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Executives

Shelley Young - Director of Investor Relations

Douglas D. Tough - Chairman and Chief Executive Officer

Nicolas Mirzayantz - Group President of Fragrances

Hernan Vaisman - Group President of Flavors

Kevin C. Berryman - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Analysts

Mark S. Astrachan - Stifel, Nicolaus & Co., Inc., Research Division

Lauren R. Lieberman - Barclays Capital, Research Division

Silke Kueck-Valdes - JP Morgan Chase & Co, Research Division

John Roberts - UBS Investment Bank, Research Division

Edward H. Yang - Oppenheimer & Co. Inc., Research Division

International Flavors & Fragrances (IFF) Q1 2013 Earnings Call May 7, 2013 10:00 AM ET

Operator

At this time, I would like to welcome everyone to the International Flavors & Fragrances First Quarter 2013 Earnings Conference Call. [Operator Instructions] I would now like to introduce Shelley Young, Director of Investor Relations. You may begin.

Shelley Young

Thank you, operator. Good morning and good afternoon, everyone, and welcome to IFF's First Quarter 2013 Conference Call. Earlier today, we issued a press release announcing our first quarter 2013 financial results. A copy of the release can be found on our website at iff.com. Please note that this call is being recorded live at and will be available for replay for up to 1 year on our website.

Before turning the call over to our senior management team, I'd like to read our forward-looking statement. Please keep in mind that during this call, we will be making forward-looking statements about the company's performance, particularly with regard to the first quarter and our outlook for 2013. These statements are based on how we see things today and contain elements of uncertainty. For additional information concerning factors that could cause actual results to differ materially from forward-looking statements, please refer to our forward-looking statements and risk factors contained in our 2012 10-K filed on February 25, 2013, and our press release that we filed this morning, all of which are available on our website.

Today's presentation will include non-GAAP financial measures, which exclude those items that we believe affect comparability. A reconciliation of these non-GAAP financial measures to their respective GAAP measures is set forth in our press release that we issued earlier today and on our website.

I'd like to introduce the participants on today's call. With me on the call is Doug Tough, our Chairman and CEO; Nicolas Mirzayantz, our Group President of Fragrances; Hernan Vaisman, our Group President of Flavors; and Kevin Berryman, our Executive Vice President and CFO. Now I'd like to turn the call over to Doug Tough.

Douglas D. Tough

Thank you, Shelley, and good morning and good afternoon, everyone. Our focus on the call this morning is to provide an overview of our first quarter results and operating performance and provide you with a more in-depth review of our Fragrance and Flavors business segments. We will also provide our current outlook for 2013 and after our prepared remarks, we will leave time for questions.

Turning to our first quarter results. We delivered solid local currency sales growth of 3%. On a like-for-like basis, which excludes the exit of low-margin sales activities in Flavors, we delivered local currency sales growth of 4%, which reflects underlying momentum in both our Fragrance Compounds and Flavors Compounds businesses, supported by strong new wins based on innovations and growth across diverse categories and geographies. Our top line performance continues to be driven by 9% growth in the emerging markets, which now account for nearly half of our sales. This is due to strong growth in many countries, including Brazil, Russia, China and Turkey.

Turning to the business segments. Flavors delivered modest growth of 2%. But on a like-for-like basis, which is a more consistent measure of growth, Flavors delivered growth of 6%. The 6% growth overlaps 6% like-for-like growth in the first quarter of 2012 and is consistent with historical growth rates in this business, once again showing the strength and stability of the business. Our Fragrances business delivered growth of 3% in total. Fragrance Compounds, which excludes Fragrance Ingredients, achieved growth of 7%. Our Fragrance Compounds business, which consists of Fine and Beauty Care and functional fragrances, was supported by strong new wins including products using our encapsulation technology as well as increased [indiscernible] participation.

Turning to our margins. This quarter, our adjusted margins improved 270 basis points over the prior year to 42.9%. The overall improvement reflects the combined benefit of pricing and declining raw material costs, volume growth, the benefits of our hedging programs as well as other cost improvement initiatives. Kevin Berryman, our CFO, will address our margin progression in more detail later in the presentation.

Our margin gains this quarter were also due to exit of low-margin sales activities in Flavors business, which has had an overall 30 basis point favorable impact on our margins. The solid top line performance and margin expansion more than offset increased RSA costs this quarter and resulted in 13% growth in our adjusted operating profit. And adjusted earnings per share, which includes a lower effective tax rate, increased 19% to $1.19.

As we have done in the past, this quarter, we continued to optimize our manufacturing footprint by making the decision to close both our Flavors plant in Sweden and our Fragrances plant in Jakarta, Indonesia and transferring the production from these facilities to our larger facility in The Netherlands and our new facility in Singapore, respectively. The company looks to operate as efficiently as possible to remain competitive, and these actions were taken with this objective in mind. Lastly, we also announced our intention to close our Fragrance Ingredients plant in Augusta, Georgia and consolidate the production into existing facilities. We provided a strategic review of our Ingredients business to our Board and are now executing on our plan to improve the profitability and the competitiveness of our Fragrance Ingredients business, thereby strengthening our competitive cost position in the Fragrance business.

We are also taking steps to strengthen our innovation platform. During the quarter, we issued a press release on the successful outcome with an outside partner, Evolva Holding, in the production and scale-up of a natural sustainable vanillin through a biosynthetic process. We are very pleased with our partnership and believe the program with Evolva will increase the availability and sustainability of vanillin, which is a key flavor ingredient in many food products.

Last week, we entered into a multiyear collaboration with Amyris, a leading biotechnology company, to develop and commercialize renewable cost-effective fragrance ingredients. We continue to work with R&D and creative teams to commercialize products that will provide us with a competitive edge in the market. These 2 biotechnology programs are complementary, and we believe collaborations such as this are critical to driving our future growth and profitability. Our earnings per share growth this quarter enables us to continue making investments that will secure our future. I would now like to turn the call over to Nicolas Mirzayantz, our Group President of Fragrances.

Nicolas Mirzayantz

Thank you, Doug, and good morning and good afternoon, everyone.

Turning to our top line results. Our overall Fragrance business delivered 3% local currency sales growth, which reflects 7% growth in Fragrance Compounds partially offset by an 11% decline in ingredients. Our growth was supported by strong new wins plus the benefit of increased core list participation, though this quarter was also supported by strong growth in the emerging markets. The emerging markets accounted for 54% of our Fragrance Compounds sales. Within Fragrance Compounds, the emerging markets grew by 18%. In Compounds, we achieved very strong growth in many areas of the world, including Brazil, the Middle East, Mexico, Turkey and Indonesia, among others. Brazil continues to be one of our leading markets and has strong double-digit growth again this quarter. We had a solid first quarter and we are seeing strong momentum on many fronts.

Our Fine and Beauty Care category, which includes fine fragrances, toiletries and hair care, grew by 4% this quarter, driven by double-digit growth in Latin America of 25% and Greater Asia of 11%, which more than offset volume softness in North America and EAME. To put this quarter's growth into perspective, this quarter followed exceptional growth in the first quarter of 2012. As you may recall, in the fourth quarter of 2012, Fine and Beauty Care delivered growth of 19%, driven by a -- by 17% growth in North America. We believe that part of the softness in North America in the first quarter is related to the Christmas holiday, which appears to have impacted first quarter demand in the industry. Still, there are many new launches in 2013, including recent launches with Balenciaga and new launches such as L’eau de [indiscernible] and Katy Perry Killer Queen, which had its first launch last week, which we believe will help improve sales momentum going forward.

Functional Fragrances, which includes fabric care, home care and personal wash, achieved local currency sales growth of 9% this quarter on top of 12% growth in the fourth quarter with positive growth in every region, led by double-digit growth of 13% in both Latin America and Greater Asia and strong growth in EAME. This marks our 19th consecutive quarter growth in functional fragrances, led by double-digit growth in fabric care and high-single-digit growth in personal wash. This strong growth reflects new wins, our increased core list participation and increased use of products using our encapsulation technology.

Turning to Fragrance Ingredients. We saw continued top line pressure in our external portfolio, primarily from AD [ph] products. And overall Fragrance Ingredients sales declined 11%. As you know, we have developed a strategy to improve our overall profitability and competitiveness in our external foreign [indiscernible] business and have been continuing to finalize our execution plan. As Doug mentioned, last week, we announced our intention to close our Augusta, Georgia facility, consolidate production into existing Fragrances Ingredients facility. This is in line with our plan to improve manufacturing efficiencies and increase the competitiveness of this business, and Kevin will speak about the financial impact related to the Augusta closure.

I want to underscore the strategic importance of our Ingredient business. Our Ingredient business provides innovative and cost-effective ingredients to our perfumers for their use in creating winning solutions, winning fragrances for our customers, thereby providing a significant strategic benefit to our overall Fragrance business. We do not take decisions such as this lightly, as you know. But moving production to existing locations and further consolidating our manufacturing footprint will create synergies and improve operating efficiencies. Our decision is based on an ongoing business review and is one of several actions we will be taking to improve the competitiveness of our Fragrance Ingredients business.

Turning to profitability. Our segment operating profit increased $12 million or 22% to $68 million in the first quarter. Modest decreases in raw material costs combined with residual pricing, volume and mix improvements as well as other costs and margin improvement initiatives more than offset increased RSA, resulting in a 280 basis-point segment margin improvement this quarter to 18.4% versus 15.5% in the prior year quarter. Although our margin this quarter benefited from modest input cost reduction, input costs remains at very high levels, and the margin improvement that we are seeing over the past 2 years is driven less by pricing and more by our strategic initiatives. Kevin will discuss this further later on in our presentation.

In accordance with our strategic priorities, we have implemented many programs to improve the profitability of our portfolio and optimize our geographic footprint. During the quarter, we made a decision to close our fragrance facility in Jakarta, Indonesia, and transfer production to our new facility in Singapore, which is a state-of-the-art manufacturing plant. We also took action to strengthen our innovations platforms by announcing our multiyear collaboration with Amyris to develop and commercialize sustainable cost-effective Fragrance Ingredients. We are excited to strengthen our biotechnology platform and continue exploring additional opportunities that biotechnology offers.

Looking ahead, in the second quarter of 2013, we expect we will benefit from new wins in Fine products [ph] and Beauty Care and Functional Fragrance, and we see continued sustained performance in our Fragrance Compounds category. We also expect to see some improvement in our Ingredient sales performance.

I would now like to turn the call over to my colleague, Hernan Vaisman, our Group President of Flavors.

Hernan Vaisman

Thank you, Nicolas. Good morning and good afternoon, everyone. Turning to our top line performance. In the first quarter, Flavors delivered local currency sales growth of 2%. Excluding the exit of low-margin sales activities, which includes sales in both savory and sweet, Flavors like-for-like growth would have been 6%. The 6% growth is consistent with our historical growth rate, and reflects strong new wins from our motivation tools. The first quarter also marked our 29th consecutive quarter of local currency sales growth and was supported by mid-single-digit like-for-like growth in every region.

This quarter, we exited over 10 million on sales activities affecting both savory and sweet end-use categories. We expect to exit the same level of business in the second quarter of 2013 and after that, we are largely finished within this program. As a percentage of sales, we would expect the impact in the second quarter of exited sales to be approximately 3 percentage points. This quarter growth was supported by strong new wins, particularly those using some of our health and wellness motivation technologies, and we ended the quarter with a strong pipeline of new wins. Flavors and dairy are benefiting from these technologies, all contained in our FLAVORFIT brand umbrella, and much of our growth in these categories is being reinvigorated by our health and wellness programs.

We also saw some momentum in our citrus toolbox offerings. Citrus is one of our biggest Flavors profiles in this Beverage category. In North America, like-for-like growth was 4% excluding the exit of low-margin sales activities. This best-performing category was Beverage, which was up strong single digits on local currency basis on account of strong new wins in the citrus area as well as increased volume of products using our citrus modulation tools.

Within our EAME region, local currency growth was led by strong results in Western Europe, specifically Spain, Portugal and the U.K. with new business using natural flavoring as well as increased customers’ orders in Beverage and Savory. Greater Asia, which is our largest region, achieved 6% in local currency growth due to strength in Australasia, China and India. We saw strong growth in both Dairy and Savory. In Latin America, we saw strong growth in Beverage and Dairy. We recently won new business in the region, and we have a lot of new projects in the pipeline. We expect to have a stronger growth in Latin America in the quarters to come, and we're pleased that we are picking up momentum in this business.

Turning to our profitability this quarter. This quarter, our segment profit improved 4% or $3 million to $83 million. The exit of low-margin sales activity contributed 60 basis points to our gross margin improvement. This quarter, we benefited from the favorable relationship between raw material costs and pricing, although our input prices remain at historically high levels. Kevin will talk more about it. The gross margin improvement more than offset increased RSA costs associated with R&D. For this first quarter, our segment operating margin improved 50 basis points to 23.3% versus the prior year of 22.8%.

As we mentioned on our fourth quarter conference call, this quarter, we announced that we have entered in a preproduction phase to develop and scale up via a third-party [indiscernible] for commercial application through a cost-effective sustainable route. This collaboration with Evolva [ph] and is consistent with our strategy to strengthen our innovation platform.

Also this quarter, we took several actions to consolidate our manufacturing footprint, improve efficiency and better meet our customers' changing needs. We made the decision to close our Fragrances plant in Sweden and transfer production to our plant in the Netherlands. We also announced the formal opening of our Flavors plant in Guangzhou, China, and we continue to build out our plant in Gebze, Turkey. We also continue to invest in commercial offices and satellite labs in Asia to better serve our customers in the region, with locations in Chengdu and Beijing now fully operational.

For the second quarter, we expect to see improved top line growth, although our overall growth will still be impacted by the exit of low-margin sales activities for one final quarter. On a like-for-like basis, we expect to achieve mid- to high-single-digit growth fueled by broad-based geographic growth. Although it is still early in the second quarter, based on our orders in-house, we believe we are off to a very strong start. With that, I would like to turn the call over to Kevin Berryman, our CFO.

Kevin C. Berryman

Thank you, Hernan, and good morning and good afternoon, everyone.

Turning to our summary quarterly results. Reported revenues for the first quarter totaled $728 million compared with $711 million in the prior year quarter or an increase of 2%. Excluding the impact of foreign currency, our local currency sales increased 3%. And on a like-for-like basis, which excludes the impact of the exit of low-margin sales activities in Flavors, our local currency sales growth was 4%.

Our growth was again fueled by our geographic footprint in the emerging markets. Importantly, we continue to see momentum behind our Fine and Beauty Care, Functional and Flavors businesses. We collectively refer to this business as our Compounds business, which represents our total business excluding the internal sales of our Fragrance Ingredients.

The growth momentum in the first quarter for the compound portion of our business remains quite healthy, even with some softness in Fine Fragrances. As Nicolas mentioned, we believe the short-term softness is due to the impact of the very strong fourth quarter sales we realized just last year. And as Nicolas previously noted on the call, Fine and Beauty Care growth in Q4 was 19% and was driven by strong growth in Fine Fragrances. Importantly, our consolidated compound like-for-like growth levels over the last 12 months have consistently remained at 6% or better and represented an annual growth over the last 12 months of 8%. We believe that this is an indication of our traction against our strategic initiatives of focusing on our advantaged positions, driving innovation into our portfolio and providing winning, value-added solutions to our customers.

Adjusted gross margins this quarter improved 270 basis points to 42.9%, up from 40.2% in the prior year quarter. The improved performance was due to the impact of moderating input costs and the benefits of residual pricing, as well as an improved sales mix including the benefits of exiting lower-margin sales activities in Flavors, continued cost improvement initiatives and gains associated with our foreign currency hedging program. I will provide more detail on our trends in gross margins in a moment.

These gross margin improvements more than offset increases in RSA due to higher compensation expenses, pensions and training costs and resulted in an adjusted operating profit improvement of 13% or plus $16 million to $139 million for the quarter. The adjusted operating profit improvement, combined with a lower effective tax rate due to the reinstatement of the U.S. R&D tax credits in 2013, resulted in adjusted EPS growth of 19% to $1.19 this quarter.

Importantly to reiterate what Doug, Nicolas and Hernan have already noted, we recently took several proactive steps to ensure we maintain a cost-effective structure as part of our continuing efforts to drive efficiencies in all that we do. We will be initiating the closure of 3 facilities over the course of the next year, our Fragrance plant in Sweden, our Fragrances plant in Indonesia and our Fragrance Ingredients plant in Augusta, Georgia. In Q1, we recognized restructuring costs for Sweden and Indonesia, which totaled $1.2 million. Our closure of the Augusta plant is the most material and represents our commitment to ensuring our Fragrance Ingredients operations remain competitive longer term. Our Fragrances Ingredients plant closure will be a second quarter accounting event.

To summarize the impact of this initiative, we expect to incur onetime costs of $6 million to $9 million, including personnel-related costs and plant shutdown and other related costs. We also expect to take a charge of $10 million to $12 million related to accelerated depreciation of 6 assets associated with the facilities. As for the phasing of the cost of savings, approximately $3 million to $4 million of these costs will be recorded in the second quarter, with the remainder expected to be recognized over the following 4 quarters. Once fully implemented by mid-2014, the plant closure is expected to generate savings of approximately $6 million to $8 million per year.

Turning to our gross margins. With gross margin growing 270 basis points to 42.9% as noted earlier, this quarter, we again achieved improvements from the year-ago figure. We are pleased with our success in driving this margin improvement, but it certainly is important to understand what continues to be the fundamental driver in the improvement of this critical metric. As you know, our industry has seen substantial input cost increases over the last 2-plus years, resulting in input cost increases to IFF of approximately 14% in our raw materials, with an increase that was even more pronounced in Fragrances. The increased costs have had a significant impact on our gross margins in Q1 2013 versus pre-inflation levels. We estimate the negative impact on our margins from these cost increases to be roughly 400 basis points versus the pre-inflation level.

As you also know, we have, as a necessity, been very active in implementing price increases over the 2011 and 2012 years to help offset the impact of these input cost increases. Importantly, the company has been able to effectively recover the absolute dollar costs through price increases, allowing us to recover nearly 250 basis points of that input cost pressure. While pricing was enough to recover the absolute increase in input costs, it was not enough to cover the full impact of input cost increases on gross margins. The net effect is that our gross margin still remains pressured by 170 basis points in the current quarter versus the pre-inflation period prior to the run-up in raw material costs. This drag on our margin is shown by the red bar on the chart.

As a result, the improvement that we are now seeing in gross margins is less about the net impact of pricing and input costs and more about our strategic initiatives. The improvement is effectively being driven by our strategic plans and the disciplined execution of same. Our strategy to accelerate our innovation, drive efficiencies in all that we do in 6 underperforming assets while focusing on our advantage positions has translated into strong improvement in our gross margins. In fact, these efforts have resulted in 330 basis points of improvement as can be seen on the green bar on the chart. Importantly, these actions have more than offset the net 170 basis-point pressure from input costs and pricing and have resulted in the company realizing an overall increase of 160 basis points over the last 3 years since before the input costs inflation began. You can see why we are pleased regarding the execution of our strategy, as our margin progression ensures that we will be able to continue to make investments in R&D and other business-building initiatives, all to drive our growth plans into the future.

Turning to RSA cost. This quarter, RSA expense as a percentage of sales increased 100 basis points to 23.9%, up from 22.9% of sales in the prior year quarter. The higher RSA reflects higher compensation expense, incentive compensation accruals, pension cost, increases related to our deferred compensation plan program and training. In addition, spending on key R&D initiatives showed double-digit growth this quarter, consistent with our strategy investing in those opportunities, which we believe can deliver the greatest incremental value to IFF. IFF's R&D spending remains an important focus area for the company.

Turning to foreign currency impacts. Foreign currency translation this quarter had a limited impact on our reported sales growth. However, as a result of our hedging activities, foreign currency had a 40-basis point favorable impact on our gross margin, thereby contributing to our $0.19 EPS improvement. Again, to remind you, in 2013, we remain nearly 80% hedged against the euro at levels that approximate $1.29, effectively consistent with the average exchange rate levels for the full year 2012.

Turning to our cash flow. Our cash flow from operations for the 3 months ended March 31, 2013, was $19 million, or $34 million lower than the prior year quarter. The decrease this quarter primarily reflects higher year-over-year incentive compensation payments, as last year's incentive payments in Q1 2012 were abnormally low. In addition, we also made additional pension contributions in the U.S. These incremental outlays were offset in part by an improvement in the cash flow versus last year in core working capital of $7 million and increased net income due to our improved operating performance in the first quarter 2013 versus the year ago period. As you may know, our Q1 cash flow is historically our lowest cash-generative quarter, and the results in Q1 of this year indicate solid cash flows as compared to historical levels. It is worth noting that we paid out our normal fourth quarter dividend in late December as opposed to early January, so our net cash flow in Q1 also benefited from not having this normal outflow during the first quarter.

Finally, turning to our capital structure. During the quarter, we began implementing our share buyback program by buying back approximately 200,000 shares at an average price of $70 a share. As you know, we announced the $250 million share buyback program at the end of last year as a way of providing value to our shareholders. After the quarter end, we also successfully executed a $300 million bond offering in the public markets. This 10-year senior note carries a rate of 3.2%, and this was our first public offering in more than 10 years. By issuing this bond, it has enabled us to take advantage of attractive rates while diversifying our sources of funding as well as our investor base. We also maintained our quarterly dividend at $0.34. And per our normal course of action, we will be evaluating our dividend payout in our July meeting when we will decide on future actions relative to dividend increases.

In summary, before handing it back over to Doug, we ended the year with increased optimism and see many areas of the business positioned for future growth and profitability. Here are some key takeaways. First, we delivered solid top line growth led by new wins owing in part to our innovations and to our expanded quarter’s participation. Our growth this quarter was supported by 9% growth in the emerging markets as we continue to grow with our customers in the developed markets. Our ability to anticipate consumer preferences with innovative products such as those using our sweetness and sodium modulation tools in Flavors or those using our encapsulation technology and Fragrances were critical drivers to our new-win successes. Our diversification with regards to categories, products and customers provides us with ongoing stability and supports our growth. Our compound growth in the quarter of 6%, combined with our latest 4 quarters trailing growth of 8%, indicates the continued momentum in this portion of our business. We also made investments in our future growth as evidenced by our recent announcement of our multiyear collaboration with Amyris to develop and commercialize sustainable ingredients.

Second, we improved our gross margins again this quarter, owing to moderating raw material costs, residual benefits of previously taken pricing, innovation and improved product mix and cost reductions. Over the last few years, our ability to protect and expand our margins has been less about the net impact of pricing and input costs and more about our efforts to maximize our portfolio. Importantly, the improved margin profile enables us to strategically invest in innovation and business-building initiatives such as those involving Evolva and Amyris.

Third, we are looking to continue to leverage our geographic presence. We are in the process of building out our facility in Gebze, Turkey. And this quarter we announced the formal opening of our plant in Guangzhou, China, which we expect to commence commercial production in the third quarter of 2013. In addition, satellite labs and creative centers that have opened in the last 12 months include Chengdu and Beijing in China and Delhi in India. We believe we are very well positioned for the near and longer terms and continue to execute on our plans.

Fourth, we are taking continued action to consolidate our manufacturing footprint and realize operating efficiencies, and we have recently decided to close 3 plants including our Fragrance Ingredients plant in Augusta, Georgia.

Fifth, we have made changes to our capital structure to provide us with ample liquidity and added financial flexibility, while continuing to return cash to shareholders both through a share repurchase program and quarterly dividend payment.

Clearly, a lot is happening at IFF and all of it is about driving our strategic agenda forward. With that, I would like to turn the call over to Doug for his outlook on 2013.

Douglas D. Tough

Thank you, Nicolas, Hernan and Kevin. We are pleased with the progress we have made over the past few years in driving growth across both businesses based on our innovations and our capable teams. The diverse and stable nature of our business, combined with our customer intimacy and consumer insights, enabled us to deliver solid results again this quarter. We feel confident that based on the diversification in terms of our portfolio, geographies and customers, we will continue to expand our presence along with our customers and continue to achieve solid growth. The accelerated momentum we see in the Flavor and Fragrance Compounds business is fueled by the strategic investments we have made in the emerging markets over many years, combined with our ability to provide customers with products that meet or surpass consumer expectations, and potentially lead to market share growth for both our customers and for us. We are committed to driving the business for long term, creating new and innovative products that will appeal to customers, consumers all around the world and collaborating with global and local customers to bring these products to market. We continued to execute on our 3 strategic pillars, which are helping us to chart our growth.

At the same time, we are focused on our performance and making sure we produce strong results. Our outlook for the full year 2013 is to deliver growth and profitability in line with our long-term targets. We believe we will be able to deliver these results based on our current view of the environment and our performance within it. In addition, our R&D pipeline should provide us with longer-term growth, while also providing us with sustainable cost-effective raw materials that give us the competitive edge, enable us to grow our gross margin.

For the second quarter of 2013, we expect to see improved local currency sales growth in Flavors, even though we will continue to be impacted by the continued exit of low-margin sales activities. In Fragrances, we expect momentum to increase in Fine and Beauty Care and maintain our solid growth in Functional. While we expect to see improved volume trends in Ingredients for the full year, we still expect year-over-year declines in the second quarter. Of note, notwithstanding Fragrance Ingredients sales softness centered on high volume and low-cost items, we expect to maintain Fragrance Ingredients margins. We have a committed and a dedicated group of people whose mission is to see the company succeed. We are pushing ahead to meet our internal financial objectives and expect to be able to deliver top line growth in line with our long-term targets due to our diversity and our ability to provide value to customers year after year in every region.

In conclusion, we believe our strong performance at IFF this quarter is the result of our geographic footprint, our product diversity and our ability to work with our customers to develop new products that will help shape the industry and delight consumers. We believe we are very well positioned in the market and we plan to continue to selectively invest in those areas where we see the most growth. We are investing in the future, making daily changes to advance the business. We will continue to proactively manage our performance and calibrate costs in line with our top line growth as we continue to execute against our business plans. We will continue to focus on excellence in the execution of our strategies.

Before we take your questions, I wanted to mention that we are gearing up for our 2013 Investor Day, which will be held on Wednesday, June 5, in New York from 8 a.m. to 1 p.m.. If you've already received an invitation, please access the online registration site and sign up by the end of the month. If you have not received an invitation and you are interested in attending, please reach out to Shelley Young and let her know of your interest. The theme of this year's event is innovation, and we will be showcasing some of our leading technologies and providing you with an update on our 3 strategic pillars. We hope you can make it, and we look forward to seeing our IFF analysts, investors and prospective investors at the New York event.

Thank you for your attendance and for your participation. I will now open the call to questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first response is from Mark Astrachan of Stifel, Nicolaus.

Mark S. Astrachan - Stifel, Nicolaus & Co., Inc., Research Division

I guess a couple questions to try to clarify and sort of get some thoughts around the outlook. One is just trying to understand the confidence in the second quarter sales improvement, including how much is pulled forward into the fourth quarter or pushed out into the second quarter this year in terms of just overall puts and takes on what the number was in the first quarter, including maybe some comments on what's going on with new wins or existing business. And then secondly a bit of a longer-term point of view, EBIT and EPS outlook, what is the full benefit from the facility rationalization that you've talked about so far, the 3 facilities? I guess in particular the Sweden and Indonesian pieces, and now the Augusta, Georgia, benefit from an EBIT standpoint. So what's the incremental for those 2? And then on the clarification, does several actions within ingredients specifically mean there's more to come in that specific business?

Douglas D. Tough

Okay, Mark. You have got several questions in there. Let me start to talk to a couple of them. And then I'll ask [indiscernible] Hernan, Nicolas to talk to volume and Kevin with the question on rationalization benefits. Certainly, on the volume, you'll know we almost always see a certain degree of lumpiness in the results. And I think Nicolas pointing out that the 19% performance in Fine Fragrance in the previous quarter was an indication of extremely solid results then offset by weaker results now. So when they, in the moment, talk about the volume performance in the outlook for Q2 and beyond -- I'll let them address specific wins, specific commercial results and so forth. But certainly as it relates to this quarter and in particular, we have a good line of sight on order book results and on both the results of the wins and then the forward orders. And it's an encouraging picture, which is why we elaborated the way we did on the outlook for Q2. Only because it might come up elsewhere, but in the context of the Fragrance Ingredients issues, we have had a comprehensive review with our Board of Directors. There are several opportunity areas to improve the business. We will be advising the marketplace as and when we are ready to commit to those. But certainly, the first one we've done was the announcement on Augusta. And you're correct in assuming there might be more there, but we won't be talking about that today. And I'll come back to the volume discussion now and the projections and start with Hernan as it looks to Flavors in Q2 and beyond.

Hernan Vaisman

Hi, Mark, this is Hernan speaking. Regarding why we are confident in Q2 is basically we have a visibility in our orders in-house. Because the high volumes coming, truly because we placed some orders starting in the first quarter, but also because we have a big wins in some regions that we will be launching in the quarter. So basically, that's why we are confident, firstly, the wins that is going to impact. And then secondly, we have some order issues and order -- particular order issues in the first quarter and now is correcting in the second quarter.

Nicolas Mirzayantz

Mark, it's Nicolas. Regarding pretty similar comments regarding Q2, where we're seeing we have very, very strong pipeline of new wins that already started in Q1, and looking at the way that the quarter has started and the order in-house, we believe that we have good momentum going on. Regarding your questions of pushing and pulling versus the different quarters and the customer dynamics, obviously if you had the Q4 performance in Fine & Beauty of 19 plus 4% in Q1, that's about 11% growth over the 2 quarters. And we know that the Christmas season was positive but probably not as a strong as expected, therefore, it's impacting our intake. But it is fair to say that North America is probably not as strong, starting the year not as strong as we could have expected in terms of consumer trends. But as far as new wins participation and pipeline of new projects, it remains very strong. And if you add new wins in Q1 we’re above historical levels.

Kevin C. Berryman

Mark, this is Kevin. I'll follow up on one quick comment on the volume and then talk about the restructuring question that you had. The only other point to add to what's already been said is that in Q1, our win rates were actually quite strong. So our growth associated with new business offset by any losses that we might have had was actually near strong levels, and not necessarily at historical levels but very strong. So if there was any weakness in Q1, it was relative to some of the erosion that we saw in our business. So underlying the growth outlook going forward is a continued momentum in terms of that win performance. So that's one comment. On your second question on the ingredients -- excuse me, on the restructurings or closures of the additional plants, we already talked to the benefits associated with the Fragrance Ingredients effort. We do have the other 2 plants. We expect that the savings associated with those plants will, once that's fully instituted, probably be $4 million plus or thereabouts. We'll start to see some of that this year because the timing that we'll be facing over the second half of the year. However, I would say that will largely be offset this year because at the same time, we'll be ramping of our facility, our new facility in Guangzhou, China, which is the new Flavors facility. So that's probably a net loss roughly speaking in 2013 in the back half. So I think we'll start to see those benefits in 2014 and beyond for Sweden and Indonesia in Fragrance.

Operator

Your next response is from Lauren Lieberman of Barclays.

Lauren R. Lieberman - Barclays Capital, Research Division

I was hoping you could give a little more color first on where you stand on the work to migrate Ingredients business from Ingredients into Compounds. It doesn't feel there was much of that in the current period. And then thinking through it again, I would think it probably takes more than – it’ll be a perfect match between Ingredients, losing Ingredients business, and getting that to flow through to Compounds. So could you talk a little bit about that?

Nicolas Mirzayantz

Lauren, it's Nicolas. Lauren, you are right. It takes some time for the migration to occur. And then the migration, from the visibility that we have, will occur in Q2, so we will see that migration from one part of our business to the other. It will be progressive. So we have not seen that benefit yet, and it will come later in the year.

Lauren R. Lieberman - Barclays Capital, Research Division

Okay. And then just following up on all the comments you all just shared on the volumes and answering the first question. It is a little -- comparisons get a lot more difficult in the back half of this year. And so I just wanted to make sure I'm hearing it clearly that when you talk about the run rate of the business and kind of, I think Kevin, you said you had 7% or 8% run rate for the Fragrance Compounds business that, that you think is indicative of where things stand this quarter, a bit of an operation deceleration. But even versus tougher comps in the second half, that should be sustainable?

Kevin C. Berryman

Lauren, this is Kevin. If you think about the outlook that Doug has provided in terms of the full year, at the end of the day, we're thinking we’re going to be able to deliver against our long-term financial target of 4 to 6, and we're comfortable with that. So by definition, that translates into us having to have incremental performance in the back 3 quarters of the year relative to our start at 3%. So I think that remember, our 4 to 6 has always been including the exit of low-margin business. So we said we would hit our long-term targets even with those exits, the impact of the exits. So the fact that we're at 3% in Q1 I just won’t indicate we're going to have to see some improvement in the back 3 quarters.

Lauren R. Lieberman - Barclays Capital, Research Division

Great, perfect. And then my final thing, sorry, the partnership with Amyris, I was just curious because I believe from Minex [ph] who also put out a press release earlier this year about having a similar relationship. Or at least the way press release read, it was kind of similar. So if you're able to kind of offer any color around what’s different with what you're doing versus your understanding of what competition is doing, what would be exclusive, what wouldn't be and so on?

Nicolas Mirzayantz

Lauren, it's Nicolas again. In this type of collaboration and partnership, it's really linked to your own portfolio. And so everybody's really developing different agreement regarding their different portfolio, their strengths, unique complementary expertise from both the company we’re partnering with and with ours. So they are very, very specific to what we do, what we can for and our existing portfolio, which is different as you know, in ingredients. We don't compete with our key competitors on the same portfolio. We are not competing against them. Therefore, it's very, very specific to what we do and probably -- I’m not aware of their [indiscernible] but what they are doing on their side is indicative to their portfolio.

Operator

Your next response is from Jeff Zekauskas of JPMorgan.

Silke Kueck-Valdes - JP Morgan Chase & Co, Research Division

This is Silke Kueck for Jeff. I was wondering whether you could clarify like what percentage of the Ingredients business of the Augusta plant represents? My recollection is that wasn’t a particularly large plant servicing the Ingredient business. And my -- I have 2 follow-up questions. I was also wondering what you thought about the sustainability of the Fragrance margins in the second quarter and for the year. Because seeing some bigger margins that are -- these are much higher margins than I would have expected. I know you’ve commented on ingredients, but not on the Fragrance business as a whole. And lastly on the Amyris question, I was wondering whether you could just talk about what applications you are working on with Amyris, whether this is for Fine Fragrance applications or Functional. Maybe you could just give a little bit more detail, if you wouldn't mind.

Nicolas Mirzayantz

Yes. I will start with your last question -- it's Nicolas, regarding Amyris. One thing which is really critical to underscore and the strengths or the critical importance of ingredients to us, that usually you can use one ingredient across all categories. So whatever progress improvement, cost effectiveness you can gain or even access to more a longer-term source of supply really benefits not only your ingredients but it benefits your compound business. And that's why for us to be vertically integrated has significant benefit to our business, enabling us to win more business and to support the growth that we are making. So that's why Amyris, it's really broad-based in terms of the impact in our business. Regarding other stuff, we don't disclose the relative importance of our plants, so we cannot provide that detail. And regarding also the quality of the margin, I think it's important to recognize that our focus has been in terms of the margin protection, margin improvement as you saw for the last quarters, and also as a result of our greater focus and emphasis on the economic profitability, we’re really asking the team to focus on every part of the business that can improve our position. And as Kevin was talking about, the majority of our improvement came from this margin improvement, efficiencies in the business to help to regain some of the margin pressure that we are facing.

Silke Kueck-Valdes - JP Morgan Chase & Co, Research Division

So the way I take this answer is just that you hope to sustain these margins, yes?

Nicolas Mirzayantz

Yes.

Douglas D. Tough

Yes. I mean, I think it's important to understand some of the elements that Nicolas talked about is the wins, the briefs [ph] we're going after, the target margins we've set, the basis for innovation and a number of other internal productivity moves that have all contributed more to the margin improvement than did the pricing recovery. So the focus of that group is very much on margin preservation enhancement and increasing.

Silke Kueck-Valdes - JP Morgan Chase & Co, Research Division

That is helpful.

Operator

Your next response is from John Roberts from UBS.

John Roberts - UBS Investment Bank, Research Division

You started with the strength in the emerging markets. Would you hazard a guess as to what percent of your sales now are to developed markets? Did the customers re-export their products to the emerging markets?

Kevin C. Berryman

We don't have an exact read on that. But if you look at it on an overall basis, the emerging markets represent 49% of our overall sales. Now included in that figure is the fact that ingredients, our Fragrance Ingredients business, is actually 80-20 the other way or 80-20 focused on development -- developed markets. Certainly, some of that is going to the emerging markets, but we don't have a good ability to really indicate what that is. So probably at the end of the day, that means more than 50% of our business is supporting emerging market business, but we don't have the clarity as it relates to what that number actually is.

Nicolas Mirzayantz

And John, if I can maybe augment the comments regarding compounds, we say that now we are at 54% of our Compound sales in emerging markets. And there is one category which is more global, which is Fine Fragrance, for which you really would typically capture sales in North America and Europe. But you know that these products are then reexported to the rest of the world. Most of the other categories are manufactured locally and regionally. So if you think about fine fragrance now being reexported, our share of emerging market would be greater than 54%.

John Roberts - UBS Investment Bank, Research Division

And then secondly, a follow-up on the Flavor side. I’ve seen a few specialty chemical companies recently talk about their specialty food and ingredients businesses. I am not talking about bulk ingredients, but the specialty additives in food, and they're looking to build out. Would you benefit or do you think you could create value by partnering in the food ingredient area beyond Flavors?

Hernan Vaisman

Well, we -- this is Hernan. We're always looking to enhance our portfolio. I don't know exactly what you mean by putting in and which type of food ingredients. But definitely, we have some partnership with some including ingredients varieties to help us to formulate better flavors.

John Roberts - UBS Investment Bank, Research Division

You're actually pretty narrow in Flavors, right? I mean, you're just talking about your work with other companies. You don't have anything formally in terms of a JV outside of the Flavors area?

Hernan Vaisman

In fact, we have, we have many. But we usually for a strategic point of view, we are not disclosing that. But we have several partnerships with different companies to really enhance our portfolio.

Douglas D. Tough

John, I think there's a broader question here. And it's really if you look at what we're doing with Evolva and Amyris, we will be increasing a focus on external partnership and opportunities. So through our innovation or beneficial commercial opportunities perhaps in fragrance -- flavor ingredients, perhaps in other categories, the company would have an interest in those.

Operator

Your next response is from Edward Yang of Oppenheimer.

Edward H. Yang - Oppenheimer & Co. Inc., Research Division

Are any customers asking for price concessions now that raw materials are declining? I know in the past, your pricing was relatively fixed once you were placed within the product. Or are you -- are they asking for any volume discounts?

Douglas D. Tough

Well, I think the answer, we'll always be having conversations with customers about whether we need a price increase or they’re looking at opportunities in the context of a benign cost of goods environment or opportunities to perhaps renegotiate things with us, so that's an ongoing phenomena. But I think that Kevin touched upon it I think really well in one of the slides was that we still are not fully recovered all that we had from the standpoint of our cost increases. So in some cases with customers, we continue to have dialogue surrounding getting that price increases to help us recover our margins.

Edward H. Yang - Oppenheimer & Co. Inc., Research Division

And Doug, you mentioned Kevin’s comments on, you said you’ve effectively recovered absolute cost increases, but you still have about 170 basis points in gross margin to recover. So are you think about it from a gross margin percentage standpoint, are you basically done in terms of looking at the absolute cost increases?

Douglas D. Tough

It's the former, trying to regain the margins we had.

Edward H. Yang - Oppenheimer & Co. Inc., Research Division

Okay. And Nicolas talked about the Christmas impact on Fine Fragrance, and that was offset by some of the new wins that you’ve had. Typically, what's the volume overhang after Christmas like we did? Are you satisfied that the inventory levels are now back to levels that won’t be a headwind?

Nicolas Mirzayantz

I think we are looking at really the 2 quarters together and we know that the market did not grow at 19% in Q4. I think the market was a more modest growth of maybe 3%, 4%. Therefore, also reported by lot of new activities. We had a very, very strong new win pipeline last year. So a lot of the effort to promote these new launches at Christmas. So that affected obviously our volume intake in Q1. But what I said earlier, our pipeline of new wins and the benefit that we saw in Q1 going into Q2 gave us good perspective on the business moving forward. If you are comparing about those 2 inventory level compared to 2 years ago, I think that the industry has learned a lot at everything, all level of the supply chain, and we’re not seeing the same pressure that we have or exposure 2 years ago than today. So the inventory period, what is in the trade is father than it was 2 years ago.

Edward H. Yang - Oppenheimer & Co. Inc., Research Division

Okay, that's helpful. And just the tax rate, is 24% good for the rest of the year?

Kevin C. Berryman

This is Kevin. Really the benefits associated with the tax rate were associated with the carryover R&D tax credit. As you may recall, our friends in Washington finally decided on implementing the 2012 push under the R&D tax credit after the end of the year. I think it was at 12:15 or something in the morning on January 1. So effectively, the reduction in the tax rate for the first quarter is really recognizing the full year benefit of 2012 R&D tax credit in Q1 2013. The more normalized figure should be when you’re thinking about the balance of the year, 26% to 26.5%, perhaps a little higher in terms of the tax rate.

Operator

We have a follow-up from the line of Lauren Lieberman of Barclays.

Lauren R. Lieberman - Barclays Capital, Research Division

Just quickly, I want to make sure I thoroughly understood. I think you guys talked about ingredients, obviously it would still be down in Q2, but at more moderate rate of decline. And then did you say up for the full year?

Nicolas Mirzayantz

No.

Lauren R. Lieberman - Barclays Capital, Research Division

No, okay.

Nicolas Mirzayantz

Lauren, this is Nicolas. I think that your perception on Q2 is accurate, but it's not -- it's -- we should not expect any positive growth ingredients for the year.

Operator

There are no further responses in the queue at this time.

Douglas D. Tough

Well, thank you, all, for participating on the call today. And we look forward to seeing you at the Investor Day if you make it on June 5 in New York. Thank you. Or we'll see you in our Q2 call in early August.

Operator

Thank you. This concludes today's conference call. You may now disconnect.

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