Owens-Illinois´ CEO Discusses Q1 2011 Results - Earnings Call Transcript

Mr. John Haudrich, Vice President of Finance begins the conference.

John Haudrich

.... Good morning, and welcome everyone to O-I´s first quarter 2011 earnings conference call. I´m joined today by Al Stroucken, our Chairman and CEO; Ed White, our Chief Financial Officer; and several other members of our senior management team.

Today, we will discuss key business developments, review our financial results for the first quarter and discuss future trends affecting our business in 2011. Following our prepared remarks, we´ll host a question-and-answer session. Presentation materials for this earnings call are also being simulcast on the company´s website at o-i.com. Please review the Safe Harbor comments and disclosure of our use of non-GAAP financial measures included in those materials.

Unless otherwise noted, the financial results we are presenting today relate to adjusted net earnings, which exclude certain items that management considers not representative of ongoing operations. A reconciliation of GAAP to non-GAAP earnings can be found in our earnings press release and in the appendix to this presentation.

I´ll now turn the call over to Al, who will start on Chart 2.

Albert Stroucken

Thank you, John, and good morning. Our adjusted earnings were $0.47 per share in the first quarter of 2011, compared to $0.48 last year. Overall, higher shipments and production levels were offset by additional costs, including incremental cost inflation.

Our total shipments in tonnes were up 7% over the first quarter of 2010. More than 5% of the increase was attributable to our recent acquisitions in South America and China. The rest came from organic growth, driven primarily by our global sales and marketing initiative, Glass Smart, which is successfully generating profitable business with new and existing customers.

Sales volumes were up across all regions and end-use categories. Higher shipments increased production levels, and our machine operating rate improved to approximately 93% on a global basis during the first quarter.

Significant flooding in Australia during January impacted sales and production at our Brisbane plant, which reduced our earnings by $0.04 per share in the first quarter.

While our selling prices were up slightly, the combined effect of price and product mix was essentially flat with prior year. Overall, additional costs offset the benefit of higher volumes and production levels. We incurred incremental cost inflation due to a higher labor, raw material and energy prices. In particular, energy prices in some markets increased rapidly over the course of the quarter and I´ll expand on that later.

Operating expenses were up as we roll out our new global Glass Smart sales and marketing program and begin the deployment of our SAP system in North America. Furthermore, additional debt to fund the recent and future acquisitions led to a higher interest expense.

We expect to see similar business trends in the second quarter. Shipments will be up in all regions on a year-over-year basis. Our recent acquisitions and continued organic growth will drive stronger volumes as our markets continue to recover. Improved shipments will translate into increased production and higher operating rates.

Yet we also anticipate higher costs. Cost inflation has accelerated again due to rapidly increasing energy prices. Operating expense and interest expense will also be up in the second quarter. However, a stronger demand profile, as well as terms in our key customer contracts, should support the pass-through of additional cost inflation over the course of 2011, and this should start supporting earnings in the second half of the year.

Now let me review our operating performance, beginning with Chart 3. Here, we show first quarter segment operating profits for the company, as well as for each of our 4 regions. Total operating profit was $199 million in the first quarter, up from $193 million last year, primarily driven by stronger performance in both Europe and South America. Our European operating profit was $71 million, up $15 million from the first quarter of 2010. Shipment levels improved by low-single-digits from the prior year, led by stronger growth in both wine and spirits. Demand was particularly strong in France and Spain.

Despite additional cost inflation, higher production levels led to lower manufacturing costs on a per tonne basis.

In North America, operating profit was $59 million, down from $63 million in the prior year, due to the increased investments and several initiatives, including Glass Smart and SAP, which I mentioned previously.

Shipments in North America were up slightly in the first quarter of 2011, despite poor winter weather and the residual impact from prior year contract renegotiations. Volume trends improved over the quarter, indicating a more favorable run rate heading into the second quarter. In fact, we expect to restart 2 idled furnaces in the second quarter to meet increasing demand. This will improve capacity utilization and benefit segment profits in the second half of the year.

Our North American team finalized our multi-planned union negotiations in the first quarter, and we believe both parties are satisfied with the terms of this agreement. Importantly, new hourly employees will be eligible for a cash balance pension plan rather than the traditional defined benefit pension plan.

Our South American region generated operating profit of $45 million in the first quarter, a 22% improvement over the prior year. Total shipments were up approximately 50%, 5-0 percent. The acquisitions in Brazil and Argentina accounted for 35 percentage points of the volume boost. Robust organic growth represented the rest of this improvement.

To support rapid growth, we have been importing glass into Brazil. Leveraging our extensive footprint is one of our great strength at O-I, but this has led to increased transportation costs, which impacted our South American margins. Most of the markets that we serve in South America continue to experience robust improvement in their GDP, and our growth rates have exceeded general market trend. This performance underscores the clear appreciation of glass in these markets, as well as the efforts of our entire team in the region.

Given strong growth, we continue to increase productivity in our current footprint. Also we are planning future capacity expansion in the region, which will help reduce higher transportation costs.

Our Asia Pacific operating profit was $24 million, down $13 million compared to the first quarter last year. $9 million of the decline pertained to the flooding in Queensland, Australia, which shut down our plant in Brisbane for several weeks. Our Australian team did a great job bringing the plant back into production safely and serving our customers during this very challenging situation.

Total glass container shipments were down more than 10% in Australia and New Zealand. In addition to weather issues, the strong Australian and New Zealand dollars negatively impacted exports, particularly wine. Also higher interest rates have reduced disposable income and domestic consumption levels in those countries.

Growth remains strong in China, and we have begun integrating the 3 plants we purchased in the fourth quarter. One of our recent acquisitions is just outside the city of Guangzhou, and we are in the process of expanding capacity at this new site and selling our property in the Guangzhou central business district that will be developed for other retail or commercial uses. We expect the proceeds from this sale will fund our future expansion in the area. And as a result, we will both increase our capacity and improve our overall cost position in one of China´s most important glass markets.

Globally, we are seeing market conditions improve, and our recent acquisitions are beginning to generate real value for O-I. And I´ll now turn the call over to Ed.

Edward 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 2011 segment sales increased 10% to almost $1.7 billion. The combined effect of price and mix was essentially flat with last year. While average selling prices increased slightly compared to the prior year, this increase was offset by a shift in product mix as beer business began to improve. Normally, we break out the impact on price of North American monthly or quarterly cost pass-through provisions. However, the impact was immaterial in the first quarter as natural gas prices have not shifted much, and escalating freight costs should be passed through in future periods.

7% higher sales volume increased the top line by $95 million, reflecting both additional organic sales and benefits from last year´s acquisitions. Finally, currency translation increased our top line by $59 million in the first quarter.

Moving over to segment operating profit. The first quarter was $199 million, up $6 million from the same period last year. Segment operating profit benefited slightly from price and mix. Higher volumes improved operating profit by $18 million, largely driven by strong growth of higher margin business in South America. Manufacturing and delivery costs increased $6 million. The combination of inflation of $49 million this quarter and the $9 million impact of the Brisbane plant flooding, offset the $52 million benefit from last year´s footprint activities and from higher capacity utilization this year.

As expected, operating expense increased $12 million, reflecting investments made in several initiatives that Al mentioned, including Glass Smart and our North American SAP deployment. And currency translation provided a small benefit this quarter.

Overall in the first quarter, we saw about $40 million to $45 million of contribution from positive operating leverage, driven by organic growth. This is reflected in both the volume line and the benefit of the higher capacity utilization, which flows through manufacturing and delivery.

Operating leverage was most pronounced in Europe and was the biggest factor that led to Europe´s 27% year-over-year increase in segment profits this quarter. However, cost inflation offset operating leverage, and we will review this factor more in a minute.

Finishing with the EPS reconciliation, our adjusted net income was $0.47 per share in the quarter compared to $0.48 in the prior year quarter. Operating profit was up $0.03 from the prior year and reflected the benefits of higher sales and production volumes this quarter. Earnings were impacted $0.04 from unfavorable nonoperating items, largely due to higher interest expense on incremental debt to fund future acquisitions as well as those completed during 2010. Corporate and retained costs were down slightly from the prior year, mostly due to the benefit of additional machine and equipment sales during the quarter.

Furthermore, certain corporate initiatives, including our glass advertising campaign, as well as other supply chain and IT projects, were light in the first quarter but will ramp up as the year progresses.

Finally, our only Note 1 item this quarter was a $6 million after-tax restructuring charge related to the closure of our plant in Guangzhou and the planned sale of its property that Al mentioned earlier.

Let´s move to Chart 5 for more detail on our balance sheet and free cash flow. On March 31, 2011, cash was $430 million, and total debt was nearly $4.4 billion. So net debt was $3.9 billion, an increase of over $900 million from the first quarter of last year as we put our balance sheet to work to fund several acquisitions in 2010.

Our net-debt-to-EBITDA ratio was about 3 at the end of the first quarter, and that´s at the upper end of our annual leverage target of between 2x and 3x EBITDA.

Shifting to free cash flow. Please keep in mind that 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 of the year. The first quarter was a $158 million use of free cash flow compared to $80 million use of cash in the first quarter last year. This greater use of cash was due to a larger increase in working capital compared to the first quarter of 2010. The working capital increase this year reflected higher receivables due to sales growth and additional inventories to support seasonally stronger shipment. However, the working capital investment was partially offset by lower capital expenditures, restructuring payments and asbestos payments.

Regarding asbestos, let me reiterate our position, given the recent unfavorable jury verdict in McLean County, Illinois. First, our basic fact pattern has not changed, and asbestos remains a limited and declining liability for the company. As far as the recent jury verdict, we continue to deny the conspiracy claim made in this case and will vigorously challenge this verdict if necessary in the appellate courts. O-I, as well as other defendants, have successfully challenged similar conspiracy jury verdicts in the past. Therefore, we have not made any changes to our asbestos-related liability, and we do not anticipate any changes to our 2011 financial outlook as a result of this case.

Now moving to the right side of Chart 5, you see our debt maturity schedule as of the end of the first quarter. Our most current bonds are not due until 2014, that leaves only the bank debt due prior to that time. Given current attractive credit markets, we are in discussions with our bank group regarding refinancing options of our bank credit agreement in the second quarter.

On Chart 6, we present our business outlook for the second quarter. I will walk through the usual directional guidance on key business drivers that affect earnings and cash flow and will also provide an update on cost inflation.

Let´s review each of the key business factors, starting with price mix. Given modest cost inflation in 2010, we saw only minimal benefit from annual cost pass-through provisions in the first quarter this year. Consistent with this, prices should be up only slightly in the second quarter, and we expect this benefit will be offset by a change in mix. However, we anticipate a more receptive marketplace for higher pricing over the course of this year, particularly in Europe. Al will expand on this shortly.

Sales volume, like the first quarter, we expect second quarter shipment trends will remain in line with our full year outlook for volume, which we anticipate will improve between 5% and 10% from 2010 levels.

Cost inflation. On our last earnings call, we provided a 2011 inflation outlook that ranged between $150 million and $180 million. Since that time, we´ve seen a number of events impact the global energy markets. Well I would like to update you on our energy exposure by region. In South America and Asia Pacific, the clear majority of our energy is purchased under annual fixed agreements.

In North America, more than 85% of our customer agreements include monthly or quarterly cost pass-through provisions. So we have limited exposure to further escalating energy prices in those regions during 2011.

In Europe, a majority of our energy spend is fixed for 2011, but the remainder is subject to market pricing, especially natural gas. Given recent volatility in European energy prices, which is impacting our variable price position, we are providing more information on the right-hand side of this chart. If average first quarter energy prices in Europe persists for the full year, our global 2011 cost inflation should approximate $200 million. The annualized impact would, of course, be even higher than this projection if we didn´t have the majority of energy already covered by fixed price contracts.

We estimate that a 5% change in European energy prices, mostly natural gas from the first quarter average, impacts our energy costs in the region by $7 million to $10 million on an annual basis. While it is very difficult at this stage to accurately forecast energy inflation this year, this information should provide additional insights on our cost profile.

Now moving to other manufacturing and delivery costs. We expect to see footprint savings and higher operating rates benefit our manufacturing costs in the second quarter.

Other costs. Regional operating expense should increase $10 million from the prior year due to the investments in Glass Smart and SAP. Corporate costs will increase about $8 million to $10 million from the prior year, mostly due to higher pension expense and various corporate initiatives.

Finally, second quarter net interest expense should remain in line with first quarter levels. Now I will turn it back to Al.

Albert Stroucken

Thanks, Ed. I would like to comment on the market dynamics we have seen over the last few years and add some more recent observations, and I will focus on Europe, given our energy exposure there.

Since 2007, we have increased our selling prices to successfully repair our margins even during the recession. Yet in 2010, our prices in Europe declined slightly, given the combination of cost deflation and soft market conditions in the region. While we maintained our focus on price, some of our European competitors took a different route, reporting price deterioration of more than 6% while at full capacity utilization.

We were still seeing pockets of pricing pressure this last fall when we negotiated our 2011 annual European customer contracts. Since then, several things have changed in Europe. Demand for our glass containers has strengthened, and energy prices have rapidly increased. Our long-term European customer contracts contain pass-through provisions that allow us to recover inflation albeit with some time delay. But most of our business in Europe is covered by annual contracts based on pricing that was set last fall. Nevertheless, because market conditions have changed so significantly, we have notified these customers that we are instituting an energy surcharge to recover rapidly escalating fuel costs.

As we look through the balance of 2011, demand should improve further, especially as we enter the summer season in Europe. Supply is tightening, in part due to the permanent capacity closures over the last 2 years.

Strong demand, tightening supply and cost inflation are clear signals that the tide is turning, and this sets the stage for a more robust 2012 pricing negotiation, which will commence later this year. Also, our annual cost pass-through provisions on long-term contracts will result in higher 2012 pricing.

Globally, we are also seeing stronger demand and tightening supply. In particular as markets improve in Europe and North America, there is less capacity or less excess capacity, I should say, available to supply the fast-growing emerging regions. As a result, we are restarting the 2 furnaces in North America and plan to add capacity in Latin America and China. This should support continued improvement in free cash flow generation.

Of course, we will remain flexible and respond to changing market conditions. Over the long term, we do, of course, remain committed to our business strategy. That means we will continue to expand in attractive emerging markets, both through acquisitions and organic growth initiatives. We are investing in innovation and technology, and we are strengthening our ability to offer our customers innovative and brand differentiating glass packaging solutions. Through our execution of these strategies, we expect to create additional shareholder value and to increase free cash flow to approximately $300 million in 2011. Thank you, and now, I will ask Angela to open up the lines for your questions.