O-I Glass, Inc. (OI) Q2 2008 Earnings Report, Transcript and Summary

Good morning my name is Regina and I will be your conference operator today. At this time I would like to welcome everyone to the Owens-Illinois Second Quarter 2008 Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks there will be a question-and-answer session. [Operator Instructions]. Thank you, I would now like to turn the call over to Ed White, Senior Vice President and Chief Financial Officer.

Thank you, Regina and good morning from Perrysburg, Ohio. We're here today to discuss our second quarter 2008 results, answer any questions you may have. With us on the call this morning is our Chairman and CEO, Al Stroucken and our Vice President of Investor Relations, Paul Butts. Several other members of the senior management team are here as well. We've just completed another great quarter. We reported the highest earnings per share from ongoing operations of any quarter, since our IPO in 1991, that's 17 years. And with record high-energy prices and accelerating inflation, we are on track to significantly outperform 2007's record results in earnings per share and more importantly free cash flow. But I'm getting ahead of myself, before I go on let me turn the call over to Paul to review the company's position on forward-looking statements. When he has finished, I will talk more about our results and then Al will offer his perspective on the quarter and our performance in different regions around the world. Afterwards we'll be glad to take your questions. Paul?

Thanks Ed. I would like to remind you that in discussing the company's performance today, members of management may make forward-looking statements within the meaning of Section 21E of Securities and Exchange Act of 1934 and Section 27A of the Securities Act of 1933. Such statements relate to future events and expectations and involve both known and unknown risks and uncertainties. The company's actual results or developments may differ materially from those projected forward-looking statements. For summary of the specific risk factors that could affect results, please refer to the company's most recent 10-Q and 10-K filed with the SEC. The company does not assume any obligation to update or supplement any particular forward-looking statement made during this call. Also during the call members of management may refer to certain non-GAAP financial measures. Information regarding those non-GAAP financial measures as well as the reconciliation to GAAP financial measures is available on the OI website. Yesterday after the market close the company released it's second-quarter results. The earnings release stated that additional information would be posted on our website. Ed will refer to those charts this morning to help illustrate and reconcile results with prior year. If you've not have accessed those charts you can go to our website at www.o-i.com, click on Investor Relations and look for the charts under the events and presentation. Chart numbers are in the lower right-hand corner. Ed?

Thanks Paul. As I've already mentioned, we had a strong second quarter performance, which was in line with our expectations against prior year comparisons. This what we accomplished in the quarter, we increased our sales with price and product mix which translated directly in the higher segment operating profits. And more than offset the small profit penalty resulting from lower sales volume and from the cost penalties of building inflationary pressures. Consequently, second quarter margin from reportable operating segments was 17.8%, 260 basis points higher than the 15.2% margin reported in the second quarter of 2007. Further, the second quarter margin was higher than this year's first quarter results of 16.7%. As you may recall, I told you during our last earnings call to expect continued margin expansion, albeit a smaller rate of improvement in quarter one's increase over the first quarter of 2007. Likewise, the operating results from the four business units were consistent with what we shared with you on our first quarter call and at the Investor Day conference in May. All businesses exceeded prior year results with the exception of our North American unit. Here we continue to be restricted by the tail end of some significant long-term contracts that hinder our ability to fully recover inflation and move to a value pricing approach. Al will provide more background on the performance of all the businesses shortly. And finally and again most importantly, free cash flow exceeded that of the prior year's quarter by more than $20 million. Now let me take you through the website charts, which provide a little more detail on our financial performance for the quarter. Chart one offers some of the quarter highlights. Now let's start with chart number two. Our reconciliation of GAAP to non-GAAP items for the quarter. Here we show the effects of our earnings per share of the discontinued plastics operations, unusual items and the restructuring and impairment charges associated with the realignment of our global footprint. The note one item for restructuring and asset impairment in this quarter was only $4.2 million after tax. When we announced this global project in mid-2007, we expected pre-tax charges to be in a range of about $150 million over the course of the program and that the cash spending would be completed before the end of the first quarter 2009. We've already taken $121 million in charges against this program. The announcement earlier this week that we will close one of our two plants in Toronto signaled the end of the first phase of our global review. We're now beginning a second phase of the global assessment and realignment. We consider this a new phase because several elements of the equation have changed and we have new considerations to make. First and foremost improvements in efficiency and productivity at most plants have added capacity to the system. As a result, we can focus our attention on streamlining the factory with higher operating costs. Second is energy. Energy costs have become a more significant factor in determining our cost of goods sold and we'll endeavor to optimize our furnace utilization. And third, that the fact we have a better understanding of the market dynamics to value pricing. We expect the smooth phase of our realignment to be finished by the end of 2009 and to result in another $150 million of expected charges. This will bring us to a combined total of $300 million in pretax charges for the global footprint realignment. Chart number three shows the reconciliation of GAAP to non-GAAP item for the first six months, all of which is consistent with the three-month review. So let's move to chart number four, the net sales reconciliation. Segment sales were almost $2.2 billion, an increase of $230 million over the prior year quarter, price and product mix contributed $154 million to the increase. This was a 7.9% improvement over the prior year quarter and it was also higher than the 7.1% improvement recorded in the first quarter of this year. On the downside, sales volume was lower by $124 million or 6.3%. The sales volume decline was a combination of factors. There was... first the effect of loss sales due to pricing actions taken in the second half of last year and the first half of this year. This was fully expected and is consistent with our price over volume strategy. Our closure of two Canadian glass plants, Quebec and Toronto are clearly the consequences of eliminating lower-margin business from our portfolio, which then creates the opportunity to more fully utilize other existing production assets. And we can see how this approach is making product mix a much more important contributor to the price mix equation. The second contributor to the reduced sales volume this quarter was weakened demand in some regions, which we had attributed in part to a softer economy. However what we've been watching for but have not seen is any significant shift away from glass containers to alternative packaging materials except for some North American consumers trading down to a lower price beer in cans. Moving now to chart number five. The segment profit reconciliation for the second quarter. Here you see the same pattern we experienced in our first quarter 2008 results. The impact on profits of the lower sales volume was considerably smaller from the benefits brought by the improvement in price mix. Price mix contributed $154 million to the quarter's profits and was the single biggest driver in the $92 million year-over-year profit improvement. And here I must take a minute to praise our regional pricing teams, who've done a phenomenal job of implementing our strategy, their pricing actions are the principal reason that OI is turning in record results at a time when high inflation and high energy cost challenge us on every front. Continuing with this topic of inflation. The manufacturing and delivery reconciliation line shows the impact of inflation, along with the effects of productivity, production volume and warehouse delivery costs. Not surprisingly, energy and energy-related inflation were the primary components of the $97 million favorable comparison to second quarter 2007. And we've seen a clear acceleration over first quarter 2008 which was a $55 million unfavorable. I will return to the issues of inflation and energy, when I conclude with the financial outlook. I like you now to turn to chart number six, the EPS reconciliation for our review of the retained corporate cost, currency translation, interest expense and tax rate. All of these elements were favorable contributors to the EPS improvement this quarter. First you have the year-over-year improvement of $0.06 on the line called retained corporate cost and other. This resulted both from having no material claims against our captive insurance subsidiary and higher pension income for the quarter and year to date. Also this category continues to reflect our 2008 allocation change, which transfers costs from the corporate center to the four regions. The offset of this allocation flows to the operating expense line. Currency translation. Again it benefited OI, since less than 30% of our sales and earnings are denominated in U.S. dollars. For reference, chart number nine shows the foreign currency translation impact on our results. As well as the movement of the euro and the Australian dollar against the U.S. dollar. These are the two currencies that currently impact us the most. Next and not unexpected, was the continued improvement in EPS from lower interest expense, with year-over-year rate lower for our variable debt. Approximately, 60% of our debt is currently exposed to variable rates to our bank facility, our receivables financing programs and the fix to floating interest rate swaps on some of our senior notes. Finally, the benefit of a low effective tax rate added $0.02 in this quarter. Considerably less than the $0.19 in the first quarter. As we indicated on our first quarter earnings call, the ETR, which is always a year-to-date calculation, it vary quarter-to-quarter for discreet items and for changes in the earnings mix. For the full-year, 2008 effective tax rate should be about 100 basis points lower than the 24.4% rate in 2007. However, because of the successive quarterly declines experienced in the ETR during 2007, EPS impact could become less favorable through the balance of this year and become an unfavorable comparison in the fourth quarter, against the fourth quarter '07 rate of 15%. The last chart to discuss is number seven, the free cash flow chart. Starting at the bottom of the schedule, you see free cash flow for the second quarter was $126 million, $23 million ahead of the prior year quarter. And you also see that free cash flow for the first half of 2008 was $102 million, which was $71 million ahead of the prior year half. Looking to the body of the schedule let me touch on the three largest uses of cash. First, asbestos-related payments this quarter were $63 million, a $11 million more than the prior year quarter. The cash payment reduced the number of pending claim from 14,000 to 13,000 during the quarter. And also reduced by $2 million, the balance of previously settled but unpaid claims. New filings in the first half of 2008 were down 12% from prior year. And for any listener not familiar with OI's asbestos story, let me share with you that we exited this business 50 years ago and we've been dealing with these legal issues for almost 30 years. For OI, asbestos remained a limited and declining liability which we will continue to manage in a consciences and responsible manner. The second cash item I want to highlight is the change in working capital, which was a $71 million use in the quarter. The $20 million increase over prior-year can be attributed to higher selling prices reflected in the receivable balance and higher manufacturing inflation captured in the inventory value. The last two cash component was capital spending of $84 million, which was $14 million higher than the second quarter of 2007. Our capital spending guidance continue to be in the range of 80% to 85% of depreciation and amortization or about $400 million to $420 million for 2008. Now let me wrap up by saying we expect to have a record second half. If you will return to chart number four, the net sales reconciliation, you will see that sales volume declined in the first half of the year by 4.8%. We expect a similar or slightly more moderate in the back half of the year. On the upside, we see the potential for an increase, over the first half 7.5% price and product mix benefit and we see this due to the ongoing mix management and some entry year pricing actions. If you return now to chart number five, the segment operating profit reconciliation. I'd like to comment specifically on two elements included in the manufacturing and delivery line that is inflation and production cost. First on the inflation front, about 50% of our global energy buy is fixed with the balance of 2008. Fixed with NYMEX hedges in the U.S., fixed the contract negotiated on an annual basis or fixed because in some countries rates are regulated by government tariffs. Therefore energy spikes or the sustained weekly increases we've been reading about have a lag of three months to six months before they become part of our cost basket. Nevertheless, two weeks ago when I saw rent crude oil entered a high, was a $147 per barrel and NYMEX was approaching $14 per million Btus. I thought I'd have to tell you that energy would burn through the entire inflation range adjustment, we made during our first quarter earnings call. But recent trends appear to be bringing the back half projection back into the top end of our last estimated inflation range. The second element is production cost. For this you need to understand our cash focus. Typically our inventories are at their peak in the second quarter in order to support high seasonal demand through the summer period. As we enter the back half of the year we monitor inventories closely and if necessary we'll reduce production output short-term, by scheduling the line shutdown and potentially entire furnace shutdown to achieve our working capital targets. Of course, the benefit of each furnace shutdown is that we save about $500,000 per month in melting energy. On the other hand, these short-term curtailments also reduce fixed cost absorption in the operations and increase the cost per ton packed overall. With a combination of higher production input cost and reduced production volume could make the manufacturing and delivery line about $150 million more in the back half of 2008 than it was in the first half of the year. And now ending with chart number seven. The first-half free cash flow of $102million, you see we need $400 million of cash in the second half to achieve our $500 million free cash flow target. You remember the conditions I listed at the end of our first quarter call when I gave this free cash flow target. And they were, if exchange rates and if cost inflation stayed at the then current levels. So, although those conditions have moved for and against us over the past three months, we are still relatively confident that $500 million is a reasonable free cash flow range. But should we see even more adverse fluctuations in any of these factors we may need to readjust our forecast. Over the last several months, our management team has spent time with investors in Europe and North America. A question we've heard over and over is, will your strategies continue to be effective in the current economic environment? Clearly this quarter results show that they can be, the fact that we can report this kind of performance under such adverse economic conditions is really a credit to our 24,000 employees all over the world. And with the strength of our balance sheet today along with our liquidity and positive cash flows we are well positioned for whatever comes in our way. That concludes my review of the financials. Let me turn the floor over to Al.

Thank you, Ed, and good morning, everyone. It is indeed a pleasure for me to reflect once again on another great quarter for OI. We are particularly pleased with our performance this quarter given the difficult environment in which we achieved these results. Inflation and especially the pace of inflation have been and will continue to be the most difficult issue we face. Fortunately all of our direct competitors, as well as those who offer alternative packaging materials, are facing the same pressures. The inflation challenge has only strengthened our resolve to adhere to our pricing strategy, which puts value before volume. No matter how you look at it, there is no realistic scenario in which we could achieve volume driven economies that would make up for this type and pace of inflation. In light of these challenges, we continue to place a great deal of emphasis on ensuring that our footprint is appropriately adjusted. Within the next three to four months, we expect to complete the realignments to our footprint that we announced last year and, as part of this plan, we released the information about our Toronto facility earlier this week. With the current evolution of energy costs and no indication of change in the future it is clear that we must manage our global furnace base more aggressively and use it more effectively. With more than 170 furnaces and the productivity advances of last year we are certain that we can move some volume among the under filled furnaces to free up another 10 to 15 furnaces which could then be shut down or mothballed. This would reduce energy cost as well as improve operational efficiency and asset utilization. So as Ed already mentioned, we expect therefore to take an additional charge totaling approximately $150 million between the fourth quarter of this year and the end of 2009 for these changes. The economics for making these types of adjustments are very attractive and generally allow a payback period of less than two years. But our story is not restricted to one of streamlining and reduction. In addition to optimizing what we have in place in regions of lower growth, we are expanding in those regions where we have an attractive growth profile. Earlier this year, we announced the completion and immediate doubling of the size of our new plant in Lurin, Peru. That expansion plan was followed earlier this week with the announcement of a $60 million investment to expand capacity in our Auckland, New Zealand plant. Demand in New Zealand remains buoyant and its wine industry had a record harvest this year. Currently we import glass for the New Zealand market from our Chinese and Australian plants. The $60 million investment will increase our glassmaking capacity in Auckland by two thirds, reduce energy cost per ton packed and enable bottle light weighting. Upon completion, the new furnace will be fully utilized and the glass previously exported from China and Australia will be redirected to satisfy growth in their local markets. Overall sales in our Asia-Pacific region were up considerably this quarter with a growth rate of 15% and a more than 26% improvement in the segment operating profit. Selling price, plus favorable mix continues to exceed inflationary impacts in the region. We've also seen benefits from added rigor and freight pricing and through the collection of fees for value-added services such as extended warehouse use and production schedule interruptions. On the downside, costs in China, particularly energy costs, are rising rapidly and dramatically. As a result we are temporarily running behind in our price adjustments there. Also, inventories in the Australian wine industry seem to be at a high level; however, the wine harvest for 2008 is better than initially predictions. And wine exports though are presently negatively impacted by the strength of the Australian dollar in comparison to the US dollar. Now turning to North America where our value pricing strategy has not yet shown the positive results as it has in other regions. Here we continue to operate under some legacy contracts that impair our progress because of their limited price adjustment provisions for past and present inflation. Fortunately our overseas sales are three times our North American sales, which lessens the overall impact of such contracts. And the good news is that most of these North American legacy contracts are coming to an end in the next 12 to 18 months. We have had some North American contracts renew this year and we are pleased to report that we have been meeting our pricing targets in those negotiations, including those where we moved up the timeline. Our beer volumes in the United States and Canada are off by a little under 1% this quarter. And as Ed mentioned, the impact from substitution in beer is minimal, probably because alternative packages are facing the same cost inflation drivers we are facing. Weak volumes in other categories, including double-digit declines in non-alcoholic and ready-to-drink beverages, are impacting the overall volume comparison with last year. Some of those declines are the result of our decision to walk away from non-profitable business, others are combinations of substitution, inventory reductions and lower demand. So we are adjusting our production schedules accordingly. European sales were up by all most 16% and operating results by 60% [ph] in the second quarter. After a fairly strong glass market in the first three to four months of 2008 we are seeing a slowdown in European volumes due to a variety of factors. The strong euro is impacting our customers' export sales, which typically drive the growth for wines and spirits, Higher oil prices have affected the consumer's purchasing power resulting in a reduction in consumption; and poor weather is impacting beer consumption and delaying vegetable crop harvests. Our pricing activities earlier in the year have also begun to have an impact on volume. These pricing actions had an affect on the food and beer industries in some countries where customers have long been enjoying prices well below an acceptable profit level. As general demand is softening some volume migration to opportunistically available alternative glass supply is likely to continue. But as I said earlier, given the rapid and significant inflation we're all facing, we remain committed to our value-based pricing strategy. We see the $17 million year-over-year increase in segment operating profit in Europe as an indication that our strategies are on target and successful. North America's business developed very strongly this quarter with a 27% increase in sales, a 46% improvement in segment operating profit. Our markets in Peru, Ecuador and Brazil were very strong. Colombia and Venezuela lost some of their earlier momentum due to the inflationary pressures brought by the international economic situation. Our returnable bottle strategy in South America got some additional support with two brewers deciding to focus more heavily on the returnable segment. Our new facility in Lurin, Peru that I had mentioned earlier is running well above expectations and both the new engineering center as well as the Lurin capacity expansion project are proceeding according to plan. Before I wrap up today, I want to talk more about what's happening in the economy and how it's actually a positive for our business. Most people heaved a big sigh of relief when we saw the price of oil retreat two weeks ago. However, even though we may see some temporary price corrections to the downside, the economic scenario that has developed over the last couple of years presents a quite compelling argument that we'll continue to see cost increases for energy and raw materials in the future. We're now also beginning to see the impact these inflationary pressures have on consumption patterns and perhaps even lifestyle choices. If hydrocarbons and raw materials like aluminum, steel and plastic continue to become more and more expensive we may see a paradigm shift. Up until now we have assumed that market conditions have stood in the way of consumers taking full advantage of the most economic and ecological packaging alternative available, namely the refillable glass bottle. I've spoken often about the economic drivers that make glass the package of choice for food and beverages in many developing nations. But let me point out that the principal does not only apply to faraway countries. We only have to go a few miles north of Toledo to Canada where they have a very successful refillable and returnable glass bottle system. Let's look at their beer industry. Some 40 Canadian brewers use their own proprietary refillable bottle or the brewing industry's standard refillable bottle. Over 60% of the beer sold in Canada in 2007 was in refillable glass bottles, all of which were supplied by OI, and they have an average recovery rate of more than 96%. A typical refillable bottle in Canada is used 12 to 15 times before it's then recycled back into a new refillable beer bottle. Canada uses a deposit refund system for its refillable containers structured much like the deposit return programs operating in California, Michigan and in New York. In some Canadian provinces customers can return the bottles to the retail establishment where they were purchased. Empty containers are then returned to the beverage filler on the same truck that supplies the retailer with new beverages. As a result of the widespread use of deposit refund systems Canadians now recycle a higher rate of all types of non-refillable glass containers instead of hauling them with other waste to landfills. The Ontario deposit system alone has enabled us to increase our receipts of locally sourced recycled glass by more than 60% in the first half of 2008. This means fewer truckloads of recycled glass need to be imported from Quebec and Michigan, reducing greenhouse gas emissions for longer haul trucking. In addition, we conserve energy and lower carbon dioxide emissions at our factories when we increase the amount of recycled glass melted to make new bottles. The Canadian model shows that a refillable system is both sustainable and economical. Interestingly I'd like to point out that this is not a new system; up until the 1970s the United States had a similar returnable system. So although inflation is painful and impacting the choices we make, it is possible that it is also improving the relative position of the glass container industry. This all supports the argument we continue to make that glass is the most economical and sustainable packaging choice available. We believe sustainability will be a key component of our competitive advantage in the future. We recently named a new Vice President of Sustainability to our management team, Jay Scripter. Jay will be working on strategies and initiatives for OI that position glass as the most sustainable packaging material. Now let me return to the topic of inflation. As we look forward to 2009 we can see that we will need to aggressively reset prices to recover the increased inflation we are incurring this year, along with the inflation that we expect to face in 2009. So far through the first half of 2008, our mechanisms have allowed us to stay ahead of the truly challenging phase of cost increases this year, and we expect that to be the case going forward. We've had a tremendous result in the second quarter and overall we expect 2008 to be a record year for the company. As trust I've given you a good overview of the second quarter and we will now open it up for your questions. Question and Answer

[Operator Instructions]. Your first question comes from the line of George Staphos of Banc Of America Securities.

Thanks. Hi everyone good morning.

Hi George.

I just wanted to ask more of a guidance-related type question to start off and then I'll turn it over. So weaving everything together you're looking at a back half that is a record and therefore up versus last year's back half. And my sense is even though inflation is in the upper end of your guidance range, because you probably have to pull back production relative to shipments in the second half, we're probably looking at something like $400 million combined in manufacturing, etc., inflation or costs, excuse me, in the second half. Is that correct?

George, that question may be a little too granular. I would have back up a little bit and say what you're really starting to see after the great acceleration and momentum we had in '07, you're going to see in '08 that more reflects the historical type of seasonal performance across the business. So we're saying we ought to have a record back half, but at the same time you're going to start to see a fourth quarter that looks more like the traditional fourth quarters that had that drop off due to the seasonality, the inventory adjustments and some of the capital spending activity. So where last year's fourth quarter actually continued to go up, you're going to see a more traditional pattern. So a record second half, but a second half that's more reflective of the kind of history you'd have in this glass business that has the strong seasonality in quarters two and three.

Okay. Historically I remember fourth quarter dropping off something like $0.15, $0.20, somewhere in that range. Is that what you're...

The high drops were like $0.40 and the low drops were about that $0.10, yes.

Okay, fair enough. And then last question, what do you think... if this is a correct statement, what do you think producing above your shipment level added to your earnings in the first half? Thanks.

If you looked at that line called all other, some of that favorable delta was the fact that we had been producing, and you put... I don't want to make accountants out of people, while you're putting your inventory into standard cost. As inflation was getting our actual cost higher than standard we had some pretty large second-quarter inventory adjustments where you actually took inventories up which give you a P&L benefit. So we had good full cost absorption, we had some inventory adjustments in the second quarter. So you see that bump in that all other line between the first and second quarter then that goes away in the back half.

But that is basically no different than what we've typically seen in all the other years where basically in the first half we've always built up inventory and then, first of all, pulling inventory out of the warehouses along with additional adjustments in our manufacturing operations in the second half is basically a continuation of what we have seen in the past.

Okay. Great job in the quarter, guys. Thank you.

Thanks, George.

Your next question comes from the line of Ghansham Panjabi of Wachovia.

Hi guys, good morning.

Good morning.

In trying to put the 6% volume decline in context, you clearly had a tough comparison from what I remember in the second quarter of '07. But how much of the decline do you think is end market weakness versus just sales lost on pricing? Is it 50-50? I'm just trying to get some color on that. Thanks.

The last time I looked at this it was, it about 50-50 in the ratio. And of course, as you had already indicated, the second quarter of last year showed some very strong demand; I think it was up by about 55% or so in volume which of course led to discussions about shortages and so on. Which also shows you the very narrow balance at this point in time between supply and demand.

Okay. And just in terms of the competitive environment, how many of your customers are just walking away purely because someone is undercutting you on price versus you just deciding to phase out certain product lines?

To make that statement on a global basis is, of course, very difficult. But you will recall that I had mentioned that we, particularly in Europe where we have many small customers , and strangely enough, the small customers are the ones that have the greatest flexibility because they can much easier move volume from one supplier to the other because there's always enough room to accommodate them. That's really where we see the greatest flexibility, where people are just still jumping from supplier to supplier. Even if the suppliers are increasing they generally make three or four jumps before we see them back again.

Okay. That's helpful. Thank you.

Your next question comes from the line of Tim Thein of Citi.

Hi, thank you. Good morning. The first part was just, Ed, can you help? I'm not sure I quite got you there in terms of when you were walking through the manufacturing and delivery forecast there. I thought I heard you say the manufacturing and delivery would be up $150 million from the first half. Is that just a component of it?

To help people because we are going into more normalized type of quarter-over-quarter performance, but obviously at much higher and we enjoy this at much higher levels than we've had historically. So I showed the first-half manufacturing delivery line was an unfavorable $150 million. And we said directionally you could expect that to go up by another $150 million when you factor in higher inflation in the back half, plus lower production in the back half as we adjust to our inventory levels.

Okay, great. And just lastly, on the CapEx, are there particular projects, I mean you're implying a pretty big build in the second half. Are there certain things you'd call out in that to get to that $300 million or $400 million range from where you are on the first half?

Well, typically, given the dynamics of our business and it has a little bit into, what I said earlier having lower production in the second half of the year which is really traditionally the way we've done things. That's the time that we use them to invest money and to spend the money for modifications to our equipment or upgrading to our equipment and that basically leads to an overall higher investment profile in the second half of the year, but still within the confines of what we had predicted. And of course, in the second quarter of this year we see some additional expansion and costs for Lurin, which we had announced earlier in the year.

And you'll pick up a little bit in New Zealand in the fourth quarter. But probably the biggest delta, single biggest delta is about $40 million increase in our CapEx due to FX rates around the world in Australia and Europe and South America.

Okay, thanks.

Your next question comes from the line of Claudia Hueston of J.P. Morgan.

Good morning. I was just hoping you could talk a little bit about the European business a little bit more specifically. The operating margins there were stronger than I had expected. Could you just talk a little bit about what drove the improvement there?

A lot of it of course has to do with what we refer to internally as cutting the tail, which basically means taking a very analytical look at your product portfolio and make decisions based on those that are the lowest contributors to the overall profile. And say those are the ones where we have to get the most significant price increases and the risk profile is very little because it's not a very profitable business anyway, so if you lose it it's not going to significantly impact you. And it also has an impact on the average prices and the average margin that you achieved then on the business that you retain. So that is one significant part. And then we have also been very successful in those cases where we have retained the business at a higher price and also adds on top of what I just mentioned earlier. So it's really a combination of these two factors of mix as well as price increases which is really leading to the expansion of our profits in Europe along with the productivity improvements that we've been talking about all along, which are considerably helping us in this environment of rapid inflation.

Thanks. And where would you say you are in that process of both business review and cutting the tail, if you will? And then also just in terms of the productivity improvement that you've seen in Europe, where would you say you are?

Well, as you heard me say in the comments, we're right now looking at a further streamlining of our operations. But the perspective this time is a bit different. Initially when we were looking at this we were making determinations that based on our changed strategy we were most likely going to lose some volume and that would require us to adjust some of our capacities. The way we're looking at it now is with the productivity improvements that we have and the much greater visibility of the utilization of individual furnaces, we're going to move volume around from one furnace to another to basically create a consolidated picture that gives us a very high utilization per furnace that we operate. And that means that we will free up furnaces that have an ongoing energy consumption, as Ed mentioned, of let's say $500,000 a month, whether you pull it full or you pull it at only 30%, 40%. So there is a different economic driver behind the steps that we can take. So I think from an operational standpoint and cost improvements we still have quite a bit of runway ahead of us. And then as I had mentioned in earlier comments, we will continue to, with our pricing actions in the market, first of all because we're compelled to based on the inflation rates that we're facing, but also because we really have not yet fully recovered what we have lost in past years.

Okay, thanks. That's really helpful color. Thank you.

Claudia, I want to add just one other thing on the inflation piece. That three to six month lag we talk about in energy is very much the European kind of energy view. And so a lot of the energy costs that ran up in the first and second quarter this year, that's driving a lot of our inflation that we'll be seeing in the back half. So Europe hasn't gotten the full brunt of inflation, they're going to see more of it in the back half than any of our other businesses.

Okay. Thanks a lot.

Your next question comes from the line of Ric Skidmore of Goldman Sachs.

Good morning. To clarify on slide five, Ed. You mentioned $150 million in manufacturing in the second half of the year, that does not include your energy inflation. Is that correct?

What we've said here is if you look at that first-half column and it says $152 million was the increase of costs over the first half of last year, we said that number can be $150 million larger in the second half. It was not $150 million again but $300 million basically.

So $300 million in the back half.

Yes.

Okay. And then just to clarify. What's in that all other 63, you talked a little bit about the inventory adjustment, but does that 63 go away as we go forward?

A lot of it does because one of it is we had the non-recurrence of a loan write-off in Russia last year. The all other is so lumpy, to try to give you a view of our underlying operations we throw the noise down there. And so you had that, you had some equity earnings coming through that didn't repeat, but basically inventory valuations this year and last year, the non-recurrence of a loan write-off in Russia.

Okay. And then just make sure, I understand this right. If you're talking back to the manufacturing deliveries, you're at $300 million in the back half plus the $150 million, that's $450 million but your --?

No, no. Rick, it's what we we're saying is take the first half number, make the second half a $150 million larger for a total of $300 million.

Okay.

It would be $450 million for the year. And what that... in the back half really has two components. It has an inflation component and then it has the higher cost per ton from lower fixed cost absorption from lower output as we do our curtailments to match up our inventory levels.

But you would see that also when you look at previous years as a natural trend.

Right but... so if we get to the end of 2008, that line item in the fourth quarter for the full year '08 might read something like $450 million?

While we've gone or we can go on to really specific numbers. We don't give any guidance that detailed, I think you all have your own models and you have to work your model.

But I'm just trying to understand your $450 million versus your $300 million to $375 million inflation guidance as well.

We do... I think we were saying that we expect in the second half of the year an additional cost impact of inflation as well as utilization of $150 million over the first half of the year.

Yes, Rick, we're bumping around at the high end of the inflation range which is showing up in that number or what's also showing up in that number is the higher cost from lower production and that is normally most probably in your models, if you have followed the company for a number of years.

Thank you.

Your next question comes from the line of Joe Stivaletti of Goldman Sachs.

I just had a bigger picture of question as just wondered given the significant improvement in your balance sheet where you have might be in terms of acquisitions or any kind of major expansion given that you have obviously quite a bit of flexibility to do that kind of things?

As we have said in previous communications, certainly our focus has changed from sole focus on debt reduction to how are we going to apply the cash to grow the company, and to grow the profitability of the company, and geographic expansion, and that means acquisition is of course one of the core activities and we're spending quite a bit of time on that. Of course we cannot discuss individually what's going on, but it is quite obvious that... especially in the regions and geographies where we're not yet well represented, there's plenty of consolidation opportunity or acquisition opportunity still left for us. The other part that I believe is important to us that also in those areas where we have high growth and where we do have already a significant position, we will invest new capital, new capacity as we just did in Peru and in New Zealand. And I believe that with the cash requirements that we also are predicting with regard to the further streamlining and optimizing of our facilities, I think we have plenty of still good uses for cash at this point in time that we can apply significantly improved cash streams to.

So, in the past you've talked about a goal of getting, I believe it was net debt to EBITDA down to two times. You've exceeded that goal already. So as you look at possible opportunities to expand can you give us what your framework would be in terms of a leverage target or your comfortable level of leverage when you consider possible ways to expand and finance those expansions?

I think we would still try to stay within those general leverage areas that Ed mentioned. I think that.... it may vary a little bit up and down given the time when these acquisitions take place. But I think for us to remain healthy, to remain viable and to remain independent as well with regard to what may happen in the marketplace and ready to act, I think a two times EBITDA ratio for us is on a continuing basis a very good ratio.

Great. And just one quick other question on the asbestos. Would it be far off to assume a doubling of your first-half cash payments for a full year kind of forecast for what you'll invest in that?

Joe, the current portion of our liability for asbestos, we're keeping it at $200 million right now, we spent $100 million in the first half. And so you'd expect to be spending about that in the back half. So we see ourselves way down from the $350 million we had, but we see ourselves in a period here where it's going to be bouncing above the $150 million where we were a year ago.

Okay. Great. Thanks a lot.

Your next question comes from the line of Chris Manuel of Keybanc Capital Markets.

Good morning, gentlemen. Congratulations on another terrific quarter.

Thanks Chris.

Couple of questions for you. First, let me just clear up the curtailment issue or that.... it sounds like here we're running in the smaller pressures in the second half but it yet Europe, if I got you correctly, you are still anticipating a record second half which make your second half in aggregate better than what you did in the second half last year. Is that correct?

Right.

Okay, that's helpful. Moreover can you give us by chance, what the volumes relate by someone other specific regions, North America, South America, Europe, Asia Pacific, etcetera?

I think I've given you the specifics... specificity that I can't give at this point that we don't want to create a road map for our competitors.

Alright, that's fair. When we look at... for example in Asia Pacific, you mentioned you're seeing some challenges and you're still a little behind on the cost price. But yet your margins moving up, you've done a good job of laying out for a sort of the contracts come up here in North America. Can you help us a little there in Asia Pacific, if memory serves you about 45% or so the way through putting in your value price mechanism there. Can you talk about... is that the contracts, you haven't been throughout yet you're seeing pressure. And when you anticipate, being through the bulk of those contracts?

I think you have to look at Asia-Pacific a little bit differentiated because Australia and New Zealand are different than the rest of the region. The pressures I was talking about specifically relate to China where we have had significant inflation and energy in the first half of the year because the government has changed some of its policies towards energy. And in the dynamic environment of China and the many manufacturers that still exist there is a lot of volume shifting around, moving around, which makes it very difficult to try to get increases on the first try. But that is something I think that will work itself out because the pressures will be just too great for people to just negate the issue. I think, and most contracts or business arrangements in China are basically ad hoc and very short term. In Australia and New Zealand it's more comparable to what we see as a combination of Europe and North America. The long-term contracts that we have in the region have generally much more adjusted price adjustment formula. So we do not have to eat inflation for a long period of time. And so we're really at a point in this scenario where we have made some significant progress in the region in looking at these relationships and these contracts and making the adjustments that we need to make. So I'm pretty comfortable with where we are at this point in time.

Okay, and then last question I want to ask was, as you're looking at your capacity, re-alignment that you've talked about the two phases. Thus far has been adding more capacity in Australia... I'm sorry New Zealand and South America would it be safe to us. Where the principal regions I should say, you're looking at adding and where principally you're looking at moving from?

I would say that given the overall growth profiles that we see in the European and in the North American market, the only opportunity that I would see in those markets for some new capacity would perhaps be Eastern Europe. But overall I don't think that in this environment it makes a lot of sense for us to create new capacity in either region because our productivity improvements are moving at a faster pace than the demand growth. So we're basically keeping track of whatever there may be an increased demand with productivity improvements which of course is the optimum way of serving the market because it saves us a lot of capital.

Okay. Thank you.

Your next question comes from the line of Alton Stump of Longbow Research.

Thanks Rajeena. And this will be our last question I see its 9.30.

Good morning guys this is [inaudible].

Good morning.

Very, very quickly in regards to pricing --.

Cannot not hear you, can you speak up closer to your phone.

Yes can you hear me now.

Yes.

In regards of price and products sales mix contribution. Can you give us the percentage contribution to the quarterly sales growth?

A very difficult to separate, we can give you the combination, which was 7.9% we don't spit those.

Okay. Got you. Ad then switching gears in regards to geographical expansion looking to the southern part of South America. Can you maybe give us an update, I know in the Analyst Day you guys mentioned possibly going into Argentina?

Yes we are still evaluating that then and looking at what is the best option and strategy for us then. And we've discussions with a variety of parties to see what would be the best approach. But it is quite obvious that there is a significant demand in Argentina that is presently not fully met and I think it's a great opportunity for us.

Okay. Thanks guys

Okay. Thank you. And thank you everyone for joining us. And hope to talk to you the third-quarter.

This concludes today's Owens-Illinois second quarter 2008 conference call. You may now disconnect.