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Owens-Illinois (NYSE:OI)

Q1 2012 Earnings Call

April 26, 2012 8:30 am ET

Executives

John Haudrich - Vice President of Investor Relations

Albert P. L. Stroucken - Executive Chairman, Chief Executive Officer, President and Member of Risk Oversight Committee

Edward C. White - Chief Financial Officer, Principal Accounting Officer and Senior Vice President

Jason Bissell -

Analysts

George L. Staphos - BofA Merrill Lynch, Research Division

Scott Gaffner - Barclays Capital, Research Division

Ghansham Panjabi - Robert W. Baird & Co. Incorporated, Research Division

Christopher D. Manuel - Wells Fargo Securities, LLC, Research Division

Adam J. Josephson - KeyBanc Capital Markets Inc., Research Division

Phil M. Gresh - JP Morgan Chase & Co, Research Division

Debbie Jones - Deutsche Bank AG, Research Division

Albert T. Kabili - Crédit Suisse AG, Research Division

Timothy Thein - Citigroup Inc, Research Division

Philip Ng - Jefferies & Company, Inc., Research Division

Alex Ovshey Ovshey - Goldman Sachs Group Inc., Research Division

Chip A. Dillon - Crédit Suisse AG, Research Division

Alton K. Stump - Longbow Research LLC

Todd Wenning - Morningstar Inc., Research Division

Operator

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 First Quarter 2012 Earnings Conference Call. [Operator Instructions] I would now like to turn the call over to Mr. Jason Bissell, Director of Investor Relations. You may begin now.

John Haudrich

Thank you, Angela. Good morning, and welcome, everyone, to O-I's First Quarter 2012 Earnings Conference Call. I am 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 development, review our financial results for the first quarter, and discuss future trends affecting our business in 2012. Following our prepared remarks, we'll host a question-and-answer session. Presentation materials for this earnings call are also being simulcast from the company's new website at o-i.com. Please review the Safe Harbor comments and 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. And 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.

Albert P. L. Stroucken

Thank you, Jason, and good morning. Our adjusted net earnings were $0.73 per share in the first quarter of 2012 compared to $0.53 last year. As we announced in the first quarter update 2 weeks ago, our manufacturing operations performed very well this quarter. Cost control measures implemented last year and high operating rates in most regions resulted in very good performance as we enter the stronger upcoming shipping season.

We also benefited in the first quarter this year from the nonrecurrence of significant flooding in Australia that impacted prior year results. Global sales volumes vary by region. Shipments were flat in Europe, up slightly in South America and up a little bit more in North America however, Asia Pacific sales volumes were down compared to the prior year quarter.

This was largely driven by lower shipment levels in China as a result of several furnace rebuilds and the residual impact from the 2010 closure of our Guangzhou facility. Overall, global volumes were down almost 2% but excluding the impact of China, our volumes would have been flat in the first quarter. While our selling prices were up and covered this year's inflation, their average impact was somewhat muted in the first quarter because increases went into effect at different times over the course of the first 3 months.

Looking to the second quarter, we expect that stronger year-over-year financial results will be led by improved operating performance in North America. We expect global shipments will, again, be slightly down on a year-over-year basis, primarily from lower volumes in Europe and Asia Pacific. Our price negotiations are now largely complete for 2012 so we should see a stronger price inflation spread.

Moving to the remainder of the year, our visibility of demand trends in the second half remains limited, especially in Europe. As a result, at this time, we expect the financial results of the second half of 2012 to track in line with the second half of 2011, which includes the improvements achieved in the back half of last year.

Let me review our operating performance beginning with Chart 3. Here, we show the first quarter segment operating profit for each of our 4 regions. Total operating profit was $260 million in the first quarter, up from $208 million last year. As you can see on the chart, 3 regions were well ahead of the prior year.

Our European operating profit was $108 million, up $32 million from the first quarter of 2011. The primary driver of improved results in Europe was good manufacturing performance of the plants, which operated at higher production rates in prior year and this helped us build inventory to support the seasonality for the wine, beer and food markets. In addition to strong operations, profit in the region benefited from higher prices that covered inflation in the quarter and also allowed for the recovery of some of the margin erosion that we experienced last year.

Overall, price and manufacturing performance were the key factors that drove improvement while shipment levels for the quarter were flat compared to the first quarter 2011. Year-over-year sales volumes varied considerably by country, end market and by month through the quarter. The quarter started out strong likely due to customer purchases in advance of price increases, but volumes weakened as the quarter progressed and then ended, again, on a somewhat stronger note.

Northern Europe showed higher volumes while southern Europe was down. The beer market was ahead of prior year, while the wine and champagne markets were not. Most of our annual customer negotiations in Europe are now complete, and we saw a decline in wine volumes in the first quarter partially due to our pricing strategy and partially to challenging economic conditions in some countries. For example,, volumes were down overall in Spain as we exited some low-margin beer business and closed a furnace at the end of 2011.

In addition, the weak local economy in Spain created higher competitive pressures in the wine sector. Although generally lower wine volumes are expected in Europe for the year, it is difficult at this time to determine the amount of the decline since many of our customers are small producers who typically vary their order patterns during the off-season but become more dependent on availability of supply as the season progresses. Overall clarity for our sales projections across all end uses remains limited, and there's a challenge for our demand and capacity plan.

Nevertheless, we remain fully committed to our pricing strategy to repair our margins, and we are prepared to adjust our capacity to align our operations to the customer needs. We recently idled a furnace in Europe temporarily to better match our production levels with demand, and we will continue to monitor volume trends in the region to determine if additional capacity actions are necessary.

In North America, operating profit was $78 million, up from $63 million in the prior year. Year-over-year shipments in this region were up 1.5% in the first quarter of 2012, with most end-use categories higher. We believe this is partially attributable to a mild winter season.

Based on the actions we have taken to improve operating performance in this region, inventory levels are up about 25% over the first quarter 2011. This will help meet expected higher shipment levels in the second quarter due to the approaching summer. And finally, we successfully deployed SAP in this region in early February, and we were very pleased with the way the business and the implementation team worked so well together.

Moving to the Asia Pacific region, operating profit was $36 million, up from $24 million in the first quarter of 2011. This is largely due to the nonrecurrence of a flood that impacted our facility in Brisbane, Australia last year.

Now let me give you some color on the 2 largest markets in this region. Australian volumes were down by a mid-single-digit percentage from the prior year due to reductions of in-country bottling by wine producers. Beer volumes were also down in the quarter as high interest and savings rates continued to negatively impact consumer spending. At the end of March, we closed a second furnace in Australia to further lower our cost and better match capacity with demand.

In China, year-over-year shipments were down more than 25% in the first quarter largely due to 2 factors. First, in southern China last year, we were still selling product out of inventory from our Guangzhou facility after we ceased operations there, and we did not have the benefit of those sales this year.

As I mentioned on our last earnings call, we have started to replace some of the lost capacity from the Guangzhou closure by building a new furnace at a nearby facility. This new furnace should start up by the end of the third quarter. The second factor that impacted sales this quarter was operational in nature. We had several furnace rebuilds in the seasonally slower first quarter, which limited our ability to supply the spot market in China.

And finally to our South American region. Operating profit was $38 million, down from $45 million in the prior year's first quarter. This was a result of scheduled furnace rebuilds, higher repairs and maintenance activity, and a onetime adjustment to employee benefit costs in the region. Total shipments were up slightly, but keep in mind that we are currently supporting growth in Brazil through imports.

To reduce the high freight costs associated with these imports, we are in the process of constructing a new furnace in southern Brazil and we expect it to be operational in the fourth quarter. Overall, we are encouraged by our first quarter performance and the benefits that we're seeing from our improved execution and cost control program.

Looking to the second quarter, we expect similar benefits, particularly due to the significant improvement in our North American operations year-over-year. And I will now turn the call over to Ed.

Edward C. White

Thanks, Al. Let's begin our financial review with the first quarter reconciliations for sales, operating profit and EPS on Chart 4. First quarter 2012 segment sales were $1.7 billion. Price and mix in the quarter was up $63 million from the prior year. Because pricing actions progressed through the first 3 months, we exit the first quarter with price mix up more than 4%.

As in prior quarters, cost pass-through provisions had a small impact on sales. These provisions are in certain customer contracts and are principally for energy cost movement. Lower sales volume decreased the top line by $4 million.

Finally, currency translation decreased our top line by $22 million in the quarter, primarily due to a weaker euro and also some effect from a weaker Brazilian real.

Moving over to segment operating profit. The first quarter was $260 million, up $52 million from the same period last year. Globally, price mix improvement stayed ahead of inflation by $13 million this quarter. Although lower volumes slightly impacted the top line, this had little to no impact on segment profit as a result of favorable regional mix. Manufacturing delivery costs were $31 million lower and were the main drivers of higher segment profit this quarter. The primary factors for this improvement were, first, increased production levels which resulted in higher fixed cost absorption, cost savings from productivity and footprint initiatives. This also contributed to better manufacturing results. And as Al mentioned, the nonrecurrence of approximately $9 million of cost penalties associated with flooding in Australia last year.

Finally we had a $6 million year-over-year benefit in the first quarter as a result of higher inventory values due to standard cost inventory changes. These standard cost provisions occur in the first quarter every year, but were somewhat larger this year primarily due to changes in normal capacity levels in Europe.

Moving to operating and other costs. They were $13 million lower than prior year as a result of global cost reductions and the timing of SAP-related project costs. The major category on this line is SG&A cost at the regional level.

Finishing with the EPS reconciliation. Our adjusted net income was $0.73 per share in the quarter compared to $0.53 in the prior year quarter. Operating profit was up $0.24 from the prior year while nonoperational items were unfavorable by $0.04. The key elements were corporate and retained costs, which were higher because of reduced earnings from lower machine and equipment sales, as well as higher incentive compensation costs.

The tax rate for the first quarter was higher than prior year based on our current expectations of our regional earnings mix. We continue to believe our full year effective tax rate will range between 24% and 26%.

Offsetting some of this, we had net interest expense which was lower due to redemptions of higher cost debt in mid 2011. Finally, there were no items in this quarter that management considers not representative of ongoing operations. Therefore, Note 1 on the earnings release only shows a prior year item.

Let's move to Chart 5 for more detail on our balance sheet and free cash flow. On March 31, 2012, cash was $299 million and total debt was $4.1 billion. So net debt was $3.8 billion, a decrease of more than $100 million from the first quarter of last year. Our net debt-to-EBITDA ratio was about 3x at the end of the first quarter consistent with the prior year quarter.

Shifting to cash flow. As we've discussed in the past, seasonality in our business usually results in the use of cash in the first half of the calendar year followed by a strong source of cash in the back half. The first quarter was a $164 million use of underlying free cash flow similar to the prior year use of cash. Higher earnings in the first quarter this year were offset by larger working capital use.

Finally on the right-hand side of the chart, you see our capital allocation priorities for 2012.

On Chart 6, we present our business outlook for the second quarter, including operating profit by segment, non-operational costs, and overall adjusted earnings. Starting with Europe. Our second quarter segment profit should closely approximate the prior year. With the variability and shipment patterns that we have seen to date, it's difficult to project our overall sales volume in the next quarter. However, our current expectation is that volumes will be down low single digits from the prior year. We expect the benefit of price increases to cover inflation by a greater amount than in the first quarter of 2012. This should offset most, if not all of the impact from lower sales and lower production volumes.

Lastly, at current exchange rates, foreign currency looks to be a year-over-year headwind in the second quarter for Europe. In North America, we expect operating profit to be up considerably versus the prior year, which reflects the step we have taken to avoid supply chain inefficiencies experienced in the second quarter last year. We have replenished our inventory levels and are well positioned to meet stronger seasonal demand in the second quarter.

We also expect year-over-year volumes to be up to low single digits. Since the second quarter of last year, we've reduced cost at both the factory and SG&A level, and this should also improve our improvement in the upcoming quarter. In Asia Pacific, we also expect operating profit to be up over the prior year second quarter but only modestly. In Australia, we do not yet see a pickup in the beer end-use, and we expect some additional shift from bottled wines to bulk shipments.

However, we're seeing the benefits of our Australian footprint initiative and cost savings measures. Further, later in the second quarter, the second quarter we plan to permanently close a machine line at one of our facilities to better match demand expectations.

In South America, second quarter segment profit should approximate the strong prior year level. Sales volumes in the second quarter are expected to be up by low single-digits, but higher cost to import inventory to support Brazilian growth will continue to temper margin. We also have expenses associated with capital spending for the new furnace we are constructing in Brazil.

Currency also appears to be a headwind for the entire region in the second quarter. Overall, we're pleased with our progress in South America and see the investments we are making today positioning us for a significant year-over-year improvement in the back half of this year.

Turning to non-operational items. We expect our second quarter corporate costs and effective tax rate to both be higher than prior year's second quarter levels but should approximate first quarter 2012. So overall, we expect the second quarter adjusted earnings to exceed the prior year.

Before concluding, let me also provide some commentary on our expected results with the back half of 2012. As Al mentioned, at this time, we expect our second half results to be in line with prior year second half results.

This may appear puzzling to some but let me share some of the important factors that lead to this early outlook. First, as you may recall, to improve our operating performance in the second half of last year, we took several key actions, which included boosting production and inventory levels in North America. In fact, we produced almost 150,000 tons more than normal to restore our North American supply chain last year.

Next, implementing price surcharges in Europe in the second half of last year and instituting broad-based cost-cutting initiatives. So these activities improved our performance in the second half of 2011, and we are enjoying these in the first half of this year. They are now built into our base when we enter the second half of 2012. So we will face higher comps while at the same time we have limited clarity into European volumes. Now I will turn it back to Al for closing remarks on Chart 7.

Albert P. L. Stroucken

Thanks, Ed. Overall, we are encouraged by our start to the year. Our progress has been driven by improved operational performance and initiatives, and our pricing strategy is creating value and providing margin repair.

Looking to the balance of 2012, we are optimistic that we will continue to see strong performance from operational excellence initiatives that are well within our control. From a commercial standpoint, sales demand trends look good in the Americas, yet challenges still exist in certain areas of Europe and Asia Pacific.

Importantly, we are prepared to manage our global manufacturing footprint to ensure it's aligned with varying demand levels. We remain committed to generating higher levels of cash, and we now expect our underlying free cash flow not to be below $250 million for this year.

Our priorities for capital allocation this year are the same as we shared with you on our last earnings call, continued progress to lower our debt to leverage ratio, restructuring and capacity adjustments in some regions, and construction of new furnaces in faster growing areas.

Thank you, and now I will ask Angela to open up the lines for your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And your first question is from George Staphos with Merrill Lynch.

George L. Staphos - BofA Merrill Lynch, Research Division

I guess, the first question I had was on volume in the outlook. Al, Ed, as you look at the outlook for the second half, we appreciate the details you gave us, I realize it's a pretty uncertain environment right now. If you took the current volume run rate realizing that there are a number of months yet to go and that you have uncertainty, would you still be at a flat year-on-year comparison in the second half or would you be higher, and it's just the uncertainty that we all know about in the market that's making you have your guidance flat year-on-year versus second half?

Albert P. L. Stroucken

I mean, that's pretty simple to answer. It would certainly be higher because we have gotten a significant contribution from a high run rate in our operations. But as you know, to achieve the cash flow numbers, that we have set as a target, we need to make adjustments in our operations if the sales are not coming up to the levels that we hope for, and that is really the balance that we are trying to strike in our projection at this point in time.

George L. Staphos - BofA Merrill Lynch, Research Division

Okay, I appreciate that. The other question on volume. In North America, you've had a good start to the year. You mentioned over the course of the quarter that we just experienced, your regions had, at different time, different paces to their volume trend. How did North America exit the quarter? How has it performed thus far early in 2Q?

Albert P. L. Stroucken

North America has basically been solid throughout the quarter. I mean, there are some slight variations from month to month just because of the pace that you have in the months. But in comparison to the previous year, it's been pretty solid and performing at a similar ratio throughout the entire 3 months period. So there is no discernible variation in trend.

Operator

And your next question is from Scott Gaffner with Barclays.

Scott Gaffner - Barclays Capital, Research Division

I just wanted to dig a little bit deeper on your cautious tone on Europe. Can you just go in a little bit more depth on why you're a little bit cautious maybe on the end markets and then also by region?

Albert P. L. Stroucken

Yes, if you look at Europe, there is a separation, of course, in economic strength in the region at this point in time between north and south, but there's also a difference in the product, main product lines. If you'd go further south, you have more wine in your portfolio; if you go further north, you have more beer in your portfolio. Beer is doing generally pretty well at this point in time and, of course, there are 2 significant events this summer in Europe as well. One has to do with soccer, the other one are the Olympics, and that clearly, I think, gives us a little bit more confidence. With regard to wine, the 2 or 3 main countries in Europe, France, Italy and Spain, 2 of those countries, of course, are in the limelight with regard to their economic situation and that is impacting domestic consumption. And that is putting quite a bit of pressure on the marketplace with regard to where are the volumes going to go from that market, and that's creating a different dynamic and that makes it a little bit more difficult for us to really become predictive. Now we know that the wine business typically is a business that has a somewhat higher margin than the beer business and that is an additional component you have to take into consideration when you look at our outlook.

Scott Gaffner - Barclays Capital, Research Division

And then just as a follow-up on your pricing strategy in Europe, how much do you think that would impact your volumes versus the industry?

Albert P. L. Stroucken

It's very difficult to say at this point in time. As you saw in Europe, our volumes were flat with the previous year in the first quarter, so we really haven't seen an impact yet overall. Now the question is really going to be how is this going to work out in the second quarter? And as I mentioned in my comments, especially our small wine customers typically have the greatest flexibility in the off-season to move their volume around because their volume can easily be placed somewhere else in the off-season. But when you go to the more demand-driven season, then suddenly that volume dries up and then we'll see some of those customers coming back, and that's really the uncertainty we see at this time.

Operator

And your next question is from Ghansham Panjabi with Baird.

Ghansham Panjabi - Robert W. Baird & Co. Incorporated, Research Division

The -- going back to the inventory build in the first quarter, was any of that sort of planned for the European capacity footprint adjustments?

Albert P. L. Stroucken

Yes, of course. It also gives us greater ability then if we have to make decisions -- to make those decisions rapidly as we go forward because we basically have sufficient capabilities built in to deal with some shifts -- some regional shifts in supply.

Ghansham Panjabi - Robert W. Baird & Co. Incorporated, Research Division

Okay. And can you just, Al, just sort of talk about what an appropriate margin target might be for Europe once you're done with the restructuring just given -- assuming that the current operating environment is sort of the status quo for the next couple of years?

Albert P. L. Stroucken

On a longer-term basis, we have always talked of a margin between 16% and 18% EBITDA. We're trying to achieve Europe at its best rate was, I think, at 14% or so 2 or 3 years ago. We would hope that under normalized European conditions eventually, we'll get closer to the 15% range because the 16% to 18%, of course, is an average for our global business.

Operator

And your next question is from Chris Manuel with Wells Fargo.

Christopher D. Manuel - Wells Fargo Securities, LLC, Research Division

A couple of questions I had. When you're -- could you talk maybe a little bit about what's happening in Brazil? Where are you shipping the volume in from maybe the amount that you're taking in there and what you feel underlying markets are like? I know you said that you were kind of flat there or up just a little bit, but I guess I'm trying to get a sense as to how much you're bringing in, how much that impact might be and what the underlying market is doing.

Albert P. L. Stroucken

All right. Let me start with the last point first. Overall, Brazil has gone through a little bit of a coaster ride over the last couple of months. The government is clearly opening the faucet at this point in time to drive economic activity, again, and certainly in the projections that we're getting from our customer base, that's clearly reflected for the latter part of the year. Even in the first quarter, Brazil was up in volume. I know that in some other product lines, volume was down. And we were very confident with where we are at this point in time. And we're also getting more and more comments from our customer base that their preference going forward for new product lines, new product introductions is going to be in glass rather than in alternative packaging materials. Reflection of this growth is also in the impact that we saw in the first quarter because we are continuing to import well over 100,000 tons on an annualized basis from other countries in the region to supply the Brazilian market, and that's one of the main reasons that we're building this additional furnace in Rio, which should be onstream and producing in the fourth quarter of this year because that really then takes the volume that we've been building up and makes it domestic and therefore, of course, would give us some decent margin expansion, and we will then continue to have additional buffer capacity available for continued growth as we go forward. So it's really reducing the risk of our investments significantly as we go forward.

Christopher D. Manuel - Wells Fargo Securities, LLC, Research Division

Okay. And Last question I had was, is there a way maybe, Ed, for you to quantify heading into 2Q what the -- I think last year, if memory serves, when you talked about profit being up significantly in North America, I have a footnote here that it was something in the neighborhood of $25 million range that you had estimated that the manufacturing input or the manufacturing issues were in North America. Is that about what we would anticipate to reverse? And then the second question, along those lines of unusual items last year was, is there any lingering flooding impact that -- or things of that nature to help us in Australia?

Albert P. L. Stroucken

If I can try to take a stab at it, and then I'm going to let Ed correct me. What I recall is that last year we had talked about a $25 million or so impact of the operational inefficiencies, and we certainly would not see those this year. We also do not believe that in the Australian market, there was a lasting impact of the flooding in Brisbane that we would be lapping in the second quarter. We had the full impact of the Brisbane floods last year in the first quarter, so there was no additional effect. What we would see as improvement in the second quarter in Australia is most probably because we hit the brakes last year in the second quarter in our manufacturing output significantly and we're in a much more controlled environment at this point in time. Ed?

Edward C. White

In the U.S., we're also operating at higher efficiencies right now. Sales are up over prior year, so those will all be additive to the $25 million we just talked about.

Operator

And your next question is from Adam Josephson with KeyBanc.

Adam J. Josephson - KeyBanc Capital Markets Inc., Research Division

To what extent was the inventory build-up in the quarter planned and to what extent that it results from demand weakening as the quarter progressed as, I think, Al spoke of earlier?

Albert P. L. Stroucken

When I was talking about some weakening, we were talking specifically about Europe because it was up and down throughout the quarter. Overall, we clearly went into the year with the intent of using our manufacturing capabilities early because we would typically have a very, very strong second quarter because we would have a combination of operational efficiencies and higher sales. Yet it also sometimes then led to logistics costs that were quite considerable and unforeseen because sometimes our customer base does not have a very good picture about their demand profile either. So we felt that it's perhaps leading to a more steady process and steady stream of income if we ship some of that production earlier into the year. We will not keep it for very long, so it's not a very huge cash strain for us but it, at least, allows us to serve the variability that our customers may have in their projections much easier and with much less strain on the system.

Edward C. White

To give you a data point, our second quarter sales typically are 15% higher than the first quarter as we move into the season. So building in the first is certainly the support of much higher sales pace in the second.

Adam J. Josephson - KeyBanc Capital Markets Inc., Research Division

And then one follow-up, how did the recent accounting change going from LIFO to average cost in the U.S. affect results in the quarter?

Edward C. White

It actually took us down year-over-year about, I think, was it $0.04, Jason?

Jason Bissell

Yes, about $0.04 in North America.

Albert P. L. Stroucken

$0.04 to $0.05, I believe.

Adam J. Josephson - KeyBanc Capital Markets Inc., Research Division

COGS were higher...

Edward C. White

And part of that -- also a part of that, let me jump in, as natural gas goes down, that takes your standard costs down. And I think some people have questioned, well, gee, if natural gas is so low, why isn't North America making more? But that's all on the pass-through, which is that big line that shows up in our sales reconciliation.

Albert P. L. Stroucken

And that also has an impact on the price comparison because, of course, if we look at our overall global pricing, the pass-through in North America of lower natural gas prices reduces the overall price differential between last year and this year.

Operator

And your next question is from Phil Gresh with JPMorgan.

Phil M. Gresh - JP Morgan Chase & Co, Research Division

Just looking at the guidance for 2Q and kind of trying to think about it relative to 1Q, if I kind of plug in what you said, it sounds like it's kind of flattish quarter-over-quarter. And so I guess, as I think about it, you said pricing cost is going to be more positive. Volume is typically higher second quarter versus first quarter. Currency, it sounds like it's more negative. Could you just give a little bit more color on that? Is that fair -- that you're saying flattish, because it seemed like there's some moving pieces that could imply higher?

Edward C. White

Well, in South America, we have the continued project work going on and in Asia Pac, they enter their weakest quarter in terms of their own seasonality. And then in Europe, we built the inventory, so now you're not going to have quite -- you're not going to be building inventory ahead of sales and we've actually taken a furnace down, which is going to carry some unabsorbed fixed cost and then we've already talked about North America in earlier questions. So there's kind of puts and takes to it, which is why we wanted to kind of give this kind of clarity for the second quarter.

Albert P. L. Stroucken

And I think I also have to be very clear with the uncertainty that we get from our marketplace. I would say it would be misplaced to push all these concerns aside and be optimistic.

Phil M. Gresh - JP Morgan Chase & Co, Research Division

Understood. Okay, and then in terms of the production impact, I think you've previously said it'd be about a $40 million negative for the year. Is that mostly loaded in the third and fourth quarter, or do we start seeing that here in the second quarter?

Albert P. L. Stroucken

Yes, it's mostly loaded in the third and fourth.

Operator

And your next question is from Debbie Jones with Deutsche Bank.

Debbie Jones - Deutsche Bank AG, Research Division

I was hoping you guys could talk about the comments you made in Brazil about new product announcements and how your customers are looking at glass versus alternatives. And I was wondering if you could just talk about other regions and what you're seeing on glass packaging versus alternatives.

Albert P. L. Stroucken

Well, I would say overall, we're encouraged by signs that we're seeing on a broad base throughout the world, and even in North America even though it's very early in the stages, we see glass strengthening a bit after it has gone through a period of about 3 years, where we saw some weakening of glass and that's, of course, particularly driven by beer in North America because that's the single largest product line. And typically, what we are seeing in the emerging markets, which are really the growth driving markets, there is a preference for glass packaging because, particularly, returnable glass packaging allows our customers to hit pricing points earlier in the consumer evolution, because a returnable bottle is the lowest-cost packaging alternative available by far compared to any other alternative. And that's driving quite a bit of the decision points as well because our customers really want to get brand loyalty early in the evolution of the consumer groups that are coming into the middle class, and that is a core driver for their considerations.

Debbie Jones - Deutsche Bank AG, Research Division

Okay. Are there any markets where you're seeing a shift- away from glass?

Albert P. L. Stroucken

I think we've seen most of that over the last 20 years. And even in the last couple of years, I think, I would say comparing glass, aluminum and plastics, it's clear that aluminum is outpacing plastic and glass -- plastic is outpacing aluminum and glass. But between metal and glass, I would say glass is certainly performing better over the last 10 years from the statistics that I've seen.

Edward C. White

And what we've often said before, Debbie, is that if an emerging market -- if metal and plastics have a low percent of the mix, they will be seeing maybe larger percent growth on a small base where if glass has been the dominant package, we're getting good growth in terms of units but the percent will maybe not sound quite as high but it's still there, and that's where the intent is.

Albert P. L. Stroucken

Yes, perhaps, for clarification as well because it's an interesting phenomenon that I saw. We did an analysis, for instance, of the Brazilian market and we looked at the packaging per transaction, and the share of glass per transaction is very high. So I think over 50%, close to 60% of the total packaging per transaction because you have a lot of returnable float in that packaging demand. So even if you look on the overall consumption rates that we've seen at best, glass still occupies on a per consumption base a very important space in the marketplace.

Debbie Jones - Deutsche Bank AG, Research Division

Okay. I was curious, Asia Pac, where did that come in the quarter versus what you were expecting? And then can you just give us some color or guidance on what type of margin we could see for the remainder of the year?

Albert P. L. Stroucken

Well, Asia Pac, as we have said, is mainly driven of course by what's happening in Australia and New Zealand. And I think the trends there are going to continue to show us a weakness because of the conversion of packaged wine and to bulk wine, and also the economic situation in Australia is forcing people to go to a higher savings rate so there is less consumption, and I think that's going to continue. China, clearly, is going to be a continuing growth market, as well as Southeast Asia. So overall, I think it's quite obvious to us that Asia Pacific will remain a very strong growth driver for us, but it will not come from the markets that we have traditionally been strong in.

Operator

Your next question is from Al Kabili with Crédit Suisse.

Albert T. Kabili - Crédit Suisse AG, Research Division

Just, I; guess, question on cost inflation outlook, if you could maybe provide us an update of what you see for the full year there based on current input costs. And then also if you could give us an update on hedging in your energy situation in Europe where you stand there.

Edward C. White

Well, I think we probably surprised some people at the beginning of the year when we said inflation this year would be north of $200 million. But you started to watch Brent crude while it's off its highs, its average this year is higher than the average for last year. Natural gas has been coming down, and so that looks like deflation but we're coming down the most of the U.S., and that's on a cost pass-through. We always have the unionized environment we operate globally and especially, in some markets are experiencing much higher inflation than you see in the U.S., you always get the labor inflation coming through. So that $200 million range is still there, but it's not as strong as we thought it could have been 3 months ago, so that's backed off a little bit.

Albert T. Kabili - Crédit Suisse AG, Research Division

Okay. And the hedging in Europe, sort of how much have you locked in place on the energy in Europe?

Albert P. L. Stroucken

I would say at this point in time we're around 60%, 65% is hedged. But there is another component in there, which is pass-through that we have contractually committed. So I would say we're somewhere around 75% or so or higher.

Edward C. White

That's in the ballpark there.

Albert T. Kabili - Crédit Suisse AG, Research Division

Okay, that's helpful. And then follow-on is just pricing. I know you didn't get the full benefit of some of the pricing actions in the first quarter. Can you kind of talk about as we look into 2Q, as we think about getting all the benefits of the recent pricing actions, what pricing year-on-year could look like 2Q and...

Albert P. L. Stroucken

Let me say, as Ed mentioned, as were exiting the quarter, we were on 4% or so. I think our projection for the year was 5%. I think that projection on a like-for-like basis is still valid. Now you may have an impact in North America if natural gas stays below $2. That may impact the top line, but it really doesn't have an impact then on the contribution that we get from.

Edward C. White

And with South America becoming a larger part of our regional mix over time, being south of the equator, you have Asia Pac and South America that has considerable pricing actions that are really in the back half because their seasonal year has kind of started in the July time period.

Operator

And your next question is from Tim Thein with Citigroup.

Timothy Thein - Citigroup Inc, Research Division

Just to actually continue on that last thought on the -- as we look towards the -- as the year progresses in terms of that price cost and just tying that into the comments and the guidance you gave for the second half of the year. If you -- so call it the $200 million of inflation and use that, and as you work towards that 5% kind of number. Obviously, the benefit from pricing increases as the year goes on. And at the same time, you had, I think, in the third and the fourth quarter of last year, you were negative by a $30 million, $40 million pace in each of the last 2 quarters. So presumably that swings pretty nicely in your favor. And I hear that the concerns about the outlook or just the volume picture in Europe. But are there any other -- or am I missing something and just in terms of other key elements?

Albert P. L. Stroucken

I would say, Tim, that I think we'd talked about a spread improvement of about $150 million or so as we went into the year between inflation and pricing, and I think that's still valid at this point in time. And I think your consideration with regard to the benefit in the second quarter -- in the second half of the year is also logical. Against that however, you have to set the volume reductions that we're seeing in overall production in the second half because we're not having the build-up of the inventory. And when we look at those numbers, they basically wash.

Edward C. White

While you get -- while you get such a broad range in our outlook because we feel comfortable on the price cost because we kind of see how that's going, but the absorption or unabsorption of fixed cost depending on the volume, where the greatest uncertainty sits.

Timothy Thein - Citigroup Inc, Research Division

Right, okay. But that would imply, I mean, to offset a, call it a $50 million, $60 million benefit in price costs compared to where -- an even higher net where you were a year ago, that would imply a pretty significant worsening in the volume picture from where we sit today. Is that fair?

Albert P. L. Stroucken

It's not in the sales volume, that's in the production volume.

Timothy Thein - Citigroup Inc, Research Division

Okay. And just switching gears on the South America. As you -- can you quantify -- and I don't know if the benefit will be felt in the fourth quarter, but just on a quarterly basis, as you're not incurring the freight cost related to the...

Albert P. L. Stroucken

I think if you look at the last year, you'll see a similar version progression and I think you would see something similar this year.

Timothy Thein - Citigroup Inc, Research Division

In South America, in Brazil, rather.

Albert P. L. Stroucken

Well, no, overall South America. I mean, if you look at it last year, we had some of -- wee feel that some of the same questions in the first quarter of last year and we stuck to our -- what was it, 20% or so EBITDA we were projecting for the remainder -- for the full year. And I think as that played out last year through the quarters, you will see something similar in the course of this year.

Edward C. White

When the new furnace is starting up, we're taking Rio from 2 furnaces to 3. When that third furnace starts up in Rio in the fourth quarter, I think you'll see a very strong prior year for the South American team.

Operator

And your next question is from Philip Ng with Jefferies.

Philip Ng - Jefferies & Company, Inc., Research Division

You guys flagged out Europe where you guys kind of overbuilt on the inventory into the quarter and for Q1. How much of a lift was it?

Albert P. L. Stroucken

With regard to?

Philip Ng - Jefferies & Company, Inc., Research Division

The inventory build for Europe because it sounds like it's going to reverse itself.

Albert P. L. Stroucken

I don't know off the top of my head what it was for Europe, but I think clearly in the overall results that we have, we got a significant benefit. And Ed, perhaps, you know what the number was specifically, but I don't recall offhand.

Edward C. White

Well, Europe picked up about $20 million of EBIT from an inventory build. But still, I guess, we don't use the word that we overbuilt. What we're trying to do is we're trying to prepare for a strong second quarter. And if it doesn't all get depleted, we've got the third quarter to let it go through. So what we -- we always feel building in the first quarter, we learned a little bit from last year, right?

Philip Ng - Jefferies & Company, Inc., Research Division

Sure.

Edward C. White

We worked -- we wanted to be in a good position this year.

Albert P. L. Stroucken

Yes. And then coming back to a question that was asked earlier, it doesn't make any sense to run your inventories very lean if you're contemplating potentially, making adjustments in your footprint because where you're going to get the volume to cover your customers during that transition, during that change. So that also requires some adding of capabilities.

Philip Ng - Jefferies & Company, Inc., Research Division

Got you, that makes sense. And just switching gears a little bit in North America. It didn't sound like inventory was higher than normal. One, is that fair and should we still assume that the margins in North America should pick up sequentially, because it sounds like you're pretty constructive on demand in North America?

Albert P. L. Stroucken

I believe I mentioned in my comments that our inventory in North America was 25% higher than last year, so it's a considerable shift we had from last year.

Edward C. White

Well, the sequential margin improvement you certainly are going to see it in the second quarter and you're going to see it for the full year.

Philip Ng - Jefferies & Company, Inc., Research Division

Okay, and then just lastly, if I remember correctly coming out of the recession, and you guys have obviously done a lot of rightsizing the footprint in North America. Your incrementals were quite high. Can you remind me how high are they if volumes continue to improve?

Edward C. White

Incremental margins?

Philip Ng - Jefferies & Company, Inc., Research Division

Yes, North America, I thought it was in the 40%, 50% range.

Edward C. White

Typically, I've said, depending on the plant and the location and where they were operating, it would be 40% to 60%. And we like to guide to the 40% because I think there's a lot of things that can happen.

Philip Ng - Jefferies & Company, Inc., Research Division

Okay. And is it fair to say that you guys are -- you guys have probably the most spare capacity because you lost some business to the AB contract a few years back? So if beer does come back, you guys are probably going to see a big lift...

Edward C. White

Philip, we can't have it both ways. We can't -- when we walked away from some AB business, take out capacity and say we have a lot of excess capacity, we're trying to really be balanced there.

Albert P. L. Stroucken

I would say, Phil, if the beer demand of the mega brands were to increase by 1% or 2%, the market would be extremely tight overall, and in some cases, we're already seeing some signals of that. And the other part that I want to come back to with regard to the incremental margin, that creates, of course, some of the uncertainty that we have in our forecasting because at the edge, that 1% goes either way with this significant contribution, and that makes it much more difficult for us to be predictive on our EBIT than perhaps our competitors in the metal and in the plastic end that are really converters, where most of the cost is not a fixed cost and it's basically fairly easily adjustable either in labor by reducing shifts or by using less raw materials, which is a significant component of the cost structure.

Philip Ng - Jefferies & Company, Inc., Research Division

And then on the decrementals in Europe as things do soften?

Albert P. L. Stroucken

Well, that's really why we're looking then at taking capacity out. That's really the way...

Operator

And your next question is from Alex Ovshey with Goldman Sachs.

Alex Ovshey Ovshey - Goldman Sachs Group Inc., Research Division

Can you aggregate for us some of the furnace closures that you've done over the last 12 months and expect to do for the balance of 2012 and how we should think that will impact the productivity this year?

Albert P. L. Stroucken

I would say we've had 2 closures last year. We did a closure in Australia and we had a closure in Spain, in Seville.

Alex Ovshey Ovshey - Goldman Sachs Group Inc., Research Division

Okay, that's helpful. And in North America, I think you said volumes were up 1.5% in the quarter and you mentioned that there was an impact from the favorable weather. So as you look forward with unemployment still high, some of the end market data we see for your key end markets still soft, what really gives you confidence that you, in fact, will see a real recovery in North American volumes in 2012?

Albert P. L. Stroucken

Well, when we look at the demand pattern, you know that we haven't seen any growth in North America over a period of 3 years, so 1.5% is significant even though it may look like a small percentage, that's #1. And that's really not projecting that's underlying demand at this point in time. We also know that many of our customers and especially in the beer sector are looking to stronger promotional activities because they have seen volume declining. And what we're also seeing is that employment is improving and that coincides with the comment that I made earlier that we have early signals that there is a stronger preference for glass than for cans, which is a reversal of the trend and that would also typically be an indicator that the economy is strengthening.

Alex Ovshey Ovshey - Goldman Sachs Group Inc., Research Division

And just last question. Asia Pac, how does the profit break out between Australia and New Zealand and China given the volume difficulty in China in the quarter, did you guys lose money in China this quarter?

Albert P. L. Stroucken

Well, in China, we're building up also an infrastructure that's quite significant. As you know, China have been managed in the past strictly out of Australia. We're building infrastructure because we now have about 4,000 employees in China and that clearly is having an impact. If I look at individual facilities in China, there are facilities in China that are providing pretty decent margins. There are others that are losing money, and that's what we're working on to correct that situation.

Operator

And your next question is from Chip Dillon with Vertical Research.

Chip A. Dillon - Crédit Suisse AG, Research Division

On one of the slides, I think, you mentioned, if you sort of divide the volume impact, I think it was a very small number into the revenue. It looks like it was only about 0.2%, and I believe Al, you mentioned that the volume decline was more like 20% -- or was more like 2%. And maybe I just misheard you or maybe there was some M&A shifts that might have affected that number. Could you shed some light on that?

Edward C. White

Chip, is this the sales volume number on Chart 4 that was our segment reconciliation?

Chip A. Dillon - Crédit Suisse AG, Research Division

Yes. You got it.

Edward C. White

That was kind of in my comments as I walked through that. So sales volumes were down $4 million and you don't see an operating profit swing. It means that it was the regional mix, so you are down in some countries where you would say we lost because we had less sales. In other areas, we were up and it had a better contribution. So what you're doing is the contributions of all the ups and downs kind of had it flattened out on the sales volume line.

Albert P. L. Stroucken

And that comes back to the comment I made earlier about -- in China that we are basically improving the facilities. And so if that facility that we're trying to improve is not producing during the time that we're putting some infrastructure in there, that's not having a huge impact on your profitability.

Chip A. Dillon - Crédit Suisse AG, Research Division

Got you. And then secondly, could you just remind us when you look at Europe, I would imagine that the wine business, in particular, is much more seasonal than the beer business. And just sort of tell us how and when during the year you have a better feel for how the wine business is going to shape up.

Albert P. L. Stroucken

I don't see a huge difference in the seasonality because it's really in the consumption where the seasonality is. If you look at the packaging, basically you have your harvest, of course, during the September -- August, September, October time period, but the filling of the bottles basically occurs throughout the year.

Chip A. Dillon - Crédit Suisse AG, Research Division

Got you. And then the last question, this might have been asked, but -- and obviously, the China volumes were down largely because of the closure of the furnace there. But what's happening in the broader market in China, especially I mean you hear a lot of people that make other containers talking about their opportunities because glass is so big. But that being said, are you still seeing the market growing over time, or do you think it's stagnated?

Albert P. L. Stroucken

No, the market is still growing very strongly. And I smile sometimes when I see these comments about China, everybody is worried that growth in China goes from 9% to 8.5%. Look at our own growth numbers in North America and in Europe, it's a huge opportunity market. It will continue to be a market that absolutely is key for us in our strategic positioning. It's a challenging market, there's no question about it, but growth is not one of the challenges.

Chip A. Dillon - Crédit Suisse AG, Research Division

Got you. And just lastly, and this might have been asked on North America. Are you seeing a disproportionate amount of the growth in your business? And I guess, this would be kind of a surprise looking back a year or so from the craft side versus the more broad-based brands.

Albert P. L. Stroucken

Well, I think in North America, we're seeing, certainly with some new product introductions that are happening in the market, a greater level of activity that we have seen in the past. That's not universal across the board. That really depends from brewer to brewer at this point in time. But certainly, the expansion and continued growth of the micro brewers is going to continue. And we've had announcement, I think, from 2 microbreweries that they're going to build new breweries out here in the east, which I think is a clear significant signal that they expect, as well that they will continue with double-digit growth as we are seeing in the first quarter as well.

Operator

And your next question is from Alton Stump with Longbow Research.

Alton K. Stump - Longbow Research LLC

I was just looking at the share situation in Europe. I know you mentioned...

Edward C. White

Alton, you need to speak up, we're not able to hear you in our conference room.

Alton K. Stump - Longbow Research LLC

Okay, sorry. Just with your mentioning that there was some share shifting going on in Europe in wine, just want to get any clarity of if there was any material share shifting in beer in Europe or if it was just contained to wine.

Albert P. L. Stroucken

I don't think that I would at this point in time already talk about significant share shifting. It's too early to make that call because I do not know at this point in time how much really is driven by economy and how much is driven by our pricing actions, which of course as you go through a period of economic instability is very difficult to determine. I don't really see dramatic share shifts in Europe on a broad base. If they do occur, they typically occur with a small manufacturing grabbing some volume, but it does not really affect the overall picture of share in the marketplace.

Alton K. Stump - Longbow Research LLC

Okay. And then just one quick follow-up to that, I think, last call you mentioned that you thought you would get 5% to 6% higher pricing this year in Europe. Are we still in that number now that you have finalized more contracts?

Albert P. L. Stroucken

We still expect price improvement of around 5% on a global basis.

Operator

And your final question is from Todd Wenning with MorningStar.

Todd Wenning - Morningstar Inc., Research Division

Research and development spending was down slightly year-over-year. And should we expect the R&D expense in the second half to approximate the prior year second half spending? It's about $18 million or $19 million per quarter.

Albert P. L. Stroucken

We'll see some strengthening in the second half of the year because some of the projects are just timed differently than they were last year.

Todd Wenning - Morningstar Inc., Research Division

Okay. And have there been any changes so far this year regarding the asbestos liability?

Albert P. L. Stroucken

No. As you saw, we were still in the same range as far as payments are concerned, and these liabilities of course are more longer term in nature as we look at them and they don't change from quarter-to-quarter.

Edward C. White

Todd, what we try to do is if you look at our current -- the current portion of it, that tends to align with what we think our cash spend will be this year, which is lower than last year.

Todd Wenning - Morningstar Inc., Research Division

Higher pricing this year in Europe. Are you still in that number now that you have finalized more contracts?

Albert P. L. Stroucken

As I said earlier, we still expect price improvement of around 5% on a global basis.

All right before I end -- before we end and before I hand it over to Jason, I'd like to use this opportunity to thank Ed for his almost -- career that almost spanned 5 decades. He has not been here 50 years, but he's been here during 5 decades of the company and the many contributions he has made and the wise counsel he has given me and the wise counsel he has given the company.

It's really been highly appreciated Ed, and thank you very much and wish you all the best in your retirement. And now I'll hand it over to Jason.

Jason Bissell

Thank you, everyone. That concludes our first quarter earnings conference call. Please note our second quarter conference call is scheduled for Thursday, July 24 at 8:30 a.m. Eastern. Again, thank you, and have a good day.

Operator

This concludes today's O-I First Quarter 2012 Earnings Conference Call. You may now disconnect.

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