied to discrete production issues, which we do not expect to recur. Nevertheless, we are conducting thorough manufacturing audits of our 19 North American facilities to determine if there are any unidentified production risks. Of course, we will take the necessary actions to remediate if anything is found. Finally, we are actively collaborating with our customers to improve the SKU accuracy of their demand forecast, as well as our production forecast. This will then help avoid the many unplanned changes and changeovers that compromise productivity. A more effective supply chain will benefit both O-I and our customers. And for future customer contracts, we will look to include provision from forecast accuracy to create clarity about supply commitments and ownership of cost variances.
To avoid additional disruption in this difficult period, we have delayed our SAP implementation in North America until early 2012. Let me reiterate, our second quarter performance in North America was unacceptable and full remediation of these issues is priority number one.
Now moving from North America to Asia-Pacific on Chart 6. Heading into the second quarter, we expected our Asia-Pacific profits would be down from the prior year as a result of lower demand in Australia and New Zealand. And we've been discussing this trend over the past few quarters. However, actual results were significantly lower than anticipated. Asia-Pacific earned $9 million, down $22 million from the prior year. Although total regional shipments were up slightly from the prior year, all growth was attributable to our 2010 acquisitions in China. Our shipments of wine and beer bottles in Australia and New Zealand were down nearly 20% from the prior year. This resulted in $7 million of lower profit contribution from sales. Two macroeconomic headwinds drove the precipitous drop in shipments in these 2 countries. Stronger currencies have negatively impacted wine exports and led to some fundamentally different approaches by our wine customers to their future business models. Domestically, beer consumption was down considerably as high interests and savings rates have lowered consumers' disposable income, and this has cost a severe cutback in consumer spending.
While we anticipated lower shipments, demand trends in the wine and beer markets deteriorated faster than expected in the second quarter. In particular, Australia wine producers reduced in-country bottling given the dramatic increase in the value of the Australian dollar. In response, we reduced production to balance supply with lower demand, resulting in $10 million of unabsorbed manufacturing costs on top of the loss sales contribution from lower costs. Given these developments, we are taking the following actions. First, we recently named Steve Bramlage as the new President of the Asia-Pacific region, who replaced Greg Ridder who is leaving the company. Greg will report to me and serve as a member of the global leadership team. He previously served as the Treasurer and Vice President of Finance for O-I, and more recently as the General Manager of our New Zealand operations. We believe Steve will provide a fresh perspective to address the market challenges in the region.
Second, some of the issues that we face in Australia are longer term in nature. And as a result, we will need to properly align our capacity with changing long-term demand. We will restructure our Australian operations in several phases. In July, we implemented the first phase by permanently closing one machine line in Australia. And for the immediate future, other supply and demand imbalances will be managed through continued temporary downtime.
The next phase of our restructuring plan will likely require additional permanent capacity adjustment in Australia. This plan must ensure that we retain the right capabilities and invest in the necessary technologies for our customers. Also we need to maintain flexibility to meet future demand levels in the event of an upswing in the market. Australia is now entering its seasonally strongest period, so it's prudent to delay restructuring activities until later this year. And we expect that restructuring will conclude by the mid-2012. This restructuring in this region may result in up to $50 million of capital expenditures and severance costs. Up to half of this cost will be incurred in 2011, and the balance would fall into 2012. Overall, these actions should improve our cost profile in Australia. And I will keep you updated on our decisions regarding the scope and implementation of restructuring activities in future earnings calls.
Now moving to Chart 7. We remain committed to our long-term strategy, which continues to deliver value for O-I. For example, our focus on operational excellence has generated $245 million of savings between 2007 and 2010, driven by our footprint realignment initiative. As we refocus on our core operations, we have been redesigning our organizational structure in each region. We are bringing manufacturing and supply chain functions under one regionally integrated operations list. This structure will remove the functional clutters in our operations and provide a more holistic approach to optimize the entire process flow. And this will help maximize operational efficiency and provide better visibility and control over production costs.
Regarding strategic and profitable growth, in 2010, we acquired 10 plants located in fast-growing emerging markets that are generating an average operating profit margin of approximately 20% and creating a significant growth momentum. Last March, our new go-to-market approach has enhanced the effectiveness of our organic marketing efforts and has boosted our growth in South America 5 to 7 percentage points above average market growth. We are already seeing success in our other regions as we replicate this initiative globally. New capabilities like Vortex or Lean+Green wine bottles and Black Glass are driving additional sales in all regions. While our strategies are driving value, a number of other factors have undermined our ability to generate the improved financial performance that we expected when we set our longer-term targets back in 2010. And these factors include, first, the economic downturn impacted the markets that we serve longer than we expected at that time, especially with continued high unemployment in the developed market. And also the mega beer brands have not recovered as we anticipated when we were exiting the recession. Second, the expropriation of our highly profitable Venezuelan operations and of course, throughout the recent challenge with our operating performance that I discussed in detail with you. And finally, I believe that at present, our current earnings profile does not support acquisitions of the magnitude, speed and impact that we discussed at the last Investor Day. And given these developments, it is unlikely that we will achieve the longer-term targets that we discussed early last year, and we are currently revisiting these targets. I will now turn the call over to Ed.
Thank you, Al. Let's move to Chart 8. We included much of this information in our press release and in Al's comments, so I will only touch on the highlights. Second quarter 2011 segment sales increased nearly 17% to more than $1.9 billion. Recent acquisitions and improving market conditions drove more than a 6% increase in tonnes shipped. This boosted the top line by $97 million. You can also see that currency translation substantially increased the top line, especially in Europe. Moving over to segment operating profit. The second quarter was $225 million compared to $271 million last year. Higher volumes contributed $26 million, but manufacturing and delivery costs increased by $78 million. Higher costs were largely driven by $61 million of cost inflation as expected. But an additional $26 million of North American production issues and another $10 million of unabsorbed fixed costs in Australia and New Zealand were not foreseen.
Finishing with the EPS reconciliation. Our adjusted net income was $0.59 per share in the quarter compared to $0.84 in the prior year. Lower operating profit reduced earnings $0.21 from the prior year. Earnings were impacted $0.04 from unfavorable non-operating item, largely due to higher interest expense on incremental debt to fund 2010 acquisitions. Retained corporate costs were about flat with the prior year. Higher marketing spending and non-cash pension expenses were offset by $10 million of lower management compensation, which reflects adjustments to multiyear incentive plans and the impact of lower 2011 earnings. Also the merger of businesses in Brazil resulted in a tax benefit. Finally, we had 2 Note 1 expenses this quarter as outlined in our earnings release.
Let's move to Chart 9 for more detail on our balance sheet, cash flow and capital structure. On June 30, 2011, cash was $260 million, and total debt was approximately $4.3 billion. The net debt was $4.1 billion, an increase of more than $1.2 billion from the prior year's second quarter, reflecting financing for acquisitions made last year and the impact of foreign currency translation on our debt. Our net debt to EBITDA ratio was 3.2x as with the end of the second quarter, well below the bank covenant limit of 4x. However, our ratio now exceeds our leverage target of between 2 and 3x EBITDA, so future debt reduction will be a priority. We believe this range represents an efficient capital structure for O-I and provides the financial flexibility needed to execute our strategy.
Free cash flow was $97 million in the second quarter, compared to a $6 million use of cash last year. Lower working capital levels and capital spending more than offset a decline in earnings. Let me shift now to our capital allocation priorities, and repeat what Al has said. We are clearly disappointed with our results this quarter, and we regret the impact that this has had on the O-I share price and on our shareholders. At our current stock price, we understand that a share buyback may be viewed as a compelling use of cash. However, we need to focus on debt reduction to lower our leverage to below 3x EBITDA by year end 2011. Further, it is essential that we dedicate some of our current year cash flow to restructure Australia, to rebuild inventories in North America and to begin to expand capacity in South America.
Turning to capital expenditures. Our 2011 estimate has been reset. We now expect up to $375 million of CapEx, given the restructuring and capacity expansion I just mentioned. Finally, we're very pleased with the successful completion of our $2 billion bank credit agreement earlier in the second quarter. We also redeemed in the second quarter higher cost senior notes using attractively priced term debt. On Chart 10, we present our business outlook for the third quarter. There are clearly many moving parts in our business, especially as we are taking actions to address our operating performance. As a result, we're providing directional outlook on operating profit by segment, for non-operational costs and overall adjusted earnings.
Our European third quarter profit should be in line with the prior year. We expect earnings will benefit from higher volumes and energy surcharges, yet cost inflation will remain elevated during the third quarter. As noted on the right, global cost inflation in excess of price will likely impact O-I's 2011 margins by more than $130 million, which we expect to recapture through the higher pricing mostly in 2012. In North America, we expect segment operating profit will lag the prior year. However, the manufacturing cost penalties we incurred in the second quarter should moderate as we increase capacity, run full and improve operational and supply chain efficiencies over the course of the quarter.
Our segment for Asia-Pacific operating performance will remain below prior-year earnings, given continued temporary production curtailment in Australia and New Zealand. However, earnings should benefit on a sequential basis from seasonally stronger demand. In South America, segment operating profit should improve from the prior year. We anticipate shipments will remain very strong, and we also expect higher selling prices as we pass through the inflation incurred in the first half of 2011. Turning to non-operational items. We expect higher year-over-year corporate costs due continued sales and marketing initiatives and the higher pension expense we've seen all year. Further details are provided on the chart.
Overall, we expect the operating performance to improve over the close of the third quarter, but we will still incur high manufacturing costs during the transition. Therefore, we expect third quarter adjusted earnings to have improved on the second quarter but will likely lag the prior year third quarter results. Now I will turn the call back to Al for closing remarks on Chart 11.
Thanks, Ed. While this has been a sobering quarter for O-I, we should not lose sight that our business fundamentals remain strong. Many glass markets are strengthening, and we have the tools and capabilities that we need to refocus our operation. We have a very good understanding of what went wrong over the last few months, and we have taken this situation very seriously and realize that we disappointed our investors as well as some customers. We're implementing corrective action plans in North America and Asia-Pacific as described, and we expect to bring the operating performance of both regions up to the high standard we have demonstrated in the past.
We now expect free cash flow for 2011 to be in the range of $200 million to $250 million, and we're focusing our capital allocation on remediation plans, expansion in South America and debt reduction. Further, we do not foresee any significant acquisitions at this time in the second half of 2011. And as you can see, our priorities are focused on operational excellence in the near term, which ultimately is the foundation of our long-term strategy. Thank you, and now I will ask Angela to open the lines for your questions.
[Operator Instructions] And your first question is from Alex Ovshey with Goldman Sachs.
Alex Ovshey - Goldman Sachs Group Inc.
You mentioned that you're hoping to raise prices enough in Europe in 2012 to more than offset the inflation you saw in 2011 but also to think about getting ahead of inflation in 2012. Can you just talk about the level of confidence in being able to achieve that, and how that will actually work? Do you actually expect to restructure the contracts where beyond 2012, you have that ability, or is it just the fact that things have tightened up in Europe? But at least for 2012, you feel reasonably good that you could be able to get in front of inflation in Europe.
I think Europe, as you know, is a market where about 70% to 80% of our volume is really tied to annual contracts, so we have an opportunity to reset the price levels every year. However, what we have seen in the past as well, Europe is also a market where normal pass-through provisions have an actual -- or have an additional dependency, and that is the new supply-demand picture. So if supply is long and demand is weak, it's very difficult to pass through inflation. But once supply and demand is balanced as we are seeing this year, and in fact in the peak season, we see supply is outstripped by demand, you really then get pricing power. And one of the indications that gives me the confidence for next year is the fact that we went into the market with an energy surcharge, that we were able to negotiate with our customers in quite a few countries fairly successfully, and that I believe gives me the confidence that we are seeing some good opportunity for price improvement. Equally, we have been negotiating certain longer-term contracts that were reset in the course of this year, because they don't all come due at the end of the year. And in some of those cases -- or in most of those cases that I'm aware of, we have been able to raise our prices mid to high-single digits. So I think that indicates that there is some pricing power that is being regained in the marketplace.
Alex Ovshey - Goldman Sachs Group Inc.
That's helpful. Can you just talk about the demand trends that you're seeing across the key end markets in Europe, and where you're seeing the most pockets of strength and perhaps anywhere that you may still be seeing sluggish underlying activity?
Overall, Europe has been growing in virtually all applications, even in the beer sector. A lot of the growth in the beer that we have seen in Europe has come from exports, and we covered the export markets for the traditional export brands. But the driver of the growth has been liquor, has been wine and crude, as the overall underlying consumption has started to improve. And I believe it's also indicative of a longer-term trend that we are observing that those brands and those products that allow customers to be more individualistic in their choice of beverage, which favor the wine, the liquor, as well as the microbrewery brands rather the mega brands. And I think we will continue to see that trend for quite a while.
And your next version is from the line of Ghansham Panjabi with Robert W. Baird.
Ghansham Panjabi - Robert W. Baird & Co. Incorporated
It looks like you guys are seeing a dislocation in Australia based at least in part due to currency. Brazil also has a very strong currency, which some of your peers and your customers are saying is affecting local demand. Why shouldn't we expect your Brazilian business to also face potentially lower volumes? And also what kind of demands in area are you baking in for the new capacity that you're adding?
We're seeing quite some strong growth in the high-single digits in Brazil as far as organic growth is concerned, of course, in addition to the acquisitions that we made. And we have been seeding the market with imported products at this point in time. So whatever we're putting in place as far as additional capacity is not for future demands that has not yet materialized. It's basically to serve already existing demand that we're serving from a higher cost basis. With regard to the currency impact, comparing it to Australia, really, the issue in Australia is one of having such a significant export component and a huge consumer of glass, which the wine industry represents. When I look at our demand profile in Brazil, virtually -- almost all with very few exceptions, less than 1% I would say, is consumed domestically. There is not a lot of export of Brazilian brands into the rest of the world. So I would say that based on the information that we have at this point in time and also the growth that we saw continuing in the second quarter, Brazil still continues to be on a very positive path for us going forward, and we have to be ready to serve the demand. Now I know you have heard, and you have seen that a lot of new capacity is added in the aluminum industry as well, looking forward to a continued growth in Brazil. And I think that there too, there is a level of confidence that certainly in the long-term, Brazil will continue to be a significant contributor to the growth profile of their business.
Ghansham Panjabi - Robert W. Baird & Co. Incorporated
Got it. And just one follow-up, since you pre-announced in mid-June and switching to North America, I think on the margin the consumer spending environment in North America is worse, not better. And here you are ramping up inventory because you obviously ran out of stock during the quarter itself or you couldn't produce fast enough. How do we know -- what gives you comfort that you're not going to overproduce by the back end of the year, and we're going to have the opposite problem in 2012?
Because we can fairly rapidly see as we see weakening demand occurring in the second half of the year and our production is ramping up fast, then we will have to eventually make a judgment and say, okay, we're not going to need that inventory if fundamental conditions of the market change. And of course, we're all are a little bit antsy at this point in time with regards to what the issues related to foreign sovereign debt have to -- or sovereign debt have to do with the overall economic impact. I mean, if we do not get to a resolution in the United States over the next week, that may have considerable repercussions on a global scale. So there is a level of uncertainty there. But I think the instrument that we're using is an instrument that we can fairly, quickly then adjust and correct. So it's not something where we make a decision today, and then we have to live with it for the next year. Because the seasonality of our business always makes the fourth quarter, especially the month of December, the natural throttle for our inventory adjustments that we do year-over-year.
And your next question is from George Staphos from Bank of America Merrill Lynch.
A couple of questions. First on operations, Al,Ed, are there any facilities right now where you are producing from a sub-optimal level relative to the mix of products? i.e. You're making wine bottles on beer machines. You're making mayonnaise on triple pans, is there any of that right now in your operations? And where to point, how long do you think it will take the North America to get out of this operational issue?
I think a lot of that was covered with the refootprinting that we did 1 year, 1.5 year ago, so we don't have a lot of that happening. The issue is much more -- that because of the demand of individual SKUs, we had to shift the volume from one facility to the other but still be a beer unit or would still be a beer facility, but it might not be in proximity. So it would be a couple of hundred miles away, which of course added significantly to the logistics cost. The other part that really contributed to the cost as well is that due to the changeovers -- during the changeover periods, we create quite a bit of material that we cannot really sell, that we have to reuse in our operations and that of course contribute significantly to the product loss. But fundamentally, from an infrastructure perspective, we are basically placed very well. I believe one thing that we perhaps misinterpreted and misunderstood was that facilities that typically were used to run wine and beer runs for a particular brand, and suddenly had to have a lot more changeovers had difficulty spiking with that additional complexity.
Okay. So how long do you think it will take to get out from this? And then the second question I had was, as I look back to what happened in the quarter it would seem that there was not necessarily the level of communication that you or Ed would have liked within your business groups, how do you -- if you agree with that premise, how do you incentivize that going forward, and how do you feel about your information systems allowing you to get the information you need to manage the business going forward?
Okay, well with regards to information systems, that, of course, was the intent of the implementation of SAPs to get better structure, information flow and information system that also follows a process rather than is aligned to its functions that we've been working on. Clearly, we're not communicating well enough at the beginning of the quarter to understand the issues and the complexities. I believe a decision was made to serve the customers at all cost, which I think is a very laudable conclusion. And that, however, lead them to complexities we've created for ourselves rather than perhaps also working with the customers to get greater accuracy in their forecasting. But it's clearly our fault, we have to fix it, and we have to deal with that. And I can assure you that information flow and communication has increased quite a bit over the last couple of weeks to make sure that we don't have the same occurrence in the future.
And your next question is from the line of Phil Gresh with JP Morgan.
Phil Gresh - JP Morgan Chase & Co
So earlier this year, we were talking about the opportunity for significant incremental margins in the developed markets. It looks like you did achieve that in Europe this quarter. Obviously there is the operational issues in North America, but I guess, what I'm wondering is, specifically in North America, where you're talking about more SKUs and shorter runs in craft beers, wines, spirits, et cetera, did that kind of take off the table, the potential for these higher incremental margins on a recovery in the future, or how are you thinking about that now?
It doesn't. It really is reinforcing the higher margins because typically, of course, if you have smaller SKUs, you also tend to get higher pricing points and better margins. It's really the operational flexibility that you have to have in place. And we fortunately have examples. In Latin America and in Europe where we have, for many years, had this flexibility because many of these plants serve quite a variety of uses and of applications, and clearly also have a great number of customers. Whereas in the United States, the entire customer environment has been more monolithic, and we have been focusing on large beer runs as our main focus areas in the past. And we just felt at the time when we entered into a more proactive pursuit of these smaller SKUs and higher pricing points, that because we have the capability in the company that we would have the capability in North America as well. And I think that's really where we perhaps misunderstood the complexity it adds to the plant floor and to the shop floor, and that's where we are taking corrective action at this point in time. But that certainly doesn't stand in the way of higher margins.
Phil Gresh - JP Morgan Chase & Co
Okay. And then in North America, you talked about the volume. But do you have -- can you talk about what pricing was like in North America? I know the volume was down slightly and if I back into it, it looks like maybe the pricing was down? I wasn't quite sure, do you think you can expose the details there, so do you have any color on that?
Well, I think pricing in the United States was slightly down. But basically, what -- that is also caused by the fact that we pass-through provisions for energy, and energy in the United States have decreased from last year. So the U.S. is behaving a little bit atypical to the rest of the world with regard to energy inflation.
Phil Gresh - JP Morgan Chase & Co
Okay. And just one final question, you talked about negative mix in Brazil, but you didn't really elaborate on it. It seemed to offset the price. So what is the mix issue there, and is that something that continues?
No. The mix in Latin America has predominantly to do with the fact that we are importing products and supply the markets in Brazil and Southern Brazil, so we're importing from Colombia, Peru, and that of course adds quite a bit of shipping cost, warehousing cost and importation cost attached to it, and that's really compressing the margin. That's also the justification, of course, to build capacity locally. Because then you automatically get margin expansion because you're no longer incurring those costs, and so the investment really pays for itself.
Your next question is from the line of Tim Thein with Citigroup.
Timothy Thein - Citigroup Inc
Just to circle back on Europe. Have you seen any change in terms of your customer ordering patterns that would corroborate your view that you mentioned earlier in terms of the market tightness, i.e. giving you orders further out than maybe they would have in the past if there is, if in fact they concern about security of supply?
Given the many thousand customers that we have in Europe, it's very difficult to really speak of a pattern. I mean, what we did see is, of course, higher demand in the marketplace. Now we have to see as we come out of the high season, how much of that was anticipatory orders. Because they knew the market was tight, so it's better perhaps to place 2 orders rather than 1 order, because I may need that additional volume, and then if I have to order it on short notice, I might not get it. So we have to balance a little bit as we're coming out of the high season now, whether all of the demands that we're seeing was really actual demand for actual shipments on the part of the customers. But a good sign -- despite the fact that we were the first ones out with an energy surcharge in the marketplace, we were reasonably successful and where we are the market leader in a country. And I believe that indicates that demand is still performing at a fairly decent level, even though we keep hearing from our customer base that a lot of that demand is not coming from Europe itself, it's coming from increased exports.
Timothy Thein - Citigroup Inc
And the corporate expense, I think the last quarter, Ed, you had mentioned up call it $10 million year-on-year. Can you just remind us what's flowing through that? If you look in the second half of the year, that implies at a rate -- you have 2.5x that of the first half, just kind of outline some of the key buckets in there that's driving that meaningful increase in expense in the back half of the year?
Well you've got 2 things. One, in the first half, we reversed some accruals from management incentives that I talked about in my prepared remarks, that number is $10 million. So you had a number in the second quarter that was $10 million lower because they don't repeat. There's nothing left to reverse in the back half. So that you go up 10 for that. And then our Glass Smart program, which is really showing dividend globally, is being led from the center. So you have the marketing initiatives that are coming through there, and we also have some of the SAP deployment costs. So although we slowed down the go live, we're still doing some of the configurations. Some of that work is still going on, which is also -- a lot of it is embedded at the corporate center.
And your next question is from the line of Alton Stump with Longbow Research.
Alton Stump - Longbow Research LLC
I guess first off in the Australian market, you mentioned beer and wine shipments being down 20%. Could you break out how much of that might be due to currency? And if it should come back, if we see currency trends stabilize, versus how much may actually be permanent long-term demand loss?
Well, Alton, I believe that's, of course, the 64-million-dollar question for the customers as well. But I believe they were hoping throughout the entire year last year that eventually currency would weaken, and they would be able to reoccupy the shelf space for their wine. And typically, you go into the stores, you find Australian or New Zealand wine at a particular price range, generally it's around the $10 price level. And with, right now, the Australian dollar at $1.10 to the U.S. dollar versus $0.70 or so 1 year, 1.5 year ago, of course, the entire margin has disappeared out of that business. And to try to reprice the product would require rebranding because people are not going to buy the same brand they used to buy for $10 suddenly for $20. So that's a very long-term proposition. I believe that fundamentally, the vintners have come to the conclusion that long-term, given the continued demand for basic raw materials in Australia, most probably the currency will continue to be at a high-level and therefore, that situation is not likely to change. So you see why the dramatic and significant changeover from packaged shipments, packaged product shipments to bulk shipments. They're not giving up on the market, but they're approaching the market in a different model, and that of course does not affect the overall consumption of glass on a global scale. Because what we're losing in Australia and New Zealand, we may be picking up in the U.K. or may be picking up in North America, and that's why we're seeing in North America, for instance, a fairly strong trend for wine bottles at this point in time. So it's a fairly complex equation, but I don't think that we can expect that the Australian dollar is going to weaken so significantly that we can reoccupy the price spot in the shelf.
Alton Stump - Longbow Research LLC
That's helpful. And just as a one follow-up with the $26 million production cost here in 2Q in North America, any color as to how much, if any of that, will bleed into 3Q?
Well those costs are basically reflected in the second quarter. So as we go into 3Q, we're coming out of this hole, and so it's going to be a gradual improvement that we're going to be working on in Q3 and then Q4 to improve that. I would say that most probably, most significant improvement we will see initially is in the reduction of freight cost. Because we are moving into a position where we've added additional capacity to our operations with those 2 furnaces, and that would help us -- hopefully help us a little bit to avoid these cross shipments that had so significantly contributed to the cost overrun.
And your next question is from the line of Philip Ng with Jefferies.
Philip Ng - Jefferies & Company, Inc.
Obviously, a lot had happened, and you guys have alluded to it. So I don't think anyone's holding you to the top line expectation you guys laid out a few years back. But overall, I think globally, the market is generally pretty tight. Do you still feel like you could hit the low end of your 16% to 18% margin target going forward?
Well, again, we have to keep in mind when we look at the numbers for this year, we are in a year that's typical for the glass industry, which is coming out of a period of no inflation, moving into a period of inflation, the glass industry's margins always are compressed. We have tried to counteract some of that in the past by making sure that in our long-term agreements and contracts, we have quarterly or monthly pass-through provisions for the most volatile cost component. But if you have considerable increases in raw material, if you have considerable increases in labor cost, or if you have considerable increases in energy prices in those markets where you don't have long-term contracts with pass-through provisions, you automatically get a contraction or compaction of your margin. What we then also typically find is that when we go down in the following year, where most of that inflation has run its course, we typically see margin expansion. Because that's when these inflationary forces will be passed through in the pricing and pricing arrangements we have with our customers. So I would say what we're seeing today is not necessarily indicative of a weakness in our overall objectives and targets as far as margin contribution from the glass industry is concerned. It is just that because of the way contracts are set up, it really has quite a bit of variability from year-to-year depending on when inflation occurs and at what place inflation occurs.
Philip Ng - Jefferies & Company, Inc.
That's very helpful. I'm just switching gears a little bit and focusing on Europe. Should we expect margins to get back to that 13% run rate, just because that market's obviously very tight right now, and it sounds like supply is pretty short?
As taken from our comments, that's where we have seen the greatest unrecovered inflation so far, and so that's where we would expect to see the greatest margin expansion as we go into next year -- or margin correction, I should say, it's not really an expansion, it's going back to what we had previously. And it's only logical that we see that. And what gives me confidence to say this is also that really from last year, market conditions have changed. The market is much more balanced in supply and demand than we've seen in the past 2 years, so we see much less interference of non-traditional competitors coming into the market and disrupting.
And your next question is from the line of Tom Mullarkey with Morningstar.
Thomas Mullarkey - Morningstar Inc.
When I look at South America now, it's the second consecutive quarter of sub-20% operating margins. And given that you just said Europe is going to see the biggest uptick in margin recovery next year, how much longer do think it's going to take to bring on the new capacity in order to eliminate a lot of the higher transportation costs that are keeping South America's margins down?
Well, I didn't say that Europe was going to see the greatest margin recovery. I said that Europe was going to get a recovery to the margins that we've seen before, and that of course is related to the inflation pass-through. The situation in Latin America is different. As we have said, we have been importing product from other regions. We have been doing some bottlenecking. We have been doing some footprint realignment in Southern Brazil to open up some of capacity that we still have available in our operations, which is going to reduce that import component in the second half of the year. And I would expect that our margins are going to be back over the 20% level in Latin America in the second half of this year.
From a seasonality standpoint, the softest quarter for South America is always the second quarter, so they're now coming into their seasonally strongest half, the back half.
Thomas Mullarkey - Morningstar Inc.
And my second question for your guys is I thought I understood the Vortex bottle in North America was under an exclusive contract that may have expired some time this year. Are you going to open that product up to other customers with the internal embossing?
Well, we're working with internal embossing around the world with other customers. In the United States, we had exclusivity for Pierre [ph] for this particular design with Miller, and that is still valid.
Angela, we have time for one more question.
And your final question is from the line of Chip Dillon with Vertical Research.
James Armstrong - Henry Armstrong Associates
It's James, calling in for Chip. My first question is, you mentioned that the Australian wine industry is making changes to its business model that would impact O-I long term. Can you walk us through what's changing?
What's changing is that they used to basically bottle their wine in the Australian region. Given the pricing points that they need to achieve on the shelves in the markets where they have positioned themselves, they are trying to reduce the freight cost. They're trying to reduce the labor cost in the country, so what they're doing is they're basically putting the wine into large containers and shipping these bulk containers then overseas, and then basically bottling in the market of destination. If in the market of destination, labor costs are high or comparable with Australia, at least they have saved the freight. If in the destination markets, labor costs are low, they have the added benefit of low labor cost as well as reduced freight. And that is allowing them to at least occupy the shelf space at a margin that is better than the margin they're getting at this point in time. So it's really an effort on their part to take costs out of the system and still be able to serve the markets that have led to such a significant expansion of the wine industry in Australia and in New Zealand.
And the bulk shipping is really more for the lower price wines. Your higher wines, your mid-price wines will always be estate bottled. So they would be bottled now where they grow the grape. But truly the bulk is on the low end.
James Armstrong - Henry Armstrong Associates
Okay. Would you expect to see volumes increase in other regions to make up for that then?
Well, we see stronger wine bottle demand in Europe, particularly also in the U.K., which is a core market for Australia and New Zealand wine. And we also see fairly -- very strong growth for wine in North America. So that's indicative of the fact that some of this is already occurring and is happening. And in addition to that possibly, European wines or domestic wines have taken the space, the shelf space that was occupied by New Zealand or Australian wines.
Thank you, everyone. That concludes our second quarter earnings conference call. Please note that our third quarter 2011 conference call is currently scheduled for Thursday, October 27 at 8:30 a.m. Eastern Time. We appreciate your interest in O-I. Have a good day.
This does conclude today's conference. You may all now disconnect.
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